c ont 492. Security Analysis and Portfolio Manageme" Review Problems some of the ratios for this firm are as follows, 1. ALtd. has an equity base of €10 cron Current debt to total debt =0.40 Total debt to equity =0.10 Fixed assets to equity = 0.85 Total assets tumover = 2 times Inventory tumover = 8 times Given this data, you are required to calculate (a) total debt; (b) fixed assets; (c) total capi, (a) total assets and (e) sales and inventories. SouvTios Given that debt equity ratio = 0.10 (a) PEt - 0.10 or Debt = 10 x 0.1 = 8 crore Equity (b) Fixed assets to equity = 0.85 Fixed assets Equity (c) Total capital = Equity + Debt = 10 + 1 = 211 crore = 0.85 or Fixed assets = 0.85 x 10 = %8.5 crore (d) Total assets = Fixed assets + Current assets = €11 crore or, 1] = 8.50 + current assets or current assets = %2.50 crore (c) Total asset turnover ratio = S25. oy 2 = SMHS 6, sates = 222 crore Assets Sales 22 Inventory tumover = SS oy g= 7? or tnventory = 22 Inventory Inventory 8 or —_Inventory = 82.75 crore Using the following information, complete the balance sheet, Assume 360 days in a yext (a) Long-term debt to net worths = 0.4 (b) Total asset turnover = 3.5 (c) Average collection period = 15 days (d) Inventory tumover = 6 (c) Gross profit margin = 15% (A) Acid test ratio = 1:1 Plant and equipment Inventory ity 1,50,000 Retained earnings 75,000 Long-term debt Notes and payables 75,000 Accounts receivable CashFinancial Statement Analysis 493 ya Net worth = 1,50,000 + 75,000 = 29 25 000 term debt/net worth = 0.4, Long-term debt = 2 eae = 2,25,000 x 0.4 = 290, Total liabilities = (1,50,000 + 75,000 + 75,000 + 90,000) = 90 gales/Total assets = 3.5 of 3.5 x %3,90,000 = 213,65 0 = B00 (-; Total assets = Total liabilities) ie P/Sales = GP/Sales = 0.15 or Cost of goods sold = 13,65,000 x 0.85 = 211,60,250 ¢ goods sold/Inventory = 6 or Inventory = 11 ,60,250/6 = &1,93,375 cial ‘Accounts receivables = sales/360/15 = 756875 ‘Acid-test / Quick ratio = Cash + Accounts receivable Notes and accounts payable 75000, Plant and equipment = 3,90,000 — [(1,93,375 + 56,875 + 18,125)] = &1,21,625 or Cash = 218125 | | 4 BLtd. has achieved sales of %40 million and a net profit of %5 million in the current year. The | lowing figures are obtained from the current year’s balance sheet: | Paid-up capital = %5 million | Reserve and surplus = €3 million | Long-term loans = %8 million Current liabilities and provisions = %4 million. Ifthe company wants to increase the return on equity by 7.5% percentage points next year, then byhow much should the profit margin change, other ratios remaining the same? Sourtion Equity 8 Atpresent (ROE) = Net profit _ 5 _ 9.695 or 62.5% HOE can be decomposed as: Net profit __ Sales Net profit, _-"—_x ; Sales Total assets Equity Given; | 240 million Net profit = %5million; Sales Total liabilities =Total debt + Net worth aes Current liabilities an = Long-term loans + equity share capital + Reserve and surplus 2844) +543) = e20 provisions + Paid-up lion Net profit __5 12.5% Net profit _ Sales. 40 = 220 million Big ‘sting net profit margin = Total assets = Total liabilitiesment 494 Security Analysis and Portfolio Manage! ‘Total assets tumover 20 a 2.50 Total assets to equity aio = er won +3) Existing ROE = 62.5% Required ROE = 62, 5 + 7.5% = 10% ROE -— yy ~ Required net profit margin = ‘ales eis” 2.00% 2.50 hy . , Sales, Total assets Total assets Net worth <+ Change in net profit margin = 14% ~ 12.5% = 1.5% (increase) 4. If markets are truly efficient, does it matter whether firms engage in eamings manapeney On the other hand, if firms manage eamings, what does they say about management’ ey efficient markets? Sovution Eamings management should not matter in a truly efficient market, where all publicly asi information is reflected in the price of a share of stock. Investors can see through attemps to manage earings so that they can determine a company’s true profitability and, hence, te intrinsic value of a stock. However, if firms do engage in earnings management, then te cee implication is that the managers do not view financial markets as efficient. 5. Firm A and firm B have the same ROA, yet Firm A’s ROE is higher. How can you explit | this? So.vtion ROE =(1~Tax rate) [Roa + (ROA ~ Intereset rate) Det Equity ROE, > ROEg, Firms A and B have the same ROA. ‘Assuming the same tax rate and assumin, ig that ROA > Interest rate, then Firm A must have ell a lower interest rate or a higher debt ratio, 6. Mumbai Ltd. has a profit margin on sal industry average. What does this imply Sonution les below the industry average, yet its ROA is above about its asset tumover? Mumbai Ltd’s asset turnover must be the above of industry average.Financial Statement Analysis 495 ise the DuPont system and the following data to fin, id return Leverage ratio (assets/equity) 2,2 ee | Total asset turnover 20 Net profit margin 5.5% | Dividend payout ratio 31.8% | goutTION | Ror Net income Net income | Sales _ Assets Equit es Assets” Equtiy iquity Sales Assets” Equtiy = Profit margin x Asset turnover x Leverage ratio = 5.5% X 2.02.2 = 24.2% 4, Acompany has reduced its allowance for bad and doubtful debts from 2.5% of sales to 1.5% of sales. Ignoring taxes, what are immediate effects on (a) operating income and (b) operating cash flow SouvTio (e) Lower bad debt expense will result in higher operating income. (b) Lower bad debt expense will have no effect on operating cash flow until the company actually collects receivables. 10. Afirm has an ROE of 3%, a debt to equity ratio of 0.5, a tax rate of 35%, and pays an interest rate of 6% on its debt. What is its operating ROA? Sourtion 1 ROA + (ROA ~ Interest rate) x Peet ROE = (1-1) x} (( ( rane o 0.03 = (0.65) x [ROA + (ROA — 0.06) x 0.5] o 0.03 = 0.975 x ROA ~ 0.0195 o 0.975 x ROA = 0.0495 or ROA = 5.08% | 1A firm has a tax burden ratio of 0.75, a leverage ratio of 1.25, an interest burden of 0.6 and a | tetum on sales of 10%, The firm generates %2.40 in sales per @ of assets. What is the firm’s ROE? Sou LUTION Net income Net income Taxable income | EBIT ROE =F guity Taxable income EBIT Sales les Assets sets Equity ROE =0.75 x 0.6 x 0.1 X 2.40 x 1.25 = 13.5% the dividend Yield fora firm is 0.3, whose P/E multiple and EPS ate 3 and 26, respectively, ‘nd out the dividend per share of the firm. mio P/E =3; EPS=6; P=P/EXEPS=%18 Dividend yield = dividend per share/Market price per shareement 496 Security Analysis ond Portfolio Manag! So, Dividend pet 13, Ifthe price eamings ratio is 12, asset (rm what would be the dividend yield? ice = 0.3 x 18 = 85.40 = Dividend yield x Market price = 0. 3 3 r share = over ratio is 0.9 and the dividend pay out rai, 5, ae 06, i.e. DPS/EPS = 0.6. 5 = 12, dividend pay-out ratio is 0.6, ae - 12 EPS = 12 x DPS/0.6 5% ois 60% and dividend per shares Price per share = DPS? i.e. dividend yield = 0.6/12 = 14, If the retum on equity is 25%, dividend payout rati out the EPS of the company. Souvtion / Dividend pay-out ratio = DPS/EPS. DPS = 3.00, dividend pay-out ratio is 0.60, EPS = DPS/Dividend pay-out = 3/0.60 = %5.00. 15. For X Ltd,, net profit margin is 7.5%, while total assets tumover is 1.20. If retumn on equity fy the company is worked out as 12%, find out the debt asset ratio. Souution From DuPont analysis, ROE = Net profit/Sales x Sales/TA x TA/TE or, 12% = 7.5% 1.20 XT-AX TIE or 12% = 9% x (T-A/ TE) or Lotal Equity _ 5. 5 Total assets 16, Ifthe earning power of a firm is 0.3, the average of total assets are €20,000 and interest expense is 71,500, find out the interest coverage ratio, Hence, the debt-asset ratio for the company is 1 — 0.75 = SoLution EBIT = Total assets x Eaming power = 20,000 x 0.3 = 26000 Interest = 71,500. Therefore, interest coverage ratio = EBIT/Interest = 6000/1500= 4. 17. What will be the capitalization rate i of a company whose market pri is B88 income is 22 million and the number u arket price per share of outstanding shares is 0.56 million? Sowwti0n Capitalization rate = Net income/(Price per f Per share X no, of outstanding shares = 2(25 x 0.56) = 0.127 or 12.7% ane 18. Following figures are extracted from the bo Term loan @12% pa to installments during the coming years Bonds @ 14% pa. to be repaid iM during the coming years Perpetual preference shares @15% p.a. Sou Net worth 20 lakh oks of X Ltd, be repaid in 5” equal anual %10 lakh. in 6 equal annual installmeneFinancial Statement Analysis 497 | 6,00, 100% govontte Bxed cHITEES COVETAEE ratio i arts _ ; : charges coverage ratio= : EBDIT \* Debt interest + £020 repayment installment _ Prefence dividends 1~ Tax rate 1-Tax rate sg, inereston ter Toan and Bonds = 10% 12% +24 x 14% = 4.56 lakh Loan repayment installments = 2 een preferce dividend = 20 x 0.15 = %3.00 lakh Theamount of dividend paid by the company = 71.50 x 6,00,000 = 29 lakh and the net profit of accompany is 9+ 3 = €12 lakh. So the profit before tax = 12/(1 — 0.4) = 20 lakh Hence, the profit before interest, depreciation and taxes were (20 + 5.44 + 4.56) = 730 lakh so, the required fixed charges coverage ratio is _ 30 30 30 1 534 x 6+3. 45641500 1956 ~ 56+ —— 4964 Toa 19, Suppose the current assets and inventory are 140% and 20% of current liabilities, an increase of 10% in current assets (without any increase in inventory), how much will increase the quick ratio? Soution LetheC.L, be 100. Then the CA and stock will be 140 and 20, respectively. Current ratio = 120/100 = 1.2 140+ 14). fern nance of 10% in current assets, the Figure changes 1 158. : Current ratio = 134/100 = 1.34 Pe Inerease in current ratio = (1.34 ~ 1.20)/1.2= 1 i ROL, at a tax te ROE of a firm is 20%, cost of debt is 10%, debt eats ratio is 1.5, what is a firm is 20%, 0s Tale of 359% 0x ROE = [ROI + (ROI 1) DEI (I~ ) 02 =[RoL+ (Rol -0.1) 1-5) 0 -0.35) : 0.2 = [ROI + 1.5 ROI- 0.15] * (0.65) 9 gain . 02 = [2.5 ROI 0.15] (0.65) 0221 a % 0.2975 = 1.625 ROI or ROI= 18.31jement 498 Security Analysis and Portfol’o Managé 21. Current ratio 2; Working capital = €4,00,000; Capital block to current asset Fixed asset tumover ratio Sales cashveredit = 1:2 Long-term loan/share capital Stock velocity = 2 months Creditors’ velocity = 2 months Debtors’ velocity = 2 months Gross profit ratio = 25% Capital block: Net Profit 10% of turnover Reserve 2.5% of tumover = 1:2 Prepare a balance sheet. SotuTion Working notes: i nee (1) Current ratio of 2 implies that current assets are twice of current liabilities. CA o> or CA=2CL cL Working capital = CA - CL= %4,00,000 or CA=2x 4,00,000 = %8,00,000 and CL =%4,00,000 (2) Capital block to current assets ratio 3:2 implies that long-term capital funds (Equity + Long: term loans) are 1.5 times of current assets, i.e. 8,00,000 x 1.5 = 12,00,000. (3) Total assets = Total liabilities = 716,00,000 (Equity + Long-term loans + Current liabilities (4) Total assets = %16,00,000 out of which current asset is %8,00,000 (assuming no long‘ investments) Fixed assets = %8,00,000. Tumover is 3 times of fixed assets. Therefore, tumover is €24,00,000. Credit sales is234 of 24,00,000 = 16,00,000 and cash sales 1/srd of 224,00,000 = 38,00,000 Gross profit = 25% of %24,00,000 = %6,00,000 Cost of goods sold = 718,00,000 1(2 Debtors tum a = +|— eect (2) or Amount of debtors (t x 16,00,000 = 22,6,667 Stock = %18,00,000/6 (Stock turn “ 00, lover ratio = a a (assume cash) 8,00,000 — (3,00,000 +. 2,66:667)-¢, e a Pee 5% of 824,00,000 = 260,000 ‘ost of goods sold + Closing stock = 18,00,000 + 3,00,000 = %21,00,000 Reserve Credit purchases =Financial Statement Analysis. 499 «(12 1 tumover ratio (2) or — cit 2 6 F21,00,000 = 83,50,000 ote current liabilities (74,00,000 — 3,50, 00) = %50,00¢ 90) = 750,000, Joan to share capital 1:2, implies th yt 7 hat | =| i Lo apital (2 long-term loan = share capital). © “erm loan in value arc equal to one half A . utter capital block is 712,00,000 (as per note 2). = 2 long-term loan + Shi _112,00.000 fare capital + Net % jpg. =3 foneterm loan +£2 40,000 + 60, 000 arenes ¥ gmno00 =3 fong-tem loan or long-term Loan = £30,000 "share capital = €6,00,000 (%9,00,000~3,00,000) | ai Balance Sheet as on cpoeers* funds: soa capital esene and surplus (24.000 + 60,000) Longer borrowings 9,00,000 3,00,000 caren liabilities Creditors: ter curtent liabilities ieresented by: ‘Tangible fixed assets (net) ‘Lng-term investments Caren assets Sox Debtors Ca 3,00,000 2,66,667 233333. Sonnet 16,00,000. ts ratio of 3. The debt equity ratio is 1.0, "1 "Minti ra in of 49 les to asse profit margin of 4% and a sal + re RBIT being €40,000, Compute the sites payments and taxes being £10,000 each an and the return on the assets. ty Tox i "8to DuPont analysis | ROA = (Net profit/Sales) x (Sales * x (Average asse! ‘Average assets) ts/Average equity) bs nny =1+DE=1+1=2 | Equity = 4x3 x2 = 24% p-a- PAT = 40,000 — 10,000 = €30,000yement 500 Security Analysis and Portfolio Manage 30,000/0.04 = 77,50,000 Sales = 50,000 = 22,50, ‘Average assets See = 40,000/2,50,000 = 16% ROA =E a AAT. 23. Eye Ltd. has the following, balances as on | 5,70,000 Fixed assets. 199.500 3s: Depreciation _1,99,500_ Less: Deprecii — Stocks and debtors 2,37,500 Banks balance sas Creditors ,000 Bills payable 38,000 2,85,000 Capital (shares of $100 each) The company made the following estimates for the financial years 2017-18. (i) The company will pay a free of tax dividend of 10%, the rate of tax being 25%, (ii) The company will acquire fixed assets costing €95,000 after selling one machine for8i9, costing 247,500 and on which depreciation provided amounted to €33,250. (iii) Stocks and debtors, creditors and bills payables at the end of financial year are expeceia be 2,80,250, 274,100 and 249,400, respectively. (iv) The profit would be 752,250 after depreciation of $57,000. Prepare the projected cash flow statement and ascertain the bank balance of Eye Ltd. SoLuTion Cash flow from operations ali sia z Profit for the year $2,250 ‘Add: Depreciation (non-cash item) $7,000 1,09,250 Less: Profit on sale of machine 4,750 Note: W.D.V. of machine [47,500 — 33,250] or 214.250 1,04,500 Sold at 719,000. Profit on sale 4750. (%19,000 - %14250) Less: Increase in stocks and debtors (2,80,250-~2,37,500) (42,1750) Add: Increase in creditors and bills Payabl (74,100 ~ $7,000) = 17,100 (49,400 - 38,000) = 11,400 +28,500 90,250 Dividend @10% on share canal GE ividend @10% on share capital of £285,000 Dividend paid %28,500 and tax on it @25%4 = 9 500(1/3 of 28,500)Financial Statement Analysis SOL | Projected Cash Flow Statement | | nse as 08 17472017 iow OF cash Ad gle of machine ash fom operation 21,09:250_ 142,500 jase of fixed assets eS ment of dividend id ‘Tox pal Jance as on 31/3/2018 Bank bal sales of @6 crore, variable costs of €3,50 crore and fixed costs of 70.65 crore. The firm 4 fim has 8 pasa debt of €7 crore at 10% and equity of 710 crore. Given this data, compute: 1) Thefirm’s ROI. The EBITif the sales decline to 4 crore. o iif industry’ asset tumover is 4 times, does the firm have high or low asset turnover? jut Rin crore) We will first compute the EBIT and EBT. Sales 7 [__ 6.00 ‘Less: variable costs _ 3.50 Contribution T2350) [ Less: Fined costs EBIT 85 Less: Interest on debt E 070 | aaa eer ‘y) Assuming D + E = Total investment I BIT Retum on i _ EBIT. 199-3 _ x.100 on investment= 55 *100= Deb + Equity 185_ 190 = 0.1088 or 10.88% 7+10 ers BIVifsales decline witews, z Sales (a 33.33% decline) 4.00 d off) 2.33 Less: variable cost (roundes 1.67 Contribution 0.65 [ Less: Fixed cost_ 1.99 | ee Vefim’s EBIT will [re decline to €4 crore. be €1.02 crore if the firm’s sales deelagement 502 Security Analysis and Portfollo Manag Net sales as 0.3529 ; (6) Asset turnover = “yy 7410 The firm has a very low asset tumover a compared to inet asset turnover, . : ; lance sheet of X Ltd. (3 25, From the following information, prepare ue ae oo a Inve , 5 Fra in Captal tumover ratio 1.5; () Fixed assets turnover 1240 33 (A) Gross pg as SDebtors collection period 2.5 months: (D ‘reditors pay! Period 70 days, Ther profit ers ooo. Closing stock was €60,00 in excess of opening stock, Bs SovvTion ; no or25= 75,00,000 GP ratio = (G.P/sales) x 100 = (75,000/Sales) x 100 or a or 25 § = 75.00,000 or Sales = %3,00,000 (3,00,000 — 75,000) = %2,25,000 ales — Gross profit = ( ventory) OF 5 = (2,25,000/Averag ing Cost of goods sold/averags Cost of goods sold Inventory turnover rati tory) | or Average inventory = %45,000 (2,25,000/5) Average inventory = (opening stock + closing stock)/2 = 745,000 Closing stock + opening stoc! al (a) ising uci t56/000 or closing stock = 48,000 (b) Capital turnover ratio = (Cost of goods sold/capital) or, 1.5 = 2,25,000/capital; or capil: (2.25,000/1.5) = %1,50,000 | Fixed assets turnover ratio = (Cost of goods sold/fixed assets) or 3 = (2,25,000/F/A) orf | 25,000/3) or 875,000 Average collection period = 2.5 months. Debtors turnover ratio = (360/2.5) or 360/75 = 48.4° | sume, sales to be on credit sales and debtors turnover ratio is based on year end figures. We have 00,000/debtors or debtors = (3,00,000/4.80) or $62,500. Creditors payment period = 70.45 Creditors turnover ratio = 360/70 = 5.14, Assume, all purchases are credit purchases, the amoutt | Credit purchases is, Cost of goods sold = Opening stock + Purchas: Closing stock. 2.25,000 = 42,000 + Purchases ~ 48,000 or Purchases = %2.31,000 awsuming creditors tumover ratio is on year end figure, the amount of creditors will be: S47 (2.31,000/creditors). or 5.14 creditors = 2.31,000; or creditors = 44,942 Balance Sheet 150,000 44,942 Equity Current Liability: Creditors Represented by: Tangible F/A Closing stock 75,000 Debtors 48,000 62,500 Cash (balancing figure) 1,94,942 Buyback of SharesFinancial Statement Analysis 503 jareholders. The company has sufficient bank ba ott The following information is available as on san make the payment for buyback ds - Tui share capital (C10 each fully paid) 50,00, General reserve 10,000 pividend equalisation reserve nae Balance of profit and loss A/C (cr) seca 10% Debenture (7100 each) mae | Bank overdraft ounoey Current abilities ea \eify whether the buyback plan of the company meets the conditions specified by the companies 4.2013 as regards fo the maximum amount of buy back. Also pass necessary journal entries in the saisofthe company to give effect of the process, if the plan is found to be in place. suction Deemnination of maximum buyback of shares permissible under the Companies Act, 2013 1. Shares outstanding te: Maximum permissible limit = 25% of outstanding shares Total no, of outstanding shares -5,00,000, Maximum limit 25% of 5,00,000 shares = —_ 1,25,000 nos. 2. Resource test: Maximum permissible limit = 25% of paid up capital plus free reserve Equity Share Capital Free reserve = General reserve + Dividend equlisation reserve + Profit and loss A/c (cr. bal.) Shareholders’ fund = 25% of €1,25,00, 000 permissible as pet law +. No. of shares that can be bought back = (®31,25,000/%20 per share) = 1,56.250 3. Debt equity ratio test: Debt after buyback can’t exceed twice the paid up capital plus free Teserves, zg T 1,81,00,000 ‘al debt (75,00,000 + 40,00,000 + 66,00,000) ———. h inimum equity to be maintained after rabeed in the ratio (2: 1) scent equity) ‘id-up capital plus free reserve before buyback (Present 0— Fours paidup capital pus fee reserves (note 1) (1,25,00.00 1,50,009) Maxi —90,50,000) ee imum permissible buyback (1,13,50,000 ~ 90.90! 20 ‘wback price per share 1,15,000 Sof shares that can be bought backic it 504. Security Analysis and Portfolio Managemen mee es and securities prem i tof free reserves and securities premium, a compan Incase buyback of shares is done ou re buyback to Capital Redemp ma . f the s a 8 ual to the nominal value o1 : ; a Foe ae aaa ean after buyback includes CRR, Now, CRR is nota free ieee can't For ital plus frce reserve after buyback. - He, it can't form part of paid-up ca Let the nominal value of shares bought back is X. Then CRR after Baya is X. Moree, premium on buyback is X. So total amount to be deducted from shareholders fund for buyback X (capital) + X (premium) = 2X. Moreover, free reserves to be reduced by X. Total paidup capital plus free reserves after buyback = 1,25,00,000 ~ X(CRR) ~ 2X (ie. buy proceeds) Conditionally, 31,25,00,000 - X - 2X = 790,50,000 or X =%11,50,000 Nominal value of buyback = 11,50,000 Summary of Three Test Results Permissible buyback as per law Number of Shares 1. Shares outstanding test 1,25,000 2. Resource test 1,56,250 3. Debt equity ratio test 115,000 4 Maximum permissible buyback (least of the three) 115,000 Actual buyback plan ~1,00,000_ , ; o) Actual buyback plan is below the permissible limit, the company can buy 1,00,000 shares" | each : Fa ee Dr cr Equity share buyback Ale 20.00.00 | — hk 20,00,000 Equity share cap, Ale Pn CS To equity share buyback A/c Sect 20,00,000 General reserve Ale lmaeniag a ToCRR Ale ene 0 Multiple Choice Questions i eee ? 1. From the following information, sli " the yi = 1.S:1; Current liabilities = 249,999, PY is ——. Current ratio = 2.6:15 Li! (a) 755,000 () %22,000 (©) %44,000 (d) %1,04,000