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Analysis of Financing Activities 285
P10-5 A. and B Pro Forma Income Statements
Equity Debt
Financing Financing
Sales revenue $ 429,600 $429,600
C.
Net income
Stockholders’
equity
Return on
equity
Actual 2007 results
$33,600
$102,000
32.94%
Financing the acquisition of new equipment with equity has the ef-
fect of cutting 2008’s return on equity by more than one-half (from
32.94% to 14.04%). Even financing with debt, however, will dilute the
return on equity somewhat (from 32.94% to 29.23%). Of the two op-
tions, debt financing is clearly the better choice if management
286 Chapter 10
P10-6 A. The following ratio values might be helpful in identifying the firm’s
capital structure.
Ratio
Computation
2004
2003
Long-term debt to total assets
a ÷ c
0.17
0.17
B.
Current Ratio
2004
2003
P10-7 A. Return on equity = net income ÷ stockholders’ equity
2004 = 52.2% ($4,504 ÷ $8,633)
Analysis of Financing Activities 287
P10-8 Primary alternatives for raising additional capital include long-term debt,
preferred stock, and common stock. Risk issues that should be consid-
ered include the risk of default and bankruptcy and the risk of loss of
control. Return issues include the cost of debt, payment of preferred div-
idends, and dilution of earnings available for common stockholders.
Also, preferred stock normally does not have voting rights. Therefore,
current owners could retain control of the company. Dividends paid on
preferred stock reduce the earnings and cash flows available for common
stockholders. But preferred stockholders do not necessarily participate in
earnings to the same extent as common stockholders. Therefore, the fam-
288 Chapter 10
P10-9 A. Debt to Equity
Clipper Company: 2008 2007 2006
$3,273 ÷ 2,727 1.20
B. Return on Equity:
Clipper Company: 2008 2007 2006
$300 ÷ 2,727 11%
Return on Assets:
Clipper Company: 2008 2007 2006
$300 ÷ 6,000 = 5.0%
Financial Leverage:
Clipper Company: 2008 2007 2006
$6,000 ÷ 2,727 2.20
Clipper Company had a greater increase in ROA over the three years
than did Battle Company. However, Battle Company has had an
increase in financial leverage over the years, while Clipper Company
Analysis of Financing Activities 289
C. Dividend Payout Ratio:
Clipper Company: 2008 2007 2006
$75 ÷ 300 25%
D. Students may point out that each company has had the same income
each year so that the investment decision might be based solely on
the dividends paid out. Some investors may prefer a higher dividend
distribution, while others may prefer investing in companies that re-
P10-10 A.
Halyard Company
Spinnaker Company
i. Debt-to-equity ratio
33.3%
300.0%
ii. Debt-to-assets ratio
25.0%
75.0%
Debt to equity: The debt-to-equity ratio is a measure of the amount of
290 Chapter 10
Debt to assets: The debt-to-assets ratio also measures the amount of
debt financing in use. It reveals the portion of assets that are financed by
B.
Halyard Company
Spinnaker Company
Bad
Year
Normal
Year
Good
Year
Bad
Year
Normal
Year
Good
Year
i. Return on assets
(3.13)
9.38
21.88
(3.13)
9.38
21.88
P10-11 A. James Company 2008 2007 2006
Debt/Equity 150% 150% 150%
Debt/Assets 60% 60% 60%
Analysis of Financing Activities 291
B.
In the year 2006, when Joyce Company had a higher net income than
James Company, the existence of financial leverage magnified
C. James Company 2008 2007 2006
Debt/Equity 66.7% 66.7% 66.7%
Debt/Assets 40% 40% 40%
80
100
292 Chapter 10
P10-12 A. Return on equity (as reported) = 8.04% ($74 net income ÷ $920 S.E.)
Proof: Revised financial statements after issuing $225 million of debt
and repurchasing $225 million of stock would be as follows.
C. Higher financial leverage increases risk. If a net loss occurs, causing
return on assets to be negative, financial leverage reduces return on
30
40
50
60
Joyce ROA
Analysis of Financing Activities 293
P10-13 A. An analysis of profit performance would include computation of the
return on assets and return on equity for the periods under consid-
eration.
2004
2003
2002
The company experienced a significant dip in ROA and ROE during
B.
2004
2003
2002
Financial leverage
294 Chapter 10
P10-14 Johnson & Johnson does not appear to be facing financial problems. It
has used cash to pay dividends, repurchase stock, and pay off both long-
Increased Decreased
Financial Financial
Financing activity Leverage Leverage
Payment of dividend ($2,746 + $3,251) $ 5,997
P10-15 M E M O R A N D U M
DATE: (today’s date)
TO: Wellington Smythe
FROM: (student’s name)
SUBJECT: Credit worthiness of Sunny Meadow Enterprises
I am responding to your concerns about the recent net loss of Sunny
Meadow Enterprises and the implications of the loss for the company’s
ability to make its principal and interest payments. While not favorable,
Analysis of Financing Activities 295
Also worrisome is the current portion of long-term debt that comes
due in this next year. While last year’s cash flow from operations of
$144.2 million was more than sufficient to meet last year’s then-current
portion of long-term debt of $31.6 million, this is not the case now. If next
year’s cash flow from operations is about the same as this year (i.e., $6.8
P10-16 A. A leveraged buyout involves the massive issuance of debt and use
of the proceeds to buy back the outstanding common stock of the
owns.
B. Whenever bonds are issued with a nominal rate less than the market
C. When a company increases its debt and decreases its equity, it be-
D. The reversal of net income to net loss is not encouraging. Still, the
immediate issue is whether the company can make the interest pay-
296 Chapter 10
P10-17 A. Financing Cash Flows:
During the three-year period, the company issued debt, paid off debt,
B. Dividend Policy:
Inspection of the cash flow statement (financing activities section)
C. Company value:
Year 2004 2003
Highpoints:*
P10-18 There are at least two unethical activities in this case. First, the company
is intentionally hiding debt from interested parties. The only reason the
partnerships are established is to make Endrun’s financial statements
Analysis of Financing Activities 297
P10-19 A.
Ratio
Formula
Computation
Today’s
Ratio
Value
Current ratio
Current assets
Current liabilities
11,200 + 15,000 + 10,000
18,550 + 39,550
0.62
B. Comparison to
Ratio Today’s Value Industry Benchmarks
Current ratio 0.62 (incredibly) Weak
C. Option #1: Obtain short-term bank loan
Ratio
Formula
Computation
New
Ratio
Change
From
Today
298 Chapter 10
Option #2: Sell new shares of common stock
Ratio
Formula
Computation
New
Ratio
Change
From
Today
Current
Current assets
Current liabilities
11,200 + 15,000 + 10,000 + 90,000
18,550 + 39,550
Option #3: Issue long-term bonds payable
Ratio
Formula
Computation
New
Ratio
Change
From
Today
Current
ratio
Current assets
Current liabilities
11,200 + 15,000 + 10,000 + 90,000
18,550 + 39,550
2.17
Better
D. Option #2 Only Option #2 improves all four ratios. The other ratios
improve some ratios but not all. For example, Option #1
Analysis of Financing Activities 299
P10-20
High Income
Low Income
Current
Less Debt
More Debt
Current
Less Debt
More Debt
Operating income
$ 647,585
$ 647,585
$ 647,585
$ 200,000
$ 200,000
$ 200,000
Return on assets
5.30%
6.34%
4.26%
0.13%
1.17%
−0.91%
Note: Students may observe slight rounding errors between their solutions and the solutions
presented here. Rounding errors typically occur because of the number of significant digits
Excel uses in its calculations.
P10-21
1
2
3
4
5
6
7
8
9
10
Effect of Financial Leverage on Return
0.08
0.10
0.12
300 Chapter 10
CASES
C10-1 At the end of 2007, Terabyte Technology’s capital structure consisted of
48.7% equity ($4,257 ÷ $8,742) and 51.3% debt. Long-term debt accounted
for 9.1% ($792 ÷ $8,742) of the capital structure. At the end of 2008, the
capital structure consisted of 49.4% ($4,630 ÷ $9,375) equity and 50.6%
nancial problems.
C10-2 Summary of actual results and projected results of the events noted in
the case (dollar amounts in millions)
Actual
Results
Event A
Event B
Event C
Net
income
$3
$3.45
$2
$3.8
*Assumes preferred stock is part of equity
A. The substitution of common stock for existing bonds would have
Analysis of Financing Activities 301
Current liabilities $ 2,400,000 no change
Long-term debt (9% bonds) 0 all bonds repurchased
B. The reduction of net income by $1 million would leave it at $2 million.
Capital structure would be changed only by the amount of net in-
come. At year-end 2007, therefore, the capital structure of the firm
would be as follows:
Current liabilities $ 2,400,000 no change
C. The purchase of $8 million of new assets would increase net income
by $1.6 million before allowing for $800,000 of additional interest ($8
302 Chapter 10
At year-end 2007, total assets would also equal $34,800,000. There-
fore, the return on assets decreases from 11.5% to 10.9% because
fault.
C10-3 Students will have their own ideas and their own way of weighing the var-
ious considerations. Here is a brief outline of factors that students may
consider:
I. Factors in the decision to lend money to Sporty Footware, Inc.
a. Debt is a small part of the company’s capital structure and there-
II. Factors in the decision to invest in the stock of Sporty Footware, Inc.
a. According to the cash flow statement, cash from operations has
increased each of the three years presented here, indicating suc-
cess.
