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Case Problem 6.

1 Sara Decides to Take the Plunge

Sara Thomas is a child psychologist who has built a thriving practice in her hometown of Boise,
Idaho. Over the past several years she has been able to accumulate a substantial sum of money.
She has worked long and hard to be successful, but she never imagined anything like this. Even
so, success has not spoiled Sara. Still single, she keeps to her old circle of friends. One of her
closest friends is Terry Jenkins, who happens to be a stockbroker and who acts as Sara’s
financial advisor.

Not long ago Sara attended a seminar on investing in the stock market, and since then she’s been
doing some reading about the market. She has concluded that keeping all of her money in low-
yielding savings accounts doesn’t make sense. As a result, Sara has decided to move part of her
money to stocks. One evening, Sara told Terry about her decision and explained that she had
found several stocks that she thought looked “sort of interesting.” She described them as follows:

 North Atlantic Swim Suit Company. This highly speculative stock pays no dividends.
Although the earnings of NASS have been a bit erratic, Sara feels that its growth prospects
have never been brighter—“what with more people than ever going to the beaches the way
they are these days,” she says.
 Town and Country Computer. This is a long-established computer firm that pays a modest
dividend yield (of about 1.50%). It is considered a quality growth stock. From one of the
stock reports she read, Sara understands that T&C offers excellent long-term growth and
capital gains potential.
 Southeastern Public Utility Company. This income stock pays a dividend yield of around
5%. Although it’s a solid company, it has limited growth prospects because of its location.
 International Gold Mines, Inc. This stock has performed quite well in the past, especially
when inflation has become a problem. Sara feels that if it can do so well in inflationary times,
it will do even better in a strong economy. Unfortunately, the stock has experienced wide
price swings in the past. It pays almost no dividends.

Questions
a. What do you think of the idea of Sara keeping “substantial sums” of money in savings
accounts? Would common stocks make better investments for her than savings accounts?
Explain.
b. What is your opinion of the four stocks Sara has described? Do you think they are
suitable for her investment needs? Explain.
c. What kind of common stock investment program would you recommend for Sara? What
investment objectives do you think she should set for herself, and how can common
stocks help her achieve her goals?

A In my opinion there should be planned investment. Investment should done in a proper

Way. A part of the saving should be kept in saving account or fixed deposit, a part in

mutual fund, a part in real estate and remaining may be in stock market .I would advise

not to invest substantial part of her saving in stock market. Instead of saving in bulk she

should invest systematically. She should understand the stock market and price

fluctuation.

It is hard to say that common stock will be better saving than normal saving account.

Initially She should invest a part of her saving in the common stock and check the return.

Return should include notional loss also. If Sara invests with full of analysis and

calculation investment in common stock may be better than saving account.

B. Out of all the four stocks

11. North Atlantic Swim Suit Co. :

It would advise not to invest because it is speculative share and company is not paying

any dividend. She is new in the market so she should not invest in this share.

2. Town & Country Computer:

Payment of dividend is modest but there is potential of long term growth so being a

New investor she may consider to invest in this share. Dividend is irrespective if

company is strong and return may be greater than saving account.


3. South Eastern Public Utility Company:

Payment of dividend is 5 % but growth potential is limited because of geographical

restriction. If Sara is getting income in the form of interest which is less than 5% then

she should consider to invest in this share otherwise no.

4. International Gold Mines Inc.

Gold falls under commodity and during the inflation companies which are into

Commodity market either do well or worse. During the inflation gold rate had

touched all time high so company had done well. Company is not paying any dividend

so I would advise her not to invest in this company.

C. In my opinion I would advise Sara to invest in the common stock in two ways. No. 1

Invest in the market through mutual funds where mutual fund will invest after proper

analysis and due diligence. No. 2 invest in those companies which have good track and

reputation irrespective they are paying dividend.

She should set goal for herself. In this process she should analysis income which she

earned in the past Now in future she should analysis her income from the stock market

on monthly basis if earning is more than the saving account interest she should continue

her investment. In case if income is less than the saving account interest she should not

consider the same. She can achieve through proper analysis and systematic investment.
Case Problem 6.2 Wally Wonders Whether There’s a Place for Dividends

Wally Wilson is a commercial artist who makes a good living by doing freelance work—mostly
layouts and illustrations—for local ad agencies and major institutional clients (such as large
department stores). Wally has been investing in the stock market for some time, buying mostly
high-quality growth stocks as a way to achieve long-term growth and capital appreciation. He
feels that with the limited time he has to devote to his security holdings, high-quality issues are
his best bet. He has become a bit perplexed lately with the market, disturbed that some of his
growth stocks aren’t doing even as well as many good-grade income shares. He therefore decides
to have a chat with his broker, Al Fried.

During their conversation, it becomes clear that both Al and Wally are thinking along the same
lines. Al points out that dividend yields on income shares are indeed way up and that, because of
the state of the economy, the outlook for growth stocks is not particularly bright. He suggests
that Wally seriously consider putting some of his money into income shares to capture the high
dividend yields that are available. After all, as Al says, “the bottom line is not so much where the
payoff comes from as how much it amounts to!” They then talk about a high-yield public utility
stock, Hydro-Electric Light and Power. Al digs up some forecast information about Hydro-
Electric and presents it to Wally for his consideration:

Year Expected EPS ($) Expected Dividend Payout Ratio (%)

2016 $3.25 40%

2017 $3.40 40%

2018 $3.90 45%

2019 $4.40 45%

2020 $5.00 45%

The stock currently trades at $60 per share. Al thinks that within five years it should be trading at
$75 to $80 a share. Wally realizes that to buy the Hydro-Electric stock, he will have to sell his
holdings of CapCo Industries—a highly regarded growth stock that Wally is disenchanted with
because of recent substandard performance.

Questions
a. How would you describe Wally’s present investment program? How do you think it fits
him and his investment objectives?

Wally has limited time to devote to his investment program and this one appears to be a long
term growth plan which seems right for him.

b. Consider the Hydro-Electric stock.


1. Determine the amount of annual dividends Hydro-Electric can be expected to pay
over the years 2016 to 2020.

(1) (2) (1X2)

Year Expected EPS($) ExpdDiv Payout Ratio Expected


Divid

2016 $3.25 40% $ 1.30

2017 3.40 40 1.36

2018 3.90 45 1.76

2019 4.40 45 1.98

2020 5.00 45 2.25

2. Compute the total dollar return that Wally will make from Hydro-Electric if he
invests $6,000 in the stock and all the dividend and price expectations are
realized.

c. He could purchase 100 shares of stock ( 6,000/60)

Year Dividends Share 100 Shares Total

2016 $ 1.30 100 $ 130.00

2017 1.36 100 136.00

2018 1.76 100 176.00

2019 1.98 100 198.00

2020 2.25 100 225.00


Total dividends for 5 years is $ 865.00 If the stock is selling at 80.00 per share in 5 years then his
100 shares would be $ 8,000.00 so his capital gains would be $ 2,000.00 ( 8,000-6,000=2,000)
So his total return would be $ 2,865.00

1. If Wally participates in the company’s dividend reinvestment plan, how many


shares of stock will he have by the end of 2020? What will they be worth if the
stock trades at $80 on December 31, 2020? Assume that the stock can be
purchased through the dividend reinvestment plan at a net price of $50 a share in
2016, $55 in 2017, $60 in 2018, $65 in 2019, and $70 in 2020. Use fractional
shares, to 2 decimals, in your computations. Also, assume that, as in part b, Wally
starts with 100 shares of stock and all dividend expectations are realized.

(1) (2) (3) (4) (5) (6)= (4/5)

Year # of share beg year Dividends per share Total Dividends


Purchase Price No of Shares Purc

2016 100.00 1.30 130.00 50.00 2.60

2017 102.60 1.36 139.54 55.00 2.54

2018 105.14 1.76 185.05 60.00 3.08

2019 108.22 1.98 214.28 65.00 3.30

2020 111.52 2.25 250.92 70.00 3.58

So he would have 15.10 more shares by the end of 2017

If the shares were traded at 80.00 a share then his shares would be worth $ 9208.00 (115.1 x 80)

d. Would Wally be going to a different investment strategy if he decided to buy shares in


Hydro-Electric? If the switch is made, how would you describe his new investment
program? What do you think of this new approach? Is it likely to lead to more trading on
Wally’s behalf? If so, can you reconcile that with the limited amount of time he has to
devote to his portfolio?

No he would not be going in a different direction if he decides to buy shares in Hydro-Electric,


but rather changing the thrust of it which is common in aggressive investors in a long term plan.
If or when things change Wally would go back investing in his long term stocks and that way
his trading did increase, but since it is a limited amount of trades it should not affect his time.
Case Problem 7.1 Some Financial Ratios Are Real Eye-Openers

Jack Arnold is a resident of Lubbock, Texas, where he is a prosperous rancher and businessman.
He has also built up a sizable portfolio of common stock, which, he believes, is due to the fact
that he thoroughly evaluates each stock he invests in. As Jack says, “You can’t be too
careful about these things! Anytime I plan to invest in a stock, you can bet I’m going to learn as
much as I can about the company.” Jack prefers to compute his own ratios even though he could
easily obtain analytical reports from his broker at no cost. (In fact, Bob Smith, his broker, has
been volunteering such services for years.)

Recently Jack has been keeping an eye on a small chemical stock. The firm, South Plains
Chemical Company, is big in the fertilizer business—which is something Jack knows a lot about.
Not long ago, he received a copy of the firm’s latest financial statements (summarized here) and
decided to take a closer look at the company.

Cash $ 1,250

Accounts receivable $ 8,000 Current liabilities $10,000

Inventory $12,000 Long-term debt $ 8,000

Current assets $21,250 Stockholders’ equity $12,000

Fixed and other assets $ 8,750 Total liabilities and

Total assets $30,000 stockholders’ equity $30,000

South Plains Chemical Company Balance Sheet ($ thousands)

Sales $50,000

Cost of goods sold $25,000

Operating expenses $15,000

Operating profit $10,000


Interest expense $ 2,500

Taxes $ 2,500

Net profit $ 5,000

Dividends paid to common stockholders ($ in thousands) $ 1,250

Number of common shares outstanding 5 million

Recent market price of the common stock $ 25

South Plains Chemical Company Income Statement ($ thousands)

Questions
a. Using the South Plains Chemical Company figures, compute the following ratios.

Latest Industry Latest Industry


Averages Averages

Liquidity Profitability

a. Net working N/A h. Net profit margin 8.5%


capital

b. Current ratio 1.95 i. Return on assets 22.5%

Activity j. ROE 32.2%

c. Receivables 5.95 Common-Stock Ratios


turnover

d. Inventory turnover 4.50 k. Earnings per share $2.00

e. Total asset 2.65 l. Price-to-earnings ratio 20.0


turnover
Latest Industry Latest Industry
Averages Averages

Leverage m. Dividends per share $1.00

f. Debt-equity ratio 0.45 n. Dividend yield 2.5%

g. Times interest 6.75 o. Payout ratio 50.0%


earned

p. Book value per share $6.25

q. Price-to-book-value 6.4
ratio
b. Compare the company ratios you prepared to the industry figures given in part a. What
are the company’s strengths? What are its weaknesses?
c. What is your overall assessment of South Plains Chemical? Do you think Jack should
continue with his evaluation of the stock? Explain.

Part (a)

Liquidity Ratio
-the company’s ability to meet day-to-day operating expenses and satisfy short-term obligations
as they become due.

a) Net working capital


= Current assets – Current liabilities
= $ 21,250,000 - $ 10,000,000
= $ 11,250,000

b) Current ratio
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑡𝑒𝑠
=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
$ 21,250,000
= $ 10,000,000
= 2.125

Activity Ratio
-how well the company is managing its assets.
-measure how efficiently the firm’s assets generate operating profit.
c) Receivables turnover
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
= 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
$ 50,000,000
= $ 8,000,000
= 6.25

d) Inventory turnover
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
= 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
$ 50,000,000
= $ 12,000,000
= 4.167

e) Total asset turnover


𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
= 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
$ 50,000,000
= $ 30,000,000
= 1.67

Leverage Ratio
-measure the impact of using debt capital to finance assets.
-firms use debt to level up (increase) returns on common equity.

f) Debt-equity ratio
𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡
= 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
$ 8,000,000
= $ 12,000,000
= 0.67

g) Times interest earned


𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠
= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
$10,000,000
= $ 2,500,000
= 4.0

Profitability Ratio
-measure how successful the company is at creating profit.
-how well is the firm’s managers maximizing shareholder wealth?
-are owners (ordinary shareholders) and other investors receiving an adequate return on their
investment?

h) Net profit margin


𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
= 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠
$ 5,000,000
= $ 50,000,000
= 10%

i) Return on assets
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
= 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
$ 5,000,000
= $ 30,000,000
= 16.67 %

j) Return on equity
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
= 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
$ 5,000,000
= $12,000,000
= 41.67 %

Common Stock Ratio


-converts key financial information into per-share basis to simply financial analysis.

k) Earnings per share


𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑖𝑛𝑑𝑠
= 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
$ 5,000,000
= 5,000,000
= $ 1.00

l) Price/earnings ratio
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
= 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
$ 25
= $1
= 25x

m) Dividends per share


𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
= 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
$ 1,250,000
= 5,000,000
= $ 0.25 per share

n) Dividend yield
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
= 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘
$ 0.25
= $ 25 x 100%
=1%

o) Payout ratio
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
= 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
$0.25
= $1
= 0.25
p) Book value per share
𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
= 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
$ 12,000,000
= 5,000,000
= $ 2.40 per share

q) Price-to-book-value ratio
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
= 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
$ 25
= $ 2.40
= 10.42

Part (b)
Compare liquidity

We can see that the SPC company’s net working capital is $ 11,250,000. This indicate that the
SPC Company has $ 11.25 million of working capital available to pay its bill and grow the
business. This value is a good sign for SPC Company, because it is higher amount than the
industry average.

Current Ratio

2.125
2.15

2.1

2.05

2 1.95 SPC Company


Industry Average
1.95

1.9

1.85
Current ratio
SPC Company 2.125
Industry Average 1.95

Next, we can see the current ratio for SPC company is 2.125 that is more than 0.175 when
compare to industry average, 1.95. This indicate that SPC Company is able to pay its accounts
creditor on time and get the discounts for prompt payment and credibility from future supplies.
SPC Company may able to do essential maintenance and replacement of fixed assets, it will
result in reduce operating expenses, such that selling expenses and depreciation expenses. Also,
the company has liquid cash for new investment project, which may increase future growth rate
of the company. This ratio is a good sign for the company.

Compare activity ratio


Activity Ratio

7 6.25 5.95

6
4.5
5 4.167
4
2.65
3
1.67
2
1
0
Receivables Inventory turnover Total asset
turnover turnover
SPC Company 6.25 4.167 1.67
Industry Average 5.95 4.5 2.65

SPC Company Industry Average

From the graph above, we can see that the receivables turnover for SPC Company is 6.25 that is
more than 0.3 when compare to industry average, 5.95. This means that the SPC Company
collecting its accounts receivable (sales to customers on credit) more quickly than industry
average. The SPC Company may have a valuable discipline on credit control, resulting the
potential for bad debt decrease. It is good for SPC Company.

However, the inventory turnover for SPC Company is 4.167 that is less than 0.333 when
compare to industry average, 4.5. This is due to the SPC Company may have too much
inventories in hand than industry average. It is expensive because inventories take up costly
warehouse space, some inventories may become spoiled or obsolete and also high risk of stock
pilferage.

The total asset turnover for SPC Company is 1.67 that is less than 0.98 when compare to industry
average, 2.65. This indicate that the company is less able to squeeze out more sales dollars out of
its assets than industry average. The company should reduce the selling price in order to achieve
higher sales volume, especially if that business line is in nature very price competitive. When the
sales volume increase, given no new investment in fixed assets, then the total asset turnover will
increase.

Compare Profitability Ratio


We can see that the net profit margin, ROA, and ROE for SPC Company is 10%, 16.67%,
41.67% compare to the industry average, 8.5%, 22.5% and 32.2% respectively. Results are
mixed.

Compare Common Stock Ratios

We can see that the dividends per share for SPC Company is $ 0.25 that is less than $ 0.75 when
compare to the industry average, $ 1.00. This amount of dividends paid out to the common
stockholder is less than the average.
Also, the dividend yield for SPC Company is 1 % that is less than 1.5 % when compare to the
industry average, 2.5 %. This indicate that the rate of current income earned on the investments
dollar is less than the average.
Moreover, the price-to-book-value for SPC Company is 10.40 that is higher 4.0 when compare to
the industry average, 6.4. This indicate that the stock for SPC Company is overpriced than
average.

Part(c)
No, the stock for SPC Company is overpriced. We can see the fact from the price-to-book-value
for SPC Company is 10.42 that is higher 4.0 when compare to the industry average, 6.4.

Case Problem 7.2 Doris Looks at an Auto Issue

Doris Wise is a young career woman. She lives in Phoenix, Arizona, where she owns and
operates a highly successful modeling agency. Doris manages her modest but rapidly growing
investment portfolio, made up mostly of high-grade common stocks. Because she’s young and
single and has no pressing family requirements, Doris has invested primarily in stocks that offer
the potential for attractive capital gains. Her broker recently recommended an auto company
stock and sent her some literature and analytical reports to study. One report, prepared by the
brokerage house she deals with, provided an up-to-date look at the economy, an extensive study
of the auto industry, and an equally extensive review of several auto companies (including the
one her broker recommended). She feels strongly about the merits of security analysis and
believes it is important to spend time studying a stock before making an investment decision.
Questions
a. Doris tries to stay informed about the economy on a regular basis. At the present time,
most economists agree that the economy is getting stronger. What information about the
economy do you think Doris would find helpful in evaluating an auto stock? Prepare a
list—and be specific. Which three items of economic information (from your list) do you
feel are most important? Explain.
b. In relation to a study of the auto industry, briefly note the importance of each of the
following.
1. Auto imports
2. The United Auto Workers union
3. Interest rates
4. The price of a gallon of gas
c. A variety of financial ratios and measures are provided about one of the auto companies
and its stock. These are incomplete, however, so some additional information will have to
be computed. Specifically, we know the following:

Net profit margin 15%

Total assets $25 billion

Earnings per share $3.00

Total asset turnover 1.5

Net working capital $3.4 billion

Payout ratio 40%

Current liabilities $5 billion

Price-to-earnings ratio 12.5

a) Doris tries to stay informed about the economy on a regular basis. At the present
time, most economists agree that the economy, now well into the third year of a
recovery, is healthy, with industrial activity remaining strong. What other information
about the economy do you think Doris would find helpful in evaluating an auto
stock? Prepare a list- and be specific. Which 3 items of economic information (from
your list) do you feel most important? Explain.
According to the resent report most economists agree that the economy, now well
into the third year of a recovery, and this expected development will affect positively
the company. Other factors that Doris should take into consideration before invest are
the following:

1- Jobs and Unemployment,to qualify for financing to purchase an automobile,


people must typically show some source of income. By extension, jobs and
unemployment rates can have an influence on car sales.

2- Interest Ratesfall in interest rates increase consumer spending by making auto-


loan cheaper. If the borrowing rates become too high, buyers may shy away and
instead spend more money maintaining their existing vehicles.Over time, auto
sales data and rate data have shown a correlation.

3- Inflation Rate Whenever prices start to rise, people often worry about inflation,
and with good reason. The real return on an investment is not how many more
dollars are in your account, but how much more you can buy with the money you
have. Because the inflation negatively affects your investments.

4- Taxes:atax break can provides a savings through tax deductions, tax credits, tax
exemptions and other incentives, giving the people a boost to spend more money.

5- Labor Relations: U.S. automakers often have a disadvantage compared to their


foreign counterparts. This is because a sizable portion of the U.S. labor force
working in the automobile industry is unionized or under some form of union
influence. And they aggressively negotiate for pay raises, medical and retirement
benefits. However, it can be expensive. In order to cover those expenses, the
domestic automaker may have to reduce costs on production or raise the price of
their cars. Both of these options can have an impact on sales.
Source: http://www.investopedia.com/articles/stocks/08/auto-
stock.asp#ixzz4E39xU3ji
From above economic factors I feel most important are; the Inflation, the Interest rate and
the unemployment. These factors have a greater impact on car sales.

b) In relation to a study of the auto industry, briefly note the importance of each of the
following
1. Auto imports: Imported automobiles and those built by foreign manufacturers
in the U.S. (commonly known as transplants) have had a tremendous impact
on the domestic industry. By spurring further competition for the U.S. Big
Three and raising quality standards, imports and transplants changed the U.S.
industry forever. (Arnholt & Keenan, 1996)
Imported automobile have a significant part of the market and this goes to
domestic company end up losing revenue.
2. The United Auto Workers union: Their unions aggressively negotiate for
labor benefits.
3. Interest rates: The average price of a new car now tops $33,000, so it’s no
surprise that consumers increasingly finance their purchases with loans that
last from 6 to 10 years. The lower the interest rate, the more willing people
are to borrow money to make big purchases, such as houses or cars. When
consumers pay less in interest, this gives them more money to spend, which
can create a ripple effect of increased spending throughout the
economy. Automaker always bargains for lower interest rates to government.
4. The price of a gallon of gas:With the significant decline in the price of oil
over the past year, this distinction is essential in understanding how the auto
industry has and will be affected.As gasoline is a petroleum-based product,
price changes in crude oil directly affect the price of a gallon of gas. A
decrease in the price of gasoline means automobile owners have more
disposable income to use for other purchases.

c) A variety of financial ratios and measures are provided about one of the auto
companies and its stock. These are incomplete, however, so some additional
information will have to be computed. Specifically, we know the following:

Net profit margin 15%


Total assets $25 billion
Earnings per share $3.00
Total assets turnover 1.5
Net working capital $3.4 billion
Payout ratio 40%
Current liabilities $5 billion
Price-to-earnings ratio 12.5

Given this information, calculate the following:

1. Sales= total assets turnover X total assets = 1.5X$25 billion= $37.5 billion
2. Net profits after taxes= net profit margin X sales = 15% X $ 37.5 = $5.625 billion
3. Current ratio= current assets / current liabilitiescurrent assets = $3.4 +$5 billion = $
8.4 billionCurrent ratio= $ 8.4 billion÷ $5 billion= 1.68
4. Market price of the stock= Price-to-earnings ratio X Earnings per share= 12.5 X $3.00=
$37.5 per share
5. Dividend yield=(Earnings per share X Payout ratio)÷Market price of the stock = ($3 X
40%) ÷$37.5= 0.032 X 100 =3.2%
Case Problem 8.1 Chris Looks for a Way to Invest His Wealth

Chris Norton is a young Hollywood writer who is well on his way to television superstardom.
After writing several successful television specials, he was recently named the head writer for
one of TV’s top-rated sitcoms. Chris fully realizes that his business is a fickle one, and on the
advice of his dad and manager, he has decided to set up an investment program. Chris will earn
about a half-million dollars this year. Because of his age, income level, and desire to get as big a
bang as possible from his investment dollars, he has decided to invest in speculative, high-
growth stocks.

Chris is currently working with a respected Beverly Hills broker and is in the process of building
up a diversified portfolio of speculative stocks. The broker recently sent him information on a
hot new issue. She advised Chris to study the numbers and, if he likes them, to buy as many as
1,000 shares of the stock. Among other things, corporate sales for the next three years have been
forecasted as follows:

Year Sales ($ millions)

1 $22.5

2 $35.0

3 $50.0

The firm has 2.5 million shares of common stock outstanding. They are currently being traded at
$70 a share and pay no dividends. The company has a net profit rate of 20%, and its stock has
been trading at a P/E of around 40 times earnings. All these operating characteristics are
expected to hold in the future.
Questions
a. Looking first at the stock:
1. Compute the company’s net profits and EPS for each of the next 3 years.
2. Compute the price of the stock three years from now.
3. Assuming that all expectations hold up and that Chris buys the stock at $70,
determine his expected return on this investment.
4. What risks is he facing by buying this stock? Be specific.
5. Should he consider the stock a worthwhile investment candidate? Explain.
b. Looking at Chris’s investment program in general:
1. What do you think of his investment program? What do you see as its strengths
and weaknesses?
2. Are there any suggestions you would make?
3. Do you think Chris should consider adding foreign stocks to his portfolio?
Explain.

a. Looking first at the stock:


1. Compute the company’s net profits and EPS for each of the next 3 years.
Year one
(120/100) * 22.5 = $27 million
Therefore 27-22.5= $4.5 million
Profit= 4.5/70
= $64285.71
Year 2
20% * 35.0 = $7
$7 million/70
Profit= $100,000

Year 3
20% of 50 = $ 10 million
10million/70
Profit = $142857.14285

2. Compute the price of the stock 3 years from now.


Price of stocks= total profits in 3 years + total sales
= (4.5+7+10) + 107.5
= $129 million
3. Assuming that all expectations hold up and that Chris buys the stock at
$70, determine his expected return on this investment.
@stock= 70
Total sales = 107.5mill
Return = 107500000/70
=535714.29
Profit 20% of 535714.29
= 107142.85
Total return= 535714.29+10712.85
= $546427.14

4. What risks is he facing by buying this stock? Be specific.


The earning per share is not stable and therefore Chris might run into high
percentage loss. The 40% times earning will therefore be tempered and the
investment will drop.

5. Should he consider the stock a worthwhile investment candidate? Explain.


Yes, The Eps from the previous years have been constantly increasing and
therefore this shows a significant increase and the net profit.

b. Looking at Chris’s investment program in general:


1. What do you think of his investment program? What do you see as its
strengths and weaknesses?
The constant change of Eps is the only weakness if not so therefore this
program is good
2. Are there any suggestions you would make?
Determining appropriate asset allocation
Chris needs to have a strategy whereby the input should remain totally a
hundred percent.
3. Do you think Chris should consider adding foreign stocks to his portfolio?
Explain.
Yes, this will amplify the expansion of Chris’ investments and therefore
increasing the input per Eps.

Case Problem 8.2 An Analysis of a High-Flying Stock

Marc Dodier is a recent university graduate and a security analyst with the Kansas City
brokerage firm of Lippman, Brickbats, and Shaft. Marc has been following one of the hottest
issues on Wall Street, C&I Medical Supplies, a company that has turned in an outstanding
performance lately and, even more important, has exhibited excellent growth potential. It has
five million shares outstanding and pays a nominal annual dividend of $0.05 per share. Marc has
decided to take a closer look at C&I to assess its investment potential. Assume the company’s
sales for the past five years have been as follows:

Year Sales ($ millions)


Year Sales ($ millions)

2012 $10.0

2013 $12.5

2014 $16.2

2015 $22.0

2016 $28.5

Marc is concerned with the future prospects of the company, not its past. As a result, he pores
over the numbers and generates the following estimates of future performance:

Expected net profit margin 12%

Estimated annual dividends per share 5¢

Number of common shares outstanding No change

P/E ratio at the end of 2017 35

P/E ratio at the end of 2018 50

Questions
a. Determine the average annual rate of growth in sales over the past five years. (Assume
sales in 2011 amounted to $7.5 million.)
1. Use this average growth rate to forecast revenues for next year (2017) and the
year after that (2018).
2. Now determine the company’s net earnings and EPS for each of the next two
years (2017 and 2018).
3. Finally, determine the expected future price of the stock at the end of this two-
year period.
b. Because of several intrinsic and market factors, Marc feels that 25% is a viable figure to
use for a desired rate of return.
1. Using the 25% rate of return and the forecasted figures you came up with in
question a, compute the stock’s justified price.
2. If C&I is currently trading at $32.50 per share, should Marc consider the stock a
worthwhile investment candidate? Explain.

1.

Strengths of investing in speculative high-growth stock includes that this type of

investment has high rewards because it has a high risk. Secondly, a keen investor can end up

benefiting from the mispricing of the stock because it is volatile (Visconti, 2012). Finally, it is

suitable for investors that stress on capital gains rather over current income

In contrast, the weaknesses of investing in speculative high-growth stock includes that it

is an investment encompassed of volatility risks and as such only suitable to risk lovers and it is

also unsuitable for investors who need current income and are after preserving capital.

2.

Some of the additional suggestions includes that Chris should add viable investments such as

options in his investment to create appropriate portfolio. He should also emphasizes on

investment that will preserve as well as appreciate its capital

3.

It is recommendable for Chris to add foreign stock. This is because adding foreign stock

will help him in diversifying country risks such as political risks. In addition, he could benefit if

he effectively hedges against foreign currency fluctuation.

Case Problem 9.2 Deb Takes Measure of the Market


Several months ago, Deb Forrester received a substantial sum of money from the estate of her
late aunt. Deb initially placed the money in a savings account because she was not sure what to
do with it. Since then, however, she has taken a course in investments at the local university. The
textbook for the course was, in fact, this one, and the class just completed this chapter. Excited
about what she has learned in class, Deb has decided that she definitely wants to invest in stocks.
But before she does, she wants to use her newfound knowledge in technical analysis to determine
whether now would be a good time to enter the market.

Deb has decided to use all of the following measures to help her determine if now is, indeed, a
good time to start putting money into the stock market:

 Advance-decline line
 New highs-new lows indicator (Assume the current 10-day moving average is 0 and the last
10 periods were each 0.)
 Arms index
 Mutual fund cash ratio
Deb goes to the Internet and, after considerable effort, is able to put together the accompanying
table of data.

Questions
a. Based on the data presented in the table, calculate a value (where appropriate) for periods
1 through 5, for each of the four measures listed above. Chart your results, where
applicable.
b. Discuss each measure individually and note what it indicates for the market, as it now
stands. Taken collectively, what do these four measures indicate about the current state of
the market? According to these measures, is this a good time for Deb to consider getting
into the market, or should she wait a while? Explain.
c. Comment on the time periods used in the table, which are not defined here. What if they
were relatively long intervals of time? What if they were relatively short? Explain how
the length of the time periods can affect the measures.

Period 1 Period 2 Period 3 Period 4 Period 5

Dow Jones 8,300 7,250 8,000 9,000 9,400


Industrial Average

Dow 2,375 2,000 2,000 2,850 3,250


Transportation
Period 1 Period 2 Period 3 Period 4 Period 5

Average

New highs $ 68 $ 85 $ 85 $ 120 $ 200

New lows $ 75 $ 60 $ 80 $ 75 $ 20

Volume up 600,000,000 836,254,123 275,637,497 875,365,980 1,159,534,297

Volume down 600,000,000 263,745,877 824,362,503 424,634,020 313,365,599

Mutual fund cash $0.31 $0.32 $0.47 $0.61 $0.74


(trillions of
dollars)

Total assets $6.94 $6.40 $6.78 $6.73 $7.42


managed (trillions
of dollars)

Advancing issues 1,120 1,278 1,270 1,916 1,929


(NYSE)

Declining issues 2,130 1,972 1,980 1,334 1,321


(NYSE)

a. Based on the data presented in the table, calculate a value (where appropriate) for
periods 1 through 5, for each of the five measures listed above. (Hint: There are
no values to compute for the Dow theory; just plot the averages.) Chart your
results, where applicable.

Dow Theory-
10,000

9,000

8,000

7,000

6,000
Dow jones Industrial
5,000 Avergae
Dow Transportation Avergae
4,000

3,000

2,000

1,000

0
Period 1 Period 2 Period 3 Period 4 Period 5

Advance Decline Line-

1,120-2,130=-1,010

1,278-1,972=-694

1,270-1,980=-710

1,916-1,334=582

1,929-1,321=608
Advancing/Declining Average Total
800
600
400
200
0
Period 1 Period 2 Period 3 Period 4 Period 5 Advancing/Declining
-200
Average Total
-400
-600
-800
-1,000
-1,200

New Highs/ New Lows-

68-75=-7

85-60=25

85-80=5

120-75=45

200-20=180
New High/Lows
200

150

100
New High/Lows
50

0
Period 1 Period 2 Period 3 Period 4 Period 5

-50

Arms Index-

1,120/2,130=0.53 / 600,000,000/600,000,000=1 = 0.53

1,278/1,972=0.64 / 836,254,123/263,745,877=3.27 = 0.20

1,270/1,980=0.64 / 275,637,497/824,362,503=0.33 = 1.94

1,916/1,334=1.44 / 875,365,980/424,634,020=2.06 = .70

1,929/1,321=1.46 / 1,159,534,297/313,365,599=3.7 = .39

Mutual Fund Cash Index=

Period 1=.31/6.94=.04

Period 2=.32/6.40=.05

Period 3=.47/6.78=.06

Period 4=.61/6.73=.09

Period 5=.74/7.42=.09
b. Discuss each measure individually and note what it indicates for the market, as it
now stands. Taken collectively, what do these five measures indicate about the current
state of the market? According to these measures, is this a good time for Deb to
consider getting into the market, or should she wait a while? Explain.

c. Comment on the time periods used in the table, which are not defined here. What
if they were relatively long intervals of time? What if they were relatively short?
Explain how the length of