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Name: ________________________ Class: ___________________ Date: __________ ID: A

Homework Ch 4

____ 1. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and
easy-to-use estimates of a firm's liquidity position.

____ 2. High current and quick ratios always indicate that the firm is managing its liquidity position well.

____ 3. If a firm's fixed assets turnover ratio is significantly higher than its industry average, this could indicate that it
uses its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets.

____ 4. The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and
short-term debt obligations.

____ 5. The operating margin measures operating income per dollar of assets.

____ 6. The profit margin measures net income per dollar of sales.

____ 7. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin
of 8% for Firm B. Firm A's debt ratio is 70% versus one of 20% for Firm B. Based only on these two facts,
you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better
management, could be the cause of Firm A's higher profit margin.

____ 8. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's
operating efficiency is that the BEP does not reflect the effects of debt and taxes.

____ 9. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and
therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money,
use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. She thinks that
operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This
would probably be a good move, as it would increase the ROE from 7.5% to 13.5%.

____ 10. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must
be 0.667.

____ 11. Which of the following would indicate an IMPROVEMENT in a company’s financial position, holding other
things constant?
a. The inventory and total assets turnover ratios both decline.
b. The debt ratio increases.
c. The profit margin declines.
d. The times-interest-earned ratio declines.
e. The current and quick ratios both increase.

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Name: ________________________ ID: A

____ 12. Which of the following statements is CORRECT?


a. The use of debt financing will tend to lower the basic earning power ratio, other things held
constant.
b. A firm that employs financial leverage will have a higher equity multiplier than an
otherwise identical firm that has no debt in its capital structure.
c. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ
in the way they are financed, the firm with less debt will generally have the higher expected
ROE.
d. The numerator used in the TIE ratio is earnings before taxes (EBT). EBT is used because
interest is paid with post-tax dollars, so the firm's ability to pay current interest is affected
by taxes.
e. All else equal, increasing the debt ratio will increase the ROA.

____ 13. A firm wants to strengthen its financial position. Which of the following actions would INCREASE its quick
ratio?
a. Offer price reductions along with generous credit terms that would (1) enable the firm to
sell some of its excess inventory and (2) lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.
e. Issue new common stock and use the proceeds to acquire additional fixed assets.

____ 14. Which of the following statements is CORRECT?


a. In general, if investors regard a company as being relatively risky and/or having relatively
poor growth prospects, then it will have relatively high P/E and M/B ratios.
b. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after
giving consideration to financial leverage and tax effects.
c. The "apparent," but not necessarily the "true," financial position of a company whose sales
are seasonal can change dramatically during a given year, depending on the time of year
when the financial statements are constructed.
d. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of
accounting book value. In general, investors regard companies with higher M/B ratios as
being more risky and/or less likely to enjoy higher future growth.
e. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in
managing their fixed assets if and only if all the firms being compared have the same
proportion of fixed assets to total assets.

____ 15. Your sister is thinking about starting a new business. The company would require $380,000 of assets, and it
would be financed entirely with common stock. She will go forward only if she thinks the firm can provide a
13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net
income must be expected to warrant starting the business?
a. $58,482
b. $45,144
c. $52,326
d. $51,300
e. $39,501

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Name: ________________________ ID: A

____ 16. Last year Rennie Industries had sales of $240,000, assets of $175,000, a profit margin of 5.3%, and an equity
multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000 without affecting
either sales or costs. Had it reduced its assets by this amount, and had the debt/assets ratio, sales, and costs
remained constant, how much would the ROE have changed?
a. 3.55%
b. 3.19%
c. 3.66%
d. 3.01%
e. 3.59%

____ 17. Jordan Inc has the following balance sheet and income statement data:

Cash $14,000 Accounts payable $42,000


Receivables 70,000 Other current liabilities 28,000
Inventories 280,000 Total CL $70,000
Total CA $364,000 Long-term debt 140,000
Net fixed assets 126,000 Common equity 280,000
Total assets $490,000 Total liab. and equity $490,000
Sales $280,000
Net income 21,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio
to equal the industry average, 2.10, without affecting either sales or net income. Assuming that inventories are
sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy
back common stock at book value, by how much would the ROE change?
a. 28.16%
b. 20.93%
c. 24.28%
d. 32.29%
e. 25.83%

____ 18. Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000,
operating costs to be $265,000, assets (capital) to be $200,000, and its tax rate to be 35%. Under Plan A it
would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a
contract with existing bondholders the TIE ratio would have to be maintained at or above 3.2. Under Plan B,
the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs,
assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in
response to the change in the capital structure?
a. 7.10%
b. 7.40%
c. 8.21%
d. 8.73%
e. 7.25%

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Name: ________________________ ID: A

Following information applies to the following questions.

The balance sheet and income statement shown below are for Koski Inc. Note that the firm has no amortization
charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes
payable will be rolled over.

Balance Sheet (Millions of $)


Assets 2010
Cash and securities $1,290
Accounts receivable 9,890
Inventories 13,760
Total current assets $24,940
Net plant and equipment $18,060
Total assets $43,000
Liabilities and Equity
Accounts payable $8,170
Notes payable 6,020
Accruals 4,730
Total current liabilities $18,920
Long-term bonds $8,815
Total debt $27,735
Common stock $5,805
Retained earnings 9,460
Total common equity $15,265
Total liabilities and equity $43,000

Income Statement (Millions of $) 2010


Net sales $51,600
Operating costs except depreciation 48,246
Depreciation 903
Earnings bef interest and taxes (EBIT) $2,451
Less interest 927
Earnings before taxes (EBT) $1,524
Taxes 533
Net income $990

Other data:
Shares outstanding (millions) 500.00
Common dividends (millions of $) $346.67
Int rate on notes payable & L-T bonds 6.25%
Federal plus state income tax rate 35%
Year-end stock price $23.77

____ 19. What is the firm's days sales outstanding? Assume a 365-day year for this calculation.

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Name: ________________________ ID: A

a. 55.27
b. 66.46
c. 80.45
d. 57.37
e. 69.96

____ 20. What is the firm's EPS?


a. $2.36
b. $1.68
c. $1.98
d. $1.94
e. $1.62

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ID: A

Homework Ch 4
Answer Section

1. ANS: T PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.2) Liquidity ratios
2. ANS: F
It might have too much liquidity. Liquid assets generally provide low returns.

PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.2) Current ratio
3. ANS: T PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.3) FA turnover ratio
4. ANS: T PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.4) TIE ratio
5. ANS: F PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.5) Operating margin
6. ANS: T PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.5) Profit margin
7. ANS: F
A's higher debt ratio would tend to lower its profit margin. Since its margin is already higher, this indicates
that A is the better managed company.

PTS: 1 DIF: MEDIUM NAT: Analytic skills | Reflective thinking


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.5) Profit margin
8. ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.5) BEP ratio
9. ANS: T
DuPont equation: ROE = PM  TATO  Equity multiplier. Given the data, the statement is true.

PM X TATO X Eq Mult = ROE


5.0 % 1.5 1.0 7.5 %
4.5 % 1.5 2.0 13.5 %

PTS: 1 DIF: MEDIUM NAT: Analytic skills | Reflective thinking


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.7) DuPont equation

1
ID: A

10. ANS: T
Equity multiplier = Assets/Equity = 3.0 , so Equity/Assets = 1/3.0 = 0.333.
By definition, Equity/Assets + Debt/Assets = 1.00, so
0.333 + Debt/Assets = 1.0.
Therefore, Debt/Assets = 1.0 - 0.333 = 0.667. Thus, the statement is true.

PTS: 1 DIF: HARD NAT: Analytic skills | Reflective thinking


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.7) Equity multiplier
11. ANS: E PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (Comp.) Misc. ratios
12. ANS: B PTS: 1 DIF: EASY NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (Comp.) Leverage effects
13. ANS: A PTS: 1 DIF: EASY/MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.2) Quick ratio
14. ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (Comp.) Various ratios
15. ANS: D
Assets = Equity $380,000
Target ROE 13.5%
Required net income = Target ROE  Equity = $51,300

PTS: 1 DIF: EASY NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.5) Return on equity
16. ANS: E
Old New
Sales $240,000 $240,000
Original assets $175,000
Reduction in assets $51,000
New assets = Old assets - Reduction = $124,000
TATO = Sales / Assets = 1.37 1.94
Profit margin 5.30% 5.30%
Equity multiplier 1.20 1.20
ROE = PM  TATO  Eq Multiplier = 8.72% 12.31%
Change in ROE 3.59%

PTS: 1 DIF: MEDIUM NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.7) DuPont equation and reducing assets

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ID: A

17. ANS: E
Original balance sheet and income statement data:
Cash $14,000 Accounts payable $42,000
Receivables 70,000 Other current liabilities 28,000
Inventories 280,000 Total CL $70,000
Total CA $364,000 Long-term debt 140,000
Net fixed assets 126,000 Common equity 280,000
Total assets $490,000 Total liab. and equity $490,000
Sales $280,000
Net income 21,000

Actual current ratio 5.20


Target current ratio 2.10

Old current assets = $364,000


Current assets to have CR = Target: Target current ratio  Cur. Liab = $147,000
Reduction in current assets = Old CA - New CA = Inventory reduction = $217,000
Reduction in common equity = Reduction in inventory = $217,000
New common equity = Old equity - Reduction = $63,000

Orig ROE = NI/Old Equity: 7.50%


New ROE = NI/New Equity: 33.33%
D ROE = 25.83%

PTS: 1 DIF: HARD NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.3) DSO and net income

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ID: A

18. ANS: B
Work down the Plan A column, find the Max Debt, then use it to complete Plan B and the ROEs.
Plan A Plan B
Interest rate 8.80% 8.80%
Tax rate 35% 35%
Assets $200,000 $200,000
Debt ratio: Plan A given, Plan B calculated 25% 62.1%
Debt $50,000 $124,290
Equity $150,000 $75,710

Sales $300,000 $300,000


Operating costs 265,000 265,000 Constant
EBIT $35,000 $35,000
Interest 4,400 10,938
Taxable income $30,600 $24,063
Taxes 10,710 8,422
Net income $19,890 $15,641
ROE = NI / Equity = 13.26% 20.66%
TIE = EBIT/Interest = 7.95
Minimum TIE 3.20
$ of Interest consistent with
minimum TIE = EBIT/Min TIE = $10,938
Max debt = Interest/interest rate = $124,290
Change in ROE 7.40%

PTS: 1 DIF: HARD NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (Comp.) Debt management
19. ANS: E
DSO = Accounts receivable/(Sales/365) = 69.96

PTS: 1 DIF: MEDIUM NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.3) DSO
20. ANS: C
EPS = Net income/Common shares outstanding = $1.98

PTS: 1 DIF: EASY NAT: Analytic skills


LOC: Students will acquire knowledge of financial analysis and cash flows.
TOP: (4.6) EPS