CHAPTER 5 Discussion Questions 5-1. Such analysis allows the firm to determine at what level of operations it will break even and to explore the relationship between volume, costs, and profits. 5-2. A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an automobile company, which is generally subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. 5-3. A labour-intensive company will have low fixed costs and a correspondingly low break-even point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases. 5-4. For break-even analysis based on accounting flows, amortization is considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs. The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement. 5-5. Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy. 5-6. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 5-7. The higher the interest rate on new debt, the less attractive financial leverage is to the firm. 5-8. Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5. 5-9. At progressively higher levels of operation than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical -- as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 5-10. The starting level of sales is significant because we measure what can happen at that point. Note that in formula 5-3, we must specify the quantity or beginning point at which degree of operating leverage is being computed. 5-11. Financial leverage, or the use of debt, not only determines how much interest we must pay but also the number of shares of common stock that we must issue to support the nondebt portion of our capital structure. Only by examining “earnings per share” can we pick up the effect of outstanding shares on the operation of the firm. 5-12. The indifference point only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt. 5-13. Television broadcasters commit to production schedules, program purchases, etc., in the spring, create the fall/winter program schedule, and then send the salespeople out to sell advertising air time for the coming season. Thus, the costs are virtually 100% locked in before any revenues are generated. A minor fluctuation in advertising revenue, therefore, has a major effect on operating earnings. 5-14. Students may come up with many points worth discussing. Emphasis should be directed to the tremendous debt load that required servicing. Consumer demand slowed down affecting cash flows, and increased interest rates at the end of an economic cycle had the same effect. Coupled with the excessive prices paid (particularly for Federated Stores) this caused problems. There was only a small margin for error. Discussion may also include Robert Campeau’s ego, failure to follow advice, and failure to achieve asset sales at projected prices. Campeau’s gamble was risky but it was close. LBO in the 80’s and 90’s were financed at interest rates generally over 10% in comparison to much lower rates of today. This makes LBO less costly but there are fewer opportunities. Internet Resources and Questions 1. http://www.sedar.com/search/search_form_pc_en.htm Problems 5-1. SUS Appliances a. BE = b. FC $80,000 $80,000 = = = 16,000 toasters P - VC $20 − $15 $5 Sales – variable costs Contribution margin – fixed costs Total operating profit 5-2. Harmon Corporation a. BE = b. Q = $320,000 (16,000 × $20) 240,000 (16,000 × $15) 80,000 80,000 $ 0 FC $40,000 $40,000 = = = 3,636 bats P - VC $25.00 − $14.00 $11.00 FC + Profit $40,000 + $30,000 $70,000 = = = 6,364 bats P - VC $25.00 − $14.00 $11.00 5-3. Ensco Lighting Company a. BE = FC $100,000 $100,000 = = = 8,000 units P - VC $28.00 − $15.50 $12.50 b. BE = FC $75,000 $75,000 = = = 6,818 units P - VC $28.00 − $17.00 $11.00 The breakeven level decreases. c. With less operating leverage and a smaller contribution margin, profitability is likely to be less at very high volume levels. 5-4. Air Filter, Inc. Fixed costs $100,000 Rent Factory labour Executive salaries Raw materials Variable costs (per unit) $1.20 89,000 $189,000 BE = FC $189,000 $189,000 = = = 45,000 units P - VC $6.00 − $1.80 $4.20 5-5. Shawn Penn & Pencils a. BE (before) = BE (after) = b. Q (before ) = Q (after ) = 5-6. 0.60 $1.80 FC $80,000 $80,000 = = = 32,000 unit P - VC $5.00 − $2.50 $2.50 FC $120,000 $120,000 = = = 40,000 units P - VC $5.00 − $2.00 $3.00 FC × Return $80,000 × 1.30 $104,000 = = = 41,600 units P - VC $5.00 − $2.50 $2.50 FC × Return $120,000 × 1.30 $156,000 = = = 52,000 units P - VC $5.00 − $2.00 $3.00 Calloway Cab Company Cash related fixed costs = Total fixed costs – amortization = $4,000,000 – 20% ($140,000) = $400,000 – $80,000 = $320,000 BE = FC $320,000 = = 88,889 units P - VC $3.60 5-7. Labour intensive and capital-intensive break-even graphs The company having the high fixed costs will have lower variable costs than its competitor since it has substituted capital for labour. With a lower variable cost, the high fixed cost company will have a larger contribution margin. Therefore, when sales rise, its profits will increase faster than the low fixed cost firm and when the sales decline, the reverse will be true. 5-8. Sterling Tire Company Q = 20,000, P = $60, VC = $30, FC = $400,000, I = $50,000 a. Q (P − VC ) 20,000 ($60 − $30) = Q (P − VC) − FC 20,000 ($60 − $30) − $400,000 20,000 ($30) $600,000 CM = = = 20,000 ($30) − $400,000 $200,000 EBIT = 3.0 × DOL = b. DFL = c. EBIT $200,000 $200,000 = = = 1.33 × EBIT − I $200,000 − $50,000 $150,000 20,000 ($60 − $30) Q (P − VC ) = Q (P − VC) − FC − I 20,000 ($60 − $30) − $400,000 − $50,000 $600,000 $600,000 CM = = = $600,000 − $400,000 − $50,000 $150,000 EBT = 4.0 × DCL = d. BE = FC $400,000 $400,000 = = = 13,333 tires P - VC $60 − $30 $30 e. BE = FC $400,000 + $50,000 = = 15,000 tires P - VC $30 5-9. Harding Company Q = 10,000, P = $50, VC = $20, FC = $150,000, I = $60,000 a. Q (P − VC ) 10,000 ($50 − $20) = Q (P − VC) − FC 10,000 ($50 − $20) − $150,000 10,000 ($30 ) $300,000 CM = = = 10,000 ($30 ) − $150,000 $150,000 EBIT = 2.0 × DOL = b. DFL = c. EBIT $150,000 $150,000 = = = 1.67 × EBIT − I $150,000 − $60,000 $90,000 10,000 ($50 − $20) Q (P − VC ) = Q (P − VC) − FC − I 10,000 ($50 − $20) − $150,000 − $60,000 10,000 ($30 ) $300,000 CM = = = 10,000 ($30 ) − $210,000 $90,000 EBT DCL = = 3.33 × d. BE = FC $150,000 $150,000 = = = 5,000 skates P - VC $50 − $20 $30 e. BE = FC $150,000 + $60,000 = = 7,000 skates P - VC $30 5-10. a. BE = Mo’s Delicious Burgers, Inc. FC $80,000 $80,000 = = = 16,000 boxes P - VC $15 − $10 $5 b. 15,000 boxes 30,000 boxes $225,000 $450,000 Less: Variables Costs($10) ($150,000) ($300,000) Less: Fixed Costs ($ 80,000) ($ 80,000) Profit or Loss ($ 5,000) $ 70,000 Sales @ $15 per box c. Q (P − VC ) 20,000 ($15 − $10) = Q (P − VC) − FC 20,000 ($15 − $10) − $80,000 20,000 ($5) $100,000 CM = = = 20,000 ($5) − $80,000 $20,000 EBIT = 5.0 × DOL (20,000) = Q (P − VC ) 30,000 ($15 − $10) = Q (P − VC) − FC 30,000 ($15 − $10) − $80,000 30,000 ($5) $150,000 CM = = = 30,000 ($5) − $80,000 $70,000 EBIT = 2.14 × DOL (30,000 ) = Leverage goes down because we are further away from the breakeven point, thus the firm is operating on a larger profit base and leverage is reduced. d. First determine the profit or loss (EBIT) at 20,000 bags. As indicated in part b, the profit (EBIT) at 25,000 bags is $45,000: 20,000 bags Sales @ $15 per box $300,000 Less: Variable Costs ($10) (200,000) Less: Fixed Costs (80,000) Profit or Loss $ 20,000 DFL (20,000 ) = EBIT $20,000 $20,000 = = = 2.0 × EBIT − I $20,000 − $10,000 $10,000 DFL (30,000 ) = EBIT $70,000 $70,000 = = = 1.17 × EBIT − I $70,000 − $10,000 $60,000 e. Q (P − VC ) 20,000 ($15 − $10) = Q (P − VC) − FC − I 20,000 ($15 − $10) − $80,000 − $10,000 $20,000 ($5) $100,000 = = 20,000 ($5) − $90,000 $10,000 = 10.0 × DCL20,000 = Q (P − VC ) 30,000 ($15 − $10) = Q (P − VC) − FC − I 30,000 ($15 − $10) − $80,000 − $10,000 30,000 ($5) $150,000 CM = = = 30,000 ($5) − $90,000 $60,000 EBT = 2.5 × DCL30,000 = 5-11. a. Cain Auto Supplies and Able Auto Parts EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares EPS Cain $10,000 5,000 5,000 1,500 $ 3,500 10,000 $0.35 Able $10,000 10,000 0 0 $ 0 5,000 $0.00 EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares EPS $15,000 5,000 10,000 3,000 $ 7,000 10,000 $0.70 $15,000 10,000 5,000 1,500 $ 3,500 5,000 $0.70 EBIT Less: Interest EBT $50,000 5,000 45,000 $50,000 10,000 40,000 Less: Taxes @ 30% EAT Shares EPS 13,500 $31,500 10,000 $ 3.15 12,000 $28,000 5,000 $ 5.60 b. Operating profit (EBIT) return on assets ($150,000) = 6.67% ($10,000/ $150,000), 10% and 40% at the respective levels of EBIT. When the before-tax return on assets (EBIT/Total Assets) is less than the cost of debt (10%), Cain does better with less debt than Able. When before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on EPS. As return on assets becomes greater than the interest rate, financial leverage becomes more favorable for Able. c. 12% × $150,000 = $18,000 indifference point. OR: (S × I A − S A × I C ) (10,000 × $12,000 − 5,000 × $6,000) = EBIT = C 10,000 − 5,000 SC − S A = $18,000 5-12. Cain Auto Supplies (Continued) Cain EBIT Less: Interest $40,000 5,000 EBT 35,000 Less: Taxes @ 30% 10,500 EAT $24,500 Shares 10,000 EPS $2.45 P/E 12x Share Price 5-13. a. $29.40 Pulp Paper Company and Holt Paper Company EBIT Less: Interest EBT Less: Taxes @ 40% EAT Shares EPS Pulp $150,000 80,000 70,000 28,000 $ 42,000 140,000 $0.30 Holt $150,000 40,000 110,000 44,000 $ 66,000 220,000 $0.30 b. Share price (both firms) = P/E × EPS = 20 × $0.30 = $6.00 c. Share price (Pulp) Share price (Holt) = P/E × EPS = 15 × $0.30 = $4.50 = P/E × EPS = 26 × $0.30 = $7.80 d. Clearly, the ultimate objective should be to maximize share price. While management might be indifferent between the two plans based on earnings per share, Holt paper with the less risky plan has a higher share price. 5-14. Mitaka Company 125,000 ($25 − $5) Q (P − VC ) = Q (P − VC) − FC − I 125,000 ($25 − $5) − $1,800,000 − $400,000 125,000 ($20) $2,500,000 CM = = = 125,000 ($20) − $2,200,000 $250,000 EBT DCL = = 8.33 × 5-15. a. Sinclair Manufacturing and Boswell Brothers Q (P − VC ) 50,000 ($20 − $10) = Q (P − VC) − FC − I 50,000 ($20 − $10) − $300,000 − $72,000 50,000 ($10) $500,000 = = = 50,000 ($10 ) − $372,000 $128,000 = 3.91 × DCL = b. 50,000 ($20 − $16) Q (P − VC ) = Q (P − VC) − FC − I 50,000 ($20 − $16) − $0 − $0 50,000 ($4) $200,000 = = 50,000 ($4) − $0 $200,000 = 1.0 × DCL = c. The combined leverage is fairly high in part a, because you are combining firms that both use operating and financial leverage. The leverage factor is only 1 × in part b, because Boswell has no financial leverage and Sinclair has no operating leverage. d. EPS will increase by 100 percent. However, there is no leverage involved. EPS merely grows at the same rate as sales. 5-16. Norman Automatic Mailer Machine Company a. Before expansion S − TVC $3,000,000 − $1,200,000 = DOL = S − TVC − FC $3,000,000 − $1,200,000 − $800,000 $1,800,000 CM = = = 1.80 × $1,000,000 EBIT DFL = EBIT $1,000,000 = = 1.67 × EBIT − I $1,000,000 − $400,000 S − TVC $3,000,000 − $1,200,000 = S − TVC − FC − I $3,000,000 − $1,200,000 − $800,000 − $400,000 CM $1800,000 = = = 3.0 × EBT $600,000 DCL = b. Income Statement after expansion Sales Less: Variable Costs (40%) Fixed Costs EBIT Less: Interest EBT Less: Taxes @ 34% EAT (Net Income) Debt $4,500,000 1,800,000 1,350,000 1,350,000 640,0001 710,000 241,400 468,600 Equity $4,500,000 1,800,000 1,350,000 1,350,000 400,000 950,000 323,000 627,000 Common Shares EPS Debt 100,000 $ 4.69 Equity 140,0002 $ 4.48 (1) New interest expense level if expansion is financed with debt: $400,000 + 12% ($2,000,000) = $640,000 (2) Number of common shares outstanding if expansion is financed with equity: 100,000 + 40,000 = 140,000 c. DOL (same for both plans) S − TVC $4,500,000 − $1,800,000 = DOL = S − TVC − FC $4,500,000 − $1,800,000 − $1,350,000 $2,700,000 CM = = = 2.0 × $1,350,000 EBIT DFL (debt ) = EBIT $1,350,000 = = 1.90 × EBIT − I $1,350,000 − $640,000 DFL (equity ) = EBIT $1,350,000 = = 1.42 × EBIT − I $1,350,000 − $400,000 S − TVC $4,500,000 − $1,800,000 = S − TVC − FC − I $24500,000 − $1,800,000 − $1,350,000 − $640,000 CM $2,700,000 = = = 3.80 × (debt ) EBT $710,000 DCL = S − TVC $4,500,000 − $1,800,000 = S − TVC − FC − I $4,500,000 − $1,800,000 − $1,350,000 − $400,000 CM $2,700,000 = = = 2.84 × (equity ) EBT $710,000 DCL = d. EBIT = (S B × I A − S A × I B ) (140,000 × $640,000 − 100,000 × $400,000) = SB − SA 140,000 − 100,000 = $1,240,000 e. The debt financing plan provides greater earnings per share level, but provides more risk because of the increased use of debt and higher DFL and DCL. The interest coverage ratio in both cases is satisfactory and interest coverage is well protected. The crucial point is expectations for future sales. If sales are expected to decline or advance very slowly, the debt plan will not perform well in comparison to the equity plan. Conversely, with increasing sales, the debt plan becomes more attractive. Based on projected overall sales of $4,500,000, the debt plan should probably be favored, although cyclical swings in sales, earnings, and profit margins should be considered. 5-17. Dickinson Company a. Income statements Return on assets = 10%; EBIT = $1,200,000 Current Plan D Plan E EBIT $1,200,000 $1,200,000 $1,200,000 1 2 Less: Interest 600,000 960,000 300,0003 EBT 600,000 240,000 900,000 Less: Taxes (45%) 270,000 108,000 405,000 EAT $ 330,000 $ 132,000 $ 495,000 Common shares 750,0004 375,000 1,125,000 EPS $0.44 $0.35 $0.44 (1) $6,000,000 debt @ 10% (2) $600,000 interest + ($3,000,000 debt @ 12%) (3) ($6,000,000 - $3,000,000 debt retired) × 10% (4) ($6,000,000 common equity)/ ($8 par value) = 750,000 shares Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Dickinson. b. Return on assets = 5%; EBIT = $600,000 Current Plan D Plan E EBIT $600,000 $600,000 $600,000 Less: Interest 600,000 960,000 300,000 EBT 0 (360,000) 300,000 Less: Taxes (45%) 0 (162,000) 135,000 EAT 0 $(198,000) $165,000 Common shares 750,000 375,000 1,125,000 EPS $ 0.00 $ (0.53) $ 0.15 Return on assets = 15%; EBIT = $1,800,000 Current Plan D Plan E EBIT $1,800,000 $1,800,000 $1,800,000 Less: Interest 600,000 960,000 300,000 EBT 1,200,000 840,000 1,500,000 Less: Taxes (45%) 540,000 378,000 675,000 EAT $660,000 $ 462,000 $825,000 Common shares 750,000 375,000 1,125,000 EPS $ 0.88 $1.23 $ 0.73 If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0. c. EBIT = (S B × I A − S A × I B ) (1,125,000 × $960,000 − 375,000 × $300,000) = SB − SA 1,125,000 − 375,000 = $1,290,000 d. Return on Assets = 10%; EBIT = $1,200,000 Current Plan D Plan E EBIT $1,200,000 $1,200,000 $1,200,000 EAT $ 330,000 $ 132,000 $ 495,000 1 2 Common shares 750,000 500,000 1,000,000 EPS $ 0.44 $ 0.26 $ 0.50 (1) 750,000 - ($3,000,000/ $12 per share) = 750,000 - 250,000 = 500,000 (2) 750,000 + ($3,000,000/$12 per share) = 750,000 + 250,000 = 1,000,000 As the price of the common stock increases, Plan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic fewer shares need to be sold under Plan E. e. EBIT = (S B × I A − S A × I B ) (1,000,000 × $960,000 − 500,000 × $300,000) = SB − SA 1,000,000 − 500,000 = $1,620,000 5-18. Lopez-Portillo Company a. Return on Assets = 15% Current Plan A Plan B EBIT $1,500,000 $2,250,000 $2,250,000 Less: Interest (a) 1,200,000 (c) 1,920,000 (e) 1,200,000 EBT 300,000 330,000 1,050,000 Less: Taxes @ 40% 120,000 132,000 420,000 EAT $ 180,000 $ 198,000 $ 630,000 Common shares (b) 200,000 (d) 300,000 (f) 700,000 EPS $ 0.90 $ 0.66 $ 0.90 (a) (80% × $10,000,000) × 15% = $8,000,000 × 15% = $1,200,000 (b) (20% × $10,000,000)/$10 = $2,000,000/$10 = 200,000 shares (c) $1,200,000 (current) + (80% × $5,000,000) × 18% = $1,200,000 + $720,000 = $1.920,000 (d) 200,000 shares (current) + (20% × $15000,000)/$10 = 200,000 + 100,000 = 300,000 shares (e) Unchanged (f) 200,000 shares (current) + $5,000,000/$10 = 200,000 + 500,000 = 700,000 shares b. DFL (current ) = EBIT $1.500,000 = = 5.0 × EBIT − I $1,500,000 − $1,200,000 DFL (Plan A) = EBIT $2,250,000 = = 6.82 × EBIT − I $2,250,000 − $1,920,000 DFL (Plan B ) = c. EBIT = (S B EBIT $2,250,000 = = 2.14 × EBIT − I $2,250,000 − $1,200,000 × I A − S A × I B ) (700,000 × $1,920,000 − 300,000 × $1,200,000) = SB − SA 700,000 − 300,000 = $2,460,000 d. EAT Common Shares EPS Plan A $198,000 250,0001 $0.79 Plan B $630,000 450,0002 $1.40 200,000 shares (current) + (20% × $5,000,000)/$20 = 200,000 + 50,000 = 250,000 shares 2 200,000 shares (current) + $5,000,000/$20 = 200,000 + 250,000 = 450,000 shares 1 Plan B would continue to provide the higher earnings per shares. The difference between plans A and B is even greater than that indicated in part (a). e. EBIT = (S B × I A − S A × I B ) (450,000 × $1,920,000 − 250,000 × $1,200,000 ) = 450,000 − 250,000 SB − SA = $2,820,000 f. Not only does the price of the common stock create wealth to the shareholder, which is the major objective of the financial manager, but it greatly influences the ability to finance projects at a high or low cost of capital. Cost of capital will be discussed in Chapter 10, and one will see the impact that the cost of capital has on capital budgeting decisions. 5-19. a. Gold-Silverman Gold Plan Sales (1,000,000 units × $5) – Variable costs – Fixed costs Operating income (EBIT) – Interest1 EBT – Taxes @ 40% EAT Shares2 Earnings per share Assets = $5,000,000 3,000,000 1,500,000 500,000 32,000 468,000 187,200 $280,800 60,000 $4.68 Sales $5,000,000 = = $1,000,000 Asset turnover 5 Debt = 40% of Assets = 40% × $1,000,000 = $400,000 Interest = 8% × $400,000 = $32,000 2 Stock = 60% of $1,000,000 = $600,000 Shares = $600,000/ $10 = 60,000 1 b. Silverman Plan (original debt ratio) Sales (1,400,000 units at $4.50) $6,300,000 4,200,000 – Variable Costs (1,400,000 units × $3) – Fixed Costs 1,500,000 Operating income (EBIT) 600,000 – Interest3 32,000 EBT 568,000 – Taxes @ 40% 227,200 EAT $ 340,800 Shares4 60,000 Earnings per share $ 5.68 Assets = Sales $6,300,000 = = $1,000,000 Asset turnover 6.3 Debt = 40% of Assets = 40% × $1,000,000 = $400,000 Interest = 8% × $400,000 = $32,000 4 Stock = 60% of $1,000,000 = $600,000 Shares = $600,000/ $10 = $60,000 3 c. Silverman Plan (alternative debt ratio) Sales (1,400,000 units at $4.50) $6,300,000 4,200,000 – Variable Costs (1,400,000 units × $3) – Fixed Costs 1,500,000 Operating income (EBIT) 600,000 – Interest3 45,000 EBT 555,000 – Taxes @ 40% 222,000 EAT $ 333,000 Shares4 50,000 Sales (1,400,000 units at $4.50) Earnings per share Assets = 3 $6,300,000 $ 6.66 Sales $6,300,000 = = $1,000,000 Asset turnover 6.3 Debt = 50% of Assets = 50% × $1,000,000 = $500,000 Interest = 9% × $500,000 = $45,000 4 Stock = 50% of $1,000,000 = $500,000 Shares = $500,000/ $10 = $50,000 d. Silverman Plan (based on Mrs. Gold’s Assumption) Sales (1,400,000 units at $4.50) $6,300,000 4,200,000 – Variable Costs (1,400,000 units × $3) 1,725,000 – Fixed Costs ($1,500,000 × 1.15) Operating income (EBIT) 375,000 – Interest 45,000 EBT 330,000 – Taxes @ 40% 132,000 EAT $198,000 Shares 50,000 Earnings per share $ 3.96 No! Mr. Gold should not shift to the Silverman Plan if Mrs. Gold’s assumption is correct. 5-20. Phelps Canning Company a. At break-even before expansion: PQ Where: = FC + VC PQ equals sales volume at break-even point Sales = Fixed costs + Variable costs (Variable costs = 50% of sales) Sales .50 sales Sales = $1,800,000 + .50 sales = $1,800,000 = $3,600,000 At break-even after expansion: Sales .50 sales Sales = $2,300,000 + .50 sales = $2,300,000 = $4,600,000 b. Degree of operating leverage, before expansion, at sales of $5,000,000 S − TVC $5,000,000 − $2,500,000 = S − TVC − FC $5,000,000 − $2,500,000 − $1,800,000 $2,500,000 CM = = = 3.57 × $700,000 EBIT DOL = Degree of operating leverage after expansion: at sales to $6,000,000. $6,000,000 − $3,000,000 S − TVC = S − TVC − FC $6,000,000 − $3,000,000 − $2,300,000 $3,000,000 CM = = = 4.29 × $700,000 EBIT DOL = This could also be computed for subsequent years. c. DFL before expansion: DFL = EBIT $700,000 = = 1.40 × EBIT − I $700,000 − $200,000 DFL after Expansion: Compute EBIT and I for all three plans: Sales – TVC (.50) – FC EBIT I – Old debt I – New debt Total interest (100% Debt) (1) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 260,000 $ 460,000 (100% Equity) (2) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 0 $ 200,000 (50% Debt and 50%Equity (3) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 120,000 $ 320,000 DFL(#1) = EBIT $700,000 = = 2.92 × EBIT − I $700,000 − $460,000 DFL(#2 ) = EBIT $700,000 = = 1.40 × EBIT − I $700,000 − $200,000 DFL(#3) = EBIT $700,000 = = 1.84 × EBIT − I $700,000 − $320,000 d. EPS @ sales of $6,000,000 (refer back to part c to get the values for EBIT and Total interest) EBIT Total interest EBT Taxes (34%) EAT Shares (old) Shares (new) Total shares EPS (EAT/ total shares) (100% Debt) (1) $700,000 460,000 240,000 81,600 $158,400 200,000 0 200,000 $ 0.79 (100% Equity) (2) $700,000 200,000 500,000 170,000 $330,000 200,000 100,000 300,000 $ 1.10 (50% Debt and Equity) (3) $700,000 320,000 380,000 129,200 $250,800 200,000 40,000 240,000 $ 1.05 EPS @ sales of $10,000,000 (100% Debt) (1) Sales - TVC - FC EBIT Total interest EBT $10,000,000 5,000,000 2,300,000 2,700,000 460,000 2,240,000 (100% Equity) (2) $10,000,000 5,000,000 2,300,000 2,700,000 200,000 2,500,000 (50% Debt and Equity) (3) $10,000,000 5,000,000 2,300,000 2,700,000 320,000 2,380,000 (100% Debt) (1) Taxes (34%) EAT Total shares EPS 761,600 $1,478,400 200,000 $ 7.39 (100% Equity) (2) 850,000 $1,650,000 300,000 $ 5.50 (50% Debt and Equity) (3) 809,200 $1,570,800 240,000 $ 6.55 In the first year, when sales and profits are relatively low, plan 2 (100% equity) appears to be the best alternative. However, as sales expand up to $10 million, financial leverage begins to produce results as EBIT increases and Plan 1 (100% debt) is the highest yielding alternative. 5-21. a. Ratio analysis Profit margin Return on assets Return on equity Receivable turnover Inventory turnover Capital asset turnover Total asset turnover Current ratio Quick ratio Debt to total assets Interest coverage Ryan Boot Company $297,000/$7,000,000 $297,000/$8,130,000 $297,000/$2,880,000 $7,000,000/$3,000,000 $7,000,000/$1,000,000 $7,000,000/$4,000,000 $7,000,000/$8,130,000 $4,130,000/$2,750,000 $3,130,000/$2,750,000 $5,250,000/$8,130,000 $700,000/$250,000 Ryan Industry 4.24% 5.75% 3.65% 6.90% 10.31% 9.20% 2.3 × 4.35 × 7× 6.5 × 1.75 × 1.85 × 0.86 × 1.20 × 1.50 × 1.45 × 1.14 × 1.10 × 64.58% 25.05% 2.80 × 5.35 × Ratio analysis Fixed charge coverage see calculation below Fixed charge coverage = Ryan Industry 1.64 × 4.62 × $700,000 + $200,000(lease ) = 1.64 × $250,000 + $200,000 + $66,000 / (1 − .34) The company has a lower profit margin than the industry and the problem is further compounded by the slow turnover of assets (0.86× versus an industry norm of 1.20 ×). This leads to a much lower return on assets. The company has a higher return on equity than the industry, but this is accomplished through the firm's heavy debt ratio rather than through superior profitability. The slow turnover of assets can be directly traced to the unusually high level of accounts receivable. The firm's accounts receivable turnover ratio is only 2.33 ×, versus an industry norm of 4.35 ×. Actually the firm does quite well with receivable turnover and is only slightly below the industry in capital asset turnover. The previously mentioned heavy debt position becomes more apparent when we examine times interest earned and fixed charge coverage. The latter is particularly low due to lease expenses and sinking fund obligations. b. Break-even in sales Sales = Fixed costs + variable costs (variable costs are expressed as a percentage of sales) Sales BE .40 S S S = $2,100,000 + .60 Sales = $2,100,000 = $2,100,000/.40 = $5,250,000 Cash break-even Sales Sales BE = (Fixed costs – non cash expenses*) + variable costs = ($2,100,000 – $500,000) + .60 Sales Sales BE .40 S Sales Sales = $1,600,000 + .60 Sales = $1,600,000 = $1,600,000/.40 = $4,000,000 * Amortization S − TVC $7,000,000 − $4,200,000 = S − TVC − FC $7,000,000 − $4,200,000 − $2,100,000 $2,800,000 CM = = = 4.0 × $700,000 EBIT DOL = DFL = EBIT $700,000 = = 1.56 × EBIT − I $700,000 − $250,000 $7,000,000 − $4,200,000 S − TVC = S − TVC − FC − I $7,000,000 − $4,200,000 − $2,100,000 − $250,000 $2,800,000 CM = = = 6.22 × (4 × 1.56 ) $450,000 EBT DCL = c. Ryan is operating at a sales volume that is $1,750,000 above the traditional break-even point and $3,000,000 above the cash break-even point. This can be viewed as somewhat positive. However, the firm has a high degree of leverage, which indicates any reduction in sales volume could have a very negative impact on profitability. The DOL of 4 × is associated with heavy fixed assets and relatively high fixed costs. The DFL of 1.56 × is attributed to high debt reliance. Actually, if we were to include the lease payments of $200,000 with the interest payments of $250,000, the DFL would be almost 3 ×. A banker would have to question the potential use of the funds and the firm's ability to pay back the loan. Actually, the firm already appears to have an abundant amount of assets, so hopefully a large expansion would not take place here. There appears to be a need to reduce accounts receivable rather than increase the level. One possible use of the funds might be to pay off part of the current notes payable of $400,000. This might be acceptable if the firm can demonstrate the ability to meet its future obligations. The banker should request to see pro forma financial statements and projections of future cash flow generation. The loan might only be acceptable if the firm can bring down its inventory position back in line and improve its profitability. d. RNF = RNF = RNF A (∆S ) − L (∆S ) − PS 2 (1 − D ) S1 S1 $4.13 mil. ($7 mil. × 20% ) − $2.35 mil. ($1.2 mil.) − 4.24%($8.4 mil.)(1 − .4) $7.0 mil. $7.0 mil. = .590 ($1,400,000) – .336 ($1,400,000) – $356,160 (.6) = $826,000 – $470,400 – $213,696 = $141,904 The RNF equation assumes that the profit margin and payout ratios remain constant. With greater efficiencies as sales expand this is unlikely, particularly if capital assets are not expanded in the same manner. e. Required funds if selected industry ratios were applied Receivables Receivables Inventory Inventory = Sales/ Receivable turnover = $7,000,000/4.35 = $1,609,195 = Sales/ Inventory turnover = $7,000,000/ 6.50 = $1,076,923 Revised A (assets) = $50,000 + $80,000 + $1,609,195 + $1,076,923 = $2,816,118 Profit Margin = 5.75% RNF = RNF = RNF A (∆S ) − L (∆S ) − PS 2 (1 − D ) S1 S1 $2,816,118 ($7 mil. × 20% ) − $2.35 mil. ($1.2 mil.) − 5.75%($8.4 mil.)(1 − .4) $7.0 mil. $7.0 mil. = .4023 ($1,400,000) – .336 ($1,400,000) – $483.000(.6) = $563,224 – $470,400 – $289,800 = – $196,976 Required new funds (RNF) is negative, indicating there will actually be an excess of funds equal to $196,976. This is due to the much more rapid turnover of inventory and the higher profit margin. f. (1) (2) (3) (4) 5-22. If Ryan Boots were at full capacity, more funds would be needed to expand plant and equipment. More funds would be needed to offset the larger payout of earnings to dividends. Fewer funds would be required as sales grow less rapidly. Fewer new assets would be needed to support sales growth. As inflation increased so would the cost of new assets, especially inventory and plant and equipment. Even if sales prices could be increased, more assets would be required to support the same physical level of sales. Increased profits alone would not make up for the higher level of assets required and more funds would be needed. Rockway Framers Ltd. (Ratio calculations and pro formas) 2012 Profitability Ratios 2011 Industry Averages Profit margin Return on assets Return on equity Gross margin 4.80% 5.12% 13.25% 40.00% 5.36% 5.95% 11.90% 40.00% 3.50% 4.00% 8.20% 38.00% 9.9× 37 2.1× 1.8× 1.1× 9.9× 37 2.6× 2.0× 1.1× 9.7× 38 2.5× 2.1× 1.1× 0.9 0.24 1.8 0.79 1.8 0.7 61.34% 2.6× 50.00% 3.9× 58.00% 3.8× Asset Utilization Ratios Receivable turnover Average collection period Inventory turnover Capital asset turnover Total asset turnover Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned (continued #22) Rockway Framers Ltd. Statement of Cash Flows For the Year Ended December 31, 2013 Operating activities: Net income (earnings aftertaxes)........................ Add items not requiring an outlay of cash: Amortization.................................... $ 23,000 Cash flow from operations Increase in accounts receivable........ (8,000) Increase in inventory........................ (36,500) Increase in accounts payable............ 25,520 Net change in non-cash working capital............. Cash provided by operating activities................. Investing activities: Purchase of land.............................. (13,200) Purchase of equipment.................... (66,000) Balance sheet adjustment (equipment) (1,000) Cash used in investing activities....................... Financing activities: Increase in notes payable................. 66,750 Decrease in bonds payable.............. (13,000) Common stock dividends paid........ (13,325) Cash used in financing activities... Net increase (decrease) in cash……………… $ 17,055 23,000 40,055 (18,980) 21,075 (80,200) 40,425 (18,700) Cash, beginning of year 20,000 Cash, end of year $ 1,300 Pro formas for 2013: same % of sales as in 2012 maintained Rockway Framers Ltd. Balance Sheets at Dec. 31 2013 2012 2011 Current assets Cash $ 24,625 Accounts receivable 45,000 Inventories 126,250 Total current assets 195,875 Land 57,700 Buildings and equipment 222,000 Less accumulated amortization (108,000) Total assets $367,575 $ 1,300 36,000 101,000 138,300 57,700 222,000 (85,000) $333,000 $ 20,000 28,000 64,500 112,500 44,500 155,000 (62,000) $250,000 Current liabilities Accounts payable Notes payable Total current liabilities Long term debt Common stock Retained earnings Total liabilities and equity $ 48,770 104,500 153,270 51,000 70,000 58,730 $333,000 $ 23,250 37,750 61,000 64,000 70,000 55,000 $250,000 $ 60,963 104,500 165,463 51,000 70,000 64,918 $351,381 Required funds (no capital investment) = $367,575 – $351,381 = $16,194 Amortization of $23,000 included to increase the cash balance (footnote #3, chap. 4) RNF = A (∆S ) − L (∆S ) − PS 2 (1 − D ) S1 S1 Same payout ratio as in 2012 gives dividend in 2013 of $22,106. $138,300 ($88,800) − $48,770 ($88,800) − 6.37%($444,000)(1 − .7813) $355,200 $355,200 RNF = $16,197 RNF = Rockway Framers Ltd. Income Statements for year ending Dec.31 2013 2012 2011 Sales $444,000 Cost of goods sold 266,400 Gross profit 177,600 Sales & administration expense102,675 Amortization 23,000 Operating income 51,925 Interest 14,200 Earnings before taxes 37,725 Taxes 9,431 Net income $28,294 $355,200 213,120 142,080 82,140 23,000 36,940 14,200 22,740 5,685 $17,055 $277,500 166,500 111,000 74,370 10,000 26,630 6,800 19,830 4,958 $14,873 Profit margin increases to 6.37%, amortization and interest expense held constant. Rockway’s profit margin, although good, has slipped. The gross margin has been maintained. Higher fixed costs (related to equipment purchases?), including interest have cut into profitability. Return on equity and assets still healthy. Efficiency ratios show credit (A/R) under control, but inventory turnover has slipped below the industry average. The asset turnover ratios have also retreated and are below industry norms. This could be the result of the large investment in previous years. However, can sales be increased on these assets and can inventory turnovers be improved? Liquidity is a cause for concern. It is evidenced by the dramatic increase in notes payable with a decrease in longer term debt. Debt ratios are way up primarily due to notes payable. They are also up due to large dividend payments. Rockway’s need is for longer term capital not short term loans. A one year loan will just perpetuate the liquidity problems. Dividends should be curtailed to build up the equity and longer term capital should be sought. Good potential if the market (sales volume) is in evidence. 5-23. Deval Leasehold Improvements Ltd. 2009 2010 2011 Profitability Ratios Profit margin Return on assets Return on equity Gross margin 2.08% 8.25% 25.75% 41.50% 1.65% 6.45% 22.78% 33.30% 1.50% 5.63% 21.44% 31.40% Asset Utilization Ratios Receivable turnover Avg. Collection period Inventory turnover Inventory holding period Accounts payable turnover Accounts payable period Capital asset turnover Total asset turnover 6.5× 56 14.6× 25 7.82 47 23.0× 4.0× 6.0× 61 16.7× 22 6.59 55 24.0× 3.9× 5.6× 65 16.5× 22 5.36 68 23.4× 3.7× 2.0 1.6 1.5 1.2 1.3 1.1 67.95% 4.3× 71.69% 5.1× 73.75% 6.6× Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned Fixed charge coverage 4.3× 5.1× 6.6× Leverage (based on gross profit not sales less variable costs) DOL DFL DCL 12.54 1.304 16.36 13.35 1.242 16.58 14.54 1.178 17.13 The profitability ratios show a weakening, although the return on equity is quite good. The lower profit and gross margins probably relate to fair prices (low?) and good workmanship (expensive). The efficiency ratios indicate a slowing in receivable turnover, but the other turnover ratios appear healthy. The receivables are a concern but not unexpected due to government contracts. The liquidity ratios have weakened which one should expect given cash flow difficulties. This is occurring because of the slower collection of receivables and is resulting in the slower payment of accounts. Most of the liquid assets are tied up in slow moving receivables. The debt ratios are high. This is an indication of the need for equity investment. Perhaps dividends could be curtailed. Increased equity would improve the liquidity ratios. The operating leverage (DOL) is probably not correct as fixed and variable costs are not identified (gross profit is not the best substitute). The high DOL does not seem likely given the limited amount of capital. The financial leverage (DFL) seems reasonable and produces reasonable results as operating profits (EBIT) expands. The high debt ratios (leverage) are a result of the heavy accounts payable which are unlikely to produce interest charges. However Deval seems to be leaning on its suppliers as noted above with the accounts payable period. As an investment Deval shows potential. The company has a high return on equity. It has survived five years and it produces good work. Increased equity would strengthen its financial situation. It should, however, examine its pricing, its dividend policy, and look for greater financial expertise. Perhaps R.C. Dare can provide the expertise. MINI CASES Glen Mount Furniture Company (Financial leverage) Purpose: The potential impact of changes in the debt level on earnings per share is the central focus of this case. However, the instructor can derive educational benefits that go well beyond this point. The central figure in this case is frustrated by security analyst’s short-term emphasis on earnings per share and their lack of concern for the long-term fundamentals associated with this firm. This rather common situation can be drawn upon to make for a more dramatic discussion process. The student is given ample opportunities to calculate EPS under different financial leverage strategies and to examine debt ratios, and degrees of leverage. a. Sales ($45,000,000 + $500,000) Variable cost (58% of sales) Fixed costs Operating income (EBIT) Interest Earnings before taxes (EBT) Taxes (34%) Earnings after taxes (EAT) Shares Earnings per share $45,500,000 26,390,000 12,900,000 6,210,000 1,275,000 4,935,000 1,677,900 $3,257,100 2,000,000 $1.63 b. Earnings per share, 2012 Earnings per share, 2011 Increase Increase Earnings per share, 2011 $1.63 1.56 $0.07 $ 0.07 $1.56 c. Sales ($45,000,000 + $500,000) Variable cost (58% of sales) Fixed costs Operating income (EBIT) Interest* Earnings before taxes (EBT) Taxes (34%) Earnings after taxes (EAT) $45,500,000 26,390,000 12,900,000 6,210,000 2,400,000 3,810,000 1,295,400 $2,514,600 Shares** Earnings per share 1,375,000 $1.83 *Interest Old debt 10.625% x $12,000,000 = New debt 11.250% x $10,000,000 = Total interest **Shares outstanding 2,000,000 – 625,000 = d. Earnings per share, 2012 Earnings per share, 2011 Increase Increase Earnings per share, 2011 = 4.5% $1,275,000 1,125,000 $2,400,000 1,375,000 $1.83 (based on more debt) 1.56 $ 0.27 $ 0.27 $1.56 = 17.3% e. f. DFL (a ) = $6,210,000 EBIT = = 1.26 × EBIT − I $6,210,000 − $1,275,000 DFL (c ) = $6,210,000 EBIT = = 1.63 × EBIT − I $6,210,000 − $2,400,000 S − TVC S − TVC − FC − I $45,500,000 − $26,390,000 = $45,500,000 − $26,390,000 − $12,900,000 − $1,275,000 $19,110,000 = = 3.87 $45,500,000 − $40,565,000 DCL (a ) = S − TVC S − TVC − FC − I $45,500,000 − $26,390,000 = $45,500,000 − $26,390,000 − $12,900,000 − $2,400,000 $19,110,000 = = 5.02 $45,500,000 − $41,690,000 DCL (c ) = g. From Figure 2: Total debt/ total assets = $17,500,000/ $40,500,000 = 43.2% After the new debt issue: Total debt/ total assets = $17,500,000 + $10,000,000/ $40,500,000 = 67.9% h. There are two conflicting factors that could influence the share price. On the positive side, earnings per share would be twenty cents higher with more debt ($1.83 verses $1.63). Based on a current price-earnings ratio of about 10 (the repurchase price for the shares is for $16 ($10,000,000/625,000) and EPS are currently $1.56, the stock might go up approximately $2.00 as a result of a $.20 increase in EPS. Two dollars represents a healthy 12.5% increase from the current value of $16 per share. However, the student must keep in mind that the debt ratio is increasing from 43.2% to 67.9%, which probably would have a negative effect on the price earnings ratio. The net effect of the increase in earnings per share versus the likely decrease in the price-earnings ratio can only be conjectured. Security analysts following Glen Mount Furniture Company seem to be highly sensitive to earnings per share performance, but there may be some question about whether the type of financial engineering used to increase the earnings per share will satisfy them. Of course, the firm can argue that the share repurchase is a strong sign of confidence by management in future company performances. One clue to the eventual reaction of the market to the recapitalization might lie in the data on the debt ratios of other firms in the industry. If 67.9% is perceived to be on the high end, there might be little positive gain associated with the increase in earnings per share. However, if other companies are in this range and the firm is merely taking advantage of underutilized debt capacity, the market reaction might be positive. Chem-Med Company (Ratio Analysis) Purpose: This case allows the student to go into financial analyses in more depth than is possible with end-of-chapter problems. In addition to computing a series of ratios, the student must consider industry data and trends for the purpose of evaluation relative performance. The student must also make use of the Du Pont system of analysis. Of special interest are the debt and performance covenants established by the potential financier. Finally, the student is forced to identify the impact of extraordinary income on ratio analysis and how it can distort one year's performance. a. Sales Growth = (Sales this year ─ Sales last year)/Sales last year for 2010: $ 3,814 ─ $3,051 / $3,051 = +25% for 2011: 5,340 ─ 3,814 / 3,814 = +40% for 2012: 7,475 ─ 5,340 / 5,340 = +40% for 2013: 10,466 ─ 7,475 / 7,475 = +40% b. Net income growth = (Net income this year - Net income last year) / Net Income last year for 2011: $1,609 ─ $1,150 / $1,150 = +40% for 2012: 1,942 ─ 1,609 / 1,609 = +21% for 2013: $2,903 ─ 1,942 / 1,943 = +49% According to Dr. Swan's estimates, net income growth will match sales growth in 2011, then slack off and rebound in 2013. However, Dr. Swan's figures are misleading: in 2011 they include $500,000 worth of extraordinary income expected to be received from the settlement of the suit with Pharmacia. The astute analyst will realize that this amount should be excluded from his/her calculations because (1) receiving the amount is by no means certain, and (2) it is a one-time event which has nothing to do with the operations of the company. When the amount is excluded from 2011's figures we see that net income growth of 11% as calculated below for 2011 is actually considerably less than 40%. After tax effect of removing $500,000 from gross income = $500 × (1 ─ tax rate) = $500 × (1 ─ .33) = -$335 New net income = $1,609 ─ $335 = $1,274 Appropriate 2011 net income growth = ($1,274 ─ $1,150) / $1,150 = 11% Failing to exclude the extraordinary amount has the effect of obscuring the "real" profitability ratios; ROE in 2003 would be 23%, not 29%. Net profit margin would be 24%, not 30%. These are facts a potential investor would want to know. c. Current ratio = Current assets / Current liabilities: for 2010 = $1,720 / $ 593 = 2.90 for 2013 = $3,261 / $1,647 = 1.98 Pharmacia has a current ratio in 2004 of 2.8, and the industry average was 2.4. Chem-Med, therefore, in 2005 was slightly more liquid than the average company. This would probably be looked upon favorably by someone considering loaning money to the company; however, the banker with whom Dr. Swan had lunch would have a problem with Chem-Med's current ratio for 2007: it falls below the 2.25 to 1 limit he would establish as a restrictive covenant. In view of that, Dr. Swan needs to revise his financial plan for 2007 in such a way that less money is invested in capital assets, and more is held in cash and equivalents (or, alternatively, shift some current liabilities to long-term debt and/or equity). d. Total debt to assets ratio = Total liabilities / Total assets for 2010: = $ 614 / $ 4,491 = .137 for 2011: = $ 857 / $ 6,343 = .135 for 2012: = $1,212 / $ 8,641 = .140 for 2013: = $1,664 / $11,995 = .139 The variation from year to year is small - no trend can be established, except, of course, that the ratio remains nearly constant, indication that Chem-Med is doing a good job in managing its debt. It was doing especially well in 2010 compared to other companies in the industry, where the average debt to assets was .52 (and Pharmacia's was .55). A potential investor in Chem-Med's stock might be pleased or displeased depending on his/her tolerance for risk and outlook for the future. (Chem-Med has much less financial risk than average, but the company, which is in a growth situation, might be considered to be underleveraged). e. Chem-Med's average accounts receivable collection period = Accounts receivable/Sales per day for 2010: = $ 564 / ($ 3,814/365) = 54 days for 2011: = $ 907 / ($ 5,340/365) = 62 days for 2012: = $1,495 / ($ 7,475/365) = 73 days for 2013: = $2,351 / ($10,466/365) = 82 days This is not a good sign. The average length of time that Chem-Med's customers are taking to pay for products they've bought is increasing steadily every year. If Chem-Med's credit policy is, say, 2/10, net 30, it is clear that very few customers are adhering to it, and the situation is getting worse. Not only is Chem-Med, in effect, granting free credit to those customers by allowing them to delay payment for so long, it is paying for such credit itself. The company's higher balances of accounts receivable must be financed in some way, either through additional debt or equity, and these additions have a cost. f. Chem-Med's return on equity ration = Net income / Total equity for 2010 = $1,150 / $3,877 = 29.66% Pharmacia's ROE in 2004 was 29.66% and the industry average was only 12.3%. A potential investor in Chem-Med would be very pleased; Chem-Med is offering a handsome return that's almost two and a half times that of the average company in the industry. Now, the investor will want to use the DuPont method to look further at Chem-Med and Pharmacia to determine the source of this return. Chem-Med: Pharmacia: ROE = .2966 = .2956 = Profit Margin .3015 .07 × × × Asset Equity Turnover × Multiplier 0.85 × 1.158 1.90 × 2.22 Note the drastic difference in the operation of the two companies, even though their ROEs are nearly the same. Chem-Med makes relatively few sales (low asset turnover), but makes a lot of money on each one (30%). Pharmacia is just the opposite: ROE is also being propped up by greater use of debt than ChemMed (Pharmacia has relatively less equity; so the same amount of income will represent a greater return to Pharmacia’s equity holders than Chem-Med’s). All other considerations being equal, a potential investor would probably prefer Chem-Med’s position, but it’s by no means certain (for example, it’s much more serious for Chem-Med to lose a sale). g. BES: 2010 964 1 ─ 1,040/3,814 = $1,325 2011 1,520 1 ─ 1,716/5,340 = $2,240 Cash: 964 ─ 264 BES 1 ─ 1,040/3,814 1,520 ─ 67 1 ─ 1,716/5,340 = $962 = $2,141 DOL: DFL: DCL: 2012 2,120 1 ─ 2,154/7,475 = $2,978 2,120 ─ 109 1 ─ 2,154/7,475 = $2,825 2013 2,645 . 1 ─ 3,054/10,466 = $3,735 2,645 ─ 66 . 1 ─3,054/10,466 = $3,642 2,774 1,810 3,624 2,604 5,321 3,201 7,412 4,767 = 1.53 = 1.72 = 1.66 = 1.55 1,810 1,716 2,604 2,402 3,201 2,899 4,767 4,333 = 1.05 = 1.11 = 1.10 = 1.10 1.53 × 1.05 = 1.62 1.72 × 1.11 = 1.91 1.66 × 1.10 = 1.84 1.55 × 1.10 = 1.71 The risk of the company is quite moderate. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
Download
Close
Close
