978-1259277160 Chapter 3 Solution Manual Part 6

Unlock access to all the studying documents.

View Full Document

Chapter 03: Financial Analysis

COMPREHENSIVE PROBLEM

Comprehensive Problem 1.

Lamar Swimwear (trend analysis and industry comparisons)(LO3) Bob Adkins has recently

been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in

Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products.

Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years

as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance

sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in

Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year.

There was a steady real growth of 3 to 4 percent in gross domestic product during the period

under study.

Comprehensive Problem 1 (Continued)

Exhibit 1

LAMAR SWIMWEAR

Income Sheet

20X1 20X2 20X3

Sales (all on credit)……………………………………… $1,200,000 $1,500,000 $1,875,000

Cost of goods sold……………………………………….. 800,000 1,040,000 1,310,000

Gross profit………………………………………………… $ 400,000 $ 460,000 $ 565,000

Selling and administrative expense*………………. 239,900 274,000 304,700

Operating profit (EBIT)……………………………….. $ 160,100 $ 186,000 $ 260,300

Interest expense…………………………………………… 35,000 45,000 85,000

Net income before taxes………………………………. $ 125,100 $ 141,000 $ 175,300

Taxes…………………………………………………………. 36,900 49,200 55,600

Net income…………………………………………………. $ 88,200 $ 91,800 $ 119,700

Shares………………………………………………………… 30,000 30,000 38,000

Earnings per share……………………………………….. $ 2.94 $ 3.06 $ 3.15

*Includes $15,000 in lease payments for each year.

Exhibit 2

LAMAR SWIMWEAR

Balance Sheet

Assets 20X1 20X2 20X3

Cash………………………………………………………….. $ 30,000 $ 40,000 $ 30,000

Marketable securities…………………………………… 20,000 25,000 30,000

Accounts receivable…………………………………….. 170,000 259,000 360,000

Inventory……………………………………………………. 230,000 261,000 290,000

Total current assets…………………………………… $ 450,000 $ 585,000 $ 710,000

Net plant and equipment………………………………. 650,000 765,000 1,390,000

of McGraw-Hill Education.

Chapter 03: Financial Analysis

Total assets…………………………………………………. $1,100,000 $1,350,000 $ 2,100,000

Liabilities and Stockholders’ Equity

Accounts payable………………………………………… $ 200,000 $ 310,000 $ 505,000

Accrued expenses……………………………………….. 20,400 30,000 35,000

Total current liabilities……………………………… $ 220,400 $ 340,000 $ 540,000

Long-term liabilities……………………………………. 325,000 363,600 703,900

Total liabilities………………………………………… $ 545,400 $ 703,600 $ 1,243,900

Common stock ($2 par)……………………………….. 60,000 60,000 76,000

Capital paid in excess of par…………………………. 190,000 190,000 264,000

Retained earnings………………………………………… 304,600 396,400 516,100

Total stockholders’ equity…………………………. $ 554,600 $ 646,400 $ 856,100

Total liabilities and stockholders’ equity………… $1,100,000 $1,350,000 $2, 100,000

Exhibit 3

Selected Industry Ratios

20X1 20X2 20X3

Growth in sales…………………………….. — 10.00% 12.00%

Profit margin………………………………… 7.71% 7.82% 7.96%

Return on assets (investment)…………. 7.94% 8.86% 8.95%

Return on equity……………………………. 14.31% 15.26% 16.01%

Receivable turnover………………………. 9.02x 8.86x 9.31x

Average collection period………………. 39.9 days 40.6 days 38.7 days

Inventory turnover………………………… 4.24x 5.10x 5.11x

Fixed asset turnover………………………. 1.60x 1.64x 1.75x

Total asset turnover……………………….. 1.05x 1.10x 1.12x

Current ratio…………………………………. 1.96x 2.25x 2.40x

Quick ratio…………………………………… 1.37x 1.41x 1.38x

Debt to total assets………………………… 43.47% 43.11% 44.10%

Times interest earned…………………….. 6.50x 5.99x 6.61x

Fixed charge coverage…………………… 4.70x 4.69x 4.73x

Growth in EPS……………………………… — 10.10% 13.30%

The stock in the corporation has become available due to the ill health of a current stockholder,

who is in need of cash. The issue here is not to determine the exact price for the stock, but rather

whether Lamar Swimwear represents an attractive investment situation. Although Mr. Adkins has

a primary interest in the profitability ratios, he will take a close look at all the ratios. He has no

fast and firm rules about required return on investment, but rather wishes to analyze the overall

condition of the firm. The firm does not currently pay a cash dividend, and return to the investor

must come from selling the stock in the future. After doing a thorough analysis (including ratios

for each year and comparisons to the industry), what comments and recommendations do you

offer to Mr. Adkins?

CP 3-1. Solution:

Lamar Swimwear

of McGraw-Hill Education.

Chapter 03: Financial Analysis

20X1 20X2 20X3

Growth in sales (Company) 25% 25%

(Industry) 10% 12%

Profit margin (Company) 7.35% 6.12% 6.38%

(Industry) 7.71% 7.82% 7.96%

CP 3-1. (Continued)

of McGraw-Hill Education.

Chapter 03: Financial Analysis

Discussion of Ratios

While Lamar Swimwear is expanding its sales much more rapidly than

others in the industry, there are some clear deficiencies in their

In terms of profitability, the profit margin is declining over time. This is

surprising in light of the 56.25 percent increase in sales over two years

(25 percent per year). There obviously are no economies of scale for this

firm. Higher costs of goods sold and interest expense appear to be

Return on equity is higher than the industry average the first year, and

then also falls far below it. This decline is particularly significant in light

The previously mentioned slower turnover of assets can be analyzed

This can also be stated in terms of an average collection period that has

increased from 51 days to 69.1 days. While inventory turnover has been

We can summarize the discussion of the turnover ratios by saying that

of McGraw-Hill Education.

Chapter 03: Financial Analysis

CP 3-1. (Continued)

The liquidity ratios also are not encouraging. Both the current and quick

The debt-to-total-assets ratio is particularly noticeable in regard to

industry comparisons. Lamar Swimwear has gone from being only 6.11

percent over the industry average to 15.13 percent above the norm

Finally, we see that the firm has a slower growth rate in earnings per

share than the industry. This is a function of less rapid growth in

earnings as well as an increase in shares outstanding (with the sale of

Investment Comments:

He would probably have difficulty justifying such an investment based

on the performance of the firm. There are no dividend payouts, so return

to the investor would have to come in the form of capital appreciation if

Comprehensive Problem 2

Sun Microsystems (trends, ratios stock performance) (LO3) Sun Microsystems is a leading

supplier of computer-related products, including servers, workstations, storage devices, and

network switches.

 In 2009, Sun Microsystems was acquired by Oracle Corporation.

of McGraw-Hill Education.

Chapter 03: Financial Analysis

Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still,

we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good

The statement would not appear to be telling you enough. For example, McNealy says the

1. Referring to Exhibit 1, compute the annual percentage change in net income per common

share-diluted (second numerical line from the bottom) for 1998–1999, 1999–2000, and

2000–2001.

2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years.

Begin with 1998.

3. What is the major reason for the change in the answer for Question 2 between 2000 and

2001? To answer this question for each of the two years, take the ratio of the major

income statement accounts to net revenues (sales).

Cost of sales

Research and development

Selling, general and administrative expense

Provision for income tax

4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 1

and 2.

Comprehensive Problem 2 (Continued)

Exhibit 1

SUN MICROSYSTEMS INC.

Summary Consolidated Statement of Income (in millions)

2001 2000 1999 1998

Dollars Dollars Dollars Dollars

Net revenues………………………………………… $18,250 $15,721 $11,806 $9,862

Costs and expenses:

Cost of sales

of McGraw-Hill Education.

Chapter 03: Financial Analysis

……………………………………………………………

Total costs and expenses……………………….. 16,939 13,328 10,286 8,748

Cumulative effect of change

in accounting principle, net

……………………………………………………….. (54) – – –

5. Analyze your results to Question 4 more completely by computing ratios 1, 2a, 2b, and 3b

(all from this chapter) for 2000 and 2001. Actually, the answer to ratio 1 can be found as part

6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:

1998 11¼

a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown

above and divide by net income per common stock-dilution from Exhibit 1.

b. Why do you think the P/E has changed from its 2000 level to its 2001 level?

A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio

Applied to Earnings per Share in Chapter 2.

Comprehensive Problem 2 (Continued)

Exhibit 2

SUN MICROSYSTEMS, INC

Consolidated Balance Sheets (in millions)

Assets 2001 2000

Current assets:

Cash and cash equivalents……………………………………………………………. $ 1,472 $ 1,849

Short-term investments……………………………………………………………….. 387 626

Accounts receivable, net allowances of $410 in 2001 and

of McGraw-Hill Education.

Chapter 03: Financial Analysis

Total current assets…………………………………………………………………… $7,934 $6,877

Liabilities and Stockholders’ Equity

Current liabilities:

Short-term borrowings………………………………………………………………… $ 3 $ 7

Accounts payable……………………………………………………………………….. 1,050 924

Accrued payroll-related liabilities…………………………………………………. 488 751

Commitments and contingencies

Stockholders’ equity:

Preferred stock, $0.001 par value, 10 shares authorized (1 share which

has been designated as Series A Preferred participating stock): no

shares issued and outstanding…………………………………………………….

– –

Common stock and additional paid-in-capital, $0.00067 par value, 7,200

$18,181 $14,152

7. The book values per share for the same four years discussed in the preceding question were:

1998 $1.18

a. Compute the ratio of price to book value for each year.

b. Is there any dramatic shift in the ratios worthy of note?

CP 3-2. Solution

Sun Microsystems

of McGraw-Hill Education.

Chapter 03: Financial Analysis

1. Percentage change in net income per common share—diluted

1999 $ .31 2000 $ .55 2001 $ .27

2. Profit margin

1998 1999 2000 2001

Net income $755 $1,030 $1,854 $927

Net revenues 9,862 11,806 15,721 18,250

7.66% 8.72% 11.79% 5.08%

3. Percent of net revenue

2000 2001

Net revenues $15,721 $18,250

The main problem between 2000 and 2001 was the increase in cost

of sales as a percentage of net revenue (48.02 percent to 55.02

percent).

CP 3-2. (Continued)

4. Return on stockholders’ equity

2000 2001

of McGraw-Hill Education.

Chapter 03: Financial Analysis

Net income $1,854 $ 927

Stockholders’ equity 7,309 10,586

25.37% 8.76%

2000 2001

Net income

Net revenues (sales)

Net income

Total assets

2.b.

Net income Sales 11.79% 1.11 5.08% 1.00

Sales Total assets

´ ´ ´

13.09% 5.08%

3.b.

( ) ( ) ( )

Return on assets 13.09% 5.08%

1 Debt/Assets 1 .484 1 .418– – –

25.37% 8.73%

The main contributing factor to the decline in the return on

stockholders’ equity (25.37 percent to 8.73 percent) was the

CP 3-2. (Continued)

6.a. P/E = Stock price/Net income per common share—diluted (EPS)

of McGraw-Hill Education.

Chapter 03: Financial Analysis

1998 1999 2000 2001

Share prices $11.25 $16.75 $28.50 $9.50

EPS .24 .31 .55 .27

P/E 46.9 54.0 51.8 35.2

b. The sharp decline in performance caused investors to pay a lower

multiple for the stock.

7.a. Price to book value = Stock price/book value

1998 1999 2000 2001

Share prices $11.25 $16.75 $28.50 $9.50

Book value 1.18 1.55 2.29 3.26

P/BV 9.53 10.81 12.45 2.91

b. Once again, the sharp falloff in price to book value between 2000

and 2001 can be attributed to the decline in performance (and the

of McGraw-Hill Education.