978-0134083308 Chapter 7 Solution Manual Part 2

Chapter 2 Securities Markets and Transactions 15

 Suggested Answers to Critical Thinking Question

Cooking the Books: What Were They Thinking?

Will this regulation be able to eliminate conflict of interest? Discuss.

Answer:In the wake of current accounting scandals, separation of internal and external audits and

auditor independence have been the focus of the Sarbanes-Oxley Act of 2002 and subsequent

The external audit, on the other hand, should give an independent review that the numbers in the

accounts, as reported to the shareholders, are a reasonable picture of how the company is doing

 Suggested Answers to Discussion Questions

7.1 a. Fiscal policy would usually remain fairly strict during a strong economy with automatic

stabilizers, such as taxes and transfer payments, restraining inflation.

7.2 a. Airline stock: revenue growth, operational efficiency, fuel prices, and employment

b. A cyclical stock: current business cycle, future predictions of economic activity, how a particular

7.3 a. 2. Activity ratios

16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

e. 1. Profitability

f. 2. Activity

 Solutions to Problems

7.1 From abbreviated financial statements (dollars in millions):

Liquidity

(2) Current ratio  Current assets/Current liabilities

Activity

(3) Total asset turnover  Sales/Total assets

Leverage

(4) Debt-equity ratio  Long-term debt/Stockholders’ equity

(5) Times interest earned  Earnings before interest and taxes/Interest

Profitability

(6) Net profit margin  Net profits after taxes/Sales

(7) Return on total assets  Net profits after taxes/Total assets

(8) Return on equity  Net profits after taxes/Stockholders’ equity

Common Stock Ratios

(9) Earnings per share  (Net profits after taxes – Preferred dividends)/

(10) Price/earnings ratio  Share price/EPS

(11) Price-to-sales ratio  Share price/Sales per share

(12) Dividends per share  Total common dividends paid/Common shares outstanding

(13) Dividend yield  Dividends per share/Share price

(14) Payout ratio  Dividends per share/EPS

Chapter 2 Securities Markets and Transactions 17

(15) Book value per share  Common equity/Common shares outstanding

(16) Price-to-book value  Share price/Book value per share

7.2 Total assets = liabilities + equity

7.3 Book value = ($750-$300)/300=$1.50

7.4 a. EPS 

Net profits after taxes Preferred dividends

Number of common shares outstanding

–

For Amherst:

EPS 

$10,000,000 $0 $4 per share

2,500,000

–=

Note: Only preferred dividends, zero here, are subtracted from net profits after taxes. Common

dividends are part of EPS.

b. Book value per share 

Stockholders’ equity

Number of common shares outstanding

For Amherst:

$45,000,000 $18 per share

18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

For Amherst:

Dividend payout ratio 

$1 25%

$4 =

Dividend yield 

Dividends per share

Market price of common stock

For Amherst:

Dividend yield 

$1 5%

$20 =

f . PEG ratio 

Stock’s P/E ratio 5/ 7.5 0.667

3 to 5 years growth rate in earnings = =

7.5 P/E  10 and P  $23.50

$23.50/E  10 $23.50/10  E  $2.35

7.6 PEG P/E (Earnings growth rate  100)

To find the earnings growth rate, treat the current $2 earnings per share as the present value and

7.7 a. Total asset turnover 

Annual sales

Total assets

For Highgate Computer:

Total asset turnover 

$27,000,000 1.80

$15,000,000 =

Net profit margin 

Net profits after taxes

Annual sales

For Highgate Computer:

Net profit margin 

$1,800,000 6.67%

$27,000,000 =

b. Return on assets (ROA) 

Net profits after taxes

Total assets

For Highgate Computer:

$1.8 million 12%

Chapter 2 Securities Markets and Transactions 19

Return on equity (ROE) 

Net profits after taxes

Stockholders’ equity

For Highgate Computer:

$1,800,000 30%

20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

Market price of stock

25 $3.75

Market price of stock $93.75

=

d. Both the EPS and P/E drop—to $1.50 and 10 times earnings:

Market price of stock

10 $1.50

Market price of stock $15.00

=

e. As shown in the case of Financial Learning Systems, higher earnings improve the stock price for

7.10 We will use the following three ratios:

Return on assets  Net profit after taxes/Total assets

Net profit margin  Net profit after taxes/Sales

Total asset turnover  Sales/Total assets

a. In this problem the most obvious way to calculate ROA is to begin by calculating profits. To do

this, we must determine sales and then apply the net profit margin to this sales figure to

Using the equation for net profit margin, net profits after taxes must be $3,696,000:

0.14 Net profits after taxes/$26.4 million

Note: Or this problem can also be solved by simply multiplying the company’s asset turnover by

its profit margin; i.e., 2.20.14 30.8%.

b. To solve this part of the problem, first find the firm’s equity. We know it has $12 million in

assets, and the problem states that 40% of the assets are financed with equity. Therefore:

Now to find ROE:

ROE 

Net Profits $3,696,000

77%

Equity $4,800, 000

= =

Note: Comparing ROE to ROA, we see that ROE is much larger (77% versus 30.8%). The reason

7.11 Price/earnings (P/E) ratio 

Market price of the stock

EPS

First, find EPS:

Net profit after taxes

EPS Number of shares of stock outstanding

=

Chapter 2 Securities Markets and Transactions 21

Since Net profit after taxes  Sales  Net profit margin:

$150,000,000 .10 $15,000,000

EPS $3 per share

5,000,000 5,000,000

$25

P/E ratio 8.3 times

$3

Market price of stock

Price-to-sales ratio Sales per share

´

= = =

= =

=

Find sales per share:

Sales $150,000,000

SPS Number of shares outstanding 5,000,000

$30 per share

= =

=

Now the price-sales ratio is:

$25

PSR 0.833

$30

Dividends per share EPS Dividend payout ratio*

Dividend yield Market price of common Market price of common

$3 0.35 $1.05 4.2%

$25 $25

= =

´

= =

´= =

*Note: Dividends per share  EPS  Dividend payout ratio

PEG ratio 

Stock’s P/E ratio

3 to 5 years growth rate in earnings

This implies: Growth 

Stock’s P/E Ratio

PEG Ratio

Growth  8.3/2  4.15%

7.12 Asset turnover = sales/assets = 3.0

Net profit margin = net income / sales = 0.09

7.13 Return on equity = net income / equity

We know that equity is $120 million, so we need to calculate net income.

If the firm has asset turnover of 2.4 and total assets of $225 million, then sales are $540 million

We could also use the relationship ROE=Profit margin × Total asset turnover × Assets/Equity

7.14 Sales: Total asset turnover × Assets

Total asset turnover  2 and total assets  $1B

22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

7.15 There is no set solution to this problem because the answer will vary with the stock selected by the

student. The students should be encouraged (or required) to actually compute the requested ratios

This problem may result in some interesting and possibly confusing responses because students

will get their information from many diverse sources. Frequently, the ratio calculations will differ.

7.16 There is no set solution to this problem. In developing an answer, the students can either look up the

ratios/information or they can be required to actually compute requested ratios from the recent

financial statements of the companies they select. In either case, the required information can be

1N/A often indicates that a negative number was involved in the computation. Targets most recent 12

Chapter 2 Securities Markets and Transactions 23

Sample analysis: Comparing General Dynamics and Boeing we see that Boeing has a higher beta meaning

that it has a stronger response to changes in the market, up or down, than General Dynamicsand may be

more risky. Boeings P/E and PEG ratios are higher indicating that investors place a higher value on

Boeing’s earnings, most likely because they expect more rapid growth in the future. Boeing’s Price/Book