Capital Investment
Appraisal
Aims…

For you to be able to understand the
concepts of Payback, ARR, IRR, DCF &
NPV

To be able to calculate Investment
Appraisal methods.
What is an Investment?
Any act which involves the sacrifice of
an immediate and certain level of
consumption in exchange for the
expectation of an increase in future
consumption.
forgo the present consumption in order
to increase resources in future
What is an Investment?
An investment requires expenditure
on something today that is expected
to provide a benefit in the future
the decision to make an investment is
extremely important because it implies;
the expectation that expenditure today
will generate future cash gains in real
terms that greatly exceed the funds spent
today
Investment Appraisal

A means of assessing whether an
investment project is worthwhile or
not

Investment project could be the purchase
of a new PC for a small firm, a new piece
of equipment in a manufacturing plant, a
whole new factory, etc
Investment Appraisal

What factors need to be considered before
investing in equipment such as this?
Source: Gergely Erno, http://www.sxc.hu
Types of
investment
appraisal:
 Payback Period

Average Rate of
Return (ARR)

Net Present Value
(discounted cash
flow)
Investment Appraisal

Why do companies invest?


Importance of remembering investment as the
purchase of productive capacity NOT buying stocks
and shares or investing in a bank!
Buy equipment/machinery or build new plant to:
 Increase capacity (amount that can be produced)
which means:
 Demand can be met and this generates sales
revenue
 Increased efficiency and productivity
Investment Appraisal
A fork lift may be an important item but
what does it contribute to overall sales?
How long and how much work would it have
to do to repay its initial cost?

Investment therefore
assumes that the
investment will yield future
income streams

Investment appraisal is all
about assessing these
income streams against
the cost of the investment

Not a precise science!
Looking at the
figures…
A failing farmer wants to
investigate the financial
implications of possible
farm diversification.
Farm Diversification – the 3
So what other
options
factors should the
Project
A
Years
Goats
0
(20,000)
1
10,000
200
0
2
10,000
200
0
3
5,000
16,000
0
4
5,000
16,000
18,000
2 years
3 years 3 mths
3 years 7 mths
7000
7522
4760
12.5%
15.5%
20%
Payback
NPV *
ARR
farmer consider
B
C
before deciding
on
Poultrywhich project
Fish hatchery
to go
(20,000) with?
(10,000)
What other factors?
State
of the farming industry
Price of land
Interest rates
The economy – growing or shrinking?
The farmers interests – no good doing
something the family has no interest in!
Competition in area
Level of demand for each option!
Capital Budgeting
Outcome
is uncertain.
Large amounts of
money involved.
Decision may be
difficult or impossible
to reverse.
Investment involves
long-term commitment.
The Five Main Investment
Appraisal Criteria Methods
Payback Method
Payback method - length of time it
takes to repay the cost of initial
investment
Payback Method
LBS Ltd uses the payback period as its
sole investment appraisal method. LBS
invests ¢ 30,000 to replace its
computers and this investment returns
¢ 9,000 annually for the five years.
From the information above evaluate
the investment using the payback.
Assume that ¢ 9,000 accrues evenly
throughout the year.
Payback Method
Solution
Year
flow
0
1
2
3
4
5
Yearly cash flow
¢
(30,000)
9,000
9,000
9,000
9,000
9,000
Therefore 3years = 27,000
then 3000/9000 x 12 = 4
Payback period = 3 years 4months
cumulative net cash
¢
(30,000)
(21,000)
(12,000)
(3,000)
6,000
15,000
Payback Period
Time period required to recover the cost of
the investment from the annual cash
inflow produced by the investment.
Amount invested
Expected annual net cash inflow
Payback Method
The length of time taken to repay the initial
capital cost
Requires information on the revenue the
investment generates
E.g. A machine costs ¢600,000
It produces items that sell at ¢ 5 each and produces
60,000 units per year
Payback period will be ?????
Payback Method

2 Years Computed as;

600,000 / 300,000 = 2
Example
Casey Co. is considering an investment of ¢130,000 in new
equipment. The new equipment is expected to last 10 years.
It will have zero salvage value at the end of its useful life. The
straight-line method of depreciation is used for accounting
purposes. The expected annual revenues and costs of the new
product that will be produced from the investment are:
Sales
Cost of goods sold
Depreciation expense
Selling & Admin expense
Income before income tax
Income tax expense
Net Income
¢200,000
¢145,000
13,000
22,000
180,000
¢20,000
7,000
¢13,000
Computation of Annual Cash Inflow
Expected annual net cash inflow =
Net income
¢13,000
Depreciation expense
13,000
¢26,000
Cash Payback Period
130,000 / 26,000
=
5 years
**Operating Cashflow
During 2009, RIT Corp. had sales of $798,456. Costs of
goods sold, administrative and selling expenses, and
depreciation expenses were $565,600, $98,555, and
$89,561, respectively. In addition, the company had an
interest expense of $223,544 and a tax rate of 35 percent.
What is the operating cash flow for 2009? Ignore any tax
loss carry-back or carry-forward provisions.
Operating Cashflow Solution
Sales
COGS
Admin & Selling Expenses
Depreciation
Interest Expense
Tax Rate
798,456
565,600
98,555
89,561
223,544
35%
Operating Cashflow = EBIT + Depreciation - Income Taxes
EBIT = Earnings Before Interest and Taxes
EBIT = Revenue - Operating Expenses
EBIT =
Sales -COGS - Admin & Selling Expenses - Depreciation
EBIT =
44,740
Tax
15,659
Operating Cashflow =
((44,740 + 89,561 - 15,659))
118,642
**Cashflow to stockholders & creditors
M & M Foods
Financial Statements
2008
2009
Sales
6,831
7,866
COGS
4,760
5,236
Interest
331
380
Depreciation
221
289
Cash
450
468
2,214
2,650
991
2,238
Inventory
2,564
2,651
Long-term debt
3,522
2,400
Net fixed assets
5,040
5,542
Common stock
2,365
3,641
566
716
Account Receivables
Current Liabilities
Taxes
A. What is the cash flow to stockholders for 2009?
B. What is the cash flow to creditors for 2009?
Solution
Cashflow to stockholders = Cashflow from Assets - Cashflow to Creditors
Cashflow from Assets
= Operating cashflow - Net Capital Spending - change in net capital
Cashflow to creditors
=
Operating Cashflow
= Sales -COGS - Depreciation + (Depreciation - Taxes)
Net New Borrowing
=
Net Capital Spending
= 2009 net fixed assets - 2008 net fixed assets + 2009 Depreciation
Change in NWC
Interest - Net new borrowing
2009 Long term debt - 2008 Long term debt
= 2009(cash + A/R + inventory - Current Liabilities)
Minus
2008 (cash + A/R + Inventory - Current Liabilities)
Operating Cashflow
=
EBIT + Depreciation - Income Taxes
Solution cont’d
Operating Cashflow = Sales-COGS- Depreciation + Depreciation -Taxes
Operating Cashflow
Net Capital Spending
1,914
= 2009 net fixed assets - 2008 net fixed assets + 2009 Depreciation
Net Capital Spending
Change in NWC
791
= 2009(cash + A/R + inventory - Current Liabilities)
Minus
2008 (cash + A/R + Inventory - Current Liabilities)
Change in NWC
Cashflow from Assets
(706)
= Operating cashflow - Net Capital Spending - change in net capital
Cashflow from assets
Net New Borrowing
Net new borrowing
Cashflow to creditors
Cashflow to stockholders
1,829
=
2009 Long term debt - 2008 Long term debt
(1,122)
1,502
327
Payback Period –
Uneven Cash Flows
Casey Co. wants to
install a machine that
costs ¢16,000 and
has an 8-year useful
life with zero salvage
value. Annual net
cash flows are:
Year
0
1
2
3
4
5
6
7
8
Annual Net
Cash Flows
$ (16,000)
3,000
4,000
4,000
4,000
5,000
3,000
2,000
2,000
Cumulative
Net Cash
Flows
$ (16,000)
(13,000)
(9,000)
(5,000)
(1,000)
Payback Period –
Uneven Cash Flows
We recover the ¢16,000
purchase price betweenYear
years 4 and 5, about 0
1
4.2 years for the
2
payback period.
3
4
4.2
5
6
7
8
Annual Net
Cash Flows
$ (16,000)
3,000
4,000
4,000
4,000
5,000
3,000
2,000
2,000
Cumulative
Net Cash
Flows
$ (16,000)
(13,000)
(9,000)
(5,000)
(1,000)
Payback = 5
years
Payback
= 3 Payback Period
Using
the
years
Consider two projects, each with a 5-year
life and each costing ¢6,000.
Year
1
2
3
4
5
Project One
Net Cash
Inflows
2,000
2,000
2,000
2,000
2,000
Project Two
Net Cash
Inflows
1,000
1,000
1,000
1,000
1,000,000
Would you invest in Project One just
because it has a shorter payback
period?
Payback method
 Payback
 Can
could occur during a year
take account of this by
reducing the cash inflows from the
investment to days, weeks or years.
Payback Method

e.g.



Cost of machine = ¢
600,000
Payback formula
= 600,000
255,000
Payback
formula
Income
= 2.35
years
2 years = 255,000
+ 255,000
= 510,000
What’s just over a 1/3 of a year?
= 2 years & some months….
Annual income streams
Year=14 months 255,000
from investment = ¢
600,000 - 510,000 = 90,000 still owing
255,000 per year
= 2 years and 5 months…
Payback is some
where between …
Year 2 & year 3 it will
pay back – but
when?
Year
2
255,000
255,000
= 21,250
12 months
3 = 4.235255,000
=Year
90,000
month
21,250
= 2 years and 5 months…
Average Rate of Return

A comparison of the profit generated by
the investment with the cost of the
investment
Average annual return or annual profit

ARR = -------------------------------------------Initial cost of investment
Average Rate of Return
Average annual operating income from asset
Average amount invested in asset


Compare accounting rate of return to company’s
required minimum rate of return for investments of
similar risk.
The minimum return is based on the company’s
cost of capital.
Accounting Rate of Return
Average Investment =
Original Investment + Residual Value
2
For Casey, average investment =
(¢130,000 + ¢0)/ 2 = ¢65,000
Solution to Accounting Rate of Return
Problem
Average annual operating income from asset
Average amount invested in asset
¢13,000
/
¢65,000
=
20%
Accounting Rate of Return
The decision rule is:
A project is acceptable if its rate of return
is greater than management’s minimum
rate of return.
The higher the rate of return for a given
risk, the more attractive the investment.
Accounting Rate of Return

An investment is expected to yield cash flows of ¢ 10,000
annually for the next 5 years.

The initial cost of the investment is ¢ 20,000
Total profit therefore is: ¢ 30,000
(50,000-20,000)


Annual profit = ¢ 30,000 / 5
= ¢ 6,000
ARR = 6,000/20,000 x 100
= 30%
Is this a worthwhile return?
Need to compare to interest rates
as well alternatives.
ARR- do you need a formula?


Total revenue (over lifetime) – purchase price = total profit
Total profit / life time of product = average profit

Average profit / purchase price = ARR x 100

= ARR %
Investment Appraisal

To make a more
informed decision,
more sophisticated
techniques need to
be used.

Importance of
time-value of
money
Discounted Cash Flows
Considers both the estimated total cash
inflows and the time value of money.
Two methods
1) net present value
2) internal rate of return
Investment Appraisal
money could
have been
alternatively
invested in say
risk-free
Government
securities
Purchasing power
would have been
lost over a year
due to inflation
Net Present Value
NPV is today’s value of the difference
between cash inflows and outflows projected
at future dates, attributable to capital
investments or long-term projects
Net Present Value

Takes into account the fact that money's value
change with time

How much would you need to invest today to
earn x amount in x years time?

Value of money is affected by interest rates

NPV helps to take these factors into consideration

Shows you what your investment would have
earned in an alternative investment regime
Net Present Value




e.g.
Project A costs ¢ 1,000,000
After 5 years the cash returns = ¢ 100,000 (10%)
If you had invested the ¢ 1 million into a bank
offering interest at 12% the returns would be
greater - You might be better off re-considering
your investment!
Net Present Value

The principle:
How much would you have to invest now to earn
¢ 100 in 1 year’s time if the interest rate was
5%?

The amount invested would need to be: ¢ 95

Allows comparison of an investment by valuing
cash payments on the project and cash receipts
expected to be earned over the lifetime of the
investment at the same point in time, i.e the
present.

Net Present Value
Future Value
PV = ----------------(1 + i)n
Where i = interest rate
n = number of years
Don’t
need to
know this
formula!!

The Present Value of ¢ 1 @ 10% in 1 year’s time is
0.9090.

If you invested 0.9090p today and the interest rate was
10% you would have ¢ 1 in a year’s time
Process referred to as:
‘Discounting Cash Flow’

Net Present Value

Cash flow x discount factor = present value

e.g. PV of ¢ 500 in 10 years time at a rate of
interest of 4.25% = 500 x .6595373 = ¢ 329.77

¢ 329.77 is what you would have to invest
today at a rate of interest of 4.25% to earn ¢
500 in 10 years time

PVs can be found through valuation tables
(Always given to you in exams!)

Discounted Cash Flow


An example:
A firm is deciding on investing in an energy
efficiency system. Two possible systems are
under investigation

1 yields quicker results in terms of energy
savings than the other but the second may be
more efficient later

Which should the firm invest in?
Discounted Cash Flow – System A
Year
Cash Flow (£)
Discount Factor
(4.75%)
Present Value (£)
(CF x DF)
0
- (600,000)
1.00
-(600,000)
1
+75,000
0.9546539
71,599.04
2
+100,000
0.9113641
91,136.41
3
+150,000
0.8700374
130,505.61
4
+200,000
0.8305846
166,116.92
5
+210,000
0.7929209
166,513.39
6
+150,000
0.7569650
113,544.75
Total
285,000
NPV
Watch this….
=139,416
Discounted Cash Flow – System B
Year
Cash Flow (£)
Discount Factor
(4.75%)
Present Value (£)
(CF x DF)
0
- (600,000)
1.00
-(600,000)
1
+25,000
0.9546539
23,866.35
2
+75,000
0.9113641
68,352.31
3
+85,000
0.8700374
73,953.18
4
+100,000
0.8305846
83,058.46
5
+150,000
0.7929209
118,938.10
6
+450,000
0.7569650
340,634.30
Total
285,000
NPV =108,802.70
Watch this….
Discounted Cash Flow

System A represents the better
investment…. But why?

System B yields the same cash return after 6
years but the NET returns of System A occur
faster and are worth more to the firm than
returns occurring in future years even though
those returns are greater
What would you
prefer…a ¢ 50
today or ¢ 100 in
3 years time?
Absolutely vital to
remember this for
evaluation!
Net Present Value Method
Find PV of future cash flows and compare
with capital outlay
 Interest rate used = required minimum
rate of return
 Proposal is acceptable when NPV is zero or
positive.
 The higher the positive NPV, the more
attractive the investment.

Net Present Value
We will assume that Casey Co’s annual
cash inflows of ¢26,000 are uniform over
the asset’s useful life.
 The present value of the annual cash
inflows can be computed by using the
present value of an annuity of 1 for 10
periods. Assume the company requires a
minimum return of 12%.

Net Present Value
Cash
Flow
(130,000)
When?
Type of
cash flow
Present
value
factor
Now
26,000 Yrs 110
Present
value of
cash flows
(¢130,000)
Annuity
5.650
NPV
Analysis of the proposal:
146,900
¢ 16,900
The proposed capital
expenditure is acceptable at a required rate of return of 12%
because the net present value is positive
Net Present Value
When annual cash inflows are unequal,
use present value of one tables.
Cash Flow
When?
Type of
cash flow
PV factor
Net
Present
Value
(130,000)
Now
Present
value
36,000
1
Lump sum
.893
($130,000)
32,148
32,000
29,000
27,000
26,000
2
3
4
5
“
“
“
“
.797
.712
.636
.567
25,504
20,648
17,172
14,742
24,000
23,000
22,000
6
7
8
“
“
“
.507
.452
.404
12,168
10,396
8,888
21,000
20,000
NPV
9
10
“
“
.361
.322
7,581
6,440
$25,687
,,
Internal Rate of Return
Interest yield of the potential investment
 The interest rate that will cause the
present value of the proposed capital
expenditure to equal the present value of
the expected annual cash inflows.

Internal Rate of Return

STEP 1.Compute the internal rate of
return factor using this formula:
Capital Investment
Annual Cash Inflows
130,000
/
26,000
=5
Internal Rate of Return
Method
STEP 2. Use the factor and the present
value of an annuity of 1 table to find
the internal rate of return.
 Locate the discount factor that is
closest to 5.0 on the line for 10 periods.

(N)
Periods
10
6%
7.360
PRESENT VALUE OF AN ANNUITY OF 1
7%
8%
9%
10%
12%
7.024
6.710
6.418
6.145
5.650
14%
15%
5.216
5.019
Internal Rate of Return
Decision Criteria
The decision rule is:
Accept when internal rate of return is equal
to or greater than the required rate of
return
Reject when internal rate of return is less
than required rate
Internal Rate of Return –
Uneven Cash Flows
If cash inflows are unequal, trial and
error solution will result if present value
tables
are used.

Use business calculators and electronic
spreadsheets

Profitability Index (PI)
Measures the benefit per unit cost, based
on the time value of money
 A profitability index of 1.1 implies that for
every ¢1 of investment, we create an
additional ¢0.10 in value
 This measure can be very useful in
situations where we have limited capital

Profitability Index (PI)

In other words, PI shows the relative
profitability of any project, or the present
value per cedi of initial cost
PV of future cash flows
Initial Cost
Compute the PI for a project with initial cost of ¢
130,000 with an NPV of ¢ 16,900
Profitability Index (PI)
Answer
Initial cost = 130,000
NPV = 16,900
PV of future cash flows = 146,900
146,900
130,000
=
1.13
**Net Present Value
Jasper Metals is considering installing a new molding machine which is
expected to produce operating cash flows of $78,000 a year for 7 years. At
the beginning of the project, inventory will decrease by $19,000, accounts
receivables will increase by $24,000, and accounts payable will increase by
$18,000.
All net working capital will be recovered at the end of the project. The initial
cost of the molding machine is $279,000. The equipment will be depreciated
straight-line to a zero book value over the life of the project. The equipment
will be salvaged at the end of the project creating a $52,000 aftertax cash
flow.
At the end of the project, net working capital will return to its normal level.
What is the Net Present Value of this project given a required return of
14.5 percent?
(B) Calculate the project Profitability Index
Solution
Cashflow for initial year
CF0
Initial cost
(279,000)
Inventory decrease
19,000
Account Receivable increase
(24,000)
Account payable increase
CF0
=
18,000
(-279,000 + 19,000 - 24,000
+18,000)
(266,000)
Solution cont’d
Cashflow for year 7
CO7
Yearly cashflow
78,000
Salvaged Equipment after tax cashflow
52,000
Inventory decrease (initial year)
(19,000)
Account Receivable increase (initial year)
24,000
Account payable increase (initial year)
(18,000)
CO7
=
(78,000 + 52,000 - 19,000 + 24,000 - 18,000)
117,000
Solution cont’d
NPV Computation
Rate of return r = 14.50% ( r = 0.145)
Period/Number of years = n = 7
NPV = CF0 + yearly cashflow * [1 - ((1/(1 + r)^n-1)/r) ] +[ CO7/(1 + r)^n]
NPV
=
(-279,000 + 78,000 * [1-1/(1+0.145)^7-1/0.145] + 117,000/(1 + 0.145)^7
78,555.24
(B)
Profitability Index, PI, is calculated as
PV of future cash flows
Initial year cashflow
PV of future cash flows
78,555.24
Initial year cashflow
PI
266,000
0.2953
Solution cont’d
( C ) An investment project cost $23,500 and has annual cash
flows of $6,800 for 6 years. If the discount rate is 20
percent, what is the discounted payback period?
PV
=
Annual cashflow * [1-((1/(1+r)^n))/r)]
Annual cashflow
6,800
Discount rate, r
20%
0.2
Period, n
PV
6
=
22,613.47
Advantages and Disadvantages of
Profitability Index

Advantages



Closely related to
NPV, generally
leading to identical
decisions
Easy to understand
and communicate
May be useful when
available
investment funds
are limited

Disadvantages

May lead to
incorrect decisions
in comparisons of
mutually exclusive
investments
Comparing Methods
Basis of
measurement
Measure
expressed as
Strengths
Limitations
Payback
period
Cash
flow s
Number
of years
Easy to
Understand
Accounting
rate of return
Accrual
income
Percent
Easy to
Understand
Net present
Internal rate
value
of return
Cash flow s
Cash flow s
Profitability
Profitability
Dollar
Percent
Amount
Considers time Considers time
value of money value of money
Allow s
Allow s
Accommodates
Allow s
comparison
comparison
different risk
comparisons
across projects across projects
levels over
of dissimilar
a project's life
projects
Doesn't
Doesn't
Difficult to
Doesn't reflect
consider time consider time
compare
varying risk
value of money value of money
dissimilar
levels over the
projects
project's life
Doesn't
consider cash
flow s after
payback period
Doesn't give
annual rates
over the life
of a project
IRR and Mutually Exclusive
Projects

Mutually exclusive projects



Intuitively you would use the following
decision rules:


9-73
If you choose one, you can’t choose the other
Example: You could have chosen to attend
graduate school at either KNUST or GTUC
(Coventry), but not both
NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR
Investment Appraisal

Key considerations for firms in
considering use:

Ease of use/degree of simplicity required

Degree of accuracy required

Extent to which future cash flows can be measured
accurately

Absolutely
vital can
Extent to which future interest rate
movements
be factored in and predicted
to also
remember this for
Necessity of factoring in effects of inflation
evaluation!

**More ratio problems
Uptown Men's Wear has accounts payable of $4,428,
inventory of $15,900, cash of $2,526 fixed assets of $16,800,
accounts receivable of $7,814, and long-term debt of $8,400.
What is the value of the net working capital to total assets
ratio?
Solution
Cash
AR
Inventory
Fixed assets
AP
Long Term Debt
2,526
7,814
15,900
16,800
4,428
8,400
Net working capital to Total assets ratio =
Net working capital =
Net Working Capital
Total Assets
Current assets - Current liabilities
Cash + AR + Inventory - Accounts payable
21,812
Total Assets
=
Cash + AR + Inventory + Fixed Assets
43,040
Net working capital to Total assets ratio =
0.51
**Some more ratio issues
The Flower Shoppe has accounts receivable of $7,930, inventory of
$7,044, sales of $548,226, and cost of goods sold of $412,899. How many
days does it take the firm to both sell its inventory and collect the
payment on the sale assuming that all sales are on credit?
Sales
COGS
AR
Inventory
548,226
412,899
7,930
7,044
Days of the year
Days in inventory =
Days in inventory =
Days' Sales in receivables
or
Average Collection Period
365
365 days
Inventory Turnover ratio
6.227
365 Days
Receivables Turnover ratio
Solution cont’d
Receivables Turnover ratio
Days' Sales in receivables
or
Average Collection Period
Sales
Accounts Receivable
5.280
Total days in Inventory and Receivables
11.507
**Some even more ratios
A firm has a debt-equity ratio of 67 percent, a total asset
turnover of 1.36, and a profit margin of 9.4 percent. The
total equity is $640,115. What is the amount of the net
income?
Debt - equity ratio
67%
0.67
Total assets turnover
Profit Margin
1.36
9.40%
0.049
Total Equity
640,511
Solution cont’d
DuPont formula on ROE
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier)
Net Income
Sales
*
Sales *
Assets
Assets
Equity
DuPont model tells that ROE is affected by three things:
Operating efficiency, which is measured by net profit margin;
Asset use efficiency, which is measured by total asset turnover;
Financial leverage, which is measured by the equity multiplier;
If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that
is underperforming.
Solution cont’d
Equity Multiplier = (1 + Debt to Equity Ratio)
Debt/Equity = 0.67
Assets - Equity
Equity
Debt = Assets - Equity
=
0.67
Assets - Equity = 0.67 * Equity
Assets = (0.67 * Equity) + Equity
Assets = 0.67Equity + Equity
Assets = Equity (0.67 + 1)
Return on equity
= Profit Margin * Total Assets Turnover * (1 + Debt to Equity Ratio)
(0.094 * 1.36 * (1 + 0.67)
Return on equity
=
Net Income
=
Net Income
Total Equity
Return on Equity * Total Equity
71,282
0.1112888
**Some more ratio issues
Use the below statements to answer question A to E
TEW COMPANY
Balance Sheet
As of December 31, 2007
Assets
Cash
Accounts Receivable
Inventory
PPE, net
Total Assets
70,000
100,000
85,000
455,000
710,000
Liabilities and Stockholders' Equity
Accounts payable
Accrued expenses
Long Term Debt
Common Stock
Paid-in capital
Retained Earnings
Total Liabilities and SE
95,000
116,000
195,000
168,000
38,000
98,000
710,000
TEW COMPANY
Income Statement
For the Year Ended December 31, 2007
Sales (all on credit)
800,000
COGS
500,000
Gross Profit
300,000
Sales and Admin Expenses
40,000
Fixed Lease Expense
20,000
Depreciation
80,000
Operating Profit
160,000
Interest Expense
40,000
Profit before Taxes
Taxes
Net Income
120,000
35%
42,000
78,000
(A). Refer to the figure above. The firm's return on equity is
ROE =
Net Income
Shareholders' Equity
0.26
B). Refer to the figure above. The firm's average collection period is
Average Collection Period=
Receivable Turnover ratio
Average Collection Period=
365
Receivable Turnover ratio
Sales on Account
Accounts Receivable
8
45.625 days
(C). Refer to the figure above. Tew's quick ratio is
Quick Ratio =
Current assets - Inventory
Current Liabilities
170,000
0.806
211,000
(D). Refer to the figure above. The firm's debt to asset ratio is
Debt to Assets ratio =
Total Debt
Total Assets
406,000
710,000
0.57
(E). Refer to the figure above. Fixed Charge coverage for Tew Company is
(E). Refer to the figure above. Fixed Charge coverage for Tew Company is
Fixed charge coverage =
Earnings before interest and taxes + fixed charge
Fixed charges + Interest
160,000
60,000
2.67
Interpretation: EBIT, Taxes, and Interest Expense are taken from the company's
income statement.
Lease Payments are taken from the balance sheet and are usually shown as a footnote
on the balance sheet.
The result of the fixed charge coverage ratio is the number of times the company can cover its
fixed charges per year.
The higher the number, the better the debt position of the firm, similar to the times
interest earned ratio.