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Solutions Manual for Foundations of Financial Management, 18th Edition by Stanley Block, Geoffrey Hirt, Bartley Danielsen Chapter 1 The Goals and Functions of Financial Management Discussion Questions 1-1

What effect did the recession of 2007-2009 have on government regulation? It was greatly increased.

1-2

What advantages does a sole proprietorship offer? What is a major drawback of this type of organization? A sole proprietorship offers the advantage of simplicity of decision making and low organizational and operating costs. A major drawback is that there is unlimited liability to the owner.

1-3

What form of partnership allows some of the investors to limit their liability? Explain briefly. A limited partnership allows some of the partners to limit their liability. Under this arrangement, one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners are designated limited partners and are liable only for their initial contribution. The limited partners are normally prohibited from being active in the management of the firm.

1-4

In a corporation, what group has the ultimate responsibility for protecting and managing the stockholders’ interests? The board of directors.

1-5

What document is necessary to form a corporation? The articles of incorporation.

1-6

What issue does agency theory examine? Why is it important in a public corporation rather than in a private corporation?

Agency theory examines the relationship between the owners of the firm and the managers of the firm. In privately owned firms, management and the owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements and the like. As a company moves from private to public ownership, management now represents all owners. This places management in the agency position of making decisions in the best interest of all shareholders. 1-7

What are institutional investors important in today’s business world? Because institutional investors such as pension funds and mutual funds own a large percentage of major U.S. companies, they are having more to say about the way publicly owned companies are managed. As a group, they have the ability to vote large blocks of shares for the election of a board of directors, which is supposed to run the company in an efficient, competitive manner. The threat of being able to replace poor performing boards of directors makes institutional investors quite influential. Since these institutions, like pension funds and mutual funds, represent individual workers and investors, they have a responsibility to see that the firm is managed in an efficient and ethical way.

1-8

Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of maximization of shareholder wealth? The problem with a profit maximization goal is that it fails to take account of risk, the timing of the benefits is not considered, and profit measurement is a very inexact process. The goal of shareholders’ wealth maximization implies that the firm will attempt to achieve the highest possible total valuation in the marketplace. It is the one overriding objective of the firm and should influence every decision.

1-9

When does insider trading occur? What government agency is responsible for protecting against the unethical practice of insider trading? Insider trading occurs when anyone with non-public information buys or sells securities to take advantage of that private information. The Securities and Exchange Commission is responsible for protecting markets against insider trading. In the past, people have gone to jail for trading on non-public information. This has included company officers, investment bankers, printers who have information before it is published, and even truck drivers who deliver business magazines and read positive or negative articles about a company before the magazine is on the newsstands and then place trades or have friends place trades based on that information. The SEC has prosecuted anyone who profits from inside information.

1-10

In terms of the life of the securities offered, what is the difference between money and capital markets? Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Capital markets refer to securities with a life of more than one year.

1-11

What is the difference between a primary and a secondary market?

A primary market refers to the use of the financial markets to raise new funds for the corporation. After the securities are sold to the public (institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. 1-12

Assume you are looking at many companies with equal risk. Which ones will have the highest stock prices? Given companies with equal risk, those companies with expectations of high return will have higher common stock prices relative to those companies with expectations of poor returns.

1-13

How is the time value of money concept related to the valuation of stocks? The value of an investment that is expected to earn money in the future can be calculated using time-value of money principles. Corporations are expected to pay dividends to their shareholders. The current value of these future dividends is the present value. The present value of a stock’s future dividends should be the same as the stock’s current price.

Chapter 2 Review of Accounting Discussion Questions 2-1.

Discuss some financial variables that affect the price-earnings ratio.

The price-earnings ratio will be influenced by the earnings and sales growth of the firm, the risk or volatility in performance, the debt-equity structure of the firm, the dividend payment policy, the quality of management, and a number of other factors. The ratio tends to be future-oriented, and the more positive the outlook, the higher it will be.

2-2.

What is the difference between book value per share of common stock and market value per share? Why does this disparity occur?

Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and preferred stock and dividing by the number of common shares

outstanding. It is based on the historical cost of the assets. Market value per share is based on the current assessed value of the firm in the marketplace and may bear little relationship to original cost. Besides the disparity between book and market value caused by the historical cost approach, other contributing factors are the growth prospects for the firm, the quality of management, and the industry outlook. To the extent these are quite negative or positive; market value may differ widely from book value.

2-3.

Explain how depreciation generates actual cash flows for the company.

The only way depreciation generates cash flows for the company is by serving as a tax shield against reported income. This non-cash deduction may provide cash flow equal to the tax rate times the depreciation charged. This much in taxes will be saved, while no cash payments occur.

2-4.

What is the difference between accumulated depreciation and depreciation expense? How are they related?

Accumulated depreciation is the sum of all past and present depreciation charges, while depreciation expense is the current year’s charge. They are related in that the sum of all prior depreciation expense should be equal to accumulated depreciation (subject to some differential related to asset write-offs).

2-5.

How is the income statement related to the balance sheet?

The earnings (less dividends) reported in the income statement is transferred to the ownership section of the balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the ownership interest in the balance sheet.

2-6.

Comment on why inflation may restrict the usefulness of the balance sheet as normally presented.

The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data may lose much of their meaning—particularly for plant and equipment and

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inventory.

2-7.

Explain why the statement of cash flows provides useful information that goes beyond income statement and balance sheet data.

The income statement and balance sheet are based on the accrual method of accounting, which attempts to match revenues and expenses in the period in which they occur. However, accrual accounting does not attempt to properly assess the cash flow position of the firm. The statement of cash flows fulfills this need.

2-8.

What are the three primary sections of the statement of cash flows? In what section would the payment of a cash dividend be shown?

The sections of the statement of cash flows are:

Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities

The payment of cash dividends falls into the financing activities category.

2-9.

What is free cash flow? Why is it important to leveraged buyouts?

Free cash flow is equal to cash flow from operating activities:

Minus:

Capital expenditures required to maintain the productive capacity of the firm.

Minus:

Dividends (required to maintain the payout on common stock and to cover any preferred stock obligation).

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The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buyout. 2-10.

Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay?

Interest expense is a tax-deductible item to the corporation, while dividend payments are not. The net cost to the corporation of interest expense is the amount paid multiplied by the difference of one minus the applicable tax rate.

For example, $100 of interest expense costs the company $65 after taxes when the corporate tax rate is 35 percent—for example, $100 × (1 – 0.35) = $65.

Problems 1.

2-1.

Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $410,000 in the year 20X1 with 301,000 shares outstanding. On January 1, 20X2, the firm issued 30,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 25 percent. a.

Compute earnings per share for the year 20X1.

Compute earnings per share for the year 20X2.

Solution:

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Frantic Fast Foods a. Year 20X1

= $410,000 / 301,000 = $1.36 b. Year 20X2 Earnings after taxes = $410,000 × 1.25 = $512,500 Shares outstanding = 301,000 + 30,000 = 331,000

Earnings per share = $512,500 / 331,000 = $1.55

2-2.

Income statement (LO1) Sosa Diet Supplements had earnings after taxes of $800,000 in the year 20X1 with 200,000 shares of stock outstanding. On January 1, 20X2, the firm issued 50,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent. a.

Compute earnings per share for the year 20X1.

Compute earnings per share for the year 20X2.

Solution: Sosa Diet Supplements a. Year 20X1

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Earnings per share = Earnings after taxes Shares outstanding = $800,000 = $4.00 200,000 b. Year 20X2

Earnings after taxes  $800,000  1.30  $1,040,000 Shares outstanding  200,000  50,000  250,000 Earning per share  $1,040,000  $4.16 250,000

2-3.

Gross profit (LO1) Swank Clothiers had sales of $375,000 and cost of goods sold of $246,000. What is the gross profit margin (ratio of gross profit to sales)?

If the average firm in the clothing industry had a gross profit of 30 percent, how is the firm doing?

Solution: Swank Clothiers a. Sales............................................................ $375,000 Cost of goods sold ........................ 246,000 Gross Profit ........................$129,000

b. With a gross profit of 34 percent, the firm is outperforming the industry average of 30 percent.

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2-4.

Operating profit (LO1) A-Rod Fishing Supplies had sales of $2,500,000 and cost of goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s operating profit?

Solution:

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A-Rod Fishing Supplies Sales ........................$2,500,000 Cost of goods sold ........................1,710,000 Gross Profit ........................790,000 Selling and administrative expense* ............. 250,000 Depreciation expense** ........................280,800 Operating profit ........................$ 259,200 * 10% × $2,500,000 = $250,000 ** 6% × $4,680,000 = $280,800 5.

Income statement (LO1) Arrange the following income statement items so they are in the proper order of an income statement: Taxes

Earnings per share

Shares outstanding

Earnings before taxes

Interest expense

Cost of goods sold

Depreciation expense

Earnings after taxes

Preferred stock dividends

Earnings available to common

Operating profit Sales

stockholders Selling and administrative expense

Gross profit

2-5.

Solution: Sales – Cost of goods sold Gross profit – Selling and administrative expense

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– Depreciation expense Operating profit – Interest expense Earnings before taxes – Taxes Earnings after taxes – Preferred stock dividends

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Earnings available to common stockholders Shares outstanding Earnings per share

Income statement (LO1) Given the following information, prepare an income statement for the Dental Drilling Company.

Selling and administrative expense ............................................... $ 112,000

2-6.

Depreciation expense ....................................................................

73,000

Sales ...............................................................................................

489,000

Interest expense ............................................................................

45,000

Cost of goods sold ..........................................................................

156,000

Taxes ..............................................................................................

47,000

Solution: Dental Drilling Company Income Statement Sales ........................$ 489,000 Cost of goods sold ........................$ 156,000 Gross profit ........................$ 333,000 Selling and administrative expense ............... $ 112,000 Depreciation expense ........................$ 73,000 Operating profit ........................$ 148,000 Interest expense ........................$ 45,000 Earnings before taxes ........................$ 103,000 Taxes ........................$ 47,000 Earnings after taxes ........................ $ 56,000

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Income statement (LO1) Given the following information, prepare in good form an income statement for Jonas Brothers Cough Drops.

Selling and administrative expense ............................................... $ 328,000 Depreciation expense ....................................................................

195,000

Sales ............................................................................................... 1,660,000

2-7.

Interest expense ............................................................................

129,000

Cost of goods sold ..........................................................................

560,000

Taxes ..............................................................................................

171,000

Solution: Jonas Brothers Cough Drops Income Statement Sales ........................$1,660,000 Cost of goods sold ........................560,000 Gross profit ........................1,100,000 Selling and administrative expense ............... 328,000 Depreciation expense ........................195,000 Operating profit ........................ 577,000 Interest expense ........................ 129,000 Earnings before taxes ........................ 448,000 Taxes ........................ 171,000 Earnings after taxes $.......................277,000

Determination of profitability (LO1) Prepare in good form an income statement for Franklin Kite Co. Inc. Take your calculations all the way to computing earnings per share.

Sales ...............................................................................................

$900,000

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2-8.

Shares outstanding ........................................................................

50,000

Cost of goods sold ..........................................................................

400,000

Interest expense ............................................................................

40,000

Selling and administrative expense ...............................................

60,000

Depreciation expense ....................................................................

20,000

Preferred stock dividends ..............................................................

80,000

Taxes ..............................................................................................

50,000

Solution: Franklin Kite Company Income Statement Sales ........................$900,000 Cost of goods sold ........................400,000 Gross profit ........................500,000 Selling and administrative expense ............... 60,000 Depreciation expense ........................20,000 Operating profit ........................$420,000 Interest expense ........................40,000 Earnings before taxes ........................$380,000 Taxes ........................50,000 Earnings after taxes ........................$330,000 Preferred stock dividends ........................80,000 Earnings available to common stockholders . 250,000 Shares outstanding ........................50,000 Earnings per share ........................$5.00

Determination of profitability (LO1) Prepare an income statement for Virginia Slim Wear. Take your calculations all the way to computing earnings per share.

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Sales ............................................................................................... $1,360,000

2-9.

Shares outstanding ........................................................................

104,000

Cost of goods sold ..........................................................................

700,000

Interest expense ............................................................................

34,000

Selling and administrative expense ...............................................

49,000

Depreciation expense ....................................................................

23,000

Preferred stock dividends ..............................................................

86,000

Taxes ..............................................................................................

100,000

Solution:

Virginia Slim Wear Income Statement Sales ........................$1,360,000 Cost of goods sold ........................ 700,000 Gross profit ........................660,000 Selling and administrative expense ............... 49,000 Depreciation expense ........................ 23,000 Operating profit ........................588,000 Interest expense ........................ 34,000 Earnings before taxes ........................554,000 Taxes ........................ 100,000 Earnings after taxes ........................454,000 Preferred stock dividends ........................86,000 Earnings available to common stockholders .$ 368,000 Shares outstanding ........................104,000 Earnings per share ........................$ 3.54 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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10.

Income statement (LO1) Precision Systems had sales of $820,000, cost of goods of $510,000, selling and administrative expense of $60,000, and operating profit of $103,000. What was the value of depreciation expense? Set this problem up as a partial income statement and determine depreciation expense as the plug figure.

2-10. Solution: Precision Systems Sales ........................$820,000 Cost of goods sold ........................510,000 Gross profit ........................310,000 Selling and administrative expense ............... 60,000 Depreciation (plug figure) ........................ 147,000 Operating profit ........................$103,000

11.

Depreciation and earnings (LO1) Stein Books Inc. sold 1,900 finance textbooks for $250 each to High Tuition University in 20X1. These books cost $210 to produce. Stein Books spent $12,200 (selling expense) to convince the university to buy its books. Depreciation expense for the year was $15,200. In addition, Stein Books borrowed $104,000 on January 1, 20X1, on which the company paid 12 percent interest. Both the interest and principal of the loan were paid on December 31, 20X1. The publishing firm’s tax rate is 30 percent. Did Stein Books make a profit in 20X1? Please verify with an income statement presented in good form.

2-11. Solution: Stein Books Inc. Income Statement For the Year Ending December 31, 20X1

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Sales (1,900 books at $250 each) ................................. $475,000 Cost of goods sold (1,900 books at $210 each) ........... 399,000 Gross profit ....................................... 76,000 Selling expense ....................................... 12,200 Depreciation expense ...................................... 15,200 Operating profit…… ....................................... $ 48,600 Interest expense ($104,000 × 12%).............................. 12,480 Earnings before taxes ....................................... 36,120 Taxes @ 30% ....................................... 10,836 Earnings after taxes ....................................... $ 25,284

12.

Determination of profitability (LO1) Lemon Auto Wholesalers had sales of $1,000,000 last year and cost of goods sold represented 78 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was $11,000 and interest expense for the year was $8,000. The firm’s tax rate is 30 percent. a.

Compute earnings after taxes.

Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to $1,050,900. The extra sales effort will also reduce cost of goods sold to 74 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at $11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to $15,800. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. Will her ideas increase or decrease profitability?

2-12. Solution: Lemon Auto Wholesalers Income Statement a. Sales ................. $1,000,000 Cost of goods sold (78% of sales) ...................... Gross profit ................. $ 220,000 Selling and administrative expense

$ 780,000

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(12% of sales) .................. $ 120,000 Depreciation .................. $ 11,000 Operating profit .................. $ 89,000 Interest expense ...................$ 8,000 Earnings before taxes .................. $ 81,000 Taxes @ 30% .................. $ 24,300 Earnings after taxes ................. $ 56,700 b. Sales ............... $1,050,900 Cost of goods sold (74% of sales) ..................... Gross profit ................. $ 273,234 Selling and administrative expense (14% of sales) ................. $ 147,126 Depreciation ................. $ 11,000 Operating profit ................. $ 115,108 Interest expense ................. $ 15,800 Earnings before taxes ................. $ 99,308 Taxes @ 30% ................. $ 29,792 Earnings after taxes ................ $ 69,516

$ 777,666

Ms. Carr’s ideas will increase profitability.

13.

Balance sheet (LO3) Classify the following balance sheet items as current or noncurrent: Retained earnings

Bonds payable

Accounts payable

Accrued wages payable

Prepaid expenses

Accounts receivable

Plant and equipment

Capital in excess of par

Inventory

Preferred stock

Common stock

Marketable securities

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2-13. Solution: Retained earnings – noncurrent Accounts payable – current Prepaid expense – current Plant and equipment – noncurrent Inventory – current Common stock – noncurrent Bonds payable – noncurrent Accrued wages payable – current Accounts receivable – current Capital in excess of par – noncurrent Preferred stock – noncurrent Marketable securities – current

14.

Balance sheet and income statement classification (LO1 & 3) Fill in the blank spaces with categories 1 through 7: 1.

Balance sheet (BS)

Current liabilities (CL)

Income statement (IS)

Long-term liabilities (LL)

Current assets (CA)

Stockholders’ equity (SE)

Fixed assets (FA)

Indicate Whether Item Is on Balance Sheet (BS) or Income

If on Balance Sheet, Designate Which Category

Item

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Statement (IS) _____ _____ _____ _____ _____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____ _____ _____ _____ _____

Accounts receivable Retained earnings Income tax expense Accrued expenses Cash Selling and administrative expenses Plant and equipment Operating expenses Marketable securities Interest expense

_____ _____ _____ _____ _____ _____ _____ _____ _____

Sales Notes payable (6 months) Bonds payable, maturity 2045 Common stock Depreciation expense Inventories Capital in excess of par value Net income (earnings after taxes) Income tax payable

2-14. Solution: 1. Balance Sheet (BS) 2. Income Statement (IS) 3. Current Assets (CA) 4. Fixed Assets (FA) 5. Current Liabilities (CL) 6. Long-Term Liabilities (LL) 7. Stockholders Equity (SE)

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Indicate Whether Item is on Income Statement or Balance Sheet

If Item Is on Balance Sheet, Designate Which Category

Accounts Receivable

Retained Earnings

Item

Income Tax Expense

Accrued Expenses

Cash

IS BS

Selling and Administrative expenses FA

IS BS

Plant & Equipment Operating Expenses

Marketable Securities

Interest Expense

Sales

Notes Payable (6 Months)

Bonds Payable (Maturity 2045)

Common Stock

Depreciation Expense

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Inventories

Capital in Excess of Par Value

IS BS

15.

Net Income (Earnings after Taxes) CL

Income Tax Payable

Development of balance sheet (LO3) Arrange the following items in proper balance sheet presentation:

Accumulated depreciation.............................................................

$309,000

Retained earnings.................................... ......................................

187,000

Cash................................................. ..............................................

14,000

Bonds payable................................................................................

136,000

Accounts receivable.................................. .....................................

54,000

Plant and equipment—original cost.................... ..........................

775,000

Accounts payable..................................... ......................................

35,000

Allowance for bad debts.............................. ..................................

9,000

Common stock, $1 par, 100,000 shares outstanding..... ...............

100,000

Inventory........................................................................................

70,000

Preferred stock, $59 par, 1,000 shares outstanding......................

59,000

Marketable securities................................ ....................................

24,000

Investments.......................................... .........................................

20,000

Notes payable........................................ ........................................

34,000

Capital paid in excess of par (common stock)......... ......................

88,000

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Assets Current Assets: Cash ............................................

$ 14,000

Marketable securities ..................

24,000

Accounts receivable .................... Less: Allowance for bad debts

$ 54,000 9,00045,000

Inventory .....................................

70,000

Total current assets ............. $153,000 Other Assets: Investments ................................. Fixed Assets: Plant and equipment ...................

$775,000

Less: Accumulated depreciation

309,000

Net plant and equipment ............ Total assets

20,000

466,000

............. $ 639,000

Liabilities and Stockholders’ Equity Current Liabilities: Accounts payable ...................................................... Notes payable ............................................................ Total current liabilities Long-term liabilities Bonds payable ........................................................... Total liabilities ....................................................... Stockholders’ equity:

$ 35,000 34,000 $ 69,000

136,000

Preferred stock, $59 par, 1,000 shares outstanding .. Common stock, $1 par, 100,000 shares outstanding © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Capital paid in excess of par (common stock) ......... Retained earnings ...................................................... Total stockholders’ equity ..................................... Total liabilities and stockholders’ equity...........

$205,000

59,000 100,000 88,000 187,000 $434,000 $639,000

16.

Earnings per share and retained earnings (LO1 and 3) Elite Trailer has an operating profit or $250,000. Interest expense for the year was $32,000; preferred dividends paid were $32,700; and common dividends paid were $38,300. The tax was $63,500. The firm has 24,100 shares of common stock outstanding. a.

Calculate the earnings per share and the common dividends per share for Elite Trailer.

What was the increase in retained earnings for the year?

2-16. Solution: Elite Trailer a. Operating profit (EBIT) ....................................... $250,000 Interest expense ....................................... 32,000 Earnings before taxes (EBT) ................................... $218,000 Taxes ....................................... 63,500 Earnings after taxes (EAT) ..................................... $154,500

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Preferred dividends ....................................... 32,700 Available to common stockholders ....................... $121,800 Common dividends ....................................... 38,300 Increase in retained earnings……………………… $83,500

= $121,800/ 24,100 shares = $5.05 per share Dividends per share = $38,300/24,100 shares

= $1.59 per share b. Increase in retained earnings = $83,500 17.

Earnings per share and retained earnings (LO1 and 3) Quantum Technology had $669,000 of retained earnings on December 31, 20X2. The company paid common dividends of $35,500 in 20X2 and had retained earnings of $576,000 on December 31, 20X1. How much did Quantum Technology earn during 20X2, and what would earnings per share be if 47,400 shares of common stock were outstanding?

2-17. Solution: Quantum Technology Retained earnings, December 31, 20X2 ....................... $669,000 Less: Retained earnings, December 31, 20X1 .............. 576,000 Change in retained earnings ............................... $93,000

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Add: Common stock dividends.....................................

35,500

Earnings available to common stockholders ................ $128,500 Earnings per share

18.

Price/earning ratio (LO2) Botox Facial Care had earnings after taxes of $370,000 in 20X1 with 200,000 shares of stock outstanding. The stock price was $31.50. In 20X2, earnings after taxes increased to $436,000 with the same 200,000 shares outstanding. The stock price was $42.00. a.

Compute earnings per share and the P/E ratio for 20X1. (The P/E ratio equals the stock price divided by earnings per share.)

Compute earnings per share and the P/E ratio for 20X2.

Give a general explanation of why the P/E ratio changed.

2-18. Solution: Botox Facial Care a. EPS (20X1) P/E ratio (20X1) b. EPS (20X2)

 $370,000

= $1.85

= Price/EPS

= $31.50 = 17.03x

 $436,000

= $2.18

200,000

$1.85

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P/E ratio (20X2) c.

19.

= Price/EPS

= $42.00 = 19.27x $2.18

The stock price increased by 33.33% while EPS only increased 17.84%.

Price/earning ratio (LO2) Stilley Corporation had earnings after taxes of $436,000 in 20X2 with 200,000 shares outstanding. The stock price was $42.00. In 20X3, earnings after taxes declined to $206,000 with the same 200,000 shares outstanding. The stock price declined to $27.80. a.

Compute earnings per share and the P/E ratio for 20X2.

Compute earnings per share and the P/E ratio for 20X3.

Give a general explanation of why the P/E changed. You might want to consult the textbook to explain this surprising result.

2-19. Solution: Stilley Corporation a. EPS (20X2) P/E ratio (20X2) b. EPS (20X3)

P/E ratio (20X3) c.

20.

 $436,000 = $2.18

200,000

= Price/EPS = $42.00 = 19.27x $2.18  $206,000  $1.03 200,000

= Price/EPS = $27.80  26.99x $1.03

As explained in the text, when EPS drops rapidly, the stock price might not decline as much, and the P/E ratio rises. A higher P/E ratio under adverse conditions is not a positive.

Cash flow (LO4) Identify whether each of the following items increases or decreases cash flow: Increase in accounts receivable

Decrease in prepaid expenses

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Increase in notes payable

Increase in inventory

Depreciation expense

Dividend payment

Increase in investments

Increase in accrued expenses

Decrease in accounts payable

2-20. Solution: Increase in accounts receivable – decreases cash flow (use) Increase in notes payable – increases cash flow (source) Depreciation expense – increases cash flow (source) Increase in investments – decreases cash flow (use) Decrease in accounts payable – decreases cash flow (use) Decrease in prepaid expense – increases cash flow (source) Increase in inventory – decreases cash flow (use) Dividend payment – decreases cash flow (use) Increase in accrued expenses – increases cash flow (source)

21.

Depreciation and cash flow (LO5) The Rogers Corporation has a gross profit of $880,000 and $360,000 in depreciation expense. The Evans Corporation also has $880,000 in gross profit, with $60,000 in depreciation expense. Selling and administrative expense is $120,000 for each company. Given that the tax rate is 40 percent, compute the cash flow for both companies. Explain the difference in cash flow between the two firms.

2-21. Solution: Rogers Corporation – Evans Corporation

Gross profit ...................................... Selling and adm. expense ............

Rogers

Evans

$880,000

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Depreciation ....................................

120,000

360,000

60,000

Operating profit................................ Taxes (40%) ......................................

$400,000

$700,000

160,000

280,000

Earnings after taxes .......................... Plus depreciation expense ................

$240,000

$420,000

$360,000

$60,000

Cash flow .........................................

$600,000

$480,000

Rogers had $300,000 more in depreciation which provided $120,000 (0.40  $300,000) more in cash flow.

22.

Free cash flow (LO4) Nova Electrics anticipates cash flow from operating activities of $13 million in 20X1. It will need to spend $8.5 million on capital investments to remain competitive within the industry. Common stock dividends are projected at $1.1 million and preferred stock dividends at $1.3 million. a.

What is the firm’s projected free cash flow for the year 20X1?

What does the concept of free cash flow represent?

2-22. Solution: Nova Electronics a. Cash flow from operations activities

$13 million

– Capital expenditures

8.5

– Common stock dividends

1.1

– Preferred stock dividends

1.3

Free cash flow

$2.1 million

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b. Free cash flow represents the funds that are available for special financial activities, such as a leveraged buyout, increased dividends, common stock repurchases, acquisitions, or repayment of debt.

23.

Book value (LO3) Landers Nursery and Garden Stores has current assets of $220,000 and fixed assets of $170,000. Current liabilities are $80,000 and long-term liabilities are $140,000. There is $40,000 in preferred stock outstanding and the firm has issued 25,000 shares of common stock. Compute book value (net worth) per share.

2-23. Solution: Landers Nursery and Garden Stores Current assets Fixed assets Total assets – Current liabilities – Long-term liabilities Stockholders’ equity – Preferred stock obligation Net worth assigned to common ...................... Common shares outstanding Book value (net worth) per share ...................

$220,000 170,000 $390,000 80,000 140,000 $170,000 40,000 $130,000 25,000

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$ 24.

5.20

Book value and market value (LO2 and 3) The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and long-term liabilities of $100,000. There is $40,000 in preferred stock outstanding; 20,000 shares of common stock have been issued. a.

Compute book value (net worth) per share.

If there is $22,000 in earnings available to common stockholders, and Holtzman’s stock has a P/E of 18 times earnings per share, what is the current price of the stock?

What is the ratio of market value per share to book value per share?

2-24. Solution: Holtzman Corporation a. Total assets...............................................

$400,000

– Current liabilities ...................................

50,000

– Long-term liabilities ...............................

100,000

– Stockholders’ equity ..............................

$250,000

– Preferred stock ......................................

40,000

Net worth assigned to common ............

$210,000

Common shares outstanding .............

20,000

Book values (net worth) per share ........

$10.50

b. Earnings available to common .................

$22,000

Shares outstanding..................................... Earnings per share .....................................

20,000

P/E ratio × 18

$1.10

earnings per share

price

$1.10

$19.80

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25.

Market value per share (price) to book value per share $19.80/$10.50 = 1.89

Book value and market value (LO2 and 3) Amigo Software Inc. has total assets of $889,000, current liabilities of $192,000, and long-term liabilities of $154,000. There is $87,000 in preferred stock outstanding. Thirty thousand shares of common stock have been issued. a.

Compute book value (net worth) per share.

If there is $56,300 in earnings available to common stockholders, and the firm’s stock has a P/E of 23 times earnings per share, what is the current price of the stock?

What is the ratio of market value per share to book value per share? (Round to two places to the right of the decimal point.)

2-25. Solution: Amigo Software, Inc. a. Total assets...............................................

$889,000

– Current liabilities ...................................

192,000

– Long-term liabilities ...............................

154,000

Stockholders’ equity ..............................

$543,000

– Preferred stock ......................................

87,000

Net worth assigned to common ............

$456,000

Common shares outstanding ................

30,000

Book value (net worth) per share ..........

$ 15.20

b. Earnings available to common ................. Shares outstanding ...................................

$ 56,300

Earnings per share .....................................

30,000

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P/E ratio × 23 c.

26.

1.88

earnings per share

price

$1.88

$43.24

Market value per share (price) to book value per share $43.24/$15.20 = 2.84

Book value and P/E ratio (LO2 and 3) Vriend Software Inc.’s book value per share is $15.20. Earnings per share is $1.88, and the firm’s stock trades in the stock market at 3.5 times book value per share, what will the P/E ratio be? (Round to the nearest whole number.)

2-26. Solution: Vriend Software Inc. 3.5 × book value per share = price 3.5 × $15.20 = $53.20

round to 28x

27.

Construction of income statement and balance sheet (LO1 and 3) For December 31, 20X1, the balance sheet of Baxter Corporation was as follows: ________________________________________________________________________ Current Assets Cash .................................................

Liabilities $ 15,000

Accounts payable ...................

$ 17,000

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Accounts receivable ........................

20,000

Notes payable ........................

25,000

Inventory .........................................

30,000

Bonds payable ........................

55,000

Prepaid expenses ............................

12,500

Fixed Assets Plant and equipment (gross)…. .......

Stockholders’ Equity $255,000

Less: Accumulated ........................

Preferred stock .......................

$25,000

Common stock .......................

60,000

depreciation .................................

51,000

Paid-in capital .........................

30,000

Net plant and equipment ................

$204,000

Retained earnings ..................

69,500

......................................................... Total assets......................................

Total liabilities and $281,500

stockholders’ equity ...............

$281,500

________________________________________________________________________

Sales for 20X2 were $245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was $24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 20X1 balances. The tax rate averaged 20 percent. $2,500 in preferred stock dividends were paid, and $5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.

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During 20X2, the cash balance and prepaid expenses balances were unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 20X2, at a cost of $40,000. Accounts payable increased by 20 percent. Notes payable increased by $6,500 and bonds payable decreased by $12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change. a.

Prepare an income statement for 20X2.

Prepare a statement of retained earnings for 20X2.

Prepare a balance sheet as of December 31, 20X2.

2-27. Solution: Baxter Corporation 20X2 Income Statement a. Sales .................................$245,000 Cost of goods sold (60%) ................................. 147,000 Gross profit .................................$ 98,000 Selling and administrative expense ................. 24,500 Depreciation expense (8%).............................. 20,4001 Operating profit (EBIT) ................................ $ 53,100 Interest expense ................................. 9,1002 Earnings before taxes .................................$ 44,000 Taxes (20%) ................................. 8,800 Earnings after taxes (EAT) ........................... $ 35,200 Preferred stock dividends................................ 2,500 Earnings available to common stockholder ..... $ 32,700 Shares outstanding ................................. 10,000 Earnings per share ................................. $ 3.27 b. 20X2 Statement of Retained Earnings Retained earnings balance, January 1, 20X2 ... 1

8% × $255,000 = $20,400

(10% × $25,000) + (12% × $55,000) = $9,100

$ 69,500

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Add: Earnings available to common stockholders, 20X2 .................................32,700 Deduct: Cash dividend declared in 20X2 ......... 5,500

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Retained earnings balance, December 31, 20X2 .................................$96,700 c.

20X2 Balance Sheet Liabilities

Current Assets Cash…………..

$ 15,000

Accounts payable

Accounts receivable……..

22,000 Notes payable….

31,500

Inventory………

33,000 Bonds payable…

42,500

Prepaid expenses

12,500

_______

$82,500

$94,400 Stockholders’ Equity

Fixed Assets Gross plant…... Accumulated depreciation…

Net plant……..

$20,400

$295,000

(71,400)

223,600

Preferred stock... $ 25,000 Common stock... 60,000 Paid in capital in excess of par… 3 Retained earnings

30,000

96,700

$51,000 + $20,400 = $71,400

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Total assets…..

$306,100

Total liability & equity………..

$306,100

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28.

Statement of cash flows (LO4) Refer to the following financial statements for Crosby Corporation:

a) Prepare a statement of cash flows for the Crosby Corporation using the general procedures indicated in Table 2–10. b) Describe the general relationship between net income and net cash flows from operating activities for the firm. c) Has the buildup in plant and equipment been financed in a satisfactory manner? Briefly discuss. d) Compute the book value per common share for both 20X1 and 20X2 for the Crosby Corporation. e) If the market value of a share of common stock is 3.3 times book value for 20X1, what is the firm’s P/E ratio for 20X2?

_______________________________________________________________________ CROSBY CORPORATION Income Statement For the Year Ended December 31, 20X2

Sales ..................................................................................................

$2,200,000

Cost of goods sold .............................................................................

1,300,000

Gross profits ...............................................................................

900,000

Selling and administrative expense...................................................

420,000

Depreciation expense .......................................................................

150,000

Operating income .......................................................................

330,000

Interest expense................................................................................

90,000

Earnings before taxes .................................................................

240,000

Taxes..................................................................................................

80,000

Earnings after taxes ....................................................................

160,000

Preferred stock dividends ....................................................................

10,000

Earnings available to common stockholders ....................................

$ 150,000

Shares outstanding............................................................................

120,000

Earnings per share.............................................................................

1.25

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Statement of Retained Earnings For the Year Ended December 31, 20X2 Retained earnings, balance, January 1, 20X2....................................

$500,000

Add: Earnings available to common stockholders, 20X2 ...............

150,000

Deduct: Cash dividends declared and paid in 20X2 .......................

50,000

Retained earnings, balance, December 31, 20X2 .............................

$600,000

Comparative Balance Sheets For 20X1 and 20X2 Year-End Assets

Year-End

20X1

20X2

Cash ............................................................................................

$ 70,000

$100,000

Accounts receivable (net) ...........................................................

300,000

350,000

Inventory ...........................................................................................

410,000

430,000

Prepaid expenses ..............................................................................

50,000

30,000

Total current assets ....................................................................

830,000

910,000

Investments (long-term securities) ...................................................

80,000

70,000

Plant and equipment.........................................................................

2,000,000

2,400,000

Less: Accumulated depreciation .................................................

1,000,000

1,150,000

Net plant and equipment ..................................................................

1,000,000

1,250,000

Total assets........................................................................................

$1,910,000

$2,230,000

Current assets:

Liabilities and Stockholders’ Equity

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Current liabilities: Accounts payable........................................................................

$ 250,000

$ 440,000

Notes payable .............................................................................

400,000

Accrued expenses .......................................................................

70,000

50,000

Total current liabilities.............................................................

720,000

890,000

Bonds payable, 20X2 ..................................................................

70,000

120,000

Total liabilities .........................................................................

790,000

1,010,000

Preferred stock, $100 par value .................................................

90,000

Common stock, $1 par value ......................................................

120,000

Capital paid in excess of par .......................................................

410,000

Retained earnings .......................................................................

500,000

600,000

Total stockholders’ equity .......................................................

1,120,000

1,220,000

Total liabilities and stockholders’ equity...........................................

$1,910,000

$2,230,000

Long-term liabilities:

Stockholders’ equity:

_______________________________________________________________________

(The following questions apply to the Crosby Corporation, as presented in Problem 27.)

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Solution 2-28 a): Crosby Corporation Statement of Cash Flows For the Year Ended December 31, 20X2 Cash flows from operating activities: Net income (earnings after taxes) .........

$160,000

Adjustments to determine cash flow from operating activities: ............ Add back depreciation ......................... Increase in accounts receivable ........... Increase in inventory ........................... Decrease in prepaid expenses .............. Increase in accounts payable ............... Decrease in accrued expenses ............. Total adjustments ............................. Net cash flows from operating activities.................................................

$150,000 (50,000) (20,000) 20,000 190,000 (20,000) $270,000

Cash flows from investing activities: Decrease in investments ........................

$430,000

Increase in plant and equipment ........... Net cash flows from investing activities Cash flows from financing activities: Increase in bonds payable .....................

10,000 (400,000) (390,000)

Preferred stock dividends paid .............. Common stock dividends paid ............... 50,000

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Net cash flows from financing ............... Net increase (decrease) in cash flows ......

(10,000) (50,000)

(10,000) $ 30,000 The student should observe that the increase in cash flows of $30,000 equals the $30,000 change in the cash account on the balance sheet. This indicates the statement is correct.

Solution 2-28 b): Cash flows from operating activities far exceed net income. This occurs primarily because we add back depreciation of $319,000 and accounts payable increase by $248,000. Thus, the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations.

Solution 2-28 c): The buildup in plant and equipment of $690,000 (gross) and $371,000 (net) has been financed, in part, by the large increase in accounts payable (248,000). This is not a very satisfactory situation. Short-term sources of funds can always dry up, while fixed asset needs are permanent in nature. This firm may wish to consider more long-term financing, such as a mortgage, to go along with profits, the increase in bonds payable, and the add© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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back of depreciation.

Solution 2-28 d): Book value

per share

Book value

Stockholders' equity  Preferred stock Common shares outstanding

 $1,120,000  $90,000  = $1,030,000 = $8.58

 $1, 220,000  $90,000  = $1,130,000 = $9.42

120,000

per share (20X1)

120,000

Book value per share (20X2)

Solution 2-28 e): Market value

= 3.3 × $9.42 = $31.09

P / E ratio

= Market value / Earnings per share = $31.09 / $1.25 = 24.87

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Chapter 3 Financial Analysis Discussion Questions 3-1.

If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?

Short-term lenders—Liquidity ratios because their concern is with the firm’s ability to pay short-term obligations as they come due.

Long-term lenders—Leverage ratios because they are concerned with the relationship of debt to total assets. They also will examine profitability to ensure that interest payments can be made.

Stockholders—Profitability ratios, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.

3-2.

Explain how the DuPont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity.

The DuPont system of analysis breaks out the return on assets between the profit margin and asset turnover.

Return on assets

Net income Total assets

Profit margin



Net income Sales



Asset turnover

Sales Total assets

In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a

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company in the capital goods industry may have a high profit margin and a low asset turnover, while a food processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets.

The modified form of the DuPont formula shows:

Return on equity =

Return on assets  investment  1  Debt/Assets 

This indicates that return on stockholders’ equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on stockholders’ equity that is influenced by large amounts of debt.

3-3.

If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?

If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing.

3-4.

What advantage does the fixed charge coverage ratio offer over simply using times interest earned?

The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.

3-5.

Is there any validity in rule-of-thumb ratios for all corporations (for example, a current

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ratio of 2 to 1 or debt to assets of 50 percent)?

No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information.

3-6.

Why is trend analysis helpful in analyzing ratios?

Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last 10 years. Trend analysis must also be compared to industry patterns of change.

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3-7.

Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions. a. b. c. d.

Return on investment. Inventory turnover. Fixed asset turnover. Debt-to-assets ratio.

Return on investment 

Net income Total assets

Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading.

Inventory turnover 

Sales Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect “inflation-influenced” dollars and the net effect will be nil.

If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.

Fixed asset turnover 

Sales Fixed assets

Fixed assets will be understated relative to their replacement cost and to sales and too high a ratio could be reported.

Debt to total assets 

Total debt Total assets

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Since both are based on historical costs, no major inflationary impact will take place in the ratio.

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3-8.

What effect will disinflation following a highly inflationary period have on the reported income of the firm?

Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.

3-9.

Why might disinflation prove to be favorable to financial assets? Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar, lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current evaluation.

3-10.

Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why?

There are many different methods of financial reporting accepted by the accounting profession as promulgated by the Financial Accounting Standards Board. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.

Problems 1.

Profitability ratios (LO2) Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of $156,000 on sales of $2,010,000. Division B is able to make only $28,800 on sales of $329,000. Based on the profit margins (returns on sales), which division is superior?

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3-1.

Solution: Low Carb Diet Supplements Division A Net income Sales

Division B

$156, 000  7.76% 2, 010, 000

$28,800  8.75% $329, 000

Division B is superior.

3-2.

Profitability ratios (LO2) Database Systems is considering expansion into a new product line. Assets to support expansion will cost $380,000. It is estimated that Database can generate $1,410,000 in annual sales, with an 8 percent profit margin. What would net income and return on assets (investment) be for the year?

Solution: Database Systems Net income = Sales  profit margin = $1,410,000  0.08 = $112,800

Return on assets (investment)

Net income Total assets $112,800  $380,000  29.7% 

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3-3.

Profitability ratios (LO2) Polly Esther Dress Shops Inc. can open a new store that will do an annual sales volume of $865,800. It will turn over its assets 1.8 times per year. The profit margin on sales will be 9 percent. What would net income and return on assets (investment) be for the year?

Solution: Polly Esther Dress Shops Inc. Assets = Sales / Total asset turnover

= $865,800 / 1.8 = $481,000

Net income = Sales × Profit Margin = $865,800 × 0.09 = $77,922

Return on assets (investment) = Net income / Total assets = $77,922 /$481,000 = 16.2%

3-4.

Profitability ratios (LO2) Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns over its assets 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit margin (return on sales)?

Solution:

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Billy’s Crystal Stores Inc.

Sales  Assets  total asset turnover $11,324,000  $5,960,000  1.9 Net income  Assets  Return on assets $476,800  $5,960,000  8% Net income  $476,800/$11,324,000 = 4.21% Sales 5.

3-5.

Profitability ratios (LO2) Elizabeth Tailors Inc. has assets of $8,540,000 and turns over its assets 1.8 times per year. Return on assets is 16.5 percent. What is the firm’s profit margin (returns on sales)?

Solution: Elizabeth Tailors Inc. Sales = Assets × Total asset turnover $15,372,000 = $8,540,000 × 1.8

Net income = Assets × Return on assets $1,409,100 = $8,540,000 × 16.5%

Net income / Sales = $1,409,100 / 15,372,000 = 9.17

Profitability ratios (LO2) Dr. Zhivàgo Diagnostics Corp. income statements for 20X1 are as follows:

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Sales ............................................................................................... $2,790,000 Cost of goods sold .......................................................................... 1,790,000 Gross profit .................................................................................... 1,000,000 Selling and administrative expense ...............................................

302,000

Operating profit .............................................................................

698,000

Interest expense ............................................................................

54,800

Income before taxes ......................................................................

643,200

Taxes (30%) ....................................................................................

192,960

Income after taxes ......................................................................... $ 450,240

a. Compute the profit margin for 20X1. b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold increases by 20 percent. The firm is able to keep all other expenses the same. Assume a tax rate of 30 percent on income before taxes. What is income after taxes and the profit margin for 20X2?

3-6.

Solution: Dr. Zhivàgo Diagnostics a. Profit margin for 20X1 Net income $450, 240   16.14% Sales $2, 790, 000

b. Sales ............................. $3,069,000* Cost of goods sold ....................................... 2,148,000** Gross profit .................................................

921,000

Selling and administrative expense .............

302,000

Operating profit ..........................................

619,000

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Interest expense ..........................................

54,800

Income before taxes ....................................

564,200

Taxes (30%) .................................................

169,260

Income after taxes (20X2) ...........................

$ 394,940

* $2,790,000 × 1.10 = $3,069,000

** $1,790,000 × 1.20 = $2,148,000

Profit margin for 20X2 Net income $394,940   12.87% Sales $3, 069, 000 7.

Profitability ratios (LO2) The Haines Corp. shows the following financial data for 20X1 and 20X2.

Sales Cost of goods sold Gross profit Selling & administrative expense Operating profit Interest expense Income before taxes Taxes (35%) Income after taxes

20X1 $ 3,230,000 2,130,000 1,100,000 298,000 802,000 47,200 754,800 264,180 $490,620

20X2 $3,370,000 2,850,000 520,000 227,000 293,000 51,600 241,400 84,490 $156,910

For each year, compute the following and indicate whether it is increasing or decreasing profitability in 20X2 as indicated by the ratio. a.

Cost of goods sold to sales.

Selling and administrative expense to sales.

Interest expenses to sales.

3-7.

Solution: Haines Corp.

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20X1 a.

Cost of goods sold Sales

$2,130, 000  65.9% 3, 230, 000

20X2 $2,850, 000  84.6% 3,370, 000

It is decreasing profitability. b.

Selling & admin. expense Sales

$298, 000 $227, 000  9.2%  6.7% 3, 230, 000 3,370, 000

It is increasing profitability. Interest expense $47, 200 $51, 600  1.5%  1.5% Sales 3, 230, 000 3,370, 000 It is not changing profitability.

Profitability ratios (LO2) Easter Egg and Poultry Company has $1,840,000 in assets and $625,000 of debt. It reports net income of $145,000. a. What is the firm’s return on assets? b. What is its return on stockholders’ equity? c. If the firm has an asset turnover ratio of 2.4 times, what is the profit margin (return on sales)?

3-8.

Solution: Easter Egg and Poultry Company a.

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b. Stockholders’ equity = Total assets – Total debt = $1,840,000 – $625,000 = $1,215,000

Sales = Total assets × Total assets turnover = $1,840,000 × 2.4 = $4,416,000

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3-9.

Profitability ratios (LO2) Network Communications has total assets of $1,500,000 and current assets of $612,000. It turns over its fixed assets three times a year. It has $319,000 of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity?

Solution: Network Communications Total assets – Current assets Fixed assets

$1,500,000 612,000 $ 888,000

Sales = Fixed assets × Fixed asset turnover $2,664,000 = $888,000 × 3 Total assets $1,500,000 – Debt 319,000 Stockholders’ equity $1,181,000

Net income = Sales  Profit margin = $2,664,000  8% = $213,120

Net income Stockholders' equity $213,120   18.05% $1,181, 000

Return on stockholders' equity 

10.

Profitability ratios (LO2) Fondren Machine Tools has total assets of $3,310,000 and current assets of $879,000. It turns over its fixed assets 3.6 times per year. Its return on sales is 4.8 percent. It has $1,750,000 of debt. What is its return on stockholders’ equity?

3-10. Solution: Fondren Machine Tools Total assets

$3,310,000

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– Current assets Fixed assets

879,000 $2,431,000

Sales  Fixed assets  Fixed asset turnover $8,751,600  $2,431,000  3.6 Net income = Sales  Profit margin $8,751,600  4.8% = $420,076.80 Total assets – Debt Stockholders’ equity

$3,310,000 1,750,000 $1,560,000

Return on stockholders' equity 



11.

Net income Stockholders' equity $420,076.80  26.93% $1,560,000

Profitability ratios (LO2) Baker Oats had an asset turnover of 1.9 times per year. a.

If the return on total assets (investment) was 10.6 percent, what was Baker’s profit margin?

The following year, on the same level of assets, Baker’s assets turnover increased to 2 times and its profit margin was 5.3 percent. How did the return on total assets change from that of the previous year?

3-11. Solution: Baker Oats a. Total asset turnover × Profit margin = Return on total assets 1.9 × ? = 10.6%

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b. 2

5.3% = 10.6%

It did not change at all because the increase in profit margin made up for the decrease in the asset turnover. 12.

DuPont system of analysis (LO3) AllState Trucking Co. has the following ratios compared to its industry for last year.

Return on sales………..

AllState Trucking 3%

Industry 8%

Return on assets………

15%

10%

Explain why the return-on-assets ratio is so much more favorable than the return-on-sales ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required.

3-12. Solution: AllState Trucking Company AllState Trucking Company has a higher asset turnover ratio than the industry. Calculations are not necessary to answer the question, but just in case a student did the calculations here is the comparison. Return on assets =Asset turnover Return on sales

15% 10% vs 3% 8%

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AllState’s turnover 5x versus 1.25x Industry turnover

13.

DuPont system of analysis (LO3) Front Beam Lighting Company has the following ratios compared to its industry for last year.

Return on assets……………

Front Beam Lighting 12%

Industry 5%

Return on equity……………

16%

20%

Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required.

3-13. Solution: Front Beam Lighting Company Front Beam has a lower debt-to-total-assets ratio than the industry. For those who did a calculation, Front Beam’s debt-to-assets was 75 percent versus 25 percent for the industry.

14.

DuPont system of analysis (LO3) Jin’s Appliances has a return-on-assets (investment) ratio of 8 percent. a.

If the debt-to-total-assets ratio is 40 percent, what is the return on equity?

If the firm had no debt, what would the return-on-equity ratio be?

3-14. Solution:

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Jin’s Appliances a.

Return on equity 

Return on assets (investment) (1  Debt/Assets)



8% (1  0.40)



8% 0.60

 13.33%

b. The same as return on assets (8%). 15.

DuPont system of analysis (LO3) Using the DuPont method, evaluate the effects of the following relationships for the Butters Corporation:

a. Butters Corporation has a profit margin of 6.5 percent and its return on assets (investment) is 16.5 percent. What is its assets turnover? b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm’s return on equity be? c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35 percent?

3-15. Solution: Butters Corporation a. Profit margin × Total asset turnover = Return on assets (investment)

6.5

= 16.5%

= 2.5x

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= 33%

= 25.4%

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16.

DuPont system of analysis (LO3) Jerry Rice and Grain Stores has $4,780,000 in yearly sales. The firm earns 4.5 percent on each dollar of sales and turns over its assets 2.7 times per year. It has $123,000 in current liabilities and $349,000 in long-term liabilities. a. b.

What is its return on stockholders’ equity? If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities.

3-16. Solution: Jerry Rice and Grain Stores a.

Net income  Sales  profit margin  $4,780,000  4.5%  $215,100 Stockholders' equity  Total assets  Total liabilities Total assets  Sales/Total asset turnover  $4,780,000/2.7  $1,770,370.37 Total liabilities  Current liabilities  Long-term liabilities  $123,000  $349,000  $472,000

Stockholders' equity  $1,770,370.37  $472,000  $1,298,370.37 Net income Stockholders' equity $215,100   16.57% $1, 298,370.37

Return on stockholders' equity 

b. The new level of sales will be:

Sales  Total assets  Total asset turnover  $1,770,370.37  3  $5,311,111.11

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Net income  Sales  Profit margin  $5,31,111.11  4.5%  $239,000

Return on stockholders' equity  

17.

Net income Stockholders' equity $239, 000  18.41% $1, 298,370.37

Interpreting results from the DuPont system of analysis (LO3) Assume the following data for Cable Corporation and Multi-Media Inc. Cable

Multi-

Corporation

Media Inc.

Net income ....................................

$ 31,200

$ 140,000

Sales ...............................................

317,000

2,700,000

Total assets ....................................

402,000

965,000

Total debt ......................................

163,000

542,000

Stockholders’ equity ......................

239,000

423,000

a. Compute the return on stockholders’ equity for both firms using ratio 3a. Which firm has the higher return? b. Compute the following additional ratios for both firms: Net income/Sales Net income/Total assets Sales/Total assets Debt/Total assets c. Discuss the factors from part b that added or detracted from one firm having a higher return on stockholders’ equity than the other firm as computed in part a.

3-17. Solution: Cable Corporation and Multi-Media Inc. a.

Cable

Multi-

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Corporation

Media Inc.

Net income $31, 200   13.05% Stockholders' equity $239, 000

$140, 000  33.1% $423, 000

Multi-Media Inc. has a much higher return on stockholders’ equity than Cable Corporation.

Cable Corporation

Net income  Sales Net income  Total assets Sales  Total assets Debt  Total assets

MultiMedia Inc.

$31, 200 $140, 000  9.84%  5.19% $317, 000 $2, 700, 000 $31, 200 $140, 000  7.76%  14.51% $402, 000 $965, 000 $317, 000 $2,700,000  .79x  2.8x $402, 000 $965, 000 $163, 000 $542, 000  40.55%  56.17% $402, 000 $965, 000

c. As previously indicated, Multi-Media Inc. has a substantially higher return on stockholders’ equity than Cable Corporation (33.1 percent versus 13.05 percent). The reason is certainly not to be found on return on the sales dollar where Cable Corporation has a higher return than Multi-Media Inc. (9.84 percent versus 5.19 percent).

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However, Multi-Media Inc. has a higher return than Cable Corporation on total assets (14.51 percent versus 7.76 percent). The reason is clearly to be found in total asset turnover, which strongly favors Multi-Media Inc. over Cable Corporation (2.8x versus 0.79x). This factor alone leads to the higher return on total assets. Multi-Media Inc.’s superior return on stockholders’ equity is further enhanced by a higher debt ratio than Cable Corporation (56.17 percent versus 40.55 percent). This means that a smaller percentage of Multi-Media Inc.’s total assets are being financed by stockholders’ equity and thus the potentially higher return on stockholders’ equity. Although not requested in the question, one could show the following:

Net income Net income / Total assets  Stockholders' equity (1  Debt/Assets) Multi-Media Inc. = 14.51%/(1 – 0.5617) = 14.51%/0.4383 = 33.1% Cable Corporation = 7.76%/(1 – 0.4055) = 7.76%/0.5945 = 13.05% 18.

Average collection period (LO2) A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is $285,000. What is the average collection period? (Use a 360-day year.)

3-18. Solution:

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Accounts receivable Average daily credit sales ($3,000,000  90%)  $285,000 / 360 days $285,000  $7,500 per day  38 days

Average collection period 

19.

Average daily sales (LO2) Martinez Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales?

3-19. Solution: Martinez Electronics Average daily credit sales 

Credit sales 360

To determine credit sales, multiply accounts receivable by accounts receivable turnover.

$80,000  15  $1,200,000 Average daily credit sales 

20.

$1,200,000  $3,333 360

Inventory turnover (LO2) Perez Corporation has the following financial data for the years 20X1 and 20X2:

20X1

20X2

Sales…………………………

$8,000,000

$10,000,000

Cost of goods sold……………

6,000,000

9,000,000

Inventory……………………..

800,000

1,000,000

a. Compute inventory turnover based on Ratio 6, Sales/Inventory, for each year.

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b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year. c. What conclusions can you draw from part a and part b?

3-20. Solution: Perez Corporation 20X1

20X2

Sales $8,000,000   10x Inventory 8,00,000

$10,000,000  10x 1,000,000

Cost of goods sold $6,000,000 $9,000,000   7.5x  9x Inventory 800,000 1,000,000

c. Based on the sales-to-inventory ratio, the turnover has remained constant at 10x. However, based on the cost of goods sold to inventory ratio, it has improved from 7.5x to 9x. The latter ratio may be providing a false picture of improvement in this example simply because cost of goods sold has gone up as percentage of sales has (from 75 percent to 90 percent). Inventory is not really turning over any faster. 21.

Turnover ratios (LO2) Jim Short’s Company makes clothing for schools. Sales in 20X1 were $4,820,000. Assets were as follows:

Cash………………………………………. Accounts receivable………………………. Inventory………………………………….. Net plant and equipment………………….. Total assets……………………………

$ 163,000 889,000 411,000 520,000 $1,983,000

a. Compute the following: 1. Accounts receivable turnover. 2. Inventory turnover.

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3. Fixed asset turnover. 4. Total asset turnover. b. In 20X2, sales increased to $5,740,000 and the assets for that year were as follows: Cash………………………………………... $ 163,000 Accounts receivable……………………….. 924,000 Inventory…………………………………... 1,063,000 Net plant and equipment…………………... 520,000 Total assets…………………………….. $2,670,000 Once again, compute the four ratios. c.

Indicate if there is an improvement or decline in total asset turnover, and based on the other ratios, indicate why this development has taken place.

3-21. Solution: Jim Short’s Company a. 1. Accounts receivable turnover = Sales/Accounts Receivable $4,820, 000  5.42 x 889, 000

2. Inventory turnover = Sales/Inventory $4,820, 000  11.73 x 411, 000

3. Fixed asset turnover = Sales/(Net Plant & Equipment) $4,820, 000  9.27 x 520, 000

4. Total asset turnover = Sales/Total assets $4,820, 000  2.43 x 1,983, 000

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b. 1. Accounts receivable turnover $5, 740, 000  6.21x 924, 000

2. Inventory turnover $5, 740, 000  5.4 x 1, 063, 000

3. Fixed asset turnover $5, 740, 000  11.04 x 520, 000

4. Total asset turnover $5, 740, 000  2.15 x 2, 670, 000

c. There is a decline in total asset turnover from 2.43 to 2.15. This development has taken place because of the slowdown in inventory turnover (11.73 down to 5.4). The other two ratios are slightly improved. 22.

Overall ratio analysis (LO2) The balance sheet for Revolution Clothiers is shown next. Sales for the year were $2,400,000, with 90 percent of sales sold on credit.

REVOLUTION CLOTHIERS Balance Sheet 20X1 Assets Cash……………………

Liabilities and Equity $

60,000

Accounts payable……………..

$ 220,000

Accounts receivable…...

240,000

Accrued taxes…………………

30,000

Inventory………………

350,000

Bonds payable

150,000

(long-term)……………………

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Plant and equipment…...

410,000

Total assets………...

$1,060,000

Common stock………………..

80,000

Paid-in capital…………………

200,000

Retained earnings……………..

380,000

Total liabilities and equity…

$1,060,000

Compute the following ratios: a. b. c. d. e.

Current ratio. Quick ratio. Debt-to-total-assets ratio. Asset turnover. Average collection period.

3-22. Solution:

Revolution Clothiers a.

Current ratio  

Current assets Current liabilities $650,000 $250,000

 2.6x b.

Quick ratio 

(Current assets  inventory) Current liabilities



$650,000  $350,000 $250,000



$300,000 $250,000

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Debt to total assets 

Total debt Total assets



$400,000 $1,060,000

 37.74% d.

Asset turnover 

Sales Total assets



$2, 400,000 $1,060,000

 2.26x e.

23.

Accounts receivable Average daily credit sales ($2,400,000  0.90)  $240,000 / 360 days $240,000  $6,000 per day  40 days

Average collection period 

Debt utilization ratios (LO2) The Lancaster Corporation’s income statement is given next. a.

What is the times-interest-earned ratio?

What would be the fixed-charge-coverage ratio? LANCASTER CORPORATION

Sales .............................................................................. Cost of goods sold ......................................................... Gross profit ................................................................... Fixed charges (other than interest) ................................ Income before interest and taxes................................... Interest........................................................................... Income before taxes ...................................................... Taxes (35%) ..................................................................

$246,000 122,000 124,000 27,500 96,500 21,800 74,700 26,145

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Income after taxes .........................................................

$ 48,555

3-23. Solution: Lancaster Corporation a.

Times interested earned  

Income before interest and taxes Interest $96,500 21,800

 4.43x b.

Fixed charge coverage 

Income before fixed charges and taxes Fixed charges



$96, 500  27, 500 $21,800  27, 500



$124, 000 $49, 300

 2.52x 24.

Debt utilization and DuPont system of analysis (LO3) Using the income statement for Times Mirror and Glass Co., compute the following ratios: a.

The interest coverage.

The fixed charge coverage.

The total assets for this company equal $80,000. Set up the equation for the DuPont system of ratio analysis, and compute c, d, and e. c.

Profit margin.

Total asset turnover.

Return on assets (investment).

TIME MIRROR AND GLASS COMPANY

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Sales .............................................................................. Less: Cost of goods sold ............................................... Gross profit ................................................................... Less: Selling and administrative expense ..................... Less: Lease expense ...................................................... Operating profit* ........................................................... Less: Interest expense ................................................... Earnings before taxes .................................................... Less: Taxes (30%)......................................................... Earnings after taxes ....................................................... *Equals income before interest and taxes.

$126,000 93,000 33,000 11,000 4,000 $ 18,000 3,000 $ 15,000 4,500 $ 10,500

3-24. Solution:

Times Mirror and Glass Co. a.

Times interest earned  

Income before interest and taxes Interest $18,000 $3,000

 6x b.

Fixed charge coverage 

Income before fixed charges and taxes Fixed charges



$18,000  4,000 $3,000  $4,000



$22,000 $7,000

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Profit margin  

Net income Sales $10,500 $126,000

 8.33% d.

Total asset turnover  

Sales Total assets $126,000 $80,000

 1.575x

Return on assets (investments) 

Net income Sales  Sales Total assets

 8.33%  1.575x  13.12%

25.

Debt utilization (LO2) A firm has net income before interest and taxes of $193,000 and interest expense of $28,100. a.

What is the times-interest-earned ratio?

If the firm’s lease payments are $48,500, what is the fixed charge coverage?

3-25. Solution:

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Times interest earned  

Income before interest and taxes Interest $193, 000 $28,100

 6.87x b.

Fixed charge coverage 

IBIT + Before tax fixed charges Interest + Fixed charges



$193,000  $48,500 $28,100  $48,500



$241,500 $76,600

 3.15x 26.

Return on assets analysis (LO2) In January 2009, the Status Quo Company was formed. Total assets were $544,000, of which $306,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation of $30,600 per year, and in 2009 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $29,000 per year each of the last 10 years. Other assets have not changed since 2009. a.

Compute return on assets at year-end for 2009, 2011, 2014, 2016, and 2018. (Use $29,000 in the numerator for each year.)

To what do you attribute the phenomenon shown in part a?

Now assume income increased by 10 percent each year. What effect would this have on your preceding answers? (A comment is all that is necessary.)

3-26. Solution: Status Quo Company a.

Return on assets (investment) =

Income after taxes Total assets

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The return on assets for Status Quo will increase over time as the assets depreciate and the denominator gets smaller. Fixed assets at the beginning of 2009 equal $306,000 with a 10-year life, which means the depreciation expense will be $30,600 per year. Book values at year-end are as follows: 2009 = $275,400; 2011 = $214,200; 2014 = $122,400; 2016 = $ 61,200; 2018 = $ 0 Return on assets (investment) =

Income after taxes Current assets + Fixed assets

2009 = $29,000/$513,400 = 5.65% 2011 = $29,000/$452,200 = 6.41% 2014 = $29,000/$360,400 = 8.05% 2016 = $29,000/$299,200 = 9.69% 2018 = $29,000/$238,000 = 12.18% b. The increasing return on assets over time is due solely to the fact that annual depreciation charges reduce the amount of investment. The increasing return is in no way due to operations. Financial analysts should be aware of the effect of overall asset age on the return-on-investment ratio and be able to search elsewhere for indications of operating efficiency when ROI is very high or very low. c.

27.

As income rises, return on assets will be higher than in part (b) and would indicate an increase in return partially from more profitable operations.

Trend analysis (LO4) Jolie Foster Care Homes Inc. shows the following data:

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Year 20X1 20X2 20X3 20X4

Net Income $155,000 191,000 208,000 192,000

Total Assets $2,390,000 2,700,000 2,730,000 2,470,000

Stockholders’ Equity $ 761,000 966,000 1,770,000 2,220,000

Total Debt $1,629,000 1,734,000 960,000 250,000

Compute the ratio of net income to total assets for each year and comment on the trend.

Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b.

3-27. Solution: Jolie Foster Care Homes Inc. a.

Net income Total assets

20X1 20X2 20X3 20X4

$155,000/$2,390,000 = 6.49% $191,000/$2,700,000 = 7.07 $208,000/$2,730,000 = 7.62 $192,000/$2,470,000 = 7.77

Comment: There is a strong upward movement in return on assets over the four-year period. b.

Net income Stockholders' equity 20X1 20X2 20X3 20X4

$155,000/$761,000 = 20.37% $191,000/$966,000 = 19.77% $208,000/$1,770,000 = 11.75% $192,000/$2,220,000 = 8.65%

Comment: The return on stockholders’ equity ratio is going down each year. The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt.

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