PRACTICE 4: FINANCIAL ANALYSIS

INTRODUCTION TO BUSINESS ADMINISTRATION

Question 1
A company has generated earnings before interest and taxes of €27,000. Suppose
the firm has used twice as much debt as equity to finance its operations, leading to
a payment of €12,000 in interest expense with a cost of debt of 8%.
Based on this information, you are asked to answer the following questions:
(a) Calculate and interpret the company’s return on assets.
(b) Calculate and interpret the company’s return on equity.
(c) Which of the two measures is more relevant for the shareholders? Why?

Question 2
A firm’s rate of return on equity is 15% and its rate of return on assets is 12%.
Knowing that the firm’s assets amount to €200,000 and it has a total debt of
€120,000, answer the following questions:
(a) Calculate the firm’s average cost of debt.
(b) Should the firm reduce its debt-to-equity ratio? Explain why.
(c) Find the value of the firm’s ROE for the following debt-to-equity ratios: 0, 1, 2
(keeping the other variables constant). What do you conclude about the effect
of the debt-to-equity ratio on ROE?

Question 3
Consider the following information provided by two companies:
Company A Company B
Price 10 €/unit Net income €4,800
Unit variable cost 6 €/unit Interest rate 8%
Total fixed cost €30,000 Debt €30,000
Quantity sold 9,600 units Debt-to-equity ratio 1
Degree of financial leverage 1
Total assets €70,000
(a) As a shareholder, in which of the two companies would you prefer to invest?
(b) If the government imposes a tax rate of 25%, would your choice be affected?

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Question 4
Suppose an entrepreneur is considering starting up a company that requires
acquiring assets worth of €200,000 to achieve a return on assets of 14%. The
entrepreneur is considering two alternatives to finance the project. The first option
is to use his own savings to cover the entire value of the investment. The other
option is to ask for a loan from the bank to cover half of the investment at an
interest rate of 10%.

(a) Which of the two alternatives would be more profitable for the entrepreneur?
(b) Suppose another bank is offering a loan of €150,000 at an interest rate of 15%.
Should the entrepreneur choose this alternative instead?
(c) What do you conclude about the combined effect of the interest rate and the
financial leverage on ROE?

Question 5
A firm’s earnings before interest and taxes amount to €6,000, which has led to a
return on assets of 8% and a return on equity of 10%. Knowing that the firm’s
interest expense amounts to €1,000, answer the following questions:
(a) Calculate the firm’s degree of financial leverage
(b) Calculate the firm’s debt-to-equity ratio.
(c) Find the firm’s degree of financial leverage for the following values of debt-to-
equity ratio: 0, 1, 2. What do you conclude about the link between the debt-to-
equity ratio and the degree of financial leverage?

Question 6
A retailer has achieved a total contribution margin of €120,000. The firm pays
€45,000 per year in wages, and its rent payment amounts to €35,000 per year.
Knowing that the firm has a debt of €200,000 and that the interest rate is 10%,
answer the following questions:
(a) Calculate the firm’s degree of financial leverage and interpret its meaning.
(b) Calculate the firm’s degree of operating leverage and interpret its meaning.

Question 7
A firm’s earnings before interest and taxes are equal to €24,000 and its ROA is
equal to 8%. In addition, its fixed assets are twice as large as its current assets, its
debt-to-equity ratio is equal to 1, and current debt is equal to long-term debt.
Calculate the firm’s current ratio and the firm’s net working capital.
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Question 8
“When assessing how efficiently two firms are being managed, one should
compare their ROA rather than their ROE because ROA is not affected by aspects
not directly related to the firm’s efficiency such as financing costs and taxation”.
True or false? Explain your answer.

Question 9
“When ROE is different from ROA, this is an indication that the firm is using
financial leverage”. True or false? Explain your answer.

Question 10
“Leaving everything else constant, a firm can always improve its return on equity
by increasing its debt-to-equity ratio”. True or false? Explain your answer.

Question 11
“If a company’s net working capital is positive, then its current ratio is larger than
zero and, therefore, the firm is in a situation of financial equilibrium”. True or false?
Explain your answer.

Question 12
“A positive cash conversion cycle means the firm has enough liquidity to sustain its
operating cycle without having to use debt”. True or false? Explain your answer.