1. Under what condition will financial leverage increase ROE?
ROE measures the profits accruing to shareholders per dollar of con- tributed equity.
Whether its decision to “lever-up” will have a positive or a negative impact on the firm’s ROE depends on the interest charged by the lender and the firm’s earning power (EP 5 EBIT/total assets).
If the firm’s earning power is less than the interest rate, then ROE will fall, and vice versa.
If EP > i, ROE increases with leverage.
If EP < i, ROE decreases with leverage.
2. Under what circumstances do you think the current ratio and quick ratio would give opposite signals of the liquidity of a firm?
3. Industry averages are often used as benchmarks in ratio analysis. Justify this practice.
4. Why is interest expense for a bank similar to cost of goods sold for a manu- facturer?
5. How do you think the average leverage ratio in the banking industry would compare to the average leverage ratio among computer manufacturers?
6. Identify the three ratios from Exhibit 13.9 that you feel are most important for
a. performance analysis by stockholders
b. performance analysis by bondholders
Justify your choices.
7. a. If one box of chocolates made by firm A cost $30 and a box made by firm B costs $10, then which chocolates are more expensive? Now, con- sider that firm A’s box holds 5 pounds of chocolates and firm B’s box holds 1 pound of chocolates. Whose chocolates are more expensive, given this new information? Why might consumers be willing to pay more per pound for B’s chocolates?
b. Let’s say that one share of Acme stock is selling for $250 and one share of Zeta stock is selling for $15. Which stock is more expensive? Consider that EPS for Acme was $100 last year and EPS for Zeta was $1. What is the P/E for Acme and the P/E for Zeta? Now which stock do you think is more ex- pensive? Why do you think Zeta may have a higher P/E than Acme?
c. Is there some similarity between the story of the relative price of choco- lates and the relative price of the stock? Explain.
8. Suppose your father owns a stock that he feels has done very well. “In fact,” he says, “it went up 18% last year!” Do you think that 18% was good per- formance? How would you go about deciding whether 18% was good, bad, or mediocre for the past 12 months?
9. A corporation has decided to change its depreciation method to write off assets over a longer term. Thus, each year depreciation expense will be significantly lower, although nothing else about the business will be materially different. What do you think will happen to the firm’s financial results because of this change? (Hint: Consider changes in depreciation expense, net income, net profit margin, ROE, ROA, and any others you wish to comment on.) What happens to cash flow because of this change?
10. Artistic Designs, Inc. has a current ratio of 3.0. What would be the impact on the current ratio if the company
a. used cash to pay off some current debt
b. used cash to repurchase some outstanding shares of stock c. used cash to pay a dividend
d. borrowed cash from a local bank to purchase a company-owned automo- bile. The loan is short-term, due in six months.
e. borrowed short term and uses the funds to increase inventory.
11. Dan Jones, the treasurer at Acme Industries, notices that the firm keeps sev- eral million dollars in marketable securities invested in very short-term trea- sury securities. Maturities are from 1 week to 3 weeks. Dan notices that by investing in longer-term government securities, the company can earn, on av- erage, one full percentage point more income on the marketable securities ac- count balance. Let’s assume that Dan implements his strategy and invests in government bonds with 10-year maturities.
a. What would happen if market interest rates suddenly rose (remember the teeter-totter of bond values from Chapter 5)?
b. What impact would Dan’s decision have on ROE if interest rates didn’t rise immediately and the long-term bonds raised income?
c. What impact would Dan’s decision have on the riskiness of the firm?
d. If stockholders knew of Dan’s action, what impact do you think it would have on their valuation of the firm?
12. Honest John’s Used Cars began an advertising campaign stating, “We’ll sell you a car. We’ll finance it.And we won’t check your credit.” John’s car lot went crazy with business. John knew he was taking some big risks by lending money to anybody, but he reasoned that he could increase his sales prices to improve his margins and pay for the inevitable increase in bad debt losses. Explain what you think will happen to Honest John’s asset turnover, inven- tory turnover, and days sales outstanding, and explain your reasoning. What do you think will happen to Honest John’s net income?
13. Borrowers pay thousands of dollars to have their bond issue rated by Stan- dard & Poor’s or Moody’s. Why would borrowers pay so much for these an- alysts’ opinions and their publication? (Hint: Why might investing in having your bonds rated be a positive NPV project?)
14. Some business people have advocated gaining market share as a good indica- tor of firm performance. What’s your opinion of this idea? (Hint: How could a company easily increase its market share, perhaps to 100%? Would this tactic be good business?)
15. Evergreen offers purchasers of its timber terms of net 30, meaning that buyers have 30 days in which to pay their bill. Does Evergreen seem to have a problem collecting its receivables?
16. A firm has sales of $3 million per year, all of which are credit sales. Its aver- age collection period is 42 days. What is the average balance in accounts receivable?
17. Total interest expense at a business was $30,000 per year. Sales were
18. A firm’s net profit margin is 12% and its asset turnover is 1.1. What is the firm’s ROA?
19. Half a firm’s capital, based on book values, comes from equity. This firm’s
ROE is 15%. What is its ROA?
20. A firm’s inventory equals its total current liabilities. The company’s quick ra- tio equals 1. What does its current ratio equal?