ECN 134: Solution Key to Problem Set 2

Financial Economics Prof. Farshid Mojaver

Part A: CF Statement. You are given the following information of XYZ Corporation for 2011
and 2012.
a) Write the 2012 income statement using the information in the table.
b) Using the table below calculate OCF, change in NWC, NCS, CFFA, Net Long-term debt,
FC from Creditors, Net New Equity, CF from Stockholders
2011 2012
Sales $ 7,835 $ 8,409
Depreciation 1,125 1,126
Cost of goods sold 2,696 3,060
Other expenses 639 534
Interest 525 603
Cash 4,109 5,203
Accounts receivable 5,439 6,127
Short-term notes payable 794 746
Long-term debt 13,460 16,050
Net fixed assets 34,455 35,277
Accounts payable 4,316 4,185
Inventory 9,670 9,938
Dividends 956 1,051
Tax rate 34% 34%
Owners' equity $ 35,103 $ 35,564
a)
2012 Income
Statement
Sales $ 8,409.00
Costs 3,060.00
Other expenses 534.00
Depreciation 1,126.00
EBIT $ 3,689.00
Interest 603.00
EBT $ 3,086.00
Taxes (34%) 1,049.24
Net income $ 2,036.76
Dividends $ 1,051.00
Addition to retained earnings 985.76
b)
Operating cash flow $ 3,765.76
Change in NWC 2,229.00
Net capital spending 1,948.00
Cash flow from assets $ (411.24)
Net new long-term debt $ 2,590.00
Cash flow to creditors $(1,987.00)
Net new equity $ (524.76)
Cash flow to stockholders $ 1,575.76
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Part B
Problem 1: Financial Ratio Analysis
A financial ratio by itself tells us little about a company because financial ratios vary great deal
across industries. There are two basic methods for analyzing financial ratios for a company: Time
trend analysis and per group analysis. In time trend analysis, you find the ratios for the company
over some period, say five years, and examine how each ratio has changed over this period. In
peer group analysis, you compare a company’s financial ratios to those of its peers. Why might
each of these analysis methods be useful? What does each tell you about the company’s financial
health?

Answer)
Time trend analysis gives a picture of changes in the company’s financial situation over time.
Comparing a firm to itself over time allows the financial manager to evaluate whether some
aspects of the firm’s operations, finances, or investment activities have changed. Peer group
analysis involves comparing the financial ratios and operating performance of a particular firm to
a set of peer group firms in the same industry or line of business. Comparing a firm to its peers
allows the financial manager to evaluate whether some aspects of the firm’s operations, finances,
or investment activities are out of line with the norm, thereby providing some guidance on
appropriate actions to take to adjust these ratios if appropriate. Both allow an investigation into
what is different about a company from a financial perspective, but neither method gives an
indication of whether the difference is positive or negative. For example, suppose a company’s
current ratio is increasing over time. It could mean that the company had been facing liquidity
problems in the past and is rectifying those problems, or it could mean the company has become
less efficient in managing its current accounts. Similar arguments could be made for a peer group
comparison. A company with a current ratio lower than its peers could be more efficient at
managing its current accounts, or it could be facing liquidity problems. Neither analysis method
tells us whether a ratio is good or bad, both simply show that something is different, and tells us
where to look.
Problem 2: Ratios and Financial Planning at East Coast Yachts
Yacht Industry Ratios
Lower Quartile Median Upper Quartile
Current ratio 0.50 1.43 1.89
Quick ratio 0.21 0.38 0.62
Total asset
turnover 0.68 0.85 1.38
Inventory
turnover 4.89 6.15 10.89
Receivables
turnover 6.27 9.82 14.11
Debt ratio 0.44 0.52 0.61
Debt-equity
ratio 0.79 1.08 1.56
Equity
multiplier 1.79 2.08 2.56
Interest
coverage 5.18 8.06 9.83
Profit margin 4.05% 6.98% 9.87%
Return on
assets 6.05% 10.53% 13.21%
Return on
equity 9.93% 16.54% 36.15%
A. Calculate all of the ratios listed in the industry table for East Coast yachts.
Answer)
A. The calculations for the ratios listed are:
Current ratio = $14,651,000 / $19,539,000 = 0.75 times
Quick ratio = ($14,651,000 – 6,136,000) / $19,539,000 = 0.44 times
Total asset turnover = $167,310,000 / $108,615,000 = 1.54 times
Inventory turnover = $117,910,000 / $6,136,000 =19.22 times
Receivables turnover = $167,310,000 / $5,473,000 = 30.57 times
Total debt ratio = ($108,615,000 – 55,341,000) / $108,615,000 = 0.49 times
Debt-equity ratio = ($19,539,000 + 33,735,000) / $55,341,000 = 0.96 times
Equity multiplier = $108,615,000 / $55,341,000 = 1.96 times
Interest coverage = $23,946,000 / $3,009,000 = 7.96 times
Profit margin = $12,562,200 / $167,310,000 = 7.51%
Return on assets = $12,562,200 / $108,615,000 = 11.57%
Return on equity = $12,562,000 / $55,341,000 = 22.70%

B. Compare the performance of East Coast Yachts to the industry as a whole. For each ratio
comment on why it might be viewed as positive or negative relative to the industry. Suppose
you create an inventory ratio calculated as inventory divided by current liabilities. How do you
interpret this ratio? How does East Coast Yachts compare to the industry average?

Answer)
B. Regarding the liquidity ratios, East Coast Yachts current ratio is below the median industry
ratio. This implies the company has less liquidity than the industry in general. However, the
current ratio is above the lower quartile, so there are companies in the industry with lower
liquidity than East Coast Yachts. The company may have more predictable cash flows, or
more access to short-term borrowing.
The turnover ratios are all higher than the industry median; in fact, all three turnover ratios
are above the upper quartile. This may mean that East Coast Yachts is more efficient than
the industry in using its assets to generate sales.
The financial leverage ratios are all below the industry median, but above the lower
quartile. East Coast Yachts generally has less debt than comparable companies, but is still
within the normal range.
The profit margin for the company is about the same as the industry median, the ROA is
slightly higher than the industry median, and the ROE is well above the industry median.
East Coast Yachts seems to be performing well in the profitability area.
Overall, East Coast Yachts’ performance seems good, although the liquidity ratios indicate
that a closer look may be needed in this area.
 Below is a list of possible reasons it may be good or bad that each ratio is higher or lower
than the industry. Note that the list is not exhaustive but merely one possible explanation
for each ratio.
If you created an Inventory to current liabilities ratio, East Coast Yachts would have a ratio that
is lower than the industry median. The current ratio is below the industry median, while the
quick ratio is above the industry median. This implies that East Coast Yachts has less inventory
to current liabilities than the industry median. Because the cash ratio is lower than the industry
median, East Coast Yachts has less inventory than the industry median, but more accounts
receivable.

Ratio Good Bad

Current ratio Better at managing current May be having liquidity problems.
accounts.
Quick ratio Better at managing current May be having liquidity problems.
accounts.
Total asset turnover Better at utilizing assets. Assets may be older and
depreciated, requiring extensive
investment soon.
Inventory turnover Better at inventory management, Could be experiencing inventory
possibly due to better shortages.
procedures.
Receivables turnover Better at collecting receivables. May have credit terms that are too
strict. Decreasing receivables
turnover may increase sales.
Total debt ratio Less debt than industry median Increasing the amount of debt can
means the company is less likely increase shareholder returns.
to experience credit problems. Especially notice that it will
increase ROE.
Debt-equity ratio Less debt than industry median Increasing the amount of debt can
means the company is less likely increase shareholder returns.
to experience credit problems. Especially notice that it will
increase ROE.
Equity multiplier Less debt than industry median Increasing the amount of debt can
means the company is less likely increase shareholder returns.
to experience credit problems. Especially notice that it will
increase ROE.
Interest coverage Less debt than industry median Increasing the amount of debt can
means the company is less likely increase shareholder returns.
to experience credit problems. Especially notice that it will
increase ROE.
 Profit margin The PM is slightly above the May be able to better control costs.
industry median, so it is
performing better than many
peers.
ROA Company is performing above Assets may be old and depreciated
many of its peers. relative to industry.
ROE Company is performing above Profit margin and EM could still
many of its peers. be increased, which would further
increase ROE.

Problem 3: Du Pont Identity If Roten Inc., has an equity multiplier of 1.35, total asset turn-
over of 2.15, and profit margin of 5.8 percent, what is its ROE?
Answer)
ROE = (PM)(TAT)(EM)
ROE = (.058)(2.15)(1.35) = .1683 or 16.83%

Problem 3: Using Du Pont Identity Y3K, Inc., has sales of $3,100, total assets of $1,580, and a
debt-equity ratio of 1.20. If its return on equity is 16 percent, what is its net income?
Answer)
This is a multi-step problem involving several ratios. The ratios given are all part of the Du Pont
Identity. The only Du Pont Identity ratio not given is the profit margin. If we know the profit
margin, we can find the net income since sales are given. So, we begin with the Du Pont
Identity:

ROE = 0.16 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E)

Solving the Du Pont Identity for profit margin, we get:

PM = [(ROE)(TA)] / [(1 + D/E)(S)]

PM = [(0.16)($1,1580)] / [(1 + 1.20)( $3,100)] = .0371

Now that we have the profit margin, we can use this number and the given sales figure to solve
for net income:
PM = .0371 = NI / S
NI = .0371($3,100) = $114.91

Problem 4: EFN The most recent financial statement for Martin, Inc., are shown here:
Income Statement Balance Sheet
25,80
Sales 0 Assets 113,000 Debt 20,500
16,50
Costs 0 Equity 92,500
Taxable income 9,300 Total 113,000 Total 113,000
Taxes (34%) 3,162
Net income 6,138

Assets and costs are proportional to sales. Debt and equity are not. A dividend of $1,841 was
paid, and Martin wishes to maintain a constant payout ratio. Next year’s sales are projected to be
$30,960. What external financing is needed?

Answer)
An increase of sales to $30,960 is an increase of: ($30,960 – 25,800) / $25,800 = .20 or 20%
Assuming costs and assets increase proportionally, the pro forma financial statements will look
like this:

Pro forma income statement Pro forma balance sheet

Sales $30,960.00 Assets $ 135,600 Debt $ 20,500.00
Costs 19,800.00 Equity 97,655.92
EBIT 11,160.00 Total $ 135,600 Total $118,155.92
Taxes (34%) 3,794.40
Net income $ 7,365.60

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year
times net income, or:
Dividends = ($1,841.40 / $6,138)($7,365.60) = $2,209.68
The addition to retained earnings is:
Addition to retained earnings = $7,365 – 2,209.68 = $5,155.92
And the new equity balance is: Equity = $92,500 + 5,155.92 = $97,655.92
So the EFN is:
EFN = Total assets – Total liabilities and equity = $135,600 – 118,155.92 = $17,444.08

Problem 5: Sales and Growth The most recent financial statements for Fontenot Co are shown
here:
Income Statement Balance Sheet
67,00 Current 68,00
Sales 0 assets 31,000 Long-term debt 0
43,80 118,00 81,00
Costs 0 Fixed assets 0 Equity 0
Taxable 23,20 149,00 149,0
income 0 Total 0 Total 00
Taxes (34%) 7,888
15,31
Net income 2
Assets and costs are proportional to sales. The company maintains a constant 30% dividend
payout ratio and a constant debt-equity ratio. What is the maximum increase in sales that can be
sustained assuming no new equity is issued?

Answer)
The maximum percentage sales increase without issuing new equity is the sustainable growth
rate. To calculate the sustainable growth rate, we first need to calculate the ROE, which is:
ROE = NI / TE => ROE = $15,312 / $81,000 = .1890
The plowback ratio, b, is one minus the payout ratio, so:
b = 1 – .30 => b = .70
Now we can use the sustainable growth rate equation to get:
Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]
Sustainable growth rate = [.1890(.70)] / [1 – .1890(.70)] = .1525 or 15.25%
So, the maximum dollar increase in sales is:
Maximum increase in sales = $67,000(.1525) = $10,217.93
Problem 6: External financing, growth and EFN. Below we have the financial statements for
the Hoffman Company (Tax rate = 34%):
HOFFMAN COMPANY
Income Balance Sheet
Statemen
t
Sales $ 500 Current assets $ 200 Current liabilities $ 250
Costs 400 Net fixed assets 300 Owners' equity 250
Taxable $ 100 Total assets $ 500 Total liabilities and $ 500
income equity
Taxes 34
Net $ 66
income
Dividen $ 22
ds
Addition
to
retaine $ 44
d
earnings
Projected sales increase =20%
Dividend payout ratio = 33%
Retention ratio = 67%
Questions:
a. Using the projected sales increase construct the pro forma financial statements.
b. What is the EFN, increase in assets, the new total debt (assuming no new equity) and the
debt-equity ratio?
c. What is ROA? Internal growth rate?
d. What is ROE? Sustainable growth rate?
Answers) a.
HOFFM HOFFM
AN AN
COMPA COMPA
NY NY
Pro Pro
forma forma
Income Balance
Statemen Sheet
t
Sales $ 600.0 Current assets $ 240.0 Current liabilities $ 250.0

Costs 480.0 Net fixed assets 360.0 Owners' equity 302.8

Taxable income $ 120.0 Total assets $ 600.0 Total liabilities and $ 552.8
equity
Taxes 40.8

Net $ 79.2
income
Dividen $ 26.4
ds
Addition $ 52.8
to
retaine
d
earnings

a. So the EFN is: $47.20

The increase in assets is: $100.0
Assuming Hoffman wishes to issue no new equity, the new total debt is: $297.20
And the new debt-equity ratio will be: 0.98
b. In long-range financial planning, two growth rates that are of particular interest are the
internal growth rate and the sustainable growth rate. The internal growth rate is the
maximum growth rate that can be achieved without external financing of any type. For
the Hoffman Company, the internal growth rate is:
ROA = 13.20%
Internal growth rate= 9.65%
c. The sustainable growth rate is the maximum growth rate a company can achieve while
maintaining a constant debt-equity ratio. For the Hoffman Company, the sustainable
growth rate is: ROE = 26.40%
Sustainable growth rate = 21.36%
7- Financial Planning: The Loftis Company is preparing its pro forma financial statements for
the next year using this model. The abbreviated financial state
Sales growth = 20% Tax rate = 34%
Income Statement
$
Sales 780,000.00
415,000.0
Costs 0
135,000.0
Depreciation 0
68,000.0
Interest 0
Taxable income $ 162,000.00
55,080.0
Taxes 0
$
Net income 106,920.00
$
Dividends 30,000.00
 $
Additions to retained earnings 76,920.00

Balance Sheet
Assets Liabilities and Equity
$ $
Current 240,000.0 880,000.0
assets 0 Total debt 0

1 O
, w
3 n
5 e
0 r
, s
0 '
0 e
0 q
. u
0 i
0 t
Net fixed assets y 710,000.00
Total assets $ 1,590,000.00 Total debt and equity $1,590,000.00
a. Calculate each of the parameters necessary to construct the pro forma balance sheet.
Cost percentage
= Costs/Sales
Depreciation rate fixed assets = Depreciation / Beginning
Interest rate = Interest paid / Total debt
Tax rate
= Taxes / Net income
Payout ratio = Dividends / Net income
Capital intensity ratio = Fixed assets / Sales
b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro
forma balance sheet?
c. In this financial planning model, show that it is possible to solve algebraically for the
amount of new borrowing.
Answers)
a. Calculate each of the parameters necessary to construct the pro forma balance sheet.
Cost percentage 0.53
Depreciation percentage 0.10
Interest
rate 0.08
Tax
rate 0.34
Payout 0.28
ratio
Fixed assets/Total assets 0.85
Capital intensity ratio 1.73
b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro
forma balance sheet?
Loftis Company Pro forma Income Statement
Sales $ 936,000.00
Costs 498,000.00
Depreciation 137,547.17
Interest 61,552.89
Taxable income $ 238,899.94
Taxes 81,225.98
Net income $ 157,673.96
Dividends $ 44,240.73
Additions to retained earnings $ 113,433.23
c. In this financial planning model, show that it is possible to solve algebraically for the
amount of new borrowing.
Loftis Company Pro forma Balance Sheet
Assets Liabilities and Equity
Current assets $ 244,528.30 Total debt $ 796,566.77
Net fixed assets 1,375,471.70 Owners' equity 823,433.23
Total assets $ 1,620,000.00 Total debt and equity $ 1,620,000.00

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