Analysis of Financing Activities ♦ 351
2. Selected financial information for Gutierrez Co. appears below:
2009
2008
2007
Total assets
$1,750
$1,875
$1,925
Total liabilities
1,000
1,500
1,700
Net income
300
250
100
Dividends
120
50
10
Required:
a.
Calculate the debt to equity ratio for each year.
b.
Calculate the dividend payout ratio for each year.
c.
Comment on the future prospects of Gutierrez Co.
2009
2008
2007
a.
Debt to Equity
$1,000 ÷ $750
$1,500 ÷ $375
$1,700 ÷ $225
b.
Dividend Payout Ratio
$120 ÷ $300
$ 50 ÷ $250
$ 10 ÷ $100
352 ♦ Chapter 10
3. Shari’s Gift Store had the following events occur. Assume that immediately after each
independent event, new financial statements were prepared. Indicate how each event would affect
the company’s financial leverage, current ratio, and debt to equity ratio. In the space provided,
indicate an increase with I, a decrease with D, and no effect with X.
Financial
Leverage
Current
Ratio
Debt to
Equity Ratio
a.
Treasury stock is sold for cash
_________
_________
_________
b.
Goods are sold on credit to customers at
less than cost
_________
_________
_________
c.
Bonds payable (long-term debt) are paid
off before their maturity date
_________
_________
_________
d.
Cash dividends are declared and paid to
shareholders
_________
_________
_________
e.
New equipment is purchased on a 5-year
note payable
_________
_________
_________
4. Levin Lumber Co. reported the following selected financial information:
Total assets
$2,000
Total liabilities
500
Retained earnings
1,000
Sales
3,600
Net income
900
Required:
a.
Compute return on assets.
b.
Compute return on equity.
c.
Explain the role of financial leverage in the results of parts (a) and (b).
Financial
Leverage
a.
b.
d.
Analysis of Financing Activities ♦ 353
5. Meteor Corporation expects net income of $2,925,000 for 2007 Pretax earnings were $4.5 million.
The firm’s total assets for 2007 were $30 million. It had no liabilities or preferred stock but had 2
million shares of common stock outstanding. Meteor is considering issuing $10 million of bonds
to repurchase 500,000 shares of its common stock. If the debt had been outstanding in 2007,
Meteor would have paid $800,000 in interest expense. Meteor’s income tax rate is 35%.
Required:
Calculate return on equity for 2007 as reported and as it would have been if the debt had been
issued.
6. Projected information for 2007 is provided below for Terremark Corporation:
(in thousands, except per share amounts)
Operating income
$ 500
Interest expense
75
Income taxes (40%)
170
Net income
255
Earnings per share (100,000 shares)
2.55
Total assets
4,250
Total liabilities
1,500
Total stockholders’ equity
2,750
Terremark has the opportunity to acquire additional assets for $140,000. These assets are expected
to increase operating income by $21,000 annually. They could be financed either by selling 50,000
shares of stock or issuing debt (at 8%).
=
Net Income ÷ Total Assets
=
$900 ÷ $2,000
=
0.45
b.
=
Net Income ÷ Stockholders’ Equity
=
$900 ÷ $1,500
=
0.60
354 ♦ Chapter 10
Required:
Prepare a projected (estimated) income statement for each financing alternative, starting with
operating income. Compute projected (estimated) return on assets and return on equity under each
alternative. How should Terremark finance the acquisition?
7. Travel Ventures reported the following information:
Total assets
$450,000
Total liabilities
240,000
Net income
45,000
Required:
a.
Compute return on assets and return on equity.
b.
Explain the difference between the two ratios.
a.
Return on assets: 10% = 45,000 / 450,000
Return on equity: 21.4% = 45,000 / 210,000
Operating income
Interest expense
Income taxes (40%)
Net income
Earnings per share
Return on assets
Return on equity
Analysis of Financing Activities ♦ 355
8. The following selected financial information is available for Pilamaya Co:
2007
2008
Total assets
$22,500
18,000
Current liabilities
5,000
2,000
Long-term debt
10,000
6,000
Common stock
4,000
4,000
Retained earnings
3,500
6,000
Sales
17,000
20,000
Net income
3,375
4,500
Required:
a.
Compute return on equity for each year.
b.
Compute return on assets for each year.
c.
Discuss the changes in financial leverage from 2007 to 2008.
= Net Income ÷ Stockholders’ Equity
2007 ROE
= $3,375 ÷ ($4,000 + $3,500)
= 0.45
2008 ROE
= $4,500 ÷ ($4,000 + $6,000)
= 0.45
b.
= Net Income ÷ Total Assets
2007 ROA
= $3,375 ÷ $22,500
= 0.15
2008 ROA
= $4,500 ÷ $18,000
= 0.25
constant, it must be that financial leverage decreased from 2007 to 2008.
= Assets ÷ Stockholders’ Equity
2007 FL
= $22,500 ÷ $7,500 = 3.00
2008 FL
= $18,000 ÷ $10,000 = 1.80
356 ♦ Chapter 10
9. Vector Corporation expects net income of $1,800,000 for 2007. Pretax earnings were $3 million.
The firm’s total assets for 2007 were $40 million. It had no liabilities or preferred stock but had 3
million shares of common stock outstanding. Vector is considering issuing $17 million of bonds to
repurchase 1,000,000 shares of its common stock. If the debt had been outstanding in 2007, Vector
would have paid $1,200,000 in interest expense. Vector ‘s income tax rate is 40%.
Required:
Calculate return on equity for 2007 as reported and as it would have been if the debt had been
issued.
10. Projected information for 2007 is provided below for Transmuter Corporation:
(in thousands, except per share amounts)
Operating income
$1,300
Interest expense
140
Income taxes (40%)
464
Net income
696
Earnings per share (100,000 shares)
6.96
Total assets
9,200
Total liabilities
4,100
Total stockholders’ equity
5,100
Transmuter has the opportunity to acquire additional assets at a price of $180,000. The additional
assets are expected to increase operating income by $40,000 annually. They could be financed
either by selling 80,000 shares of stock or issuing debt (at 9%).
Required:
Prepare a projected (estimated) income statement for each financing alternative, starting with
operating income. Compute projected (estimated) return on assets and return on equity under each
alternative. How should Transmuter finance the acquisition?
Analysis of Financing Activities ♦ 357
11. The Montana Company reported the following information:
Total assets
$600,000
Total liabilities
360,000
Net income
48,000
Required:
a.
Compute return on assets and return on equity.
b.
Explain the difference between the two ratios.
a.
Return on assets: 8% = $48,000 / $600,000
Return on equity: 20% = $48,000 / $240,000
leverage. Management has chosen to utilize debt in the capital structure.
Operating income
Interest expense
Income taxes (40%)
Net income
Earnings per share
Return on assets
Return on equity
358 ♦ Chapter 10
12. Assume the following summarized balance sheet information at December 31, 2007:
Yellow Company
Red Company
Current assets
$10,000
$11,000
Long-term assets
15,000
14,000
Current liabilities
2,500
4,500
Long-term liabilities
12,500
2,500
Common stock, $10 par
8,000
15,500
Retained earnings
2,000
2,500
During the year, operating income for both was $7,500. Yellow’s interest expense was $1,250 and
Red’s was $250. Both companies were subject to a 40% income tax rate.
Required:
a.
Describe how these two firms compare regarding use of leverage.
b.
Is the firm with the higher degree of leverage using it effectively? Discuss. Show any
supporting computations clearly and neatly.
Operating income
Interest expense
Pretax income
Income taxes (40%)
Net income
Earnings per share
($4,350 ÷ 1,550)
Analysis of Financing Activities ♦ 359
13. The following summarized balance sheet information is available at December 31, 2007
Alana Co.
Eva Company
Current assets
$22,000
$20,500
Long-term assets
28,000
29,500
Current liabilities
6,000
5,000
Long-term liabilities
5,000
29,000
Common stock, $10 par
25,000
15,500
Retained earnings
14,000
500
During the year, operating income for both was $7,500. Alana’s interest expense was $750 and
Eva’s was $4,350. Both companies were subject to a 35% income tax rate.
Required:
a.
Describe how these two firms compare regarding use of leverage.
b.
Is the firm with the higher degree of leverage using it effectively? Discuss. Show any
supporting computations clearly and neatly.
Operating income
Interest expense
Pretax income
Income taxes (35%)
Net income
Earnings per share
360 ♦ Chapter 10
14. Selected information from the annual reports of Rhino Company and Bengal Company is given
below:
Rhino
Bengal
Total assets
$50,000
$60,000
Current liabilities
25,000
18,000
Long-term debt
0
17,000
Common stock
10,000
10,000
Retained earnings
15,000
15,000
Sales
40,000
50,000
Net income
12,500
15,000
Required:
a.
For each company above, compute (1) return on assets, (2) return on equity, and (3)
debt to equity.
b.
Evaluate the financing decisions of each company and discuss how these decisions
have affected returns to common stockholders.
(1)
=
Net Income ÷ Total Assets
Rhino ROA
=
$12,500 ÷ $50,000
=
0.25
Bengal ROA
=
$15,000 ÷ $60,000
=
0.25
(2)
=
Net Income ÷ Stockholders’ Equity
Rhino ROE
=
$12,500 ÷ ($10,000 + $15,000)
=
0.50
Bengal ROE
=
$15,000 ÷ ($10,000 + $15,000)
=
0.60
(3)
Debt to Equity
=
Total Liabilities ÷ Stockholders’ Equity
Rhino Debt to Equity
=
$25,000 ÷ 25,000
=
1.00
Bengal Debt to Equity
=
($18,000 + $17,000) ÷ $25,000
=
1.40
Analysis of Financing Activities ♦ 361
15. Information for Ascension Corporation is provided below:
2009
2008
2007
Total assets
$6,000
$5,400
$4,500
Total liabilities
1,800
1,600
1,200
Net income
800
720
600
Dividends
300
270
225
Required:
Calculate a) debt to equity ratio, b) dividend payout ratio, c) return on assets, d) return on equity,
and e) comment on Ascension’s situation.
16. Information for Connolly Corporation is provided below:
2009
2008
2007
Total assets
$8,000
$7,200
$6,400
Total liabilities
4,200
3,600
3,000
Net income
600
750
900
Dividends
100
100
100
Required:
Calculate (a) debt to equity ratio, (b) dividend payout ratio, (c) return on assets,
(d) return on equity, and (e) comment on Connolly’s situation.
(a) Debt to equity ratio
(b) Dividend payout ratio
(c) Return on assets
0.075
0.104
(d) Return on equity
0.158
0.208
0.265
2009
2008
2007
Debt to equity ratio
Dividend payout ratio
Return on assets
Return on equity
362 ♦ Chapter 10
17. The following selected financial information is available for Gone.com, Inc:
Common stockholders’ equity
$80,000,000
Common shares
76,000,000
Market price per common share
$30
Required:
a.
Compute the market to book value ratio.
b.
What does this ratio measure?
c.
What does the result from part (a) say about Gone.com?
18. Data (amounts in $000, except for market price) is provided below for Synovial Company:
December 31, 2007
Current assets
$ 800
Fixed assets
4,200
Current liabilities
600
Long-term liabilities
3,000
Stockholders’ equity
1,400
Net income
225
Dividends paid
90
Market value
950
Number of common shares outstanding
40
Market price per share
$23.75
Required:
Compute (a) debt (long-term) to equity, (b) return on equity, (c) return on assets,
(d) dividend payout, (e) financial leverage, and (f) market value to book value.
(a) 2.14 = $3,000 / $1,400
(d) 40% = $90 / $225
(b) 16.1% = $225 / $1,400
(e) 3.57 = $5,000 / $1,400
(c) 4.5% = $225 / $5,000
(f) 0.68 = $950 / $1,400
a.
Market to Book = $30 ÷ ($80 ÷ 76) = 28.50 or, alternatively,
Market value = $30 × 76,000,000 = $2,280,000,000
Market to book = $2,280,000,000 ÷ $80,000,000 = 28.50
b.
Market to book is a measure of firm value.
A market to book of 28.50 indicates that each dollar of investment is worth $28.50.
Analysis of Financing Activities ♦ 363
19. Data (amounts in $000) as of December 31, is provided below for Hannibal Company:
2008
2007
Current assets
$ 500
$ 400
Fixed assets
4,000
2,800
Current liabilities
600
300
Long-term liabilities
2,400
1700
Stockholders’ equity
1500
1200
Net income
270
180
Dividends paid
27
20
Market value
1,000
720
Required:
a.
Compute return on assets, financial leverage, and return on equity.
b.
Compare conditions for Hannibal’s stockholders for 2008 and 2007
20. The information below relates to Hall Company:
Net income
$ 280,000
Dividends
105,000
Total stockholders’ equity
3,900,000
Market value
4,800,000
Required:
a.
Compute the dividend payout ratio
b.
Compute the market to book value ratio
c.
What do these two ratios tell you about Hall?
a.
Dividend payout ratio: 37.5% = 105,000 / 280,000
b.
Market to book value ratio: 1.23 = 4,800,000 / 3,900,000
only $1.23, even though the firm is paying out 37.5% of its net income.
Return on assets
270/4,500 = 0.06
180/3,200 = 0.056
Financial leverage
4,500/1,500 = 3.00
3,200/1,200 = 2.67
Return on equity
270/1,500 = 0.18
180/1,200 = 0.15
364 ♦ Chapter 10
21. Data (amounts in $000, except for the market price) is provided below for Bradford Company:
December 31, 2007
Current assets
$1,000
Fixed assets
4,300
Current liabilities
600
Long-term liabilities
2,700
Stockholders’ equity
2,000
Net income
300
Dividends paid
120
Market value
1,200
Number of common shares outstanding
48
Market price per share
$25
Required:
Compute (a) debt (long-term) to equity, (b) return on equity, (c) return on assets,
(d) dividend payout, (e) financial leverage, and (f) market value to book value.
22. Data (amounts in $000) as of December 31, is provided below for Silo Corporation:
2008
2007
Current assets
$1,000
$ 700
Fixed assets
4,000
3,400
Current liabilities
800
500
Long-term liabilities
2,600
2,400
Stockholders’ equity
1,600
1,200
Net income
420
240
Dividends paid
90
50
Market value
1,000
720
Required:
a.
Compute return on assets, financial leverage, and return on equity.
b.
Compare conditions for Silo’s stockholders for 2008 and 2007
(a) 1.35 = 2,700 / 2,000
(d) 40% = 120 /300
(b) 15% = 300 / 2,000
(e) 2.65 = 5,300 / 2,000
(c) 5.7% = 300 / 5,300
(f) 0.60 = 1,200 / 2,000
Analysis of Financing Activities ♦ 365
23. The information below relates to Lakota Company:
Net income
$1,020,000
Dividends
200,000
Total stockholders’ equity
2,000,000
Market value
4,200,000
Required:
a.
Compute the dividend payout ratio.
b.
Compute the market to book value ratio.
c.
What do these two ratios tell you about Lakota?
a.
Dividend payout ratio: 19.6% = 200,000 / 1,020,000
b.
Market to book value ratio: 2.10 = 4,200,000 / 2,000,000
ESSAY
1. Why do capital structures of companies in different industries vary?
Return on assets
Financial leverage
Return on equity
366 ♦ Chapter 10
2. Discuss how each of the following items might affect a company’s decisions regarding capital
structure.
a.
Level of interest rates in the economy
b.
Variability in the company’s earnings
3. Explain the concept of financial leverage and indicate how it is related to financial risk.
(even in a bad year), there is little risk to the firm because of the earnings stability.
Analysis of Financing Activities ♦ 367
4. There are two ways to benefit from an investment: dividends and an increase in value. For each,
give a measure of firm performance. Which type of benefit would you expect from a startup
company? Why?
5. Describe the effect that a firm’s capital structure will have on financial risk and return on equity.
6. A firm makes cash payments for interest on debt and cash payments for dividends on equity. Why
might a firm facing uncertain cash flows choose to limit the amount of debt in its capital structure?
7. Beta Company issued long-term debt. As part of the debt agreement, the creditors have placed
limits on Beta’s debt to equity ratio and dividend payout ratio. How do the creditors benefit from
these restrictions?
368 ♦ Chapter 10
8. What are the two sources of capital? Explain the effect that each will have on default risk and
return on equity.
9. A company was doing OK, but not well. A business consultant recommended that employing
financial leverage might be a good idea. Several years later, the firm is in worse shape than ever
and its EPS has declined. Explain how this could happen.
10. Financial leverage is usually defined as the use of debt in the capital structure. A friend, however,
claims that leverage can be accomplished by selling shares of preferred stock.
a.
Explain why the sale of this equity instrument can result in leverage.
b.
Devise a better definition of leverage than that given in the first sentence of this
question.
b.
An improved definition would be something like: Financial leverage is the use of