# STC Homework Solutions Session by alicejenny

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```									STC386T1, Session 3 Homework
Accounting: What the Numbers Mean, (MM), Ch 3, #’s 8, 15, 17; Ch 11, #’s 10 and 12

E3-8. a. Margin * 2.4 Turnover = 12% ROI
Margin = 5%
5% Margin = (Net Income / Sales \$12,000,000)
Net Income = \$600,000 (or \$0.6 million)

b. ROE = (\$600,000 Net income / \$3,000,000 Average owners' equity) = 20%

P3-15. a. 15% ROI = (Margin * 2.0 Turnover)
Margin required as a manufacturer = 7.5%

2.0 Turnover = (Sales / \$6,000,000 Average total assets)
Sales required as a manufacturer = \$12,000,000

7.5% Margin = (Net Income / \$12,000,000 Sales)
Net Income required as a manufacturer = \$900,000 (or \$0.9 million)
b. 15% ROI = (Net Income / \$1,000,000 Average total assets)
Net Income required as a service firm = \$150,000

15% ROI = (2.5% Margin * Turnover)
Turnover required as a service firm = 6.0

6.0 Turnover = (Sales / \$1,000,000 Average total assets)
Sales required as a service firm = \$6,000,000 (or \$6 million)

C3-17. a.                                                                                                    1999   1998
Cash and cash equivalents ................................................................. \$ 3,345 \$ 1,453
Short-term investments ...................................................................            699    171
Accounts receivable, net .................................................................          5,125  5,057
Total quick assets for acid-test ratio (A) ............................................ \$ 9,169 \$ 6,681
Inventories.......................................................................................  3,422  3,745
Deferred income taxes ....................................................................          3,162  2,362
Other current assets .........................................................................        750    743
Total current assets (B) ................................................................... \$16,503 \$ 13,531

Notes payable and current portion of long-term debt ..................... \$ 2,504                       \$ 2,909
Accounts payable ............................................................................   3,015      2,305
Accrued liabilities ........................................................................... 6,897      6,226
Total current liabilities (C).............................................................. \$12,416     \$ 11,440
C3-17 a. (continued)

Working capital (B – C) ................................................................. \$ 4,087     \$ 2,091
Current ratio (B / C) ....................................................................... 1.33       1.18
Acid-test ratio (A / C) ....................................................................  0.74       0.58

b. Common stock ............................................................................... \$ 1,838   \$ 1,804
Additional paid-in capital ..............................................................      2,572     1,894
Retained earnings ...........................................................................  8,780     8,254

Non-owner changes to equity
3,154             270
Total stockholders’ equity.............................................................. \$16,344      \$12,222
ROE = Net earnings (loss) / Average stockholders’ equity

1999 = \$817 / ((\$12,222 + \$16,344) / 2) = 5.7%

1998 = –\$962 / ((\$13,272 + \$12,222) / 2) = –7.5%

c. ROI = Margin * Turnover
= (Net earnings (loss) / Net sales) * (Net sales / Average total assets)

1999 = (\$817 / \$30,931) * (\$30,931 / ((\$28,728 + 37,327) / 2))
= (2.6% Margin * 0.94 Turnover) = 2.5% ROI

1998 = (–\$962 / \$29,398) * (\$29,398 / ((\$27,278 + \$28,728) / 2))
= (–3.3% Margin * 1.05 Turnover) = –3.4% ROI

d. Motorola’s liquidity is not a big concern, especially in 1999. With working capital of
more than \$4 billion as at December 31, 1999, the relatively low current ratio and acid-
test ratio probably reflect the company’s efforts to minimize the investment in accounts
receivable and inventory, respectively, in favor of assets that are more likely to generate
a higher ROI in the future (such as property, plant, and equipment).
Motorola’s profitability is of much greater concern. Since 1998 was a loss year, it is

difficult to properly assess Motorola’s profitability for the two-year period. An ROI of

2.5% (in 1999) is certainly on the low end for a major corporation, although this may

reflect the fact that the company was coming off a loss year. To make a more complete

assessment, it would be appropriate to look at the trend of ROI for Motorola as

compared to the telecommunications industry trend for at least 5 years.
C3-17. d. (continued)

Notice that ROE was significantly higher than ROI in 1999, which indicates that the
company is making effective use of borrowed funds—that is, the company is using
borrowed funds to increase the return to its owners. However, ROE was significantly
lower than ROI in 1998, which indicates that in a loss year, the use of borrowed funds
works against the interest of the company’ stockholders. (The idea of financial
leverage will be introduced in Chapter 7 and expanded upon in Chapter 11.)

e. Margin, or profit margin.

f. Solution approach: Determine the differences between ROI and return on average
invested capital for each year, and then discuss possible explanations of the observed
differences.

The differences to be explained are:
1999   1998
ROI (as calculated in part c) ....................... ................................... 2.5%    –3.4%
Return on average invested capital (as presented by Motorola) ..... 5.5%                          –6.2%

What might explain these differences? We can’t know for sure, because the details of
Motorola’s calculation were not disclosed, but here are some educated guesses:

1. One possibility would be the way in which “invested capital” is calculated by
Motorola as compared to the way “average total assets” is calculated in ROI. It is
unlikely that this would explain the fact that Motorola’s results are nearly twice as
large as those calculated for ROI. However, it is very possible that Motorola does
not consider the “other assets” included on their balance sheet in the calculation of
invested assets. Please see other assets on the balance sheet. If \$11,578 (for 1999)
and \$5,148 (for 1998) were to be excluded from the average total assets calculation
for the 1999 ROI calculation in part c above, the following result would occur:
ROI = Net earnings / Average total assets (excluding “other assets”)
1999 = (\$817 / ((\$28,728 – \$5,148 + \$37,327 – \$11,578) / 2))
= (\$817 / \$24,664.5) = 3.3% ROI
Thus, ROI would increase in 1999 from 2.5% to only 3.3%, so there must be
something else going on.
C3-17. (continued)
f. 2. A more likely explanation would be in the way Motorola defines “return” as
compared to the net earnings figure used in the ROI calculation. Motorola may
define “return” in the numerator as “operating income” or possibly “pretax income”
or some other income statement subtotal. If operating income (rather than net
earnings) were to be used in the 1999 ROI calculation in part c above, the following
result would occur:

ROI = Operating income / Average total assets (excluding “other assets”)

1999 = (\$1,323 / ((\$28,728 – \$5,148 + \$37,327 – \$11,578) / 2))
= (\$1,323 / \$24,664.5) = 5.4% ROI

This gets us much closer to Motorola’s reported result of 5.5%. Undoubtedly, there
are many other possible explanations for the differences observed. Perhaps Motorola
used a more refined measure of average total assets (i.e., average monthly assets).

Similar adjustments could be made using the 1998 ROI data as a starting point, but
we would need to know how much “other assets” were as at December 31, 1997 to

g. The differences to be explained are:
1999    1998
ROE (as calculated in part b) .................................................... 5.7%   –7.5%
Return on average stockholders’ equity (as presented by Motorola) 5.9%                        –7.6%

In this situation with much smaller differences to explain, it is unlikely that there are

significant variations in the numerator. The observed differences probably relate to the

way in which average stockholders’ equity is calculated in the denominator (Motorola’s

calculation is likely to be based upon more precise data).

h. Although different investors may view these trends in different ways (depending on
their           investment objectives), the following observations can be made:

1. Year-end employment: This peaked at 150,000 in 1997, and dropped significantly in
1998 and 1999. Given Motorola’s poor earnings performance during these same
years, an average investor is likely to view this trend favorably. “Downsizing”
efforts, when properly managed, often lead to greater profitability in future years.
C3-17. (continued)

h. 2. Capital expenditures: As a percentage of sales, capital expenditures are generally
decreasing over time, which is not normally considered a healthy sign for a company
having strong growth prospects. Since sales have been relatively flat since 1998 (see
the income statement data), this would be an even greater concern for an investor
who was looking for long-term value. To make a proper analysis of the trend, you
would need to consider the company’s sales growth during the 5-year period, as well
as the actual dollar amounts spent on capital expenditures, and the extent to which
the reduction in capital expenditures relates to company-wide policy decisions (i.e., it
may well be related to an overall downsizing plan).

3. Research and development: As a percentage of sales, R & D expenditures are
generally increasing over time, which is normally considered a healthy sign for a
company having strong growth prospects. At first, this may seem a little strange,
given that the trend in capital expenditures is moving in the opposite direction. Yet,
perhaps it can be explained as an effort on behalf of senior management to make
better utilization of existing facilities and technologies — a recommitment to the
company’s core competencies without over-expanding in terms of physical resources.

i. When analyzing the future growth prospects of most companies, investors would look
most closely at profitability measures, such as the first three items listed. Net earnings
as a percent of sales is a measure of margin. Return on average invested capital is
essentially a measure of ROI. Both of these measures are important to the average
investor. In a single measurement, however, ROE gives an investor the most direct and
meaningful feedback about the company’s performance in terms of their own
investment.

For companies (such as Motorola) in high-tech industries, growth-oriented investors
would also be concerned about trends in R & D, capital expenditures, employment —
because these are all indicators of the company’s ability to survive in an increasingly
competitive global environment. Yet, ROE is the single best measure to an investor.

j. Solution Approach: A “prudent investor” would be wise to take the following factors into
consideration before choosing between alternative investment opportunities:

1. What is the relative risk of the investment? In this case, although Motorola’s common
stock is considered a blue-chip investment, an investor would be interested in knowing
how investment analysts regard the potential risks/rewards of ownership.
C3-17. (continued)
j. 2. How does an investment in Motorola’s common stock "fit" within the investor's overall
portfolio? The text does not cover Modern Portfolio Theory or similar "Finance" topics,
but it is worth noting that individual investments must be considered within the context
of the investor's overall portfolio. An investment in Motorola may appear to be "too
risky" when analyzed in isolation, but it may in fact be risk-reducing and return-
enhancing when viewed as "part of" an investor's overall portfolio.
3. How does an investment in Motorola’s common stock fit within the investor's investing
objectives? Different people invest for different reasons. A young couple in their 20's
or 30's may wish to save for their retirement or for the college education of their
children. As such, they would be more inclined to invest in a "growth" portfolio than
would be a couple in their 60's or 70's who would be more likely to invest in an
"income" oriented portfolio.
4. Additional historical data concerning Motorola and its industry would be helpful in
making a more complete trend analysis. These data might include line-item details from
Motorola’s past income statements, as well as cash flows data, dividends data, and stock
price data.
5. An understanding of current events surrounding the company and its industry, as well as
an understanding of general economic conditions at the time of the proposed investment.

P11-10. a. 1. Margin = (\$1,291 net income / \$26,539 net revenues) = 4.9%
Turnover = Net revenues / Average total assets = \$26,539 / ((\$47,945 + \$44,395) /
2)
= 0.57
ROI = (4.9% margin * 0.57 turnover) = 2.8%
2. ROE = Net income / Average stockholders' equity
= \$1,291 / ((\$37,322 + \$35,830) / 2) = 3.5%

3. Price/earnings ratio = (\$32.24 market value per common share / \$0.19 diluted
earnings per common share outstanding) = 169.7

4. Dividend yield = (\$0.08 dividends declared per share / \$32.24 market value per
common share) = 0.2%

5. Dividend payout ratio = (\$0.08 dividends per common share / \$0.19 diluted
earnings per common share outstanding) = 42.1%

b. 1. Working capital = (\$17,633 current assets - \$6,570 current liabilities)
= \$11,063 million
2. Current ratio = (\$17,633 current assets / \$6,570 current liabilities) = 2.68
3. Acid-test ratio = (\$7,970 cash and cash equivalent + \$2,356 short-term
investments                   + \$1,224 trading assets + \$2,607 accounts receivable) / \$6,570
current liabilities)                = \$14,157 / \$6,570 = 2.15

c. 1. Average day's sales = (\$26,539 annual net revenues / 365 days) = \$72.710
million
Number of days' sales in accounts receivable = (\$2,607 accounts receivable /
\$72.710 average day's sales) = 35.9 days
(Note: This result may be understated to some extent because it is based on the
assumption that all of Intel’s \$26,539 net revenues resulted from credit sales. To
the extent that Intel makes cash sales, the average days’ sales result in the
denominator will decrease, thus causing the number of days’ sales in accounts
receivable to increase.)
2. Average day's cost of goods sold = (\$13,487 annual cost of sales / 365 days) =

\$36.951 million

Number of days' sales in inventory = (\$2,253 inventories / \$36.951 average day's
cost of goods sold) = 61.0 days

3. Accounts receivable turnover = Net revenues / Average accounts receivable
= \$26,539 / ((\$4,129 + \$2,607) / 2) = 7.9 times

4. Inventory turnover = Cost of sales / Average inventories
= (\$13,487 / ((\$2,241 + \$2,253) /2) = 6.0 times

5. Net property, plant and equipment turnover = Net revenues / Average net
property,                    plant and equipment = \$26,539 / ((\$15,013 + \$18,121) / 2) = 1.6
times

d. 1. Debt ratio = (Total liabilities / Total liabilities and stockholders’ equity)
= ((\$6,570 total current liabilities + \$1,050 long-term debt + \$945 deferred
tax                      liabilities) / \$44,395 total liabilities and stockholders’ equity) = \$8,565 /
\$44,395 = 19.3%

2. Debt/equity ratio = (Total liabilities / Total stockholders’ equity)
= ((\$6,570 total current liabilities + \$1,050 long-term debt + \$945 deferred
tax                    liabilities) / \$35,830 total stockholders’ equity) = \$8,565 / \$35,830 =
23.9%

3. Times interest earned = (Earnings before interest and taxes / Interest expense)
= (\$2,256 operating income / \$56) = 40.3 times
(Note: An alternative calculation for the numerator would be: (\$1,291 net income
+ \$56 interest expense + \$892 provision for taxes) = \$2,239. As a result, times interest
earned would be: \$2,239 / \$56 = 40.0 times

e. 1. Net revenues per employee = Net revenues / Average number of employees for the
year = \$26,539 / ((86,100 + 83,400) /2) =\$313,145 per employee

2. Operating income per employee = Operating income / Average number of employees
for the year = \$2,256 / ((86,100 + 83,400) /2) =\$26,619 per employee

P11-12. a.                                                                                                   2000
1999
Current assets (A) ......................................................................... \$30,308
\$21,702
Cash and short-term investments + Accounts receivable (B) .......                              27,048
19,481
Current liabilities (C) ....................................................................    9,755
8,802
Working capital (A - C) ............................................................... \$20,553
\$12,900
Current ratio (A / C) ...................................................................... 3.11
2.47
Acid-test ratio (B / C) ...................................................................      2.77
2.21

b. ROE = Net income / average stockholders’ equity

2000 = \$9,421 / ((\$41,368 + \$28,438 ) /2) = \$9,421 / \$34,903 = 27.0%

1999 = \$7,785 / ((\$28,438 + \$16,627) /2) = \$7,785 / \$22,532.5 = 34.6%

Note to instructors: The above ROE calculations are based on a mix of common and
preferred stockholdings. To calculate ROE to common stockholders, the following details
regarding Microsoft’s preferred stock would be required:
2000 1999 1998
Preferred stock (on June 30 balance sheets) ................................. \$ -- \$980
\$980            Preferred stock dividends (declared and paid for the year) . 13                 28
28

ROE to common stockholders = Net income available to common stockholders /
average                common stockholders’ equity

2000 = (\$9,421 – \$13) / ((\$41,368 + \$28,438 – \$980) /2)
= \$9,408 / \$34,413 = 27.3%

1999 = (\$7,785 – \$28) / ((\$28,438 – \$980 + \$16,627 – \$980) /2)
= \$7,757 / \$21,552.5 = 36.0%

c. ROI = Margin * Turnover
= (Net income / Revenue) * (Revenue / Average total assets)

2000 = (\$9,421 / \$22,956) * (\$22,956 / ((\$38,625 + \$52,150) / 2))
= (41.0% Margin * 0.51 Turnover) = 20.8% ROI

1999 = (\$7,785 / \$19,747) * (\$19,747 / ((\$22,357 + \$38,625) / 2))
= (39.4% Margin * 0.65 Turnover) = 25.5% ROI
P11-12. d. Price/earnings ratio = (Market price per share at year-end / Diluted earnings per share)

June 30, 2000 = \$80.00 / \$1.70 = 47.1
June 30, 1999 = \$90.19 / \$1.42 = 63.5

e. 1. Accounts receivable turnover = Revenue / Average accounts receivable
= \$22,956 / ((\$2,245 + \$3,250) / 2) = 8.4 times

2. Average day's sales = (\$22,956 revenue / 365 days) = \$62.893 million
Number of days' sales in accounts receivable = (\$3,250 accounts receivable /
\$62.893 average day's sales) = 51.7 days

f. 1. Debt ratio = (Total liabilities / Total liabilities and stockholders’ equity)
June 30, 2000 = (\$9,755 + \$1,027) / \$52,150 = 20.7%
June 30, 1999 = (\$8,802 + \$1,385) / \$38,625 = 26.4%

2. Debt/equity ratio = (Total liabilities / Total shareholders’ equity)

June 30, 2000 = (\$9,755 + \$1,027) / \$41,368 = 26.1%
June 30, 1999 = (\$8,802 + \$1,385) / \$28,438 = 35.8%

g. If stockholders were to have received dividends from Microsoft, they would not
have             been able to earn an ROE of 27.0% in 2000, or 34.6% in 1999, by reinvesting
the                dividends in other firms. Thus, stockholders of highly profitable firms
such as                   Microsoft are not inclined to place strong dividend pressures on the
firm--because
the firm does a better job managing their investment than they could do themselves.
Many stockholders also wish to avoid the tax consequences of current dividends, and
favor “growth” stocks--but the primary reason is that Microsoft can make their
money grow rapidly, via stock price appreciation.

h. Microsoft Corporation has gone through an extended period of sustained growth,
and             has achieved extraordinary levels of profitability. The firm carries no long-
term debt,            and does a good job at managing its accounts receivables. Because
Microsoft has                 been able to “corner the market,” the firm’s future earnings
prospects are also                       outstanding, as suggested by the high price/earnings
ratio. Although the company has                 been under the microscope in recent years
concerning its protracted antitrust litigation             battle, the future of Microsoft
Corporation still remains quite strong.
P11-12. h. (continued)

Note that a substantial portion of the company’s assets are held in cash and short-
term investments. Since Microsoft sells computer software (i.e., intellectual property), the
“cost of revenues” is unusually low, and gross profit is unusually high. This also
allows the company to minimize its investment in inventory and in long-term
(production-type) assets. Inventories are now so small that they are no longer
reported separately on the balance sheet.

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