Analysis of Financial Statements

Q1. DEBT TO CAPITAL RATIO Kaye’s Kitchenware has a market/book ratio equal to 1. Its stock price is $12 per
share and it has 4.8 million shares outstanding. The firm’s total capital is $110 million and it finances with
only debt and common equity. What is its debt-to-capital ratio?

Sol. For computing the debt to capital ratio, first we have to determine the equity value and debt value which
is shown below:

Equity value = Number of outstanding shares × stock price per share

= 5.2 million shares × $12

= $62.4 million

We know,

Total capital = Debt + equity

$120 million = Debt + $62.4 million

So, the debt would be

= $120 million - $62.4 million

= $57.6 million

Now the debt to capital ratio would be

= $57.6 million ÷ $120 million

= 48.00%

Q2. TIE AND ROIC RATIOS The W.C. Pruett Corp. has $600,000 of interest-bearing debt outstanding, and it
pays an annual interest rate of 7%. In addition, it has $600,000 of common stock on its balance sheet. It
finances with only debt and common equity, so it has no preferred stock. Its annual sales are $2.7 million, its
average tax rate is 35%, and its profit margin is 7%. What are its TIE ratio and its return on invested capital
(ROIC)?

Sol. 1. TIE ratio = EBIT / Interest expense

EBIT = [ (Annual sales x profit margin) / (1 - tax rate) ] + Amount of debt x interest rate

= [ ($2,880,000 x 3%) / (1 - 0.30) ] + $800,000 x 8%

= 187428.57143

= $187,428.57
 TIE ratio = $187,428.57 / ($800,000 x 8%)

TIE ratio = $187,428.57 / $64,000

TIE ratio = 2.92857

TIE ratio = 2.93

2. ROIC = [ EBIT x (1 - tax rate) ] / (Amount of debt + common stock)

= [$187428.57 x (1 - 0.30) ] / ($800,000 + $600,000)

= 0.093714285

= 9.37%

Q3. PRICE/EARNINGS RATIO A company has an EPS of $2.40, a book value per share of $21.84, and a
market/book ratio of 2.73. What is its P/E ratio?

Market to book ratio would be

Market to book ratio = (Market price per share) ÷ (book value per share)

2.73 = Market price per share ÷ $21.84

So, the Market price per share would be

= 2.73 × $21.84

= $59.62

And

Price-earnings ratio = (Market price per share) ÷ (Earning per share)

= ($59.62) ÷ ($2.40)

= 24.84 times

Q4. DuPont ANALYSIS Henderson’s Hardware has an ROA of 11%, a 6% profit margin, and an ROE of 23%.
What is its total assets turnover? What is its equity multiplier?

Using DuPont analysis:

Return On Assets = Net Profit Margin × Asset Turnover

Return On Assets ÷ Net Profit Margin = Asset Turnover

0.09 ÷ 0.075 = Asset Turnover

 1.2 = Asset Turnover

Return On Equity = ROA × Equity Multiplier

0.18 = 0.09 × Equity Multiplier

0.18 ÷ 0.9 = Equity Multiplier

2 = Equity Multiplier

Time Value of Money

Q1. FUTURE VALUE If you deposit $2,000 in a bank account that pays 6% interest annually, how much will be
in your account after 5 years?

$2,600 because 6% of 2,000 is 120 and 120 times 5 is 2,600

Q2. PRESENT VALUE What is the present value of a security that will pay $29,000 in 20 years if securities of
equal risk pay 5% annually?

29000/ (1+5%)^20 = 10,930

Q3. PRESENT VALUE OF AN ANNUITY Find the present value of the ordinary annuity; discounting occurs once
a year.

a) $600 per year for 12 years at 8%

C 600.00

time 12

rate 0.08

PV $4,521.6468

Annuity-due
PV $4,883.3786

Q4. FUTURE VALUE OF AN ANNUITY Your client is 40 years old; and she wants to begin
saving for retirement, with the first payment to come one year from now. She can save $5,000
per year; and you advise her to invest it in the stock market, which you expect to provide an
average return of 9% in the future.

a. If she follows your advice, how much money will she have at 65?
b. How much will she have at 70?
c. She expects to live for 20 years if she retires at 65 and for 15 years if she retires at 70. If her
investments continue to earn the same rate, how much will she be able to withdraw at the end of
each year after retirement at each retirement age?
Q5. LOAN AMORTIZATION Jan sold her house on December 31 and took a $10,000 mortgage as part of the
payment. The 10-year mortgage has a 10% nominal interest rate, but it calls for semiannual payments
beginning next June 30. Next year Jan must report on Schedule B of her IRS Form 1040 the amount of interest
that was included in the two payments she received during the year.

a. What is the dollar amount of each payment Jan receives?

b. How much interest was included in the first payment? How much repayment of principal was included?
How do these values change for the second payment?

c. How much interest must Jan report on Schedule B for the first year? Will her interest income be the same
next year?

d. If the payments are constant, why does the amount of interest income change over time?

a)
 Mortgage value = $10,000

Nominal Interest rate = 10%

Number of mortgage years = 10 years

a) What is the dollar amount of each payment Jan receives?

Calculating Semi-annual Payment (PMT) using financial calculator:

Semiannual Interest Rate = 10%/2

Number of Mortgage periods = 10*2

Present Value of Mortgage Value (PV) = -10000

Semi-annual Dollar Payment on Mortgage Loan (PMT) = $802.43

b) Semi-annual Payment = $802.43

Interest paid in 1st year = $10,000 * (10%/2) = $500

Principal paid in 1st year = $802.43 - $500 = $302.43

Total loan balance at the end of 1st year = $10,000 - $302.43 = $9,697.57

c) The interest amount for the second payment is $484.88

The total interest of the year = $984.88

Her income interest will not be the same next year because as years increase, interest decrease.

d) The loan is amortized, meaning that the principal amount is also repaid along with the interest
payment. The principal amount decreases period after period. Interest is calculated based on the
principal amount, the amount of interest income also changes.

Interest Rates
Q1. MATURITY RISK PREMIUM The real risk-free rate is 2.5% and inflation is expected to be 2.75% for the
next 2 years. A 2-year Treasury security yields 5.55%. What is the maturity risk premium for the 2-year
security?

5.55%- 2.5%-2.75%= 0.3% (MRP)

Q2. INFLATION Due to a recession, expected inflation this year is only 3.25%. However, the inflation rate in
Year 2 and thereafter is expected to be constant at some level above 3.25%. Assume that the expectations
theory holds and the real risk-free rate (r*) is 2.5%. If the yield on 3-year Treasury bonds equals the 1-year
yield plus 1.5%, what inflation rate is expected after Year 1?
The computation of the inflation rate is expected after Year 1 is shown below:-

the Yield on year 1 treasury bond

Let us assume the inflation rate be I

r1 = risk free rate + Inflation rate

= 2.5% + 2.25%

= 5.75%

r3 = r1 + 0.50%

= 5.75% + 1.50%

= 7.25%

Now,

r3 = risk free rate + IP3

= 7.25% = 2.5% + IP3

IP3 = 4.75%

Year 1 Inflation = 4.75%

Year 2 Inflation = I

Year 3 Inflation = 2

So, inflation rate is expected after Year 1 = (3.25% + I + I) ÷ 3 = 4.75%

(3.25% + I + I) = 14.25%

2(I) = 11%

I = 5.5%

The computation of the inflation rate is expected after Year 1 is shown below:-

the Yield on year 1 treasury bond

Let us assume the inflation rate be I

r1 = risk free rate + Inflation rate

= 2.5% + 2.25%

= 5.75%
r3 = r1 + 0.50%

= 5.75% + 1.50%

= 7.25%

Now,

r3 = risk free rate + IP3

= 7.25% = 2.5% + IP3

IP3 = 4.75%

Year 1 Inflation = 4.75%

Year 2 Inflation = I

Year 3 Inflation = 2

So, inflation rate is expected after Year 1 = (3.25% + I + I) ÷ 3 = 4.75%

(3.25% + I + I) = 14.25%

2(I) = 11%

I = 5.5%

The computation of the inflation rate is expected after Year 1 is shown below:-

the Yield on year 1 treasury bond

Let us assume the inflation rate be I

r1 = risk free rate + Inflation rate

= 2.5% + 2.25%

= 5.75%

r3 = r1 + 0.50%

= 5.75% + 1.50%

= 7.25%

Now,

r3 = risk free rate + IP3

= 7.25% = 2.5% + IP3

IP3 = 4.75%
 Year 1 Inflation = 4.75%

Year 2 Inflation = I

Year 3 Inflation = 2

So, inflation rate is expected after Year 1 = (3.25% + I + I) ÷ 3 = 4.75%

(3.25% + I + I) = 14.25%

2(I) = 11%

I = 5.5%

Q3. REAL RISK-FREE RATE You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.8%.
Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current
interest rate premiums: Inflation premium = 3.25% Liquidity premium = 0.6% Maturity risk premium = 1.85%
Default risk premium = 2.15% On the basis of these data, what is the real risk-free rate of return?

5.8%-3.25%= 2.55% = r*

Bonds & their Valuation

Q1. BOND VALUATION Madsen Motors’ bonds have 23 years remaining to maturity. Interest is paid annually,
they have a $1,000 par value, the coupon interest rate is 9%, and the yield to maturity is 11%. What is the
bond’s current market price?

Market Value of the bond is the present value of all cash flows of the bond. These cash flows include the
coupon payment and the maturity payment of the bond. Price of the bond is calculated by following
formula:

According to given data

Assuming the Face value of the bond is $1,000

Coupon payment = C = $1,000 x 9% = $90 annually

Number of periods = n = 23 years =

Current Yield = r = 11% / 2 = 5.5% semiannually

Market Value of the Bond = C x [ ( 1 - ( 1 + r )^-n ) / r ] + [ $1,000 / ( 1 + r )^n ]

Market Value of the Bond = $90 x [ ( 1 - ( 1 + 11% )^-23 ) / 11% ] + [ $1,000 / ( 1 + 11% )^23 ]

Market Value of the Bond = $743.98 + $90.69 = $834.67

Q2. YIELD TO MATURITY A firm’s bonds have a maturity of 8 years with a $1,000 face value, have an 11%
semiannual coupon, are callable in 4 years at $1,154, and currently sell at a price of $1,283.09. What are their
nominal yield to maturity and their nominal yield to call? What return should investors expect to earn on
these bonds?

Q3. EXPECTED INTEREST RATE Lourdes Corporation’s 12% coupon rate, semiannual payment, $1,000 par
value bonds, which mature in 25 years, are callable 6 years from today at $1,025. They sell at a price of
$1,278.56, and the yield curve is flat. Assume that interest rates are expected to remain at their current level.
a. What is the best estimate of these bonds’ remaining life? b. If Lourdes plans to raise additional capital and
wants to use debt financing, what coupon rate would it have to set in order to issue new bonds at par?

Risk & Rates of Return

Q1. PORTFOLIO BETA an individual has $20,000 invested in a stock with a beta of 0.6 and another $75,000
invested in a stock with a beta of 2.5. If these are the only two investments in her portfolio, what is her
portfolio’s beta?

Q2. REQUIRED RATE OF RETURN Assume that the risk-free rate is 5.5% and the required return on the
market is 12%. What is the required rate of return on a stock with a beta of 2?

The computation of portfolio's beta is shown below:-

Total Portfolio value = Value of Stock 1 + Value of Stock 2

= $20,000 + $55,000

= $75,000

Weight of Stock 1 = Value of Stock 1 ÷ Total Portfolio Value

= $20,000 ÷ $75,000

= 0.2667

Weight of Stock 2 = Value of Stock 2 ÷ Total Portfolio Value

= $55,000 ÷ $75,000

= 0.7333

Beta of Portfolio = Weight of Stock 1 × Beta of Stock 1 + Weight of Stock 2 × Beta of Stock 2

= 0.6 × 0.2667 + 2.5 × 0.7333

= 1.99
Q3. CAPM AND REQUIRED RETURN Calculate the required rate of return for Mudd Enterprises assuming that
investors expect a 3.6% rate of inflation in the future. The real risk-free rate is 1.0%, and the market risk
premium is 6.0%. Mudd has a beta of 1.5, and its realized rate of return has averaged 8.5% over the past 5
years.

Calculation for the required rate of return for Mudd Enterprises

Using this formula

Required rate of return=Risk free rate+(Market risk premium +Stock beta)

Let plug in the formula

Required rate of return=(3.7%+1.5%)+4.5%(2.3)

Required rate of return=5.2%+0.1035

Required rate of return=0.1555*100

Required rate of return=15.55%

Therefore, the Required rate of return is 15.55%

Stocks & their Valuation

Q1. CORPORATE VALUATION Scampini Technologies is expected to generate $25 million in free cash flow
next year, and FCF is expected to grow at a constant rate of 4% per year indefinitely. Scampini has no debt or
preferred stock, and its WACC is 10%. If Scampini has 40 million shares of stock outstanding, what is the
stock’s value per share?

The stock’s value per share is $10.42Explanation:For: FCF1 = Expected cash flow of the
firm = $25 million
WACC = 10% g = 4% Firm value = FCF1/(WACC - g) = 25,000,000/(0.10-0.04) =
$416,666,666.67
We know that there is no debt & preferred stock, so the firm value will be equal to Equity value
:Firm value = Equity value = $416,666,666.67stock value per share = Equity Value/No. of share
outstanding = $416,666,666.67/40,000,000 = $10.42 per share
Therefore, the stock’s value per share is $10.42
Q2. PREFERRED STOCK RATE OF RETURN What will be the nominal rate of return on a perpetual preferred
stock with a $100 par value, a stated dividend of 10% of par, and a current market price of (a) $61, (b) $90, (c)
$100, and (d) $138?

In calculating the nominal rate of return on a perpetual stock, the following formula is used,

rp = Dp/Vp.

Where,

r = rate of return,

D= dividend;

V = current market price of preferred stock

Dividend is 10% of Par

Dividend = 10% * 100

Dividend = $10

a) $61

= 10/61

= 0.16393442623

= 16.39%

b) $90

= 10/90

= 11.11%

c) $100

= 10/100

= 10%

d) $138

= 10/138

= 0.07246376811

= 7.25%
Q3. VALUATION OF A CONSTANT GROWTH STOCK A stock is expected to pay a dividend of $2.75 at the end
of the year (i.e., D1= $2.75), and it should continue to grow at a constant rate of 5% a year. If its required
return is 15%, what is the stock’s expected price 4 years from today?

Firstly, we need to calculate the stock intrinsic value as of now using dividend discounted model (DDM).
The dividend discounted model is stated as below:

Stock intrinsic value = Next year dividend/(Required rate of return - Dividend long term growth)

= 2.75/(13% - 5%) = 34.375.

This a perfectly efficient market, the stock will grow 15% each from now. So expected value of the stock
in 2 years is 34.375 x (1 + 13%)^2 = 43.89.