CHAPTER

ANALYSIS OF FINANCIAL STATEMENTS

Answers to Questions

1. The kind of decisions that require the analysis of financial statements include whether to
lend money to a firm, whether to invest in the preferred or the common stock of a firm,
and whether to acquire a firm. To properly make such decisions, it is necessary to
understand what financial statements are available, what information is included in the
different types of statements, and how to analyze this financial information to arrive at a
rational decision.

2. Analysts employ financial ratios simply because numbers in isolation are typically of
little value. For example, a net income of $100,000 has little meaning unless analysts
know the sales figure that generated the income and the assets or capital employed in
generating these sales or this income. Therefore, ratios are used to provide meaningful
relationships between individual values in the financial statements. Ratios also allow
analysts to compare firms of different sizes.

3. A major problem with comparing a firm to its industry is that you may not feel
comfortable with the measure of central tendency for the industry. Specifically, you may
feel that the average value is not a very useful measure because of the wide dispersion of
values for the individual firms within the industry. Alternatively, you might feel that the
firm being analyzed is not “typical,” that it has a strong “unique” component. In either
case, it might be preferable to compare the firm to one or several other individual firms
within the industry that are considered comparable to the firm being analyzed in terms of
size or clientele. For example, within the computer industry it might be optimal to
compare IBM to Burroughs and/or Control Data rather than to some total industry data
that might include numerous small firms.

4. In general, jewelry stores have very high profit margins but low asset turnover. It could
take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be
tremendous. On the other hand, grocery stores usually have very low profit margins but
very high asset turnover. Assuming both business risk and financial risk of the firms are
equal, the ROE’s should likewise be equal.

5. Business risk is measured by the relative variability (i.e., the coefficient of variation) of
operating earnings for a firm over time. In turn, the variability of operating earnings is a
function of sales volatility and the amount of operating leverage (i.e., fixed costs of
production) employed by the firm. Sales variability is the prime determinant of earnings
volatility. In addition, the greater the firm’s operating leverage, the more variable the
operating earnings series will be relative to the sales variability.

10 - 1
6. The steel company would be expected to have greater business risk. As discussed in
question #5, sales variability and operating leverage are the two components of business
risk. While both the steel and the retail food chain will have high operating leverage, the
steel firm is more sensitive to the business cycle than the retail food chain. That is, the
steel firm will have a very volatile sales pattern over the business cycle. Therefore, the
steel firm should have higher business risk than the retail food chain.

7. When examining a firm’s financial structure, we would also be concerned with its
business risk. Since financial risk is the additional uncertainty of returns faced by equity
holders because the firm uses fixed-obligation debt securities, the acceptable level of
financial risk usually depends on the firm’s business risk. For a firm with low business
risks, investors are willing to accept higher financial risk. On the other hand, if the firm
has very high business risk, investors probably would not feel comfortable with high
financial risk also.

8. The total debt/total asset ratio is a balance sheet ratio that indicates the stock of debt as
compared to the stock of equity. While the total debt/total asset ratio is a common
measure of financial risk, many analysts prefer to employ the fixed charge coverage ratio,
which reflects the flow of funds from earnings that are available to meet fixed-payment
debt obligations.
A cash flow ratio represents the cash available to service the debt issue, whereas a
proportion of debt ratio simply indicates the amount of debt outstanding. For example, a
large amount of debt (i.e. high proportion of debt indicating greater financial risk) could
be issued with a low coupon rate, thereby requiring only a small amount of cash to
service the debt. Generally, when these two types of debt ratios diverge, one should
concentrate on the cash flow ratios since they represent the firm's ability to make its debt
obligations.

9. Growth analysis is important to common stockholders because the future value of the
firm is heavily dependent on future growth in earnings and dividends. The present value
of a firm with perpetual dividends payment is:

Dividend Next Period

V
Required Rate of Return - Growth Rate

Therefore, an estimation of expected growth of earnings and dividends on the basis of the
variables that influence growth is obviously crucial. Growth analysis is also important to
debt-investors because the major determinant of the firm’s ability to pay an obligation is
the firm’s future success which, in turn, is influenced by its growth.

9. The rate of growth of any economic unit depends on the amount of resources retained and
reinvested in the entity and the rate of return earned on the resources retained. The more
reinvested, the greater the potential for growth. In general:

Growth = Retention Rate x Return on Equity

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11. Assuming the risk of the firm is not abnormally high, a 24% ROE is quite high and
probably exceeds the return that the equity investor could earn on the funds. Therefore,
the firm should retain their earnings and invest them at this rate.

12. This does not mean that Orange Company is better than Blue Company. In order to make
this judgment, we have to know what factors (components) caused the extra four points
of ROE. If it comes from either the profit margin or the total asset turnover component of
the ROE, we can comfortably claim that equity holders of Orange Company are better off
than equity holders of Blue Company. On the other hand, it would not be so if the extra
four points is because the Orange Company has higher financial leverage, since this extra
return is simply a compensation to its equity holders for the higher financial risk they
bear. Finally, we are not told anything about the business risks of the two firms.

13. External market liquidity is the ability to buy or sell an asset quickly with little change in
price (from prior transaction), assuming no new information has been obtained. The two
components of external market liquidity are: (1) the time it takes to sell (or buy) the asset,
(2) the selling (or buying) price as compared to recent selling (buying) prices.

Real estate is considered an illiquid asset because it can take months to find a buyer (or
seller), and the price can vary substantially from the last transaction or comparable
transactions.

14. Some internal corporate variables such as the total market value of outstanding securities
and the number of security owners are good indicators of market liquidity. If the firm has
a fairly large number of stockholders, it would be very likely that, at any point in time,
some of these investors will be buying or selling for a variety of purposes. Therefore, the
firm’s security would enjoy a liquid secondary market. On the other hand, a small
number of security holders would probably indicate an illiquid secondary market. The
ultimate indicator is the volume of trading in the security either in absolute terms or
relative turnover (shares traded as a percent of outstanding shares).

15. Student Exercise

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 CHAPTER 10

Answers to Problems

1(a).
Net Income 400,000
Return on Total Equity    34.5% based on the 3 components :
Equity 1,160,000

Sales Total Assets Net Income

ROE  x x
Total Assets Equity Sales
6,000,000 4,000,000 400,000
 x x
4,000,000 1,160,000 6,000,000
 1.5 x 3.45 x .067

 34.7% (slight difference is due to rounding)

1(b). Growth Rate = (retention rate) x (return on equity)

= (1 - 160,000/400,000) x .345
= (1 - .40) x .345
= .60 x .345
= 20.7%

1(c).
240,000
ROE   20.7%
1,160,000
ROE  1.5 x 3.45 x .04  20.7%

1(d). Growth Rate = .60 x .207 = 12.42%

If dividends were $40,000, then RR = (1 - $40,000/400,000)

= 1 - .10 = .90

Then growth rate = .90 x .207 = 18.63%

2(a). ROE = Total asset turnover x Total assets/equity x Net profit margin
Company K: ROE = 2.2 x 2.4 x .04 = .21
Company L: ROE = 2.0 x 2.2 x .06 = .26
Company M: ROE = 1.4 x 1.5 x .10 = .21

2(b). Growth Rate = Retention Rate x ROE

= (1 - Payout Rate) x ROE
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 Company K: Growth Rate = (1 - 1.25/2.75) x .21
= .55 x .21 = .1155

Company L: Growth Rate = (1 - 1.00/3.00) x .26

= .67 x .26 = .1742

Company M: Growth Rate = (1 - 1.00/4.50) x .21

= .78 x .21 = .1638
3. Current ratio = 650/350 = 1.857
Quick ratio = 320/350 = 0.914
Receivables turnover = 3500/195 = 17.95x
Average collection period = 365/17.95 = 20.33 days
Total asset turnover = 3500/2182.5 = 1.60x
Inventory turnover = 2135/280 = 7.625x
Fixed asset turnover = 3500/1462.5 = 2.39x
Equity turnover = 3500/1035 = 3.382x
Gross profit margin = (3500 - 2135)/3500 = .39
Operating profit margin = 258/3500 = .074
Return on capital (129 + 62)/2182.5 = .088
Return on equity = 129/1185 = .109
Return on common equity = 114/1035 = .110
Debt/equity ratio = 625/1225 = .51
Debt/total capital ratio = 625/1850 = .338
Interest coverage = 258/62 = 4.16x
Fixed charge coverage = 258/[62 + (15/.66)] = 3.045x

Cash flow/long-term debt = (129 + 125 + 20)/625 = .438

Cash flow/total debt = (129 + 125 + 20)/975 = .281

Retention rate = 1 - (40/114) = .65

Eddie’s current performance appears in line with its historical performance and the
industry average except in the areas of profitability (measured by return on capital and
return on equity) and leverage (debt/equity and debt/total capital ratios).

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4. CFA Examination I (1990)
1999 2003
4(a). Operating Margin = (Operating Income – Depreciation)/Sales
= (38 - 3)/542 = 6.46% = (76 - 9)/979 = 6.84%

Asset Turnover = Sales/Total Assets

= 542/245 = 2.21x = 979/291 = 3.36x

Interest Burden = Interest Expense/Total Assets

= 3/245 = 1.22% = 0/291 = 0%

Financial Leverage = Total Assets/Common Shareholders Equity

= 245/159 = 1.54x = 291/220 = 1.32x

Tax Rate = Income Taxes/Pre-tax Income

= 13/32 = 40.63% = 37/67 = 55.22%

The recommended formula is:

Return on (ROE) = [(Op. Margin x Asset Turnover) - Int. Burden] x Equity Financial
Leverage x (100% - Income Tax Rate)

1999 = [(6.46% x 2.21x) - 1.22%] x 1.54 x (100% - 40.63%)

= 13.05 x 1.54 x .5937 = 11.93%

2003 = [(6.84% x 3.36x) - 0%] x 1.32 x (100% - 55.22%)

= 22.98 x 1.32 x .4478 = 13.58%

Two alternative approaches are also correct.

ROE = [(Op. Margin - (Int. Burden/Asset Turnover)] x Financial Leverage x Asset

Turnover x (100% - Income Tax Rate)

ROE = [(Financial Leverage x Asset Turnover x Operating Margin) - (Financial Leverage

x Interest Burden)] x (100% - Income Tax Rate)

4(b). Asset turnover measures the ability of a company to minimize the level of assets (current
and fixed) to support its level of sales. The asset turnover increased substantially over the
period thus contributing to an increase in the ROE.

Financial leverage measures the amount of financing outside of equity including short
and long-term debt. Financial leverage declined over the period thus adversely affected
the ROE. Since asset turnover rose substantially more than financial leverage declined,
the net effect was an increase in ROE.

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 CHAPTER 11

AN INTRODUCTION TO SECURITY VALUATION

Answers to Questions

1. The top-down valuation process begins by examining the influence of the general
economy on all firms and the security markets. The next step is to analyze the various
industries in light of the economic environment. The final step is to select and analyze the
individual firms within the superior industries and the common stocks of these firms.
The top-down approach thus assumes that the first two steps (economy-market and
industry) have a significant influence on the individual firm and its stock (the third step).
In contrast, the bottom-up approach assumes that it is possible to select investments (i.e.
firms) without considering the aggregate market and industry influences.

2. It is intuitively logical that aggregate market analysis precede industry and company
analysis because the government and federal agencies can exert influence on the
aggregate economy via fiscal (changes in government spending, taxes, etc.) and monetary
(changing money supply, interest rates, etc.) policy. Further, inflation, another aggregate
economic variable, must be considered because of its major impact on interest rates and
the spending and saving/investment of consumers and corporations. Therefore, a major
division is the asset allocation among countries based upon the differential economic
outlook including exchange rates (the outlook for the currency).

Again, industry analysis should precede individual security analysis since there are
several factors that are generally national in scope but have a pervasive effect on some
industries - e.g., industry-wide strikes, import/ export quotas, etc. In addition, alternative
industries feel the impact of economic change at different points in the business cycle -
e.g., industries may lead or lag an expansion. Further, some industries are cyclical (e.g.,
steel, auto), some are stable (utilities, food chains, etc.).

The thrust of the argument is that very few, if any, industries perform well in a recession,
and a “good” company in a “poor” industry may be difficult to find.

3. All industries would not react identically to changes in the economy simply because of
the different nature of business. The auto industry for instance tends to do much better
than the economy during expansions but also tends to do far worse during contractions as
consumers’ consumption patterns change. In contrast, the earnings of utilities undergo
modest changes during either expansion or recession since they serve a necessity and thus
their sales are somewhat immune to fluctuations. Also, some industries “lead” the
economy while others only react late in the cycle (e.g., construction).

4. Estimating the value for a bond is easier than estimating the value for common stock
since the size and the time pattern of returns from the bond over its life are known
amounts. Specifically, a bond promises to make interest payments during the life of the
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 bond (usually every 6 months) plus payment of principal on the bond’s maturity date.
With common stock, there are no such guarantees.

5. The required rate of return on an investment is primarily determined by three major

factors: (1) the economy’s real risk-free rate (RRFR), (2) the expected rate of inflation
(I), and (3) a risk premium (RP). While this basic framework will apply no matter what
country you choose to invest in, there will be significant differences in these factors
among different countries over time. Among the specific reasons why an investor may
have different required returns for U.S. and Japanese stocks are:

The real risk-free rate: For all countries, this rate should be an approximation of the
economy’s real growth rate. However, the real growth rate among countries might be
significantly different due to differences in the growth rate of the labor force, growth rate
in the average number of hours worked, and differences in the growth rate of labor
productivity.

The expected rate of inflation: Again, there are differences between the U.S. and
Japanese inflation rate that are bound to imply a difference between the required return
between the two countries.

The risk premium: The risk premium is derived from business risk, financial risk,
liquidity risk, exchange rate risk, and country risk. Each of these components is
influenced by differences in general economic variability, political conditions, trade
relations, and operating leverage employed within the countries. It is necessary to
evaluate these differences in risk factors and assign a unique risk premium for each
country.

6. The nominal risk-free rate (NRFR) is composed of two factors: (1) real risk-free rate
(RRFR) and (2) expected rate of inflation E(I). As mentioned in the answer to question
#5, the real risk-free rate for all countries is an approximation of the economy’s real
growth rate. It is highly unlikely that two countries will have the same real risk-free rate
due to differences in the growth rates. Also, the expected rate of inflation will vary from
country to country. Taking these factors into account, one would not expect the U.S.
nominal risk-free rate to be the same as that in Germany. As Exhibits 11.6 and 11.7
illustrate, Germany’s nominal risk-free rate is expected to be lower than that of the U.S.
in 2003.

7. No, the Indonesian and United Kingdom stocks should have significantly different risk
premiums. Specifically, Indonesian stocks should have much larger risk premiums
because they are relatively new securities, lack liquidity, and in many cases the
underlying firms are involved in highly risky ventures (i.e. business risk). On the other
hand, United Kingdom stocks typically are issued by established firms, quite liquid, and
the underlying firms are typically engaged in less speculative activities.

8. No, the Singapore stock should be more risky than the United States stock based upon
similar reasoning as presented in question #7.
11 - 2
9. Student Exercise

10. Student Exercise

11. The relative valuation ratios to evaluate a stock should be used in cases where:
(1) a good set of comparable entities (e.g., industries or similar companies) exists, or
(2) when the aggregate market is not at a valuation extreme (e.g., a seriously overvalued
or undervalued market).

12. The discounted cash-flow valuation approaches can be used for stocks that pay dividends,
particularly in the case of a stable, mature firm where the assumption of relatively
constant growth for the long term is appropriate.

The present value of operating cash flow technique can be used when comparing firms
that have diverse capital structures.

The present value of free cash flow to equity is important to an equity holder since this
approach measures the amount of cash flow available to the equity holder after debt
payments and expenditures to maintain the firm’s asset base.

13. The two valuation approaches should not be considered to be competitive approaches,
rather the text suggests that both approaches should be used in the valuation of common
stock. The discounted cash flow techniques reflect how we describe value, that is, the
present value of expected cash flows. However, these techniques could generate values
that are substantially difference from the prevailing prices in the marketplace. On the
other hand, the relative valuation techniques provide information on how the market is
currently valuing the stock. These techniques should be used together in determining
equity valuation, that is, the approaches should be considered complementary.

11 - 3
 CHAPTER 11

Answers to Problems

1. Assume semiannual compounding:

Par value $10,000

Coupon Payment (every six months) $450
Number of periods 20
Required return 3.5%

Therefore,
Present value of interest payments $ 6,395.58
Present value of principal payment 5,025.66
Present value of bond $11,421.24

2. If the required return rises to 11 percent, then:

Number of periods 20
Required return 5.5%

Therefore,
Present value of interest payments $5,377.67
Present value of principal payment 3,427.29
$8,804.96

3. Annual dividend $9.00

Required return 11%

Therefore, the value of the preferred stock = $9.00/.11 = $81.82

At a market price of $96.00, the promised yield would be $9.00/$96.00 = 9.375%, which
is less than your required rate of return of 11%. Therefore, you would decide against a
purchase at this price. The maximum price you will be willing to pay is $81.82.

4. Earnings per share: last year $10.00

Dividends per share: last year $6.00
Estimated earnings per share: this year $11.00
Required rate of return 12%
Expected sales price at end of year $132.00

Since the last dividend payout ratio = $6.00/$10.00 = 60%, and assuming you maintain
the same payout ratio, then dividends per share at the end of the year is:
EPS x Payout = $11.00 x 60% = $6.60.

11 - 4
 Therefore, the present value of BBC’s share is:

$6.60 $132.00
Value    $5.89  $117.86  $123.75
(1  .12) (1  .12)

Thus $123.75 is the maximum price you would be willing to pay for BBC’s stock.

5. Earnings per share: last year $10.00

Dividends per share: last year $6.00
Required rate of return 8%
Expected sell price $110.00

$6.60 $110.00
Value    $6.11  $101.85  $107.96
(1  .08) (1  .08)

Thus $107.96 is the maximum price you would be willing to pay for BBC’s stock.

6. Dividends at the end of this year: $6 x 1.08 = $6.48

Required rate of return 11%
Growth rate of dividends 8%
$6.48
Value   $ 216 . 00
.11 - .08

Thus, you would be willing to pay up to $216.00 for BBC’s stock.

7. Estimated earnings per share $11.00

Dividend payout ratio 60%
Required rate of return 12%
Growth rate of dividends 9%

.60
P/E of BBC Company   20 x
.12 - .09

Thus, the maximum price you would be willing to pay for BBC’s stock is:
20 x $11 = $220.00

8. Dividend payout ratio 40%

Return on equity 16%

Growth rate = (Retention rate) x (Return on equity)

= (1 - payout ratio) x (Return on equity)
= (1 - .40) x (.16)
= .60 x .16
= 9.6%

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9. Dividend payout ratio 40%
Dividend growth rate 9.6%
Required rate of return 13%

.40
P/E of SDC Company   11.76 x
.13 - .096

10. Dividend payout ratio 50%

Required rate of return 13%

Growth rate = (1 - .50) x (.16)

(new) = .50 x .16
= .08

.50
P/E of SDC Company   10.00x
.13 - .08
(new)

11.
Net Income Sales Total Assets
ROE  x x
Sales Total Assets Equity
 Profit Margin x Total Asset Turnover x Leverage

As the above equation illustrates, ROE can be increased through increases in profit
margin, total asset turnover, or leverage. As an example of each, suppose ABC company
saw an increase in demand for their product, knowing that they have a clearly superior
product to others in the industry and their customers are extremely loyal, they will raise
prices, thus generating more net income per sale, and have greater profit margin. As can
be seen from the formula, holding other things constant, ABC will achieve a greater
ROE.

Likewise, suppose demand for the product has increased on an industry wide basis. ABC
knows if they raise their prices they may lose sales to the competition. As a result they
decide to increase their leverage to increase ROE.

The final method of increasing ROE is by increasing overall efficiency and thus
increasing the dollar value of sales to assets on hand.

The student should provide a numerical example of each of these effects.

12. Although grocery chains realize a very low profit margin because of heavy competition
(around 1%), they do enjoy a very high asset turnover ratio, thereby enabling them to
achieve a ROE of about 12%.

13. Student Exercise

11 - 6
14. Required rate of return (k) 14%
Return on equity (ROE) 30%
Retention rate (RR) 90%
Earnings per share (EPS) $5.00

Then growth rate = RR x ROE

= .90 x .30 = .27
D/E .10
P/E  
k - g .14  .27

Since the required rate of return (k) is less than the growth rate (g), the earnings
multiplier cannot be used (the answer is meaningless).

However, if ROE = .19 and RR = .60,

then growth rate = .60 x .19 = .114

.40 .40
P/E    15.38  15.38x
.14 - .114 .026

If next year’s earnings are expected to be: $5.57 = $5.00 x (1 + .114)

Applying the P/E: Price = (15.38) x ($5.57) = $85.69

Thus, you would be willing to pay up to $85.69 for Maddy Computer Company stock.

15(a). Projected dividends next 3 years:

Year 1 ($1.25 x 1.08) = $1.35

Year 2 ($1.35 x 1.08) = $1.46
Year 3 ($1.46 x 1.08) = $1.58

Required rate of return 12%

Growth rate of dividends 8%

The present value of the stock is:

1.35 1.46 1.58 40

V  2
 3

1.12 (1.12) (1.12) (1.12) 3
1.35 1.45 1.58 40
   
1.12 1.2544 1.4049 1.4049
 1.21  1.16  1.12  28.47  $31.96

11 - 7
15(b). Growth rate 8%
Required rate of return 12%

1.35 1.35
V   $33.75
.12 - .08 .04

15(c). Assuming all the above assumptions remain the same, the price at end of year 3 will be:

D4 1.25 x (1.08) 4 1.25 x 1.3605

P3     $42.52
k -g .12  .08 .04

16. Student Exercise

11 - 8