CHAPTER 11
ANSWERS
11-1
The four financial statements contained in most annual reports are the balance sheet, income
statement, statement of retained earnings, and statement of cash flows.
11-2
No, because the $20 million of retained earnings probably would not be held as cash. The retained
earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million
would be an investment in all of the assets of the firm.
11-3
Liquidating assets, borrowing more funds, and issuing stock would constitute sources of funds.
Purchasing assets, paying off debt, and stock repurchases would constitute uses of funds. Thus, the
following general rules can be used to determine what changes in balance sheet accounts represent
sources and uses if funds:
Sources of cash:
↑ in a liability or equity account
↓ in an asset account
Uses of Cash:
↓ in a liability of equity account
↑ in an asset account
11-4
The emphasis of the various types of analysts is by no means uniform, nor should it be. Management
is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should
be strengthened; second, management recognizes that the other parties are interested in all the ratios
and that financial appearances must be kept up if the firm is to be regarded highly by creditors and
equity investors. Equity investors are interested primarily in profitability, but they examine the other
ratios to get information on the riskiness of equity commitments. Long-term creditors are more
interested in the debt ratio, TIE, and fixed charge coverage ratios, as well as the profitability ratios.
Short-term creditors emphasize liquidity and look most carefully at the liquidity ratios.
11-5
The most important aspect of ratio analysis is the judgment used when interpreting the results to
reach an overall conclusion concerning a firm’s financial position. The analyst should be aware of,
and include in the interpretation, the fact that: (1) large firms with many different divisions are
difficult to categorize in a single industry; (2) financial statements are reported at historical costs; (3)
seasonal factors can distort the ratios; (4) some firms try to “window dress” their financial
statements to look good; (5) firms use different accounting procedures to compute inventory values,
depreciation, and so on; (6) there might not exist a single value that can be used for comparing
firms’ ratios (e.g., a current ratio of 2.0 might not be good); and (7) conclusions concerning the
overall financial position of a firm should a representative number of ratios, not a single ratio.
11-6
Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover
ratios to vary among industries. For example, a steel company needs a greater number of dollars in
assets to produce a dollar in sales than does a grocery store chain such as Safeway. Also, profit
margins and turnover ratios might vary due to differences in the amount of expenses incurred to
produce sales. For example, one would expect a grocery store chain like Safeway to spend more per
dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit
margin, and vice versa.
188
11-7
ROE can be written
ROE 
NI
NI
TA


Owners ' equity TA Owners ' equity
Total assets divided by owners’ equity, which is termed the equity multiplier, is a measure of debt
utilization (the inverse of the percent equity the firm uses); the more debt, the higher the equity
multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE.
11-8
a.
Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms
with seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will
vary unless averages (monthly ones are best) are used.
b.
Common equity is determined at a point in time, say, December 31, 2005. Profits are earned
over time, say, during 2005. If a firm is growing rapidly, year-end equity will be much larger
than beginning-of-year equity, so the calculated rate of return on equity will be different
depending on whether end-of-year, beginning-of-year, or average common equity is used as
the denominator. Average common equity is conceptually the best figure to use. In public
utility rate cases, people are reported to have deliberately used end-of-year or beginningof-year equity to make returns on equity appear excessive or inadequate. Similar problems
can arise when a firm is being evaluated.
11-9
Cash
Accounts receivable
Inventory
Current assets
Net property & equipment
Total assets
2005
$ 400
250
450
1,100
1,000
$2,100
2004
$ 500
300
400
1,200
950
$2,150
Accounts payable
Accruals
Notes payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities and equity
$ 200
300
400
900
800
1,700
250
150
400
$2,100
$ 400
250
200
850
900
1,750
300
100
400
$2,150
Source(+) or Use(-)?
+
+
–
– *
–
+
+
–
–
+
*The book value of property and equipment is stated net of depreciation. Because the book value of
fixed assets increased, and depreciation is an adjustment that reduces the account balance, Batelan
must have purchased addition fixed assets. But, without more information we cannot determine the
amount of the purchase.
The retained earning balance increased in 2005, so Batelan must have generated a positive net
income. But, without additional information (i.e. the amount of net income), we cannot tell whether
dividends were paid in 2000.
189
11-10
Total
Current
Assets
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
11-11
Cash is acquired through issuance
of additional common stock.
Inventory is sold for cash.
Federal income tax due for the previous year is paid.
A fixed asset is sold for less than its book value.
A fixed asset is sold for more than its book value.
Inventory is sold on credit.
Payment is made to trade creditors for previous purchases.
A cash dividend is declared and paid.
Cash is obtained through short-term bank loans.
Marketable securities are sold below cost.
Advances are made to employees.
Current operating expenses are paid.
Short-term promissory notes are issued to trade creditors
in exchange for past due accounts payable.
Ten-year notes are issued to pay off accounts payable.
Accounts receivable are collected.
Equipment is purchased with short-term notes.
Inventory (raw materials) is purchased on credit.
Current
Ratio
Effect
on Net
Income
+
+
+
+
+
+
0
-
+
+
+
+
+
+
+
0
-
0
+
0
+
+
0
0
0
0
-
0
0
0
0
+
0
+
0
-
0
0
0
0
0
a.
Because capital gains are taxed at lower rates than ordinary income, and only when they are
received, the tax laws would favor retention of earnings for an investor who does not need
current income.
b.
Yes. Tax rates are higher the higher one’s income. Thus, the wealthier the investor, the more
important it is to get capital gains rather than dividend income, thus deferring taxes until
later. A retiree who is in a lower tax bracket than a doctor would probably need current
income more than the doctor. Also, the pension fund manager would be more concerned with
current income than the doctor.
c.
If most of GM’s investors want capital gains rather than dividends, then GM’s stock price
would be higher if it retained and reinvested earnings. But other things are not constant—
factors other than taxes enter the question of how dividend policy affects stock prices. This
topic is discussed in detail in Chapter 10.
11-12
Double taxation refers to the fact that corporate income is subject to an income tax, and then
stockholders are subject to a further personal tax on dividends received.
11-13
If the business were organized as a partnership or a proprietorship, its income could be taken out
by the owners without being subject to double taxation. Also, if you expected to have losses for a
few years while the company was getting started, and if you had outside income, the business
losses if you were not incorporated could be used to offset your other income, and reduce your total
tax bill. These factors would lead you to not incorporate the business. An alternative would be to
organize as an S Corporation, if requirements are met. The appropriate tax rate depends on the
owner’s situation. If the owner has substantial other income, then the major concern would be the
business’s marginal contribution to taxes, so the marginal tax rate would be more relevant. Conversely, if there were no outside income, the average tax rate would be more relevant.
190
11-14
Because interest paid is deductible but dividend payments are not, the after-tax cost of debt is
lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This
point is discussed in detail in Chapters 8 and 9.
__________________________________________________________________
SOLUTIONS
11-1
a.
Dollar amounts are in millions.
Current  Current assets  $400
ratio
Current liabilitie s $105
Accounts receivable
$160
Days sales


outs tan ding
Sales / 360
 $1,435 
 360 
Unilate
Industry
Average
3.81x
3.9x
Comment
Near average
40.14 days 33.5 days Poor
Inventory Cost of goods sold $1,176.7


turnover
Inventorie s
$200
5.88x
7.2x
Poor
$1,435
Fixed assets Sales

turnover
Fixed assets $350
4.10x
4.1x
Average
45.0%
Marginal
Marginal
Debt  Total debt  $360
ratio Total assets $750
48.0%
$59
Net profit Net income


m arg in
Sales
$1,435
4.11x
4.6x
Return  Net income  $59
on assets Total assets $750
7.87%
11.8%
Poor
b.
The ratios do not show any particular strengths. However, Unilate does have a low inventory
turnover, higher than normal days sales outstanding, and poor return on assets. According to
its 2004 ratios, it appears Unilate has liquidity problems.
c.
Ratio
Current ratio
Days sales outstanding
Inventory turnover
Fixed assets turnover
Debt ratio
Profit margin on sales
Return on assets
2005
3.6 x
43.2 days
4.6 x
3.9 x
50.9%
3.6%
6.4%
191
2004
3.8 x
40.1 days
5.9 x
4.1 x
48.0%
4.1%
7.9%
Trend
Worse
Worse
Worse
Worse
Worse
Worse
Worse
This comparison shows that Unilate’s financial position worsened from 2004 to 2005.
d.
11-2
It would be helpful to know the future plans Unilate has with respect to improving its current
financial position, introducing new products, liquidating unprofitable investments, and so on.
Perhaps the fixed assets turnover ratio and return on assets figures are low because the firm
has expanded its product distribution, and this process has a large cost “up front” with
significant payoffs beginning in two or three years.
a.
Current assets
$655,000

Current liabilitie s $330,000
Industry
Average
1.98x
2.0x
Accounts receivable
$336,000

Sales / 360
$4,465.28
75.0 days
Cost of goods sold $1,353,000

Inventorie s
$241,500
5.60x
5.6x
Sales
$1,607,500

Total assets
$947,500
1.70x
3.0x
Net income
$27,300

Sales
$1,607,500
1.7%
1.2%
Net income
$27,300

Total assets $947,500
2.9%
3.6%
Net income
$27,300

Common equity $361,000
7.6%
9.0%
61.9%
60.0%
Total debt
$586,500

Total assets $947,500
b.
Campsey
35.0 days
For Campsey, ROA = PM x TA turnover = 1.7% x 1.7 = 2.9%.
For the industry, ROA = 1.2% x 3.0 = 3.6%.
c.
Campsey’s days sales outstanding is more than twice as long as the industry average,
indicating that the firm should tighten credit or enforce a more stringent collection policy.
The total assets turnover ratio is well below the industry average so sales should be
increased, assets decreased, or both. While Campsey’s profit margin is higher than the
industry average, its other profitability ratios are low compared to the industry—net income
should be higher given the amount of equity and assets. However, the company seems to be
in an average liquidity position and financial leverage is similar to others in the industry.
192
d.
11-3
11-4
If 2005 represents a period of supernormal growth for Campsey, ratios based on this year will
be distorted and a comparison between them and industry averages will have little meaning.
Potential investors who look only at 2005 ratios will be misled, and a return to normal
conditions in 2006 could hurt the firm’s stock price.
(1)
Total liabilities and equity = Total assets = $300,000.
(2)
Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.
(3)
Accounts payable = Debt - Long-term debt = $150,000 - $60,000 = $90,000.
(4)
Common stock = Total liabilities and equity – Debt – Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500
(5)
Sales = 1.5 x Total assets = 1.5 x $300,000 = $450,000
(6)
Cost of goods sold = Sales(1 - 0.25) = $450,000(.75) = $337,500
(7)
Inventory = (CGS)/5 = $337,500/5 = $67,500.
(8)
Accounts receivable = (Sales/360)(DSO) = ($450,000/360)(36) = $45,000.
(9)
(Cash + Accounts receivable)/(Accounts payable) = 0.80x
Cash + Accounts receivable = (0.80)(Accts payable)
Cash + $45,000 = (0.80)($90,000)
Cash = $72,000 - $45,000 = $27,000.
(10)
Fixed assets = Total assets - (Cash + Accts Rec. + Inventories)
= $300,000 - ($27,000 + $45,000 + $67,500) = $160,500.
a.
Finnerty
Furniture
Industry
Average
2.73x
2.0x
Debt
$135
Debt 
ratio Total assets  $450
30.00%
30.0%
Times interest  EBIT  $49.5
earned
Interest
$4.5
11.00x
7.0x
4.15x
8.5x
Current assets
$303

Current liabilitie s $111
Inventory  Cost of goods sold  $660
Inventorie s
$159
turnover
Accounts receivable
$66

Sales / 360
$795 / 360
Sales
$795
Fixed assets 

turnover
Fixed assets $147
DSO 
193
29.89 days
5.41x
24.0 days
6.0 x
b.
$795
Total assets  Sales

turnover
Total assets $450
1.77x
3.0 x
$27
Net profit Net income


margin
Sales
$795
3.40%
3.0%
$27
Return on Net income
total assets  Total assets  $450
6.00%
9.0%
Re turn on  Net income  $27
equity
Total equity $315
8..57%
12.9%
ROA = Profit margin x Total assets turnover

Net income
Sales

Sales
Total assets

$27 $795

$795 $450
 3.4%  1.77  6.0%
Finnerty
Profit margin
3.4%
Total assets turnover
1.8x
Return on total assets
6.0%
11-5
Industry
3.0%
3.0 x
9.0%
Comment
Good
Poor
Poor
c.
Analysis of the Du Pont equation and the set of ratios shows that the turnover ratio of sales
to assets is quite low. Either sales should be increased at the present level of assets, or the
current level of assets should be decreased to be more in line with current sales. Thus, the
problem appears to be in the balance sheet accounts.
d.
The comparison of inventory turnover ratios shows that other firms in the industry seem to
be getting along with about half as much inventory per unit of sales as Finnerty. If
Finnerty’s inventory could be reduced this would generate funds that could be used to retire
debt, thus reducing interest charges and improving profits, and strengthening the debt
position. There might also be some excess investment in fixed assets, perhaps indicative of
excess capacity, as shown by a slightly lower than average fixed assets turnover ratio.
However, this is not nearly as clear-cut as the over-investment in inventory.
e.
If Finnerty had a sharp seasonal sales pattern, or if it grew rapidly during the year, many
ratios might be distorted. Ratios involving cash, receivables, inventories, and current
liabilities, as well as those based on sales, profits, and common equity, could be biased. It is
possible to correct for such problems by using average rather than end-of-period figures.
a.
Here are Cary’s base case ratios and other data as compared to the industry:
194
Quick
Current
Inventory turnover
Days sales outstanding
Fixed assets turnover
Total assets turnover
Return on assets
Return on equity
Debt ratio
Profit margin on sales
EPS
Stock Price
P/E ratio
M/B ratio
Cary
0.85x
2.33
4.0
37 days
10.0x
2.34
5.9%
13.07
54.8
2.5
$4.71
$23.57
5.0x
0.65
Industry
1.0x
2.7
5.8
32 days
13.0x
2.6
9.1%
18.2
50.0
3.5
n.a.
n.a.
6.0x
n.a.
Comment
Weak
Weak
Poor
Poor
Poor
Poor
Bad
Bad
High
Bad
--Poor
--
Cary appears to be poorly managed—all of its ratios are worse than the industry averages,
and the result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The
company needs to do something to improve.
b.
11-6
A decrease in the inventory level would improve the inventory turnover, total assets turnover,
and ROA, all of which are too low. It would have some impact on the current ratio, but it is
difficult to say precisely how that ratio would be affected. If the lower inventory level
allowed Cary to reduce its current liabilities, then the current ratio would improve. The lower
cost of goods sold would improve all of the profitability ratios and, if dividends were not
increased, would lower the debt ratio through increased retained earnings. All of this should
lead to a higher market/book ratio and a higher stock price.
Operating loss in 2005 = $650,000, which can be carried back two years and carried forward 20
years.
Prior Years
Profit earned
Carryback credit
Adjusted profit
Tax previously paid (30%)
Tax refund: Taxes previously paid
2003
$150,000
(150,000)
$
0 $
45,000
$ 45,000
2004
$150,000
(150,000)
0
45,000
$ 45,000
Total check from U.S. Treasury = $45,000 + $45,000 = $90,000.
Future Years
Estimated profit
Carryover credit
Adjusted profit
Tax (at 30%)
11-7
2006
$150,000
(150,000)
$
0
0
2008
$150,000
(150,000)
$
0
$
0
2010
$150,000
(50,000)
$100,000
$ 30,000
2011
$150,000
(0)
$150,000
$ 45,000
2012
$150,000
(0)
$150,000
$ 45,000
2004 taxes = $0, because the firm had a loss. The $95,000 loss will be used to offset future income.
2005 taxes = $0; $70,000 income offset by $70,000 of 2004 loss.
195
2006 taxable income is reduced by remaining $25,000 of 2004 loss, so 2006 taxable income =
$55,000 - $25,000 = $30,000, and 2006 tax = (0.15)($30,000) = $4,500.
2007 tax = $13,750 + (0.34)($80,000 - $75,000) = $13,750 + $1,700 = $15,450.
2008 tax = $0. $110,000 of loss can be carried back to offset income from 2006 and 2007,
reducing taxes in those years to $0. The firm will get a refund of $4,500 + $15,450 = $19,950 for
taxes paid in those years. The remaining $40,000 of loss can be carried forward.
11-8
a.
b.
2005
2006
2007
Taxes as a corporation:
Income before salary & taxes
Less salary
Taxable income, corporate
Total corporate tax (15%)
$65,000.0
(45,000.0)
$20,000.0
$ 3,000.0
$85,000.0
(45,000.0)
$40,000.0
$ 6,000.0
$95,000.0
(45,000.0)
$50,000.0
$ 7,500.0
Salary
Less exemptions & deductions
Taxable personal income
Total personal tax*
Combined corp. & personal tax
$45,000.0
(23,400.0)
$21,600.0
$ 2,525.0
$ 5,525.0
$45,000.0
(23,400.0)
$21,600.0
$ 2,525.0
$ 8,525.0
$45,000.0
(23,400.0)
$21,600.0
$ 2,525.0
$10,025.0
Taxes as a proprietorship:
Total income
Less exemptions & deductions
Taxable personal income
Total proprietorship tax
$65,000.0
(23,400.0)
$41,600.0
$ 5,525.0
$85,000.0
(23,400.0)
$61,600.0
$ 8,875.0
$95,000.0
(23,400.0)
$71,600.0
$11,375.0
Advantage to corporation
$
$
$ 1,350.0
0.0
350.0
On the basis of these figures, Brown should incorporate, the tax advantage increases each
year as a corporation and because she plans to retain all income in excess of her salary in the
business. However, if Brown planned to withdraw earnings in the future, she would have to
consider the effects of double taxation on dividends she would receive when she withdrew
earnings. Of course, Brown could avoid double taxation simply by raising her salary.
Note: Problem 11-26 in the Computer-Related Problem section deals with Brown paying
dividends, using a spreadsheet model. The model is on the Computer Problem diskette, and
a hard copy of the Computer Problem solution is shown in the Instructor's Manual, Solutions
to Computer-Related Problems.
11-9
a.
Calculation of gross income:
Salary
Dividend Income
Interest Income (IBM bonds only)
ST capital gains
Gross Income (excluding LT capital gains)
LT capital gains = $22,000 - $9,000 =
**LT Capital gains tax rate = 15%.
196
2005
$60,000
10,000
5,000
1,000 = $22,000 - $21,000
$76,000
13,000
Not taxed: $10,000 interest on Florida municipal bonds
Calculation of taxable income:
Gross Income
Exemption
Deductions
Taxable Income (excluding LT capital gains)
$76,000
( 3,100)
( 5,000)
$67,900
Personal tax = Tax on taxable income (excluding LT capital gains) + LT capital gains tax
= [$4,000 + ($67,900 - $29,050)(0.25) + $13,000(0.15)
= [$4,000 + $9,712.50] + $1,950
= $15,662.50
b.
Marginal tax rate = 25%.
Average tax rate = $15,662.50/$80,900* = 19.4%. One could argue that the average rate is
really lower, because the base should consider the deductions and exemptions.
*Includes $13,000 long-term capital gain.
c.
After-tax returns:
IBM = (0.11) - (0.25)(0.11) = 8.25%
FLA = (0.09) - 0
= 9.00%
The Florida bonds provide a higher after-tax return.
d.
9%
= 11%(1 - T). Now solve for T:
9%
= 11% - 11%T
11%T = 2
T
= 2/11 = 18.18%.
At a tax rate less than 18.2 percent, Margaret would be better off holding 11 percent taxable
bonds, but at a tax rate over 18.2 percent, she would be better off holding tax-exempt
municipal bonds. Given our progressive tax rate system, it makes sense for wealthy people to
hold tax-exempt bonds, but not for those with lower incomes and consequently lower tax
rates.
11-10
a.
Salary and income:a
Donald’s salary
Interest from bonds
Income from rental property
Adjusted income
$50,000.0
2,500.0
42,000.0 = $3,500 x 12 months
$94,500.0
Expenses, exemptions, and deductions:
Exemptions = 2 x $3,100
Interest on mortgagesb
Plumbing expensesc
Total expenses and deductions
$ 6,200.0
18,000.0
1,250.0
$25,450.0
197
Taxable income
$69,050.0
Taxes = $8,000 + ($69,050 - $58,100) x 0.25 = $10,737.50
We could have included Maryanne’s salary in this section, but then we would have had to
recognize the amount she earned as an expense associated with the rental property. Because
the two items cancel each other, we need not include them here. Also, we ignore employment
taxes in this problem.
a
b
The amount of the interest and property taxes paid on both houses is tax deductible.
c
Only the plumbing expense associated with the rental property is tax deductible because it
was incurred in the generation of business revenues. Such personal expenses are not
deductible.
b.
Salary and income:
Donald’s salary
Interest from bonds
Adjusted income
$50,000.0
2,500.0
$52,500.0
Expenses, exemptions, and deductions:
Exemptions = 2 x $3,100
Interest on mortgagesa
Total expenses and deductions
$ 6,200.0
5,350.0
$11,550.0
Taxable income
$40,950.0
Taxes = $1,430 + ($40,950 – $14,300)(0.15) = $5,427.50
a
c.
11-11
Only the amount of interest and property taxes paid on the couple’s residence is applicable.
Expenses incurred to generate business income are tax deductible, but personal expenses are
not. The cost of fixing the plumbing in the rental house would be considered a business
expense, but the cost of fixing the plumbing in the Jefferson’s own house would be
considered a personal expense.
We are given ROA = 3% and Sales/Total assets = 1.5x
From DuPont equation: ROA
3%
Profit margin
=
=
=
Profit margin x Total assets turnover
Profit margin (1.5)
3%/1.5 = 2%.
We can also calculate Zumwalt’s debt ratio in a similar manner, given the facts of the problem. We
are given ROA, which is NI/A and ROE, which is NI/Equity; if we use the reciprocal of ROE we
have the following equation:
Equity
NI
Equity
1
=

= 3.0% 
= 0.60 = 60%
A ssets A ssets
NI
0.05
Debt/Assets = 1 - Equity/Assets = 1 - 0.60 = 0.40 = 40.0%
198
Thus, Zumwalt's profit margin = 2% and its debt ratio = 40%.
11-12
$1,312,500
Pr esent
current ratio  $525,000  2.5 
Minimum  $1,312,500  NP  2.0 
current ratio
$525,000  NP
$1,312,500 + ΔNP = $1,050,000 + 2ΔNP
ΔNP = $262,500.
Short-term debt can increase by a maximum of $262,500 without violating a 2-to-1 current ratio,
assuming that the entire increase in notes payable is used to increase current assets. Because we
assumed that the additional funds would be used to increase inventory, the inventory account will
increase to $637,500, and current assets will total $1,575,000.
Quick ratio = ($1,575,000 - $637,500)/$787,500
= $937,500/$787,500
= 1.19x
11-13
(1)
Current assets
 3.0 
Current liabilitie s
$810,000
 3.0 
Current liabilitie s
(2)
Current liabilities = $270,000
Current assets - Inventorie s
 1.4 
Current liabilitie s
$810,000  Inventorie s
 1.4 
$270,000
(3)
Inventories = $432,000
Current assets = Cash + Marketable securities + Accounts receivable + Inventories
$810,000 = $120,000 + Accounts receivable + $432,000
Accounts receivable = $258,000
(4)
Cost of goods sold
 5.0 
Inventory
CGS
 5.0 
$432,000
CGS = $2,160,000
199
(5)
Sales 
CGS = 0.86 (Sales)
$2,160,000
 $2,511,628
0.86
Accounts receivable
Sales / 360
$258,000

$2,511,628 / 360
(6) DSO 
 37 days
11-14
TIE = EBIT/INT, so find EBIT and INT
Interest = $500,000 x 0.1 = $50,000
Net income = $2,000,000 x 0.05 = $100,000
Taxable income (EBT) = $100,000/(1 - T) = $100,000/0.8 = $125,000
EBIT = $125,000 + $50,000 = $175,000
TIE = $175,000/$50,000 = 3.5 x
11-15
ROE = NI/Equity
Now we need to determine the inputs for the equation from the data that were given. On the left we
set up an income statement, and we put numbers in it on the right:
Sales (given)
- Cost
EBIT (given)
- INT (given)
EBT
- Taxes (30%)
NI
$10,000
na
$ 1,000
( 300)
$ 700
( 210)
$ 490
Now we can use some ratios to get some more data:
Total assets turnover = 2.0 = Sales/TA; TA = Sales/2 = $10,000/2 = $5,000
Debt/TA = 60%; so Equity/TA = 40%; therefore, equity = TA x Equity/TA
= $5,000 x 0.40 = $2,000
ROE = NI/E = $490/$2,000 = 24.5%, and ROA = NI/TA = $490/$5,000 = 9.8%
11-16
a.
Currently, ROE is ROE1 = $15,000/$200,000 = 7.5%
200
The current ratio will be set such that 2.5 = CA/CL. CL is $50,000, and it will not change, so
we can solve to find the new level of current assets: CA = 2.5(CL) = 2.5($50,000) =
$125,000. This is the level of current assets that will produce a current ratio of 2.5x.
At present, current assets amount to $210,000, so they can be reduced by $210,000 $125,000 = $85,000.
If the $85,000 generated is used to retire common equity, then the new common equity
balance will be $200,000 - $85,000 = $115,000.
Assuming that net income is unchanged, the new ROE will be ROE2 = $15,000/$115,000 =
13.04%. Therefore, ROE will increase by 13.04% - 7.50% = 5.54%.
b.
(1) Doubling the dollar amounts would not affect the answer; the ROE increase would still
be 5.54%.
(2) Current assets would increase by $25,000, which would mean a new ROE of
$15,000/$140,000 = 10.71%, which would mean a difference of 10.71% - 7.50% =
3.21%.
(3) If the company had 10,000 shares outstanding, then its EPS would be $15,000/10,000 =
$1.50. The stock has a book value of $200,000/10,000 = $20, so the shares retired would
be $85,000/$20 = 4,250, leaving 10,000 - 4,250 = 5,750 shares. The new EPS would be
$15,000/5,750 = $2.6087, so the increase in EPS would be $2.6087 - $1.50 = $1.1087,
which is a 73.91% increase, the same as the increase in ROE.
(5) If the stock was selling for twice book value, or 2 x $20 = $40, then only half as many
shares could be retired ($85,000/$40 = 2,125), so the remaining shares would be 10,000
- 2,125 = 7,875, and the new EPS would be $15,000/7,875 = $1.9048, for an increase of
$1.9048 - $1.5000 = $0.4048.
c.
We could have started with lower inventories and higher accounts receivable, then had you
calculate the DSO, then move to a lower DSO which would require a reduction in
receivables, and then determine the effects on ROE and EPS under different conditions.
Similarly, we could have focused on fixed assets and the FA turnover ratio. In any of these
cases, we could have had you use the funds generated to retire debt, which would have
lowered interest charges and consequently increased net income and EPS.
If we had to increase assets, then we would have had to finance this increase by adding either
debt or equity, which would have lowered ROE and EPS, other things held constant.
Finally, note that we could have asked some conceptual questions about the problem, either
as a part of the problem or without any reference to the problem. For example, “If funds are
generated by reducing assets, and if those funds are used to retire common stock, will the
effect on EPS and/or ROE be affected by whether or not the stock sells above, at, or below
book value?”
201
11-17
a.
Sources and Uses of Funds Analysis:
Lloyd Lumber Company
Balance Sheet, 2005
($ millions)
Cash
Marketable securities
Net receivables
Inventories
Total current assets
Jan. 1
$ 7
0
30
53
$ 90
Dec. 31
$ 15
11
22
75
$123
Gross fixed assets
Less: depreciation
Net fixed assets
Total assets
$ 75
25
$ 50
$140
$125
35
$ 90
$213
Accounts payable
Notes payable
Other current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and equity
$ 18
3
15
8
29
67
$140
$ 15
15
7
24
57
95
$213
Source
Use
$ 8
11
$ 8
22
50
10*
3
12
8
16
28
28
$102
$102
*Depreciation is not a source of cash, but it affects cash in the form of taxes on the income
statement
b.
Lloyd Lumber Company
Statement of Cash Flows, 2005
($ millions)
Operating Activities:
Net income
$ 33
Other additions (sources of cash):
Depreciation
Decrease in accounts receivable
Subtractions (uses of cash):
Increase in inventories
Decrease in accounts payable
Decrease in other current liabilities
Net cash flow from operations
Long-term Investing Activities:
Acquisition of fixed assets
$ 10
8
($22)
( 3)
( 8)
$ 18
($ 50)
202
Financing Activities:
Increase in notes payable
Sale of long-term debt
Sale of common stock
Payment of dividends
Net cash flow from financing
Net increase in cash and marketable securities
Cash and marketable securities at beginning of year
Cash and marketable securities at end of year
11-18
$ 12
16
28
( 5)
$ 51
$ 19
7
$ 26
c.
Investments were made in plant and inventories. Funds were also utilized to reduce accounts
payable and other current liabilities and to increase the cash and marketable securities
accounts. Most funds were obtained by increasing long-term debt, selling common stock,
and retaining earnings. The remainder was obtained from increasing notes payable and
reducing receivables. A quick check of the ratios shows that the company's credit has not
deteriorated—the current and quick ratios have increased, and the debt ratio has gone down
slightly. Ratio analysis and the sources and uses statement both indicate a healthy situation.
a.
Dollars are in millions.
Income
Statement
Sales revenues
Costs, except depreciation
Depreciation
Total operating costs
Net operating income (NOI)
Taxes (40%)
Operating income after taxes
Add back depreciation
Cash flow from operations
*Costs,
Cash
Flows
$12.0
( 9.0)*
( 1.5)
$12.0
( 9.0)
--
(10.5)
$ 1.5
( 0.6)
$ 0.9
1.5
$ 2.4
( 9.0) (Cash costs)
$ 3.0 (Pre-tax CF)
( 0.6) (Cash taxes)
$ 2.4
except depreciation = 0.75 x $12.0 = $9.0
Net income = (NOI – Interest)(1 – T) = ($1.5 - $1.0)(0.6) = $0.3
b.
Depreciation doubles.
Income
Statement
Sales revenues
Costs, except depreciation
Depreciation
Total operating costs
Net operating income (NOI)
Taxes (40%)
Operating income after taxes
Add back depreciation
Cash flow from operations
Cash
Flows
$12.0
(9.0)
(3.0)
$12.0
(9.0)
---
(12.0)
$ 0.0
( 0.0)
$ 0.0
3.0
$ 3.0
( 9.0) (Cash costs)
$ 3.0 (Pre-tax CF)
( 0.0) (Cash taxes)
$ 3.0
Net income = (NOI – Interest)(1 – T) = ($0.0 - $1.0)(0.6) = $(0.6)
203
c.
Depreciation halves.
Income
Statement
Sales revenues
Costs, except depreciation
Depreciation
Total operating costs
Net operating income (NOI)
Taxes (40%)
Operating income after taxes
Add back depreciation
Cash flow from operations
Cash
Flows
$12.00
(9.00)
(0.75)
$12.00
(9.00)
---
( 9.75)
$ 2.25
( 0.90)
$ 1.35
0.75
$ 2.10
( 9.00) (Cash costs)
$ 3.00 (Pre-tax CF)
( 0.90) (Cash taxes)
$ 2.10
Net income = (NOI – Interest)(1 – T) = ($2.25 - $1.0)(0.6) = $0.75
11-19
d.
The after-tax cash flows are greater if Congress increases the allowance for depreciation, so
you should prefer greater depreciation.
a.
Income
Less: Interest deduction
Plus: Dividends receiveda
Taxable income
$365,000
( 50,000)
4,500
$319,500
aFor
a corporation, 70 percent of dividends received are excluded from taxes; therefore,
taxable dividends are calculated as $15,000 (1 - 0.70) = $4,500.
Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 = $107,855
After-tax income:
Taxable income
Taxes
Plus: Non-taxable dividends receivedb
Net income
bNon-taxable
b.
$319,500
(107,855)
10,500
$222,145
dividends are calculated as $15,000 x 0.7 = $10,500.
Marginal tax rate is 39 percent
Average tax rate is $107,855/$319,500 = 33.76%
11-20
a.
The holding period is two years, so the 15 percent capital gains rate applies. There is no
capital gains tax benefit (break) to holding municipal bonds; only the annual interest is tax
exempt.
Capital gains tax liability = ($1,150 - $950) x 0.15 = $30
b.
The holding period is two years, so the 15 percent capital gains rate applies.
204
Capital gains tax liability = [($12 - $10) x 100] x 0.15 = $30
c.
The holding period is two years, so the long-term capital gains rate applies. The long-term
capital gains rate for corporations is the same as its ordinary income tax rate. So, if the firm is
a large national company, its marginal tax rate probably would be 35 percent, and the capital
gains tax liability would be:
Capital gains tax liability = [($57 - $55) x 100] x 0.35 = $70
11-21
Income
Less: Interest deduction
Plus: Interest received
Plus: Dividends receiveda
Taxable income
$150,000
( 45,000)
18,000
2,400
$125,400
aFor
a corporation, 70 percent of dividends received are excluded from taxes; therefore, taxable
dividends are calculated as $8,000 (1 - 0.70) = $2,400.
Tax = $22,250 + ($125,400 - $100,000)(0.39) = $22,250 + $$9,906 = $32,156
After-tax income:
Taxable income
Taxes
Plus: Non-taxable dividends receivedb
Net income
bNon-taxable
$125,400
( 32,156)
5,600
$ 98,844
dividends are calculated as $8,000 x 0.7 = $5,600.
Marginal tax rate is 39 percent; average tax rate is $32,156/$125,400 = 25.6%.
11-22
After-tax yield on FLA bond = 8%.
After-tax yield on AT&T bond = 11% - Taxes = 11% - 11%(0.2) = 8.8%.
Check: Invest $10,000 @ 11% = $1,100 interest.
Pay 20 percent tax, so after-tax income = $1,100(1 - T) = $1,100(0.8) = $880
$880
After  tax
rate of return  $10,000  0.088  8.8%
After-tax yield on AT&T preferred stock:
After-tax yield = 9% - Taxes = 9% - 0.3(9%)(0.2) = 9% - 0.54% = 8.46%.
Therefore, invest in AT&T bonds. We could make this a harder problem by asking for the tax rate
that would cause the company to prefer the Florida bond or the preferred stock.
11-23
The solution is given in the Instructor's Manual, Solutions to Integrative Problems.
205
11-24
The solution is given in the Instructor's Manual, Solutions to Integrative Problems.
11-25
Computer-Related Problem
a.
The revised data and ratios are shown below:
INPUT DATA:
KEY OUTPUT:
2006
Cash
A/R
Inventories
Land and bldg
Machinery
Other F.A.
$
Accts & Notes Pay.
Accruals
Long-term debt
Common stock
Retained earnings
$
Total assets
Total claims
$1,699,527
$1,699,527
Income statement
Sales
Cost of G.S.
Adm. & sales exp.
Depreciation
Misc.
Net income
P/E ratio
No. of shares
Cash dividend
84,527
395,000
700,000
238,000
132,000
150,000
275,000
120,000
404,290
575,000
325,237
__________
Cary Industry
Quick
Current
Inv. turn.
DSO
F.A.turn.
T.A.turn.
ROA
ROE
TD/TA
PM
EPS
Stock Price
1.2
3.0
6.1
33
8.3
2.5
10.5%
19.9%
47.0%
4.2%
$7.78
$46.68
1.0
2.7
5.8
32
13.0
2.6
9.1%
18.2%
50.0%
3.5%
n.a.
n.a.
6.0
1.19
6.0
n.a.
P/E ratio
M/B
$4,290,000
3,450,000
248,775
159,000
134,000
$ 178,935
6
23,000
$
0.95
Under these new conditions, Cary Corporation looks much better. Its turnover ratios are still low,
but its ROA and ROE are above the industry average, its estimated P/E ratio is better, and its stock
price is anticipated to double. There still is room for improvement, but the company is in much
better shape.
b.
The financial statements and ratios for the scenario in which the cost of goods sold decreases by an
additional $125,000 are shown next. As you can see, the profit ratios are quite high and the stock
price has risen to $66.24.
INPUT DATA:
KEY OUTPUT:
2006
Cash
A/R
Inventories
Land and bldg
Machinery
Other F.A.
$
159,527
395,000
700,000
238,000
132,000
150,000
206
Cary Industry
Quick
Current
Inv. turn.
DSO
F.A.turn.
T.A.turn.
ROA
1.4
3.2
6.1
33
8.3
2.4
14.3%
1.0
2.7
5.8
32
13.0
2.6
9.1%
Accts & Notes Pay.
Accruals
Long-term debt
Common stock
Retained earnings
$
Total assets
Total claims
$1,774,527
$1,774,527
Income statement
Sales
Cost of G.S.
Adm. & sales exp.
Depreciation
Misc.
Net income
P/E ratio
No. of shares
Cash dividend
c.
275,000
120,000
404,290
575,000
400,237
__________
ROE
TD/TA
PM
EPS
Stock Price
P/E ratio
M/B
26.0%
45.0%
5.9%
$11.04
$66.24
18.2%
50.0%
3.5%
n.a.
n.a.
6.0
1.56
6.0
n.a.
$4,290,000
3,325,000
248,775
159,000
134,000
__________
$
$
253,935
6
23,000
0.95
The financial statements and ratios for the scenario in which the cost of goods sold increases by
$125,000 over the revised estimate are shown next. As you can see, profits would decline sharply.
The ROE would drop to 12.6 percent, EPS would fall to $4.52, the stock price would drop to
$27.11, and the M/B ratio would be only 0.76.
INPUT DATA:
KEY OUTPUT:
2001
Cash
A/R
Inventories
Land and bldg
Machinery
Other F.A.
$
Accts & Notes Pay.
Accruals
Long-term debt
Common stock
Retained earnings
$
Total assets
Total claims
$1,624,527
$1,624,527
Income statement
Sales
Cost of G.S.
Adm. & sales exp.
Depreciation
Misc.
Net income
P/E ratio
No. of shares
Cash dividend
d.
9,527
395,000
700,000
238,000
132,000
150,000
275,000
120,000
404,290
575,000
250,237
__________
Cary Industry
Quick
Current
Inv. turn.
DSO
F.A.turn.
T.A.turn.
ROA
ROE
TD/TA
PM
EPS
Stock Price
P/E ratio
M/B
1.0
2.8
6.1
33
8.3
2.6
6.4%
12.6%
49.2%
2.4%
$4.52
$27.11
1.0
2.7
5.8
32
13.0
2.6
9.1%
18.2%
50.0%
3.5%
n.a.
n.a.
6.0
0.76
6.0
n.a.
$4,290,000
3,575,000
248,775
159,000
134,000
__________
$
$
103,935
6
23,000
0.95
Computer models allow us to analyze quickly the impact of operating and financial decisions
on the firm's overall performance. A firm can analyze its financial ratios under different
scenarios to see what might happen if a decision, such as the purchase of a new asset, did not
207
produce the expected results. This gives the managers some idea about what might happen
under the best and worst cases and helps them to make better decisions.
11-26
Computer-Related Problem
a.
An increase in the dividend payout ratio (DPR) would subject some income to double
taxation if Brown incorporates.
Tax liability with 50 percent dividend payout ratio:
INPUT DATA:
Business income
Itemized deductions
Number of exemptions
Exemption amount
Salary
Dividend payout rate
2005
$65,000
$11,000
4
$3,100
$45,000
50.00%
2006
$85,000
$11,000
4
$3,100
$45,000
50.00%
2007
$95,000
$11,000
4
$3,100
$45,000
50.00%
KEY OUTPUT:
Advantage to incorporation
($1,275)
($2,200)
($1,838)
MODEL-GENERATED DATA:
Taxes as a corporation:
2005
2006
2007
Income before salary & taxes
Less salary
Taxable income, corporate
$65,000.0 $85,000.0 $95,000.0
-45,000.0 -45,000.0 -45,000.0
20,000.0
40,000.0
50,000.0
Total corporate tax
$ 3,000.0 $ 6,000.0 $ 7,500.0
Salary
Less exemptions & deductions
Plus taxable div. received
Taxable personal income
$45,000.0 $45,000.0 $45,000.0
-23,400.0 -23,400.0 -23,400.0
8,500.0
17,000.0
21,250.0
30,100.0
38,600.0
42,850.0
Total personal tax
Combined corp. & personal tax
3,800.0
5,075.0
5,712.5
$ 6,800.0 $11,075.0 $13,212.5
Taxes as a proprietorship:
Total income
Less exemptions & deductions
Taxable personal income
65,000.0
85,000.0
95,000.0
-23,400.0 -23,400.0 -23,400.0
$41,600.0 $61,600.0 $71,600.0
Total proprietorship tax
$ 5,525.0 $ 8,875.0 $11,375.0
Advantage to corporation
-$ 1,275.0 -$ 2,200.0 -$ 1,837.5
At a 100 percent DPR, all of the after-corporate tax earnings are subject to personal taxes. In
this situation, incorporating would be a disadvantage.
Tax liability with 100 percent dividend payout ratio:
INPUT DATA:
Business income
Itemized deductions
Number of exemptions
Exemption amount
Salary
Dividend payout rate
2005
$65,000
$11,000
4
$3,100
$45,000
100.00%
208
2006
$85,000
$11,000
4
$3,100
$45,000
100.00%
2007
$95,000
$11,000
4
$3,100
$45,000
100.00%
KEY OUTPUT:
Advantage to incorporation
($2,550)
($4,750)
($5,625)
MODEL-GENERATED DATA:
Taxes as a corporation:
Income before salary & taxes
Less salary
Taxable income, corporate
2005
2006
2007
$65,000.0 $85,000.0 $95,000.0
-45,000.0 -45,000.0 -45,000.0
20,000.0
40,000.0
50,000.0
Total corporate tax
$ 3,000.0 $ 6,000.0 $ 7,500.0
Salary
Less exemptions & deductions
Plus taxable div. received
Taxable personal income
$45,000.0 $45,000.0 $45,000.0
-23,400.0 -23,400.0 -23,400.0
17,000.0
34,000.0
42,500.0
38,600.0
55,600.0
64,100.0
Total personal tax
Combined corp. & personal tax
5,075.0
7,625.0
9,500.0
$ 8,075.0 $13,625.0 $17,000.0
Taxes as a proprietorship:
Total income
Less exemptions & deductions
Taxable personal income
b.
65,000.0
85,000.0
95,000.0
-23,400.0 -23,400.0 -23,400.0
$41,6000.0 $61,600.0 $71,600.0
Total proprietorship tax
$ 5,525.0 $ 8,875.0 $11,375.0
Advantage to corporation
-$2,550.0 -$4,750.0 -$5,625.0
If business income doubles and Brown incorporates, her taxable corporate income increases
as well as her corporate tax; however, her personal tax liability would remain the same. If
Brown operates as a proprietorship and business income doubles, her taxable personal
income would increase, thus, increasing her proprietorship tax.
Tax liability if business income increases by 100 percent (no dividends):
INPUT DATA:
Business income
Itemized deductions
Number of exemptions
Exemption amount
Salary
Dividend payout rate
2005
2006
2007
$130,000
$11,000
4
$3,100
$45,000
0.00%
$170,000
$11,000
4
$3,100
$45,000
0.00%
$190,000
$11,000
4
$3,100
$45,000
0.00%
KEY OUTPUT:
Advantage to incorporation
$450
$(3,520)
$(5,720)
MODEL-GENERATED DATA:
Taxes as a corporation:
2005
2006
2007
Income before salary & taxes
Less salary
Taxable income, corporate
$130,000.0 $170,000.0 $190,000.0
-45,000.0 -45,000.0 -45,000.0
85,000.0 125,000.0 145,000.0
Total corporate tax
$ 17,150.0 $ 32,000.0 $ 39,800.0
209
Salary
Less exemptions & deductions
Plus taxable div. received
Taxable personal income
$45,000.0 $45,000.0 $45,000.0
-23,400.0 -23,400.0 -23,400.0
0.0
0.0
0.0
21,600.0
21,600.0
21,600.0
Total personal tax
Combined corp. & personal tax
2,525.0
2,525.0
2,525.0
$19,675.0 $34,525.0 $42,325.0
Taxes as a proprietorship:
Total income
Less exemptions & deductions
Taxable personal income
130,000.0 170,000.0 190,000.0
-23,400.0 -23,400.0 -23,400.0
$106,600.0 $146,600.0 $166,600.0
Total proprietorship tax
$20,125.0 $31,005.5 $36,605.5
Advantage to corporation
$450.0 -$3,519.5 -$5,719.5
210