CHAPTER 2: FINANCIAL ANALYSIS

1. Calculating Ratios. Here are simplified financial statements of Phone Corporate

recent year:

INCOME STATEMENT
(figures in millions of dollars)

Net sales 13,194

Cost of goods sold 4,060

Other expenses 4,049

Depreciation 2,518

Earnings before interest and taxes (EBIT) 2,566

Interest expenses 685

Income before tax 1,881

Taxes 570

Net income 1,311

Dividends 856

BALANCE SHEET
(figures in millions of dollars)
End of Year Start of Year

Assets
Cash and marketable securities 89 158
Receivables 2,382 2,490
Inventories 187 238

Other current assets 867 932

Total current assets 3,525 3,818

Net property, plant, and equipment 19,973 19,915
 Other long-term assets 4,216 3,770

Total assets 27,714 27,503

Liabilities and shareholders’ equity
Payables 2,564 3,040

Short-term debt 1,419 1,573

Other current liabilities 811 787

Total current liabilities 4,794 5,400

Long-term debt and leases 7,018 6,833

Other long-term liabilities 6,178 6,149

Shareholders’ equity 9,724 9,121

Total liabilities and shareholders’ equity 27,714 27,503

Calculate the all the financial ratios you have learnt.
2. Defining Ratios. There are no universally accepted definitions of financial ratios, but
some of the following ratios make no sense at all. Substitute the correct definitions.
long-term debt
a. Debt-equity ratio =
long-term debt + equity
EBIT – tax
b. Return on equity =
average equity
net income + interest
c. Profit margin =
sales
total assets
d. Inventory turnover =
average inventory
 current liabilities
e. Current ratio =
current assets
current assets – inventories
f. Interval measure =
average daily expenditure from operations
sales
g. Average collection period =
average receivables/365
cash + marketable securities + receivables
h. Quick ratio =
current liabilities
3. Current Liabilities. Suppose that at year-end Pepsi had unused lines of credit which
would have allowed it to borrow a further $300 million. Suppose also that it used this
line of credit to borrow $300 million and invested the proceeds in marketable securities.
Would the company have appeared to be (a) more or less liquid, (b) more or less highly
leveraged? Calculate the appropriate ratios.
4. Current Ratio. How would the following actions affect a firm’s current ratio?
a. Inventory is sold at cost.
b. The firm takes out a bank loan to pay its accounts due.
c. A customer pays its accounts receivable.
d. The firm uses cash to purchase additional inventories.
5. Liquidity Ratios. A firm uses $1 million in cash to purchase inventories. What will
happen to its current ratio? Its quick ratio?
6. Receivables. Chik’s Chickens has average accounts receivable of $6,333. Sales for the
year were $9,800. What is its average collection period?
7. Inventory. Salad Daze maintains an inventory of produce worth $400. Its total bill for
produce over the course of the year was $73,000. How old on average is the lettuce it
serves its customers?
8. Inventory Turnover. If a firm’s inventory level of $10,000 represents 30 days’ sales,
what is the annual cost of goods sold? What is the inventory turnover ratio?
9. Leverage Ratios. Lever Age pays an 8 percent coupon on outstanding debt with face
value $10 million. The firm’s EBIT was $1 million.
a. What is times interest earned?
b. If depreciation is $200,000, what is cash coverage?
c. If the firm must retire $300,000 of debt for the sinking fund each year, what is its
“fixed-payment cash-coverage ratio” (the ratio of cash flow to interest plus other
fixed debt payments)?
10. Leverage. A firm has a long-term debt-equity ratio of .4. Shareholders’ equity is $1
million. Current assets are $200,000 and the current ratio is 2.0. The only current
liabilities are notes payable. What is the total debt ratio?
11. Leverage Ratios. A firm has a debt-to-equity ratio of .5 and a market-to-book ratio of
2.0. What is the ratio of the book value of debt to the market value of equity?
12. Using Financial Ratios. For each category of financial ratios discussed in this material,
give some examples of who would be likely to examine these ratios and why.
13. Financial Statements. As you can see, someone has spilled ink over some of the entries
in the balance sheet and income statement of Transylvania Railroad. Can you use the
following information to work out the missing entries:
Long-term debt ratio 0.4
Times interest earned 8.0
Current ratio 1.4
Quick ratio 1.0
Cash ratio 0.2
Return on assets 18%
Return on equity 41%
Inventory turnover 5.0
Average collection period 71.2 days
INCOME STATEMENT
(figures in millions of dollars)
Net sales •••

Cost of goods sold •••

Selling, general, and administrative expenses 10
Depreciation 20

Earnings before interest and taxes (EBIT) •••

Interest expense •••

Income before tax •••

Tax •••

Net income •••

BALANCE SHEET
(figures in millions of dollars)

This Year Last Year

Assets
Cash and marketable securities ••• 20

Receivables ••• 34

Inventories ••• 26
Total current assets ••• 80
Net property, plant, and equipment ••• 25

Total assets ••• 105

Liabilities and shareholders’ equity •••

Accounts payable 25 20
Notes payable 30 35

Total current liabilities ••• 55

Long-term debt ••• 20
Shareholders’ equity ••• 30
Total liabilities and shareholders’ equity 115 105
CHAPTER 3. NET PRESENT AND OTHER CRITERIA
Problems 1–9 refer to two projects with the following cash flows:
Year Project A Project B
1 –$100 –$100
2 40 50

3 40 50
4 40 ---

1. IRR/NPV. If the opportunity cost of capital is 11 percent, which of these projects is

worth pursuing?
2. Mutually Exclusive Investments. Suppose that you can choose only one of these
projects. Which would you choose? The discount rate is still 11 percent.
3. IRR/NPV. Which project would you choose if the opportunity cost of capital were 16
percent?
4. IRR. What are the internal rates of return on projects A and B?
5. Investment Criteria. In light of your answers to problems 2–4, is there any reason to
believe that the project with the higher IRR is the better project?
6. Profitability Index. If the opportunity cost of capital is 11 percent, what is the profitability
index for each project? Does the profitability index rank the projects correctly?
7. Payback. What is the payback period of each project?
8. Investment Criteria. Considering your answers to problems 2, 3, and 7, is there any
reason to believe that the project with the lower payback period is the better project?
9. Book Rate of Return. Accountants have set up the following depreciation schedules for
the two projects:
Year: 1 2 3 4

Project A $25 $25 $25 $25

Project B 33 33 33 34
Calculate book rates of return for each year. Are these book returns the same as the IRR?
10. NPV and IRR. A project that costs $3,000 to install will provide annual cash flows of
$800 for each of the next 6 years. Is this project worth pursuing if the discount rate is 10
percent? How high can the discount rate be before you would reject the project?
11. Payback. A project that costs $2,500 to install will provide annual cash flows of $600
for the next 6 years. The firm accepts projects with payback periods of less than 5 years.
Will the project be accepted? Should this project be pursued if the discount rate is 2
percent?
What if the discount rate is 12 percent? Will the firm’s decision change as the discount rate
changes?
12. Profitability Index. What is the profitability index of a project that costs $10,000 and
provides cash flows of $3,000 in Years 1 and 2 and $5,000 in Years 3 and 4? The discount
rate is 10 percent.
13. NPV. A proposed nuclear power plant will cost $2.2 billion to build and then will
produce cash flows of $300 million a year for 15 years. After that period (in Year 15), it
must be decommissioned at a cost of $900 million. What is project NPV if the discount
rate is 6 percent? What if it is 16 percent?
14. NPV/IRR. Consider projects A and B:

Cash Flows, Dollars

Project C0 C1 C2 NPV at 10%

A –30,000 21,000 21,000 +$6,446

B –50,000 33,000 33,000 +$7,273

Calculate IRRs for A and B. Which project does the IRR rule suggest is best? Which project
is really best?
15. IRR. You have the chance to participate in a project that produces the following cash
flows:
C0 C1 C2

+$5,000 +$4,000 –$11,000

The internal rate of return is 13.6 percent. If the opportunity cost of capital is 12 percent,
would you accept the offer?
16. NPV/IRR.
a. Calculate the net present value of the following project for discount rates of 0, 50,
and 100 percent:

C0 C1 C2
 –$6,750 +$4,500 +$18,000

b. What is the IRR of the project?

17. IRR. Marielle Machinery Works forecasts the following cash flows on a project under
consideration. It uses the internal rate of return rule to accept or reject projects. Should
this project be accepted if the required return is 12 percent?

C0 C1 C2 C3
–$10,000 0 +$7,500 +$8,500
18. NPV/IRR. A new computer system will require an initial outlay of $20,000 but it will
increase the firm’s cash flows by $4,000 a year for each of the next 8 years. Is the system
worth installing if the required rate of return is 9 percent? What if it is 14 percent? How
high can the discount rate be before you would reject the project?
19. Investment Criteria. If you insulate your office for $1,000, you will save $100 a year
in heating expenses. These savings will last forever.
a. What is the NPV of the investment when the cost of capital is 8 percent? 10 percent?
b. What is the IRR of the investment?
c. What is the payback period on this investment?
20. NPV versus IRR. Here are the cash flows for two mutually exclusive projects:

Project C0 C1 C2 C3

A –$20,000 +$8,000 +$8,000 +$8,000

B –$20,000 0 0 +$25,000

a. At what interest rates would you prefer project A to B? Hint: Try drawing the NPV
profile of each project.
b. What is the IRR of each project?
21. IRR/NPV. Consider this project with an internal rate of return of 13.1 percent. Should
you accept or reject the project if the discount rate is 12 percent?
Year Cash Flow

0 +$100
1 –60
 2 –60

22. Payback and NPV.

a. What is the payback period on each of the following projects?
Cash Flows, Dollars
Project Time 0 1 2 3 4

A –5,000 +1,000 +1,000 +3,000 0

B –1,000 0 +1,000 +2,000 +3,000

C –5,000 +1,000 +1,000 +3,000 +5,000

b. Given that you wish to use the payback rule with a cutoff period of 2 years, which
projects would you accept?
c. If you use a cutoff period of 3 years, which projects would you accept?
d. If the opportunity cost of capital is 10 percent, which projects have positive NPVs?
e. “Payback gives too much weight to cash flows that occur after the cutoff date.” True
or false?
23. Book Rate of Return. Consider these data on a proposed project:
Original investment = $200
Straight-line depreciation of $50 a year for 4 years
Project life = 4 years
Year 0 1 2 3 4

Book value $200 — — — —

Sales 100 110 120 130

Costs 30 35 40 45
Depreciation — — — —

Net income — — — —

a. Fill in the blanks in the table.

b. Find the book rate of return of this project in each year.
c. Find project NPV if the discount rate is 20 percent.
24. Book Rate of Return. A machine costs $8,000 and is expected to produce profit before
depreciation of $2,500 in each of Years 1 and 2 and $3,500 in each of Years 3 and 4.
Assuming that the machine is depreciated at a constant rate of $2,000 a year and that
there are no taxes, what is the average return on book?
25. Book Rate of Return. A project requires an initial investment of $10,000, and over its
5-year life it will generate annual cash revenues of $5,000 and cash expenses of $2,000.
The firm will use straight-line depreciation, but it does not pay taxes.
a. Find the book rates of return on the project for each year.
b. Is the project worth pursuing if the opportunity cost of capital is 8 percent?
c. What would happen to the book rates of return if half the initial $10,000 outlay
were treated as an expense instead of a capital investment? Hint: Instead of
depreciating all of the $10,000, treat $5,000 as an expense in the first year.
d. Does NPV change as a result of the different accounting treatment proposed in (c)?
26. Capital Rationing. You are a manager with an investment budget of $8 million. You
may invest in the following projects. Investment and cash-flow figures are in millions of
dollars.

Project Discount Rate , % Investment Annual Cash Flow Project Life, Years

A 10 3 1 5
B 12 4 1 8

C 8 5 2 4

D 8 3 1.5 3
E 12 3 1 6
a. Why might these projects have different discount rates?
b. Which projects should the manager choose?
c. Which projects will be chosen if there is no capital rationing?
27. Profitability Index versus NPV. Consider these two projects:
Project C0 C1 C2 C3

A –$18 +$10 +$10 +$10

B –$50 +$25 +$25 +$25
 a. Which project has the higher NPV if the discount rate is 10 percent?
b. Which has the higher profitability index?
c. Which project is most attractive to a firm that can raise an unlimited amount of
funds to pay for its investment projects? Which project is most attractive to a firm
that is limited in the funds it can raise?
28. Mutually Exclusive Investments. Here are the cash flow forecasts for two mutually
exclusive projects:

Cash Flows, Dollars

Year Project A Project B

0 –$100 –$100
1 130 49

2 50 49

3 70 49
a. Which project would you choose if the opportunity cost of capital is 2 percent?
b. Which would you choose if the opportunity cost of capital is 12 percent?
c. Why does your answer change?
29. Equivalent Annual Cost. A precision lathe costs $10,000 and will cost $20,000 a year
to operate and maintain. If the discount rate is 12 percent and the lathe will last for five
years, what is the equivalent annual cost of the tool?
30. Equivalent Annual Cost. A firm can lease a truck for 4 years at a cost of $30,000
annually. It can instead buy a truck at a cost of $80,000, with annual maintenance
expenses of $10,000. The truck will be sold at the end of 4 years for $20,000. Which is
the better option if the discount rate is 12 percent?
31. Multiple IRR. Consider the following cash flows:

C0 C1 C2 C3 C4

–22 +20 +20 +20 –40

a. Confirm that one internal rate of return on this project is (a shade above) 7 percent,
and that the other is (a shade below) 34 percent.
b. Is the project attractive if the discount rate is 5 percent?
 c. What if it is 20 percent? 40 percent?
d. Why is the project attractive at midrange discount rates but not at very high or very
low rates?
32. Equivalent Annual Cost. Econo-cool air conditioners cost $300 to purchase, result in
electricity bills of $150 per year, and last for 5 years. Luxury Air models cost $500, result in
electricity bills of $100 per year, and last for 8 years. The discount rate is 21 percent.
a. What are the equivalent annual costs of the Econo-cool and Luxury Air models?
b. Which model is more cost effective?
c. Now you remember that the inflation rate is expected to be 10 percent per year for
the foreseeable future. Redo parts (a) and (b).
33. Investment Timing. You can purchase an optical scanner today for $400. The scanner
provides benefits worth $60 a year. The expected life of the scanner is 10 years. Scanners
are expected to decrease in price by 20 percent per year. Suppose the discount rate is 10
percent. Should you purchase the scanner today or wait to purchase? When is the best
purchase time?
34. Replacement Decision. You are operating an old machine that is expected to produce a
cash inflow of $5,000 in each of the next 3 years before it fails. You can replace it now
with a new machine that costs $20,000 but is much more efficient and will provide a cash
flow of $10,000 a year for 4 years. Should you replace your equipment now? The
discount rate is 15 percent.
35. Replacement Decision. A forklift will last for only 2 more years. It costs $5,000 a year
to maintain. For $20,000 you can buy a new lift which can last for 10 years and should
require maintenance costs of only $2,000 a year.
a. If the discount rate is 5 percent per year, should you replace the forklift?
b. What if the discount rate is 10 percent per year? Why does your answer change?
36. NPV/IRR. Growth Enterprises believes its latest project, which will cost $80,000 to
install, will generate a perpetual growing stream of cash flows. Cash flow at the end of
this year will be $5,000, and cash flows in future years are expected to grow indefinitely
at an annual rate of 5 percent.
a. If the discount rate for this project is 10 percent, what is the project NPV?
b. What is the project IRR?
37. Multiple IRRs. Strip Mining Inc. can develop a new mine at an initial cost of $5 million.
The mine will provide a cash flow of $30 million in 1 year. The land then must be
reclaimed at a cost of $28 million in the second year.
a. What are the IRRs of this project?
b. Should the firm develop the mine if the discount rate is 10 percent? 20 percent?