End of Chapter 2 Questions_ Problems and Solutions

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					End of Chapter 2 Questions, Problems and Solutions CORPORATE FINANCE Professor Megginson Spring Semester 2003 Questions
2-1) What information (explicit and implicit) can be derived from financial statement analysis? Does the standardization required by GAAP add greater validity to comparisons of financial data between companies and industries? Are there possible shortcomings to relying solely on financial statement analysis to value companies? Distinguish between the types of financial information contained in the various financial statements. Which statements provide information on a company’s performance over a reporting period and which present data on a company’s current position? What sort of valuable information may be found in the notes of financial statements? Describe a situation in which the information contained in the notes would be essential to making an informed decision about the value of a corporation. If you were a commercial credit analyst charged with the responsibility of making an accept/reject decision on a company’s loan request, with which financial statement would you be most concerned? Which financial statement is most likely to provide pertinent information about a company’s ability to service its debt? What is cash flow from operations? How is it calculated? What benefit does the firm receive from the presence of ―noncash charges‖? What is operating cash flow (OCF)? How is it calculated? Why do financial managers prefer this measure of operating flows over the accountants’ use of cash flow from operations? What is free cash flow (FCF)? How is it calculated from operating cash flow (OCF)? Why do financial managers focus attention on the value of FCF? Describe the common definitions of ―inflows of cash‖ and ―outflows of cash‖ used by analysts to classify certain balance sheet changes and income statement values. What three categories of cash flow are used in the statement of cash flows? To what value should the net value in the statement of cash flows reconcile? What precautions must one take when using ratio analysis to make financial decisions? Which ratios would be more useful for a financial manager’s internal financial analysis? How about an analyst trying to decide on which stocks are most attractive within an industry? How do analysts use ratios to analyze a firm’s leverage? Which ratios convey more important information to a credit analyst—those revolving around the levels of indebtedness or those measuring the ability to service debt? What is the relationship between a firm’s level of indebtedness and risk? What must happen in order for an increase in leverage to be successful? How is the DuPont formula useful in analyzing a firm’s ROA and ROE? What information can be inferred from the decomposition of ROE into contributing ratios? What is the mathematical relationship between each of the individual components (net profit margin, total asset turnover, and financial leverage multiplier) and ROE? Can ROE be raised without affecting ROA? How?










********************************************************* Answers to End of Chapter Questions 2-1. Financial statement analysis provides information about the company’s financial health, and its strengths and weaknesses. Using standardized GAAP rules does add validity by making comparisons between companies easier. Possible shortcomings include:  If a company is in multiple lines of business it may be difficult to make comparisons  The accounting data may not be accurate  Average performance may not be a good measure, especially if the industry is in a slump  It is possible to manipulate accounting numbers. Data on a company’s performance over a reporting period: income statement, statement of cash flows, statement of retained earnings (how much additional retained earnings will be added to existing retained earnings) Data on a company’s performance about the company’s current position: balance sheet Notes to the financial statements contain details about the composition and cost of the companies debt, any liabilities such as lawsuits that are still pending, revenue recognition, taxes, significant clients, detailed breakdowns of fixed asset accounts, executive compensation, descriptions of employee benefit plans. An example of a situation in which the notes would be essential to valuation would be a company that relied on a few clients, rather than a wide base of clients. The notes would detail current and expected revenue from those clients and how that revenue would be recognized. An analyst would need this information to develop a set of cash flows for the company which would provide the basis of a company valuation. An analyst looking at granting a loan request would be most interested in the company’s balance sheet which she could use to compute liquidity ratios (current and quick ratios) and debt ratios. A credit analyst would also want an income statement with EBIT and interest with which to compute times interest earned. Times interest earned is a measure of how well a company can pay its interest obligations, while liquidity and debt ratios show what assets are available to repay debt. Cash flow from operations is net income plus noncash charges (usually depreciation). It is calculated by taking net income from the income statement and adding back depreciation and other noncash charges from the income statement. Noncash charges are subtracted to compute taxable income, so a company will have a lower tax bill if it has larger noncash charges. Operating cash flow is earnings before interest and taxes minus taxes plus depreciation. Financial analysts like this measure because it uses only operating flows, with no financing cash flows like interest. This makes it easier to separate the effects of operating decisions from those from financing decisions. Free cash flow is operating cash flow minus change in fixed assets minus change in current assets plus change in accounts payable and change in accruals. Managers care about free cash flows because these are frequently used in valuation. The value of an asset (or company) is the discounted sum of its expected cash flows. A cash inflow is an increase in liabilities or a decrease in assets. A cash outflow occurs when there is a decrease in liabilities or an increase in assets. A statement of cash flows is divided into







operating cash flows, financing cash flows and investment cash flows. For a historical statement of cash flows, the cash outflows for the period must equal the cash inflows for the period. 2-8. With ratio analysis it is important to know the reliability of the data and the methods of accounting used to provide data for the analysis. A manager interested in internal control will focus on activity ratios, which measure the firm’s efficiency in its use of its assets, and profitability ratios, which show a firm’s returns. A financial analyst may be more interested in market ratios, which show how the market is evaluating the firm. Analysts use debt ratios to determine the firm’s financial leverage, its use of debt financing. A credit analyst is going to be concerned with a firm’s ability to repay its obligations. She will care about times interest earned which demonstrates the firm’s ability to pay its interest, and current and quick ratio, which show how much in short term assets the firm has compared to its short term liabilities. Financial leverage adds risk to a firm – the more debt, the more risk, but also the more potential reward to shareholders. For an increase in financial leverage to be successful, the firm must be profitable and earn enough to justify the additional interest expense. The DuPont system is useful in breaking down ROE and ROA into its component parts. If ROE is increasing (decreasing), a manager can see if the cause is a higher (lower) profit margin, a higher (lower) asset turnover or a higher (lower) equity multiplier. Then if one of the components is improving (declining) the firm can take steps to pay attention to that area of the business. ROE is equal to ROA times the equity multiplier. It would be possible to raise ROE by choosing to finance the firm more aggressively, even if ROA remained the same.




Problems [See problems in book] ********************************************************* Solutions to End of Chapter Problems 2-1) 2-2) Internet exercise a. Cash flow from operations = net profits after taxes + noncash charges = $2,400 + $1,600 (deprec) = $4,000 = 2,400 + 11,600 = $14,000 b. Operating cash flow = EBIT – taxes + depreciation = $4,500 -$1,300 + $1,600 = $4,800 = 4500 – 1,300 + 11,600 = $14,800 c. Free cash flow = OCF -  FA – (CA - A/P - accruals) = 4,800 – (16,800 - 17,000) – [(16,200 - 14,800) – (3,600 – 3,500) – (1,200 – 1,300)] = 4,800 – (-200) – 1,400 – 100 – (-100) = 4,800 + 200 – 1,400 –100 +100 = $3,600 = 14800 – 200 – (-1,400-(-100) – 100) = $16,000


Operating cash flow is higher than CFFO because operating does not include interest expense, while this is part of net income. Free cash flow not only looks at operations but all looks at whether a company has added assets or reduced liabilities uses of cash) or reduced assets and increased liabilities (sources of cash).

2-3) Cash + 600 (O) Accounts payable –1,200 (O) Notes payable +800 (I) Long-term debt –2,500 (O) Inventory + 400 (O) Fixed assets +600(O) Accounts receivable –900 (I) Net profits +700 (I) Depreciation +200 (I) Repurchase of stock +500 (O) Cash Dividends +300 (O) Sale of Stock +1,300 (I) 2-4) Ratio Debt

Definition Debt Total Assets Long-Term Debt Equity EBIT Interest

Calculation $36,500,000 $50,000,000 $20,000,000 $13,500,000 $3,000,000 $1,000,000

Aluminum 73

Industry Avg. .51




Times Interest Earned



Because Aluminum Industries, Inc. has a much higher degree of indebtedness and much lower ability to service debt than the average firm in the industry, the loan should be rejected. 2-5) ROE = Net Profit Margin (NPM) x Total Asset Turnover (TAT) x Financial leverage multiplier (A/E) ROE HM = $ 4,200,000 x $ 75,000,000 x $ 100,000,000 $75,000,000 $100,000,000 $ 40,000,000 ROE HM = ROE HM = .056 10.5 % $ 80,000,000 $ 30,000,000 2.67 x .75 2.50

ROE MS = $ 4,200,000 x $ 50,000,000 x $ 50,000,000 $ 80,000,000 ROE MS = ROE MS = .084 14.0% x .625 x

Metallic Stamping (MS) has an ROE of 14% as compared to 10.5% for Heavy Metal (HM). While Heavy Metal utilizes its assets more efficiently (TAT= .75 vs. .625 for Metallic Stamping), Metallic converts a greater percentage of sales into net income (NPM = .084 vs. .056 for Heavy Metal) and makes greater use of financial leverage, given its slightly higher financial leverage multiplier (2.67 vs 2.50 for Heavy Metal). 2-6) ROE HTS = $ 24,000,000 x $ 100,000,000 x $100,000,000 $100,000,000 $ 100,000,000 $ 90,000,000 ROE HTS = ROE HTS = .24 26.7% x 1 x 1.11

Heavy Metal has a lower ROA (.056 x .75 = .042 vs .24 x1 = .24 for HTS) and a higher financial leverage multiplier (2.50 vs. 1.11 for HTS) than High Tech Software, Inc. Because the average values of the three ROE components are industry-specific, DuPont analysis across industries is not very meaningful. 2-7) 2-8) Internet exercise Income Statement for Aluminum Industries Common Size % 100% 70% 30% 10% 6% 0.67% 3.33% 20% 10% 3.33% 6.67% 2.67% 4.00%

Sales Cost of goods sold Gross Profit Selling expense G&A expense Lease expense Depreciation Total operating expense Operating Profits Interest Expense Net Profit before taxes Taxes Net Profit after taxes

$30,000,000 21,000,000 9,000,000 3,000,000 1,800,000 200,000 1,000,000 6,000,000 3,000,000 1,000,000 2,000,000 800,000 $ 1,200,000

Sales have declined from $35 million to $30 million and cost of goods sold has increased as a percentage of sales (from 65.9% in 2003 to 70% in 2004), probably due to a loss of productive efficiency. Total operating expenses have decreased as a percent of sales (from 23.2% in 2003 to 20.0% in 2004); this appears favorable unless this decline has contributed toward the fall in sales. The level of interest as a percentage of sales has increased significantly (from 1.5% in 2003 to 3.3% in 2004); this is likely attributable to the firm’s relatively high debt levels in 2004. Further analysis should be therefore focus on the firm’s increased cost of goods sold and its high level of debt.

Sales Cost of goods sold Gross Profit Selling expense G&A expense

$35,000,000 23,065,000 11,935,000 4,445,000 2,205,000

Lease expense Depreciation Total operating expense Operating Profits Interest Expense Net Profit before taxes Taxes Net Profit after taxes $

210,000 1,260,000 8,120,000 3,815,000 525,000 3,290,000 1,330,000 1,960,000

2-9) Greta’s Groovy Gadgets a) Net Profit Margin = $ 180,000 = .045 = 4.5% $ 4,000,000 Total Asset Turnover = $ 4,000,000 = 2.00 $ 2,000,000 Financial Leverage Multiplier = $2,000,000 = 2.00 $1,000,000 Return on Total Assets (ROA)=Net Profit Margin xTotal Asset Turnover=0.045x2.00=0.09= 9% Return on Equity (ROE) = Return on Total Assets xFinancial Leverage Multiplier = 0.09 x 2.00 = .18 = 18% b) Sales Expenses (.90 x $6,000,000) EBIT Interest (.10 x $2,000,000) EBT Taxes @ 40% Net Income $6,000,000 5,400,000 $ 600,000 200,000 $ 400,000 160,000 $ 240,000 Current Assets Fixed Assets Total Assets Current Liabilities Long-Term Debt (@ 10%) Total Liabilities Common Equity Total Liab. & S/H Equity $ 0 $ 3,000,000 $ 3,000,000 $ 0 2,000,000 $2,000,000 $1,000,000 $3,000,000

Net Profit Margin = $ 240,000 = .04 = 4% $6,000,000 Total Asset Turnover = $ 6,000,000 = 2.00 $3,000,000 Financial Leverage Multiplier = $ 3,000,000 = 3.00 $1,000,000 Return on Total Assets (ROA) = 4% x 2.00 = 8% Return on Equity (ROE)= 8% x 3.00 = 24% As measured by ROE, which increases from 18% to 24%, the purchase of the assets is a success. c) Sales Expenses (.90 x $4,500,000) EBIT $4,500,000 4,050,000 $ 450,000 Current Assets Fixed Assets Total Assets $ 0 3,000,000 $3,000,000

Interest (.10 x $2,000,000) EBT Taxes @ 40% Net Income

200,000 $ 250,000 100,000 $ 150,000

Current Liabilities $ 0 Long-Term Debt 2,000,000 Total Liabilities $2,000,000 Common Equity 1,000,000 Total Liab. & S/H Equity $3,000,000

Net Profit Margin = $ 150,000 = .0333 = 3.33% $4,500,000 Total Asset Turnover = $4,500,000 = 1.50 $3,000,000 Equity Multiplier = Assets ÷ Equity = $3,000,000 ÷ $1,000,000 = 3.00 [Delete: not defined in text] Financial Leverage Multiplier = $3,000,000 = 3.00 $1,000,000

Return on Total Assets (ROA) = 3.33% x 1.50 = 5% Return on Equity (ROE) = 5% x 3.00 = 15% In this case, the acquisition of assets lowers ROE (from 18%to 15%) and therefore is not a good investment. d) The financial leverage multiplier [Delete: not defined in text] The equity multiplier is affected only by the financing decision – not by changes in sales. This implies that ROE can be enhanced by an increase in financial leverage only if the assets purchased with the debt are utilized at least as efficiently as existing assets in generating sales and in earning net income on those sales.

2-10) Balance Sheet Item


Debt Financing Stock Financing

Current Assets Fixed Assets Total Assets Current Liabilities Long-Term Debt Total Liabilities Common Equity Total Liabilities & S/H Equity

$ 250,000 750,000 $1,000,000 $ 300,000 0 $ 300,000 $ 700,000 $1,000,000

$ 250,000 3,750,000 $4,000,000 $ 300,000 3,000,000 $3,300,000 $ 700,000 $4,000,000

$ 250,000 3,750,000 $4,000,000 $ 300,000 0 $ 300,000 $3,700.000 $4,000,000

Income Statement Items Sales Expenses @ 40% EBIT $500,000 200,000 $300,000 $1,500,000 600,000 $ 900,000 $1,500,000 600,000 $ 900,000

Interest Expense (.10 x L-T Debt) Net Profit Before Taxes Taxes @ 40% Net Income

0 $300,000 120,000 $180,000

300,000 $ 600,000 240,000 $ 360,000 51.43%

0 $ 900,000 360,000 $ 540,000 14.59%

ROE (Net Income ÷ Stockholder’s Equity) 25.71%

All else remaining the same, Tracey should expand her operations using debt financing because this strategy will double her firm’s ROE. 2-11) Financial Statement Analysis a. Access Corporation Ratio Analysis Industry Average 1.80 0.70 2.50 37 days 72 days 50% 3.8 38% 3.5% 4.0% 9.5% 1.1 Actual 2003 1.84 0.78 2.59 36 days 78 days 51% 4.0 40% 3.6% 4.0% 8.0% 1.2 Actual 2004 1.04 0.38 2.33 56 days 76 days 40% 2.8 34% 4.1% 4.4% 11.3% 1.3

Current ratio Quick ratio Inventory turnover Average collection period Average payment period Debt-equity ratio Times interest earned Gross profit margin Net profit margin Return on total assets (ROA) Return on equity (ROE) Market/book (M/B) ratio

b. (1) Liquidity: Access Corporation’s liquidity position has deteriorated from 2003 to 2004 and is inferior to the industry average. The firm may not be able to satisfy short-term obligations as they come due. (2) Activity: Access’ ability to convert assets into cash has deteriorated from 2003 to 2004. Examination into the cause of the 20 day 21 day increase in the average collection period is warranted. Inventory turnover has also decreased for the period under review and is OK when compared to the industry. The firm may be holding slightly excessive inventory. Average payment period has stayed about the same. (3) Debt: Access’ long-term debt position has improved since 2003 and is significantly below the industry average. Access Corp.’s ability to service interest payments has deteriorated and is well below the industry average. (4) Profitability: Although the company’s gross profit margin is below its industry average, indicating high cost of goods sold, the firm has a superior net profit margin in comparison to the industry average. The firm has lower than average operating expenses. The firm has a superior return on investment and return on equity in comparison to the industry and shows an upward trend. Market: The firm’s increasing and above-industry-average market/book ratio indicates that investors are willing to pay an increasing and above-industry-average amount for each dollar of book value. Clearly investors have possible expectations of the firm’s future success. Overall, the firm maintains superior profitability at the risk of illiquidity. Investigation into the management of accounts receivable and inventory is warranted. Regardless, investors appear to feel positively about the firm’s future prospects. 2-12 Complete Ratio Analysis

MBA Company Ratio Analysis Actual 2002 1.40 1.00 9.52 45.0 days 58.5 days 1.08 0.74 0.20 0.25 8.2 0.30 0.12 0.067 0.049 0.066 $1.75 12.0 1.2 Actual 2003 1.55 0.92 9.21 36.4 days 60.8 days 1.05 0.80 0.20 0.27 7.3 0.27 0.12 0.067 0.054 0.073 $2.20 10.5 1.05 Actual 2004 1.67 0.88 7.89 28.8 days 43.8 days 1.11 0.83 0.35 0.38 6.5 0.25 0.13 0.066 0.055 0.085 $3.05 13.0 1.16 Industry 2004 1.85 1.05 8.60 35 days 45.8 days 1.07 0.74 0.30 0.39 8.0 0.25 0.10 0.058 0.043 0.072 $1.50 11.2 1.10 Time Series (TS) Cross-Sectional (CS) TS: Improving CS: Fair TS: Deteriorating CS: Poor TS: Deteriorating CS: Fair TS: Improving CS: Good TS: Improving CS: Good TS: Stable CS: Good TS: Improving CS: Good TS: Increasing CS: Fair TS: Increasing CS: Good TS: Deteriorating CS: Poor TS: Deteriorating CS: Good TS: Improving CS: Good TS: Stable CS: Good TS: Improving CS: Good TS: Improving CS: Good TS: Improving CS: Good TS: Improving CS: Good TS: Improving CS: Good

Ratio Current ratio Quick ratio Inventory turnover Average collection period Average payment period Fixed asset turnover Total asset turnover Debt ratio Debt-equity ratio Times interest earned Gross profit margin Operating profit margin Net profit margin Return on total assets (ROA) Return on equity (ROE) Earnings per share (EPS) Price/earnings (P/E) Market/book (M/B)

Liquidity: MBA Company’s overall liquidity as reflected by the current ratio and quick ratio appears to have remained relatively stable but both are below the industry average. The quick ratio is particularly poor. Activity: The activity of accounts receivable has improved, but inventory turnover has deteriorated and is currently below the industry average. It has brought its long payables down to below the industry average. Debt: The firm’s debt ratios have increased from 2002 and are very close to the industry averages, indicating currently acceptable values but an undesirable trend. Profitability: The firm’s gross profit margin, while in line with the industry average, has declined,

probably due to higher cost of goods sold. The operating and net profit margins have been stable and are also in the range of the industry averages. Both the return on total assets and return on equity appear to have improved slightly and are better than the industry averages. Earnings per share made a significant increase in 2003 and 2004. Market: The price/earnings (P/E) ratio indicates and improved level of investor confidence in the firm’s future earnings potential, perhaps due to the benefits of the financial leverage reflected in the firm’s increased debt load and higher servicing requirements. The market/book (M/B) ratio also reflects improved and above-industry-average investor confidence in the firm in 2004. In summary, the firm needs to attend to inventory and should not incur added debts until their leverage and interest coverage ratios are improved. Other than these indicators, the firm appears to be doing well-particularly in generating return on sales. *********************************************************

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