ADMINISTRATIVE A DMINISTRATIVE MATTERS MA TTERS
• Project 1 scores have been posted. Verify your score on Compass and let me know of any discrepancies. • Midterm #1 Time: 6:30-8:30, Monday, February 18 Location:
Thursday sections – 114 DKH Friday sections – 141 Wohlers Bring: IDs, pencils/erasers, calculators DO NOT NOT bri ng: ng : any electronic devices such as cell phones or audio players. Exam coverage co verage:: Chapter 1-4 & Web Appendix 3A onf lict Exam • Conflict Time: 3:00-5:00, Monday, February 18 Location: 124 Burrill Hall
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TODAY: • Chapter 4 PROBLEM 2 (Chapter 4)
Bartley Barstools has an equity multiplier of 2.4, and its assets are financed with some combination of long-term debt and common equity. What is its debt ratio? Equity Multiplier = Assets/Equity = A/E = 2.4 Debt Ratio = Debt/Assets = D/A A = D + E A/A = (D + E) / A A/A = D/A +E/A 1 = D/A + E/A D/A = 1 – E/A
⎛ ⎞ ⎜ ⎟ D 1 ⎟ = ⎜1 A ⎟ A ⎜ ⎜ ⎟ ⎝ E ⎠ D 1 ⎞ ⎛ = ⎜1 ⎟ A ⎝ 2.4 ⎠ D
= 0.5833 = 58.33%.
A
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PROBLEM 8 (Chapter 4)
Duval manufacturing recently reported the following information: Net Income ROA Interest Expense
$600,000 8% $225,000
Its tax rate is 35 percent. What is its basic earning power (BEP)? Basic Earning Power (BEP) = EBIT/TA We can calculate TA from the definition of ROA… Return on Equity = ROA = Net Income / Total Assets 0.08 = $600,000/TA Can solve for Total Assets TA = $7,500,000 Now, we also need to figure out the value of EBIT for this company.
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Net Income = $600,000 EBT = NI / ( 1 – T) = $600,000/(1 – 0.35) = $923,077 EBIT – Interest = EBT, so EBIT = EBT + Interest = $923,077 + $225,000 = = $1,148,077 BEP = EBIT/TA = $1,148,077/$7,500,000 = 15.31% PROBLEM 10* (Chapter 4)
Assume you are given the following relationships for the Brauer Corp.: Sales/total assets Return on assets (ROA) Return on equity (ROE)
1.5x (total asset turnover) 3% 5%
Calculate Brauer’s profit margin and debt ratio. We need to calculate: Profit margin = Net income / Sales Debt ratio = Total debt/Total assets Return on Assets is defined as: ROA = Net income/Total assets We can rewrite it as: 4
ROA = (Net Income/Sales) x (Sales/Total assets) or ROA = Profit Margin x Total Asset Turnover Using the info provided to us 3% = Profit Margin x 1.5 Profit Margin = 3%/1.5 = 2% Now, Return on equity is defined as: ROE = Net Income/Common Equity We can rewrite it as follows: ROE = (Net Income/Total Assets)x(Total Assets/C. Equity) = (NI/Sales)x(Sales/TA)x(TA/Equity) = = Profit Margin x Total Assets turnover x Equity Multiplier From the definition of ROA above we obtain: ROE = ROA x EM We can solve for EM now EM = ROE/ROA = 5%/3% = 5/3 5
EM = TA/Equity = 5/3 1/EM = Equity/TA = 3/5 Remember that Equity + Debt = TA so Equity/TA + Debt/TA = 1 Debt/TA = 1 – Equity/TA = 1 – 3/5 = 2/5 = Debt ratio
PROBLEM 11 (Chapter 4)
Willis Publishing has $30 billion in total assets. Its basic earning power (BEP) ratio is 20 percent, and its timesinterest-earned ratio is 8.0. Willis’ depreciation and amortization expense totals $3.2 billion. It has $2 billion in lease payments, and $1 billion must go toward principal payments on outstanding loans and long term debt. What is Willis’ EBITDA coverage ratio? EBITDA coverage ratio = (EBITDA + Lease Payments)/(Interest+Principal.P+Lease.P) 6
Note that BEP = EBIT/TA, so EBIT = BEP x TA = .20 x $30 billion = $6 billion EBITDA = EBIT + DA = $6billion + $3.2billion = $9.2billion Now, from the definition of Times-interest-earned we can calculate the interest expense. Times-interest-earned = EBIT/Interest, so Interest = EBIT/Times-Interest-Earned= = $6billion/8 = $0.75 billion Now we can plug everything into the EBITDA coverage ratio formula… EBITDA coverage ratio = ($9.2 + $2)/($0.75 + $1 + $2) = 2.9867
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PROBLEM 15* (Chapter 4)
Lloyd Inc. Has sales of $200,000, a net income of $15,000, and the following balance sheet: Cash $10,000 Receivables 50,000 Inventories 150,000 Net fixed assets 90,000 Total Assets $300,000
Acct. Payable Other current liab. Long-term debt Common Equity Total liab. & eq.
$30,000 20,000 50,000 200,000 $300,000
The new owner thinks that inventories are excessive and can be lowered to the point where current ratio is equal to the industry average, 2.5x, without affecting either sales or net income. If inventories are sold off and not replaced thus reducing the current ratio to 2.5x, if the funds generated are used to reduce common equity (stock can be repurchased at book value), and if no other changes occur, by how much will the ROE change? What will be the firm’s new quick ratio? Initially, the Return on Equity is ROE1 = Net Income/Sales = $15,000/$200,000 = 7.5% Now, we want to set the Current Ratio to 2.5 Current Assets/ Current Liabilities = 2.5 Current Assets = 2.5 x Current Liabilities = $125,000 (note that CL are not affected here)
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The original level of CA was $210,000, so the decrease amounts to $85,000, which will be used to retire equity. After the change, the value of common equity will be $200,000 - $85,000 = $115,000. Now, the Net Income is not affected by this, so the ROE2 = $15,000/$115,000 = 13.04% ROE has increased by 13.04% - 7.50% = 5.54% Quick ratio calculations: Quick ratio = (Current Assets – Inventory)/Current Liabilities CL are not affected by the change (still at $50k) CA have fallen to $125,000 due to a decrease in Inventories (by $85k). So the Inventories must be now $150k - $85k = $65k. Quick Ratio = ($125,000 - $65,000)/$50,000 = 1.2
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PROBLEM 20* (Chapter 4)
Harrelson Inc. currently has $750,000 in accounts receivable, and its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to 35 days by pressuring more of its customers to pay their bills on time. If this policy is adopted, the company’s average sales will fall by 15 percent. What will be the level of accounts receivable following the change? Assume a 365-day year. Currently, DSO0 = 55 days Note that Accounts Receivable = (DSO/365) x Sales so Sales0 = Accounts Receivable0 x (365/DSO0) = = $750,000 x (365/55) = $4,909,090.91 After the new policy has been implemented… DSO1 = 35 days Sales1 = (100% - 15%) of Sales0 = = 0.85 x $4,909,090.91 = $4,172,727.27 Now, Accounts Receivable1 = (DSO1/365) x Sales1 = = (35/365) x $4,172,727.27 = $400,124.53 10
PROBLEM 21 (Chapter 4)
Fontaine Inc. recently reported net income of $2 million. It has 500,000 shares of common stock, which currently trades at $40 a share. Fontaine continues to expand and anticipates that 1 year from now its net income will be $3.25 million. Over the next year it also anticipates issuing an additional 150,000 shares of stock, so that 1 year from now it will have 650,000 shares of common stock. Assuming its price/earnings ratio remains at its current level, what will be the stock price 1 year from today? Today’s price/earnings (P/E) ratio: P/E = Price per share / (Net Income / # of shares) = = $40 / ($2,000,000/500,000) = 10 One year from now: Price per share = (P/E) x (Net Income / # of shares) = = 10 x ($3,250,000/650,000) = $50
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