CHAPTER 3

ANALYSIS OF FINANCIAL STATEMENTS

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Current ratio Answer: a Diff: E
1
. All else being equal, which of the following will increase a company’s
current ratio?

a. An increase in accounts receivable.

b. An increase in accounts payable.
c. An increase in net fixed assets.
d. Statements a and b are correct.
e. All of the statements above are correct.

Current ratio Answer: d Diff: E

2
. Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current
ratio is 1.5. Both firms want to “window dress” their coming end-of-
year financial statements. As part of its window dressing strategy,
each firm will double its current liabilities by adding short-term debt
and placing the funds obtained in the cash account. Which of the
statements below best describes the actual results of these
transactions?

a. The transactions will have no effect on the current ratios.

b. The current ratios of both firms will be increased.
c. The current ratios of both firms will be decreased.
d. Only Pepsi Corporation’s current ratio will be increased.
e. Only Coke Company’s current ratio will be increased.

Cash flows Answer: a Diff: E

3
. Which of the following alternatives could potentially result in a net
increase in a company’s cash flow for the current year?

a. Reduce the days sales outstanding ratio.

b. Increase the number of years over which fixed assets are depreciated.
c. Decrease the accounts payable balance.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 3 - Page 1
Leverage and financial ratios Answer: d Diff: E
4
. Stennett Corp.’s CFO has proposed that the company issue new debt and
use the proceeds to buy back common stock. Which of the following are
likely to occur if this proposal is adopted? (Assume that the proposal
would have no effect on the company’s operating income.)

a. Return on assets (ROA) will decline.

b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.
e. None of the statements above is correct.

Leverage and profitability ratios Answer: e Diff: E

5
. Amazon Electric wants to increase its debt ratio, which will also
increase its interest expense. Assume that the higher debt ratio will
have no effect on the company’s operating income, total assets, or tax
rate. Also, assume that the basic earning power ratio exceeds the
before-tax cost of debt financing. Which of the following will occur if
the company increases its debt ratio?

a. Its ROA will fall.

b. Its ROE will increase.
c. Its basic earning power (BEP) will stay unchanged.
d. Statements a and c are correct.
e. All of the statements above are correct.

EVA Answer: b Diff: E N

6
. Which of the following statements is most correct?

a. A company that has positive net income must also have positive EVA.
b. If a company’s ROE is greater than its cost of equity, its EVA is
positive.
c. If a company increases its EVA, its ROE must also increase.
d. Statements a and b are correct.
e. All of the above statements are correct.

ROE and EVA Answer: e Diff: E

7
. Which of the following statements is most correct about Economic Value
Added (EVA)?

a. If a company has no debt, its EVA equals its net income.

b. If a company has positive ROE, its EVA must also be positive.
c. A company’s EVA will be positive whenever the cost of equity exceeds
the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 3 - Page 2
ROE and EVA Answer: b Diff: E
8
. Devon Inc. has a higher ROE than Berwyn Inc. (17 percent compared to 14
percent), but it has a lower EVA than Berwyn. Which of the following
factors could explain the relative performance of these two companies?

a. Devon is much larger than Berwyn.

b. Devon is riskier, has a higher WACC, and a higher cost of equity.
c. Devon has a higher operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.

Ratio analysis Answer: b Diff: E

9
. Bedford Hotels and Breezewood Hotels both have $100 million in total
assets and a 10 percent return on assets (ROA). Each company has a 40
percent tax rate. Bedford, however, has a higher debt ratio and higher
interest expense. Which of the following statements is most correct?

a. The two companies have the same basic earning power (BEP).
b. Bedford has a higher return on equity (ROE).
c. Bedford has a lower level of operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.

Financial statement analysis Answer: a Diff: E

10
. Company J and Company K each recently reported the same earnings per
share (EPS). Company J’s stock, however, trades at a higher price.
Which of the following statements is most correct?

a. Company J must have a higher P/E ratio.

b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
e. All of the statements above are correct.

Financial statement analysis Answer: e Diff: E

11
. Company A’s ROE is 20 percent, while Company B’s ROE is 15 percent.
Which of the following statements is most correct?

a. Company A must have a higher ROA than Company B.

b. Company A must have a higher EVA than Company B.
c. Company A must have a higher net income than Company B.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 3 - Page 3
Financial statement analysis Answer: e Diff: E
12
. Company A and Company B have the same total assets, return on assets
(ROA), and profit margin. However, Company A has a higher debt ratio and
interest expense than Company B. Which of the following statements is
most correct?

a. Company A has a higher ROE (return on equity) than Company B.

b. Company A has a higher total assets turnover than Company B.
c. Company A has a higher operating income (EBIT) than Company B.
d. Statements a and b are correct.
e. Statements a and c are correct.

Financial statement analysis Answer: d Diff: E N

13
. Nelson Company is thinking about issuing new common stock. The
proceeds from the stock issue will be used to reduce the company’s
outstanding debt and interest expense. The stock issue will have no
effect on the company’s total assets, EBIT, or tax rate. Which of the
following is likely to occur if the company goes ahead with the stock
issue?

a. The company’s net income will increase.

b. The company’s times interest earned ratio will increase.
c. The company’s ROA will increase.
d. All of the above statements are correct.
e. None of the above statements is correct.

Miscellaneous ratios Answer: a Diff: E

14
. Companies A and B have the same profit margin and debt ratio. However,
Company A has a higher return on assets and a higher return on equity
than Company B. Which of the following can explain these observed
ratios?

a. Company A must have a higher total assets turnover than Company B.

b. Company A must have a higher equity multiplier than Company B.
c. Company A must have a higher current ratio than Company B.
d. Statements b and c are correct.
e. All of the statements above are correct.

Miscellaneous ratios Answer: e Diff: E R

15
. Bichette Furniture Company recently issued new common stock and used the
proceeds to reduce its short-term notes payable and accounts payable.
This action had no effect on the company’s total assets or operating
income. Which of the following effects did occur as a result of this
action?

a. The company’s current ratio decreased.

b. The company’s basic earning power ratio increased.
c. The company’s time interest earned ratio decreased.
d. The company’s debt ratio increased.
e. The company’s equity multiplier decreased.

Chapter 3 - Page 4
Chapter 3 - Page 5
Medium:
Current ratio Answer: d Diff: M
16
. Van Buren Company has a current ratio = 1.9. Which of the following
actions will increase the company’s current ratio?

a. Use cash to reduce short-term notes payable.

b. Use cash to reduce accounts payable.
c. Issue long-term bonds to repay short-term notes payable.
d. All of the statements above are correct.
e. Statements b and c are correct.

Current ratio Answer: e Diff: M

17
. Which of the following actions can a firm take to increase its current
ratio?

a. Issue short-term debt and use the proceeds to buy back long-term debt
with a maturity of more than one year.
b. Reduce the company’s days sales outstanding to the industry average
and use the resulting cash savings to purchase plant and equipment.
c. Use cash to purchase additional inventory.
d. Statements a and b are correct.
e. None of the statements above is correct.

Ratio analysis Answer: c Diff: M

18
. As a short-term creditor concerned with a company’s ability to meet its
financial obligation to you, which one of the following combinations of
ratios would you most likely prefer?

Current Debt
ratio TIE ratio
a. 0.5 0.5 0.33
b. 1.0 1.0 0.50
c. 1.5 1.5 0.50
d. 2.0 1.0 0.67
e. 2.5 0.5 0.71

Ratio analysis Answer: c Diff: M N

19
. Drysdale Financial Company and Commerce Financial Company have the same
total assets, the same total assets turnover, and the same return on
equity. However, Drysdale has a higher return on assets than Commerce.
Which of the following can explain these ratios?

a. Drysdale has a higher profit margin and a higher debt ratio than
Commerce.
b. Drysdale has a lower profit margin and a lower debt ratio than
Commerce.
c. Drysdale has a higher profit margin and a lower debt ratio than
Commerce.
d. Drysdale has lower net income but more common equity than Commerce.

Chapter 3 - Page 6
 e. Drysdale has a lower price earnings ratio than Commerce.
Ratio analysis Answer: a Diff: M
20
. You are an analyst following two companies, Company X and Company Y. You
have collected the following information:

• The two companies have the same total assets.

• Company X has a higher total assets turnover than Company Y.
• Company X has a higher profit margin than Company Y.
• Company Y has a higher inventory turnover ratio than Company X.
• Company Y has a higher current ratio than Company X.

Which of the following statements is most correct?

a. Company X must have a higher net income.

b. Company X must have a higher ROE.
c. Company Y must have a higher ROA.
d. Statements a and b are correct.
e. Statements a and c are correct.

Effects of leverage Answer: a Diff: M

21
. Which of the following statements is most correct?

a. A firm with financial leverage has a larger equity multiplier than an

otherwise identical firm with no debt in its capital structure.
b. The use of debt in a company’s capital structure results in tax
benefits to the investors who purchase the company’s bonds.
c. All else equal, a firm with a higher debt ratio will have a lower
basic earning power ratio.
d. All of the statements above are correct.
e. Statements a and c are correct.

Financial statement analysis Answer: a Diff: M

22
. Which of the following statements is most correct?

a. An increase in a firm’s debt ratio, with no changes in its sales and

operating costs, could be expected to lower its profit margin on
sales.
b. An increase in the DSO, other things held constant, would generally
lead to an increase in the total assets turnover ratio.
c. An increase in the DSO, other things held constant, would generally
lead to an increase in the ROE.
d. In a competitive economy, where all firms earn similar returns on
equity, one would expect to find lower profit margins for airlines,
which require a lot of fixed assets relative to sales, than for fresh
fish markets.
e. It is more important to adjust the debt ratio than the inventory
turnover ratio to account for seasonal fluctuations.

Chapter 3 - Page 7
Financial statement analysis Answer: d Diff: M N
23
. Harte Motors and Mills Automotive each have the same total assets, the
same level of sales, and the same return on equity (ROE). Harte Motors,
however, has less equity and a higher debt ratio than does Mills
Automotive. Which of the following statements is most correct?

a. Mills Automotive has a higher net income than Harte Motors.

b. Mills Automotive has a higher profit margin than Harte Motors.
c. Mills Automotive has a higher return on assets (ROA) than Harte
Motors.
d. All of the statements above are correct.
e. None of the statements above is correct.

Leverage and financial ratios Answer: e Diff: M

24
. Company A and Company B have the same total assets, tax rate, and net
income. Company A, however, has a lower profit margin than Company B.
Company A also has a higher debt ratio and, therefore, higher interest
expense than Company B. Which of the following statements is most
correct?

a. Company A has a higher total assets turnover.

b. Company A has a higher return on equity.
c. Company A has a higher basic earning power ratio.
d. Statements a and b are correct.
e. All of the statements above are correct.

Leverage and financial ratios Answer: d Diff: M N

25
. Company A and Company B have the same tax rate, total assets, and basic
earning power. Both companies have positive net incomes. Company A has
a higher debt ratio, and therefore, higher interest expense than Company
B. Which of the following statements is true?

a. Company A has a higher ROA than Company B.

b. Company A has a higher times interest earned (TIE) ratio than Company
B.
c. Company A has a higher net income than Company B.
d. Company A pays less in taxes than Company B.
e. Company A has a lower equity multiplier than Company B.

Du Pont equation Answer: b Diff: M R

26
. You observe that a firm’s profit margin is below the industry average,
while its return on equity and debt ratio exceed the industry average.
What can you conclude?

a. Return on assets must be above the industry average.

b. Total assets turnover must be above the industry average.
c. Total assets turnover must be below the industry average.
d. Statements a and b are correct.
e. None of the statements above is correct.

Chapter 3 - Page 8
ROE and EVA Answer: d Diff: M
27
. Huxtable Medical’s CFO recently estimated that the company’s EVA for the
past year was zero. The company’s cost of equity capital is 14 percent,
its cost of debt is 8 percent, and its debt ratio is 40 percent. Which
of the following statements is most correct?

a. The company’s net income was zero.

b. The company’s net income was negative.
c. The company’s ROA was 14 percent.
d. The company’s ROE was 14 percent.
e. The company’s after-tax operating income was less than the total
dollar cost of capital.

ROE and EVA Answer: b Diff: M

28
. Which of the following statements is most correct?

a. If two firms have the same ROE and the same level of risk, they must
also have the same EVA.
b. If a firm has positive EVA, this implies that its ROE exceeds its cost
of equity.
c. If a firm has positive ROE, this implies that its EVA is also
positive.
d. Statements b and c are correct.
e. All of the statements above are correct.

Miscellaneous ratios Answer: b Diff: M

29
. Which of the following statements is most correct?

a. If Firms A and B have the same earnings per share and market to book
ratio, they must have the same price earnings ratio.
b. Firms A and B have the same net income, taxes paid, and total assets.
If Firm A has a higher interest expense, its basic earnings power
ratio (BEP) must be greater than that of Firm B.
c. Firms A and B have the same net income. If Firm A has a higher
interest expense, its return on equity (ROE) must be greater than
that of Firm B.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 3 - Page 9
Miscellaneous ratios Answer: e Diff: M
30
. Reeves Corporation forecasts that its operating income (EBIT) and total
assets will remain the same as last year, but that the company’s debt
ratio will increase this year. What can you conclude about the
company’s financial ratios? (Assume that there will be no change in the
company’s tax rate.)

a. The company’s basic earning power (BEP) will fall.

b. The company’s return on assets (ROA) will fall.
c. The company’s equity multiplier (EM) will increase.
d. All of the statements above are correct.
e. Statements b and c are correct.

Miscellaneous ratios Answer: d Diff: M

31
. Company X has a higher ROE than Company Y, but Company Y has a higher
ROA than Company X. Company X also has a higher total assets turnover
ratio than Company Y; however, the two companies have the same total
assets. Which of the following statements is most correct?

a. Company X has a lower debt ratio than Company Y.

b. Company X has a lower profit margin than Company Y.
c. Company X has a lower net income than Company Y.
d. Statements b and c are correct.
e. All of the statements above are correct.

Tough:
ROE and EVA Answer: a Diff: T
32
. Division A has a higher ROE than Division B, yet Division B creates more
value for shareholders and has a higher EVA than Division A. Both
divisions, however, have positive ROEs and EVAs. What could explain
these performance measures?

a. Division A is riskier than Division B.

b. Division A is much larger (in terms of equity capital employed) than
Division B.
c. Division A has less debt than Division B.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 3 - Page 10
Ratio analysis Answer: d Diff: T
33
. You have collected the following information regarding Companies C and
D:

• The two companies have the same total assets.

• The two companies have the same operating income (EBIT).
• The two companies have the same tax rate.
• Company C has a higher debt ratio and interest expense than Company D.
• Company C has a lower profit margin than Company D.

On the basis of this information, which of the following statements is

most correct?

a. Company C must have a higher level of sales.

b. Company C must have a lower ROE.
c. Company C must have a higher times interest earned (TIE) ratio.
d. Company C must have a lower ROA.
e. Company C must have a higher basic earning power (BEP) ratio.

Ratio analysis Answer: d Diff: T

34
. An analyst has obtained the following information regarding two
companies, Company X and Company Y:

• Company X and Company Y have the same total assets.

• Company X has a higher interest expense than Company Y.
• Company X has a lower operating income (EBIT) than Company Y.
• Company X and Company Y have the same return on equity (ROE).
• Company X and Company Y have the same total assets turnover (TATO).
• Company X and Company Y have the same tax rate.

On the basis of this information, which of the following statements is

most correct?

a. Company X has a higher times interest earned (TIE) ratio.

b. Company X and Company Y have the same debt ratio.
c. Company X has a higher return on assets (ROA).
d. Company X has a lower profit margin.
e. Company X has a higher basic earning power (BEP) ratio.

Ratio analysis and Du Pont equation Answer: d Diff: T

35
. Lancaster Co. and York Co. both have the same return on assets (ROA).
However, Lancaster has a higher total assets turnover and a higher
equity multiplier than York. Which of the following statements is most
correct?

a. Lancaster has a lower profit margin than York.

b. Lancaster has a lower debt ratio than York.
c. Lancaster has a higher return on equity (ROE) than York.
d. Statements a and c are correct.
e. All of the statements above are correct.

Chapter 3 - Page 11
Chapter 3 - Page 12
Leverage and financial ratios Answer: d Diff: T
36
. Blair Company has $5 million in total assets. The company’s assets are
financed with $1 million of debt and $4 million of common equity. The
company’s income statement is summarized below:

Operating income (EBIT) $1,000,000

Interest 100,000
Earnings before taxes (EBT) $ 900,000
Taxes (40%) 360,000
Net income $ 540,000

The company wants to increase its assets by $1 million, and it plans to

finance this increase by issuing $1 million in new debt. This action
will double the company’s interest expense but its operating income will
remain at 20 percent of its total assets, and its average tax rate will
remain at 40 percent. If the company takes this action, which of the
following will occur:

a. The company’s net income will increase.

b. The company’s return on assets will fall.
c. The company’s return on equity will remain the same.
d. Statements a and b are correct.
e. All of the statements above are correct.

Miscellaneous ratios Answer: c Diff: T

37
. Some key financial data and ratios are reported in the table below for
Hemmingway Hotels and for its competitor, Fitzgerald Hotels:

Ratio Hemmingway Hotels Fitzgerald Hotels

Profit margin 4% 3%
ROA 9% 8%
Total assets $2.0 billion $1.5 billion
BEP 20% 20%
ROE 18% 24%

On the basis of the information above, which of the following statements

is most correct?

a. Hemmingway has a higher total assets turnover than Fitzgerald.

b. Hemmingway has a higher debt ratio than Fitzgerald.
c. Hemmingway has higher net income than Fitzgerald.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 3 - Page 13
Multiple Choice: Problems
Easy:
Financial statement analysis Answer: a Diff: E
38
. Russell Securities has $100 million in total assets and its corporate
tax rate is 40 percent. The company recently reported that its basic
earning power (BEP) ratio was 15 percent and its return on assets (ROA)
was 9 percent. What was the company’s interest expense?

a. $ 0
b. $ 2,000,000
c. $ 6,000,000
d. $15,000,000
e. $18,000,000

Market price per share Answer: b Diff: E

39
. You are given the following information: Stockholders’ equity = $1,250;
price/earnings ratio = 5; shares outstanding = 25; and market/book ratio
= 1.5. Calculate the market price of a share of the company’s stock.

a. $ 33.33
b. $ 75.00
c. $ 10.00
d. $166.67
e. $133.32

Market price per share Answer: c Diff: E

40
. Given the following information, calculate the market price per share of
WAM Inc.:

Net income $200,000.00

Earnings per share $2.00
Stockholders’ equity $2,000,000.00
Market/Book ratio 0.20

a. $20.00
b. $ 8.00
c. $ 4.00
d. $ 2.00
e. $ 1.00

Market/book ratio Answer: c Diff: E

41
. Meyersdale Office Supplies has common equity of $40 million. The
company’s stock price is $80 per share and its market/book ratio is 4.0.
How many shares of stock does the company have outstanding?

a. 500,000
b. 125,000
c. 2,000,000

Chapter 3 - Page 14
 d. 800,000,000
e. Insufficient information.
Market/book ratio Answer: e Diff: E N
42
. Strack Houseware Supplies Inc. has $2 billion in total assets. The other
side of its balance sheet consists of $0.2 billion in current
liabilities, $0.6 billion in long-term debt, and $1.2 billion in common
equity. The company has 300 million shares of common stock outstanding,
and its stock price is $20 per share. What is Strack’s market/book
ratio?

a. 1.25
b. 2.65
c. 3.15
d. 4.40
e. 5.00

ROA Answer: d Diff: E

43
. A firm has a profit margin of 15 percent on sales of $20,000,000. If
the firm has debt of $7,500,000, total assets of $22,500,000, and an
after-tax interest cost on total debt of 5 percent, what is the firm’s
ROA?

a. 8.4%
b. 10.9%
c. 12.0%
d. 13.3%
e. 15.1%

TIE ratio Answer: b Diff: E

44
. Culver Inc. has earnings after interest but before taxes of $300. The
company’s times interest earned ratio is 7.00. Calculate the company’s
interest charges.

a. $42.86
b. $50.00
c. $40.00
d. $60.00
e. $57.93

Chapter 3 - Page 15
ROE Answer: c Diff: E
45
. Tapley Dental Supply Company has the following data:

Net income $240

Sales $10,000
Total assets $6,000
Debt ratio 75%
TIE ratio 2.0
Current ratio 1.2
BEP ratio 13.33%

If Tapley could streamline operations, cut operating costs, and raise net
income to $300 without affecting sales or the balance sheet (the
additional profits will be paid out as dividends), by how much would its
ROE increase?

a. 3.00%
b. 3.50%
c. 4.00%
d. 4.25%
e. 5.50%

Profit margin Answer: c Diff: E

46
. Your company had the following balance sheet and income statement
information for 2002:

Balance Sheet:
Cash $ 20
A/R 1,000
Inventories 5,000
Total current assets $6,020 Debt $4,000
Net fixed assets 2,980 Equity 5,000
Total assets $9,000 Total claims $9,000
Income Statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net income $ 240

The industry average inventory turnover is 5. You think you can change
your inventory control system so as to cause your turnover to equal the
industry average, and this change is expected to have no effect on either
sales or cost of goods sold. The cash generated from reducing
inventories will be used to buy tax-exempt securities that have a 7
percent rate of return. What will your profit margin be after the change
in inventories is reflected in the income statement?

a. 2.1%
b. 2.4%
c. 4.5%

Chapter 3 - Page 16
 d. 5.3%
e. 6.7%
Du Pont equation Answer: a Diff: E
47
. The Wilson Corporation has the following relationships:

Sales/Total assets 2.0×

Return on assets (ROA) 4.0%
Return on equity (ROE) 6.0%

What is Wilson’s profit margin and debt ratio?

a. 2%; 0.33
b. 4%; 0.33
c. 4%; 0.67
d. 2%; 0.67
e. 4%; 0.50

P/E ratio and stock price Answer: b Diff: E

48
. The Charleston Company is a relatively small, privately owned firm.
Last year the company had net income of $15,000 and 10,000 shares were
outstanding. The owners were trying to determine the equilibrium market
value for the stock prior to taking the company public. A similar firm
that is publicly traded had a price/earnings ratio of 5.0. Using only
the information given, estimate the market value of one share of
Charleston’s stock.

a. $10.00
b. $ 7.50
c. $ 5.00
d. $ 2.50
e. $ 1.50

P/E ratio and stock price Answer: e Diff: E

49
. Cleveland Corporation has 100,000 shares of common stock outstanding,
its net income is $750,000, and its P/E is 8. What is the company’s
stock price?

a. $20.00
b. $30.00
c. $40.00
d. $50.00
e. $60.00

Chapter 3 - Page 17
Current ratio and inventory Answer: b Diff: E N
50
. Iken Berry Farms has $5 million in current assets, $3 million in current
liabilities, and its initial inventory level is $1 million. The company
plans to increase its inventory, and it will raise additional short-term
debt (that will show up as notes payable on the balance sheet) to
purchase the inventory. Assume that the value of the remaining current
assets will not change. The company’s bond covenants require it to
maintain a current ratio that is greater than or equal to 1.5. What is
the maximum amount that the company can increase its inventory before it
is restricted by these covenants?

a. $0.50 million
b. $1.00 million
c. $1.33 million
d. $1.66 million
e. $2.33 million

Medium:
Accounts receivable increase Answer: b Diff: M R
51
. Cannon Company has enjoyed a rapid increase in sales in recent years,
following a decision to sell on credit. However, the firm has noticed a
recent increase in its collection period. Last year, total sales were $1
million, and $250,000 of these sales were on credit. During the year, the
accounts receivable account averaged $41,096. It is expected that sales
will increase in the forthcoming year by 50 percent, and, while credit
sales should continue to be the same proportion of total sales, it is
expected that the days sales outstanding will also increase by 50 percent.
If the resulting increase in accounts receivable must be financed
externally, how much external funding will Cannon need? Assume a 365-day
year.

a. $ 41,096
b. $ 51,370
c. $ 47,359
d. $106,471
e. $ 92,466

Accounts receivable Answer: a Diff: M R

52
. Ruth Company currently has $1,000,000 in accounts receivable. Its days
sales outstanding (DSO) is 50 days. The company wants to reduce its DSO
to the industry average of 32 days by pressuring more of its customers to
pay their bills on time. The company’s CFO estimates that if this policy
is adopted the company’s average sales will fall by 10 percent. Assuming
that the company adopts this change and succeeds in reducing its DSO to
32 days and does lose 10 percent of its sales, what will be the level of
accounts receivable following the change? Assume a 365-day year.

a. $576,000
b. $633,333
c. $750,000

Chapter 3 - Page 18
 d. $900,000
e. $966,667
ROA Answer: a Diff: M
53
. A fire has destroyed a large percentage of the financial records of the
Carter Company. You have the task of piecing together information in
order to release a financial report. You have found the return on equity
to be 18 percent. If sales were $4 million, the debt ratio was 0.40,
and total liabilities were $2 million, what would be the return on
assets (ROA)?

a. 10.80%
b. 0.80%
c. 1.25%
d. 12.60%
e. Insufficient information.

ROA Answer: e Diff: M

54
. Humphrey Hotels’ operating income (EBIT) is $40 million. The company’s
times interest earned (TIE) ratio is 8.0, its tax rate is 40 percent,
and its basic earning power (BEP) ratio is 10 percent. What is the
company’s return on assets (ROA)?

a. 6.45%
b. 5.97%
c. 4.33%
d. 8.56%
e. 5.25%

ROA Answer: c Diff: M N

55
. Viera Company has $500,000 in total assets. The company’s basic
earning power (BEP) is 10 percent, its times interest earned (TIE)
ratio is 5, and the company’s tax rate is 40 percent. What is the
company’s return on assets (ROA)?

a. 3.2%
b. 4.0%
c. 4.8%
d. 6.0%
e. 7.2%

ROE Answer: c Diff: M R

56
. Selzer Inc. sells all its merchandise on credit. It has a profit margin
of 4 percent, days sales outstanding equal to 60 days, receivables of
$150,000, total assets of $3 million, and a debt ratio of 0.64. What is
the firm’s return on equity (ROE)? Assume a 365-day year.

a. 7.1%
b. 33.4%
c. 3.4%
d. 71.0%

Chapter 3 - Page 19
 e. 8.1%

Chapter 3 - Page 20
ROE Answer: b Diff: M
57
. A firm has a debt/equity ratio of 50 percent. Currently, it has
interest expense of $500,000 on $5,000,000 of total debt outstanding.
Its tax rate is 40 percent. If the firm’s ROA is 6 percent, by how many
percentage points is the firm’s ROE greater than its ROA?

a. 0.0%
b. 3.0%
c. 5.2%
d. 7.4%
e. 9.0%
ROE Answer: d Diff: M
58
. Assume Meyer Corporation is 100 percent equity financed. Calculate the
return on equity, given the following information:

Earnings before taxes $1,500

Sales $5,000
Dividend payout ratio 60%
Total assets turnover 2.0
Tax rate 30%

a. 25%
b. 30%
c. 35%
d. 42%
e. 50%

ROE Answer: c Diff: M

59
. The Amer Company has the following characteristics:

Sales $1,000
Total assets $1,000
Total debt/Total assets 35.00%
Basic earning power (BEP) ratio 20.00%
Tax rate 40.00%
Interest rate on total debt 4.57%

What is Amer’s ROE?

a. 11.04%
b. 12.31%
c. 16.99%
d. 28.31%
e. 30.77%

Chapter 3 - Page 21
Equity multiplier Answer: d Diff: M
60
. A firm that has an equity multiplier of 4.0 will have a debt ratio of

a. 4.00
b. 3.00
c. 1.00
d. 0.75
e. 0.25

TIE ratio Answer: e Diff: M

61
. Alumbat Corporation has $800,000 of debt outstanding, and it pays an
interest rate of 10 percent annually on its bank loan. Alumbat’s annual
sales are $3,200,000, its average tax rate is 40 percent, and its net
profit margin on sales is 6 percent. If the company does not maintain a
TIE ratio of at least 4 times, its bank will refuse to renew its loan,
and bankruptcy will result. What is Alumbat’s current TIE ratio?

a. 2.4
b. 3.4
c. 3.6
d. 4.0
e. 5.0

TIE ratio Answer: b Diff: M N

62
. Moss Motors has $8 billion in assets, and its tax rate is 40 percent.
The company’s basic earning power (BEP) ratio is 12 percent, and its
return on assets (ROA) is 3 percent. What is Moss’ times interest
earned (TIE) ratio?

a. 2.25
b. 1.71
c. 1.00
d. 1.33
e. 2.50

TIE ratio Answer: b Diff: M

63
. Lancaster Motors has total assets of $20 million. Its basic earning
power is 25 percent, its return on assets (ROA) is 10 percent, and the
company’s tax rate is 40 percent. What is Lancaster’s TIE ratio?

a. 2.5
b. 3.0
c. 1.5
d. 1.2
e. 0.6

Chapter 3 - Page 22
TIE ratio Answer: d Diff: M N
64
. Roll’s Boutique currently has total assets of $3 million in operation.
Over this year, its performance yielded a basic earning power (BEP) of
25 percent and a return on assets (ROA) of 12 percent. The firm’s
earnings are subject to a 35 percent tax rate. On the basis of this
information, what is the firm’s times interest earned (TIE) ratio?

a. 1.84
b. 1.92
c. 2.83
d. 3.82
e. 4.17

EBITDA coverage ratio Answer: a Diff: M N

65
. Peterson Packaging Corp. has $9 billion in total assets. The company’s
basic earning power (BEP) ratio is 9 percent, and its times interest
earned ratio is 3.0. Peterson’s depreciation and amortization expense
totals $1 billion. It has $0.6 billion in lease payments and $0.3
billion must go towards principal payments on outstanding loans and
long-term debt. What is Peterson’s EBITDA coverage ratio?

a. 2.06
b. 1.52
c. 2.25
d. 1.10
e. 2.77

Debt ratio Answer: c Diff: M

66
. Kansas Office Supply had $24,000,000 in sales last year. The company’s
net income was $400,000, its total assets turnover was 6.0, and the
company’s ROE was 15 percent. The company is financed entirely with
debt and common equity. What is the company’s debt ratio?

a. 0.20
b. 0.30
c. 0.33
d. 0.60
e. 0.66

Profit margin Answer: a Diff: M

67
. The Merriam Company has determined that its return on equity is 15
percent. Management is interested in the various components that went
into this calculation. You are given the following information: total
debt/total assets = 0.35 and total assets turnover = 2.8. What is the
profit margin?

a. 3.48%
b. 5.42%
c. 6.96%
d. 2.45%

Chapter 3 - Page 23
 e. 12.82%
Financial statement analysis Answer: e Diff: M R
68
. Collins Company had the following partial balance sheet and complete
income statement information for 2002:

Partial Balance Sheet:

Cash $ 20
A/R 1,000
Inventories 2,000
Total current assets $ 3,020
Net fixed assets 2,980
Total assets $ 6,000

Income Statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net income $ 240

The industry average DSO is 30 (assuming a 365-day year). Collins plans

to change its credit policy so as to cause its DSO to equal the industry
average, and this change is expected to have no effect on either sales
or cost of goods sold. If the cash generated from reducing receivables
is used to retire debt (which was outstanding all last year and has a 10
percent interest rate), what will Collins’ debt ratio (Total debt/Total
assets) be after the change in DSO is reflected in the balance sheet?

a. 33.33%
b. 45.28%
c. 52.75%
d. 60.00%
e. 65.65%

Financial statement analysis Answer: b Diff: M R

69
. Taft Technologies has the following relationships:

Annual sales $1,200,000.00

Current liabilities $ 375,000.00
Days sales outstanding (DSO) (365-day year) 40.00
Inventory turnover ratio 4.80
Current ratio 1.20

The company’s current assets consist of cash, inventories, and accounts

receivable. How much cash does Taft have on its balance sheet?

a. -$ 8,333
b. $ 68,493
c. $125,000
d. $200,000

Chapter 3 - Page 24
 e. $316,667

Basic earning power Answer: d Diff: M

70
. Aaron Aviation recently reported the following information:

Net income $500,000

ROA 10%
Interest expense $200,000

The company’s average tax rate is 40 percent. What is the company’s

basic earning power (BEP)?
a. 14.12%
b. 16.67%
c. 17.33%
d. 20.67%
e. 22.50%
P/E ratio and stock price Answer: e Diff: M
71
. Dean Brothers Inc. recently reported net income of $1,500,000. The
company has 300,000 shares of common stock, and it currently trades at
$60 a share. The company continues to expand and anticipates that one
year from now its net income will be $2,500,000. Over the next year the
company also anticipates issuing an additional 100,000 shares of stock,
so that one year from now the company will have 400,000 shares of common
stock. Assuming the company’s price/earnings ratio remains at its
current level, what will be the company’s stock price one year from now?
a. $55
b. $60
c. $65
d. $70
e. $75
Current ratio and DSO Answer: a Diff: M
72
. Parcells Jets has the following balance sheet (in millions):
Cash $ 100 Notes payable $ 100
Inventories 300 Accounts payable 200
Accounts receivable 400 Accruals 100
Total current assets $ 800 Total current liabilities $ 400
Net fixed assets 1,200 Long-term bonds 600
Total debt $1,000
______ Total common equity 1,000
Total assets $2,000 Total liabilities and equity $2,000
Parcells’ DSO (on a 365-day basis) is 40, which is above the industry
average of 30. Assume that Parcells is able to reduce its DSO to the
industry average without reducing sales, and the company takes the
freed-up cash and uses it to reduce its outstanding long-term bonds. If
this occurs, what will be the new current ratio?
a. 1.75
b. 1.33

Chapter 3 - Page 25
 c. 2.33
d. 1.25
e. 1.67
Current ratio Answer: c Diff: M N
73
. Cartwright Brothers has the following balance sheet (all numbers are
expressed in millions of dollars):

Cash $ 250 Accounts payable $ 300

Accounts receivable 250 Notes payable 300
Inventories 250 Long-term debt 600
Net fixed assets 1,250 Common stock 800
Total assets $2,000 Total claims $2,000

Cartwright’s average daily sales are $10 million. Currently,

Cartwright’s days sales outstanding (DSO) is well above the industry
average of 15. Cartwright is implementing a plan that is designed to
reduce its DSO to 15 without reducing its sales. If successful the plan
will free up cash, half of which will be used to reduce notes payable
and the other half will be used to reduce accounts payable. What will be
the current ratio if Cartwright fully succeeds in implementing this
plan?

a. 1.00
b. 0.63
c. 1.30
d. 1.25
e. 1.50

Current ratio Answer: b Diff: M N

74
. Jefferson Co. has $2 million in total assets and $3 million in sales.
The company has the following balance sheet:

Cash $ 100,000 Accounts payable $ 200,000

Accounts receivable 200,000 Accruals 100,000
Inventories 500,000 Notes payable 200,000
Net fixed assets 1,200,000 Long-term debt 700,000
Common equity 800,000
Total liabilities
Total assets $2,000,000 and equity $2,000,000

Jefferson wants to improve its inventory turnover ratio so that it

equals the industry average of 10.0×. The company would like to
accomplish this goal without reducing sales. If successful, the company
would take the freed-up cash from the reduction in inventories and use
half of it to reduce notes payable and the other half to reduce common
equity. What will be Jefferson’s current ratio, if it is able to
accomplish its goal of improving its inventory management?

a. 1.43
b. 1.50
c. 2.50

Chapter 3 - Page 26
d. 2.00
e. 1.20

Chapter 3 - Page 27
Credit policy and ROE Answer: c Diff: M R
75
. Daggy Corporation has the following simplified balance sheet:

Cash $ 25,000 Current liabilities $200,000

Inventories 190,000
Accounts receivable 125,000 Long-term debt 300,000
Net fixed assets 360,000 Common equity 200,000
Total assets $700,000 Total claims $700,000

The company has been advised that their credit policy is too generous
and that they should reduce their days sales outstanding to 36 days
(assume a 365-day year). The increase in cash resulting from the
decrease in accounts receivable will be used to reduce the company’s
long-term debt. The interest rate on long-term debt is 10 percent and
the company’s tax rate is 30 percent. The tighter credit policy is
expected to reduce the company’s sales to $730,000 and result in EBIT of
$70,000. What is the company’s expected ROE after the change in credit
policy?

a. 14.88%
b. 16.63%
c. 15.86%
d. 18.38%
e. 16.25%

Du Pont equation Answer: d Diff: M

76
. Austin & Company has a debt ratio of 0.5, a total assets turnover ratio
of 0.25, and a profit margin of 10 percent. The Board of Directors is
unhappy with the current return on equity (ROE), and they think it could
be doubled. This could be accomplished (1) by increasing the profit
margin to 12 percent and (2) by increasing debt utilization. Total
assets turnover will not change. What new debt ratio, along with the
new 12 percent profit margin, would be required to double the ROE?

a. 55%
b. 60%
c. 65%
d. 70%
e. 75%

Sales and extended Du Pont equation Answer: a Diff: M

77
. Shepherd Enterprises has an ROE of 15 percent, a debt ratio of 40
percent, and a profit margin of 5 percent. The company’s total assets
equal $800 million. What are the company’s sales? (Assume that the
company has no preferred stock.)

a. $1,440,000,000
b. $2,400,000,000
c. $ 120,000,000
d. $ 360,000,000

Chapter 3 - Page 28
 e. $ 960,000,000

Net income and Du Pont equation Answer: c Diff: M N

78
. Samuels Equipment has $10 million in sales. Its ROE is 15 percent and
its total assets turnover is 3.5×. The company is 100 percent equity
financed. What is the company’s net income?

a. $1,500,000
b. $2,857,143
c. $ 428,571
d. $2,333,333
e. $ 52,500

Tough:
ROE Answer: c Diff: T
79
. Roland & Company has a new management team that has developed an
operating plan to improve upon last year’s ROE. The new plan would
place the debt ratio at 55 percent, which will result in interest
charges of $7,000 per year. EBIT is projected to be $25,000 on sales of
$270,000, it expects to have a total assets turnover ratio of 3.0, and
the average tax rate will be 40 percent. What does Roland & Company
expect its return on equity to be following the changes?

a. 17.65%
b. 21.82%
c. 26.67%
d. 44.44%
e. 51.25%

Chapter 3 - Page 29
ROE Answer: d Diff: T
80
. Georgia Electric reported the following income statement and balance
sheet for the previous year:

Balance Sheet:
Cash $ 100,000
Inventories 1,000,000
Accounts receivable 500,000
Current assets $1,600,000
Total debt $4,000,000
Net fixed assets 4,400,000 Total equity 2,000,000
Total assets $6,000,000 Total claims $6,000,000

Income Statement:
Sales $3,000,000
Operating costs 1,600,000
Operating income (EBIT) $1,400,000
Interest 400,000
Taxable income (EBT) $1,000,000
Taxes (40%) 400,000
Net income $ 600,000

The company’s interest cost is 10 percent, so the company’s interest

expense each year is 10 percent of its total debt.

While the company’s financial performance is quite strong, its CFO

(Chief Financial Officer) is always looking for ways to improve. The
CFO has noticed that the company’s inventory turnover ratio is
considerably weaker than the industry average, which is 6.0. As an
exercise, the CFO asks what would the company’s ROE have been last year
if the following had occurred:

• The company maintained the same sales, but was able to reduce
inventories enough to achieve the industry average inventory
turnover ratio.
• The cash that was generated from the reduction in inventories was
used to reduce part of the company’s outstanding debt. So, the
company’s total debt would have been $4 million less the freed-up
cash from the improvement in inventory policy. The company’s
interest expense would have been 10 percent of new total debt.
• Assume equity does not change. (The company pays all net income as
dividends.)

Under this scenario, what would have been the company’s ROE last year?

a. 27.0%
b. 29.5%
c. 30.3%
d. 31.5%
e. 33.0%

Chapter 3 - Page 30
ROE and financing Answer: a Diff: T
81
. Savelots Stores’ current financial statements are shown below:

Balance Sheet:
Inventories $ 500 Accounts payable $ 100
Other current assets 400 Short-term notes payable 370
Fixed assets 370 Common equity 800
Total assets $1,270 Total liab. and equity $1,270

Income Statement:
Sales $2,000
Operating costs 1,843
EBIT $ 157
Interest 37
EBT $ 120
Taxes (40%) 48
Net income $ 72

A recently released report indicates that Savelots’ current ratio of 1.9

is in line with the industry average. However, its accounts payable,
which have no interest cost and are due entirely to purchases of
inventories, amount to only 20 percent of inventories versus an industry
average of 60 percent. Suppose Savelots took actions to increase its
accounts payable to inventories ratio to the 60 percent industry average,
but it (1) kept all of its assets at their present levels (that is, the
asset side of the balance sheet remains constant) and (2) also held its
current ratio constant at 1.9. Assume that Savelots’ tax rate is 40
percent, that its cost of short-term debt is 10 percent, and that the
change in payments will not affect operations. In addition, common
equity will not change. With the changes, what will be Savelots’ new
ROE?

a. 10.5%
b. 7.8%
c. 9.0%
d. 13.2%
e. 12.0%

Chapter 3 - Page 31
ROE and refinancing Answer: d Diff: T
82
. Aurillo Equipment Company (AEC) projected that its ROE for next year
would be just 6 percent. However, the financial staff has determined
that the firm can increase its ROE by refinancing some high interest
bonds currently outstanding. The firm’s total debt will remain at
$200,000 and the debt ratio will hold constant at 80 percent, but the
interest rate on the refinanced debt will be 10 percent. The rate on
the old debt is 14 percent. Refinancing will not affect sales, which
are projected to be $300,000. EBIT will be 11 percent of sales and the
firm’s tax rate is 40 percent. If AEC refinances its high interest
bonds, what will be its projected new ROE?

a. 3.0%
b. 8.2%
c. 10.0%
d. 15.6%
e. 18.7%

TIE ratio Answer: d Diff: T

83
. Lombardi Trucking Company has the following data:

Assets $10,000
Profit margin 3.0%
Tax rate 40%
Debt ratio 60.0%
Interest rate 10.0%
Total assets turnover 2.0

What is Lombardi’s TIE ratio?

a. 0.95
b. 1.75
c. 2.10
d. 2.67
e. 3.45

Current ratio Answer: e Diff: T

84
. Victoria Enterprises has $1.6 million of accounts receivable on its
balance sheet. The company’s DSO is 40 (based on a 365-day year), its
current assets are $2.5 million, and its current ratio is 1.5. The
company plans to reduce its DSO from 40 to the industry average of 30
without causing a decline in sales. The resulting decrease in accounts
receivable will free up cash that will be used to reduce current
liabilities. If the company succeeds in its plan, what will Victoria’s
new current ratio be?

a. 1.50
b. 1.97
c. 1.26
d. 0.72

Chapter 3 - Page 32
 e. 1.66
P/E ratio and stock price Answer: b Diff: T
85
. XYZ’s balance sheet and income statement are given below:

Balance Sheet:
Cash $ 50 Accounts payable $ 100
A/R 150 Notes payable 0
Inventories 300 Long-term debt (10%) 700
Fixed assets 500 Common equity (20 shares) 200
Total assets $1,000 Total liabilities and equity $1,000

Income Statement:
Sales $1,000
Cost of goods sold 855
EBIT $ 145
Interest 70
EBT $ 75
Taxes (33.333%) 25
Net income $ 50

The industry average inventory turnover is 5, the interest rate on the

firm’s long-term debt is 10 percent, 20 shares are outstanding, and the
stock sells at a P/E of 8.0. If XYZ changed its inventory methods so as
to operate at the industry average inventory turnover, if it used the
funds generated by this change to buy back common stock at the current
market price and thus to reduce common equity, and if sales, the cost of
goods sold, and the P/E ratio remained constant, by what dollar amount
would its stock price increase?

a. $ 3.33
b. $ 6.67
c. $ 8.75
d. $10.00
e. $12.50

Du Pont equation and debt ratio Answer: e Diff: T

86
. Company A has sales of $1,000, assets of $500, a debt ratio of 30
percent, and an ROE of 15 percent. Company B has the same sales,
assets, and net income as Company A, but its ROE is 30 percent. What is
B’s debt ratio? (Hint: Begin by looking at the Du Pont equation.)

a. 25.0%
b. 35.0%
c. 50.0%
d. 52.5%
e. 65.0%

Chapter 3 - Page 33
Financial statement analysis Answer: a Diff: T
87
. A company has just been taken over by new management that believes it
can raise earnings before taxes (EBT) from $600 to $1,000, merely by
cutting overtime pay and reducing cost of goods sold. Prior to the
change, the following data applied:

Total assets $8,000

Debt ratio 45%
Tax rate 35%
BEP ratio 13.3125%
EBT $600
Sales $15,000

These data have been constant for several years, and all income is paid
out as dividends. Sales, the tax rate, and the balance sheet will
remain constant. What is the company’s cost of debt? (Hint: Work only
with old data.)

a. 12.92%
b. 13.23%
c. 13.51%
d. 13.75%
e. 14.00%

EBIT Answer: e Diff: T

88
. Lone Star Plastics has the following data:

Assets $100,000
Profit margin 6.0%
Tax rate 40%
Debt ratio 40.0%
Interest rate 8.0%
Total assets turnover 3.0

What is Lone Star’s EBIT?

a. $ 3,200
b. $12,000
c. $18,000
d. $30,000
e. $33,200

Chapter 3 - Page 34
Sales increase needed Answer: b Diff: T N
89
. Ricardo Entertainment recently reported the following income statement:

Sales $12,000,000
Cost of goods sold 7,500,000
EBIT $ 4,500,000
Interest 1,500,000
EBT $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000

The company’s CFO, Fred Mertz, wants to see a 25 percent increase in net
income over the next year. In other words, his target for next year’s
net income is $2,250,000. Mertz has made the following observations:

• Ricardo’s operating margin (EBIT/Sales) was 37.5 percent this past

year. Mertz expects that next year this margin will increase to
40 percent.
• Ricardo’s interest expense is expected to remain constant.
• Ricardo’s tax rate is expected to remain at 40 percent.

On the basis of these numbers, what is the percentage increase in sales

that Ricardo needs in order to meet Mertz’s target for net income?

a. 72.92%
b. 9.38%
c. 2.50%
d. 48.44%
e. 25.00%

Multiple Part:
(The following information applies to the next two problems.)

Fama’s French Bakery has a return on assets (ROA) of 10 percent and a return
on equity (ROE) of 14 percent. Fama’s total assets equal total debt plus
common equity (that is, there is no preferred stock). Furthermore, we know
that the firm’s total assets turnover is 5.

Debt ratio and Du Pont analysis Answer: c Diff: M N

90
. What is Fama’s debt ratio?

a. 14.29%
b. 28.00%
c. 28.57%
d. 55.56%
e. 71.43%

Chapter 3 - Page 35
Profit margin and Du Pont analysis Answer: a Diff: E N
91
. What is Fama’s profit margin?

a. 2.00%
b. 4.00%
c. 4.33%
d. 5.33%
e. 6.00%

(The following information applies to the next two problems.)

Miller Technologies recently reported the following balance sheet in its

annual report (all numbers are in millions of dollars):

Cash $ 100 Accounts payable $ 300

Accounts receivable 300 Notes payable 500
Inventory 500 Total current liabilities $ 800
Total current assets $ 900 Long-term debt 1,500
Total debt $2,300
Common stock 500
Retained earnings 400
Net fixed assets 2,300 Total common equity $ 900
Total assets $3,200 Total liabilities and equity $3,200

Miller also reported sales revenues of $4.5 billion and a 20 percent ROE for
this same year.

ROA Answer: d Diff: M N

92
. What is Miller’s ROA?

a. 2.500%
b. 3.125%
c. 4.625%
d. 5.625%
e. 7.826%

Current ratio Answer: b Diff: M N

93
. Miller Technologies is always looking for ways to expand their business.
A plan has been proposed that would entail issuing $300 million in notes
payable to purchase new fixed assets (for this problem, ignore
depreciation). If this plan were carried out, what would Miller’s
current ratio be immediately following the transaction?

a. 0.455
b. 0.818
c. 1.091
d. 1.125
e. 1.800

Chapter 3 - Page 36
 (The following information applies to the next three problems.)

Dokic, Inc. reported the following balance sheets for year-end 2001 and 2002
(dollars in millions):

2002 2001
Cash $ 650 $ 500
Accounts receivable 450 700
Inventories 850 600
Total current assets $1,950 $1,800
Net fixed assets 2,450 2,200
Total assets $4,400 $4,000

Accounts payable $ 680 $ 300

Notes payable 200 600
Wages payable 220 200
Total current liabilities $1,100 $1,100
Long-term bonds 1,000 1,000
Common stock 1,500 1,200
Retained earnings 800 700
Total common equity $2,300 $1,900
Total liabilities and equity $4,400 $4,000

Miscellaneous concepts Answer: e Diff: E N

94
. Which of the following statements is most correct?

a. The company’s current ratio was higher in 2002 than it was in 2001.
b. The company’s debt ratio was higher in 2002 than it was in 2001.
c. The company issued new common stock during 2002.
d. Statements a and b are correct.
e. Statements a and c are correct.

Net income Answer: b Diff: E N

95
. The total dividends paid to the company’s common stockholders during
2002 was $50 million. What was the company’s net income during the year
2002?

a. $ 50 million
b. $150 million
c. $250 million
d. $350 million
e. $450 million

Chapter 3 - Page 37
Sales, DSO, and inventory turnover Answer: b Diff: M N
96
. When reviewing the company’s performance for 2002, its CFO observed that
the company’s inventory turnover ratio was below the industry average
inventory turnover ratio of 6.0. In addition, the company’s DSO (days
sales outstanding, calculated on a 365-day basis) was less than the
industry average of 50 (that is, DSO < 50). On the basis of this
information, what is the most likely estimate of the company’s sales (in
millions of dollars) for 2002?

a. $ 2,940
b. $ 5,038
c. $ 7,250
d. $10,863
e. $30,765

(The following information applies to the next two problems.)

Below are the 2001 and 2002 year-end balance sheets for Kewell Boomerangs:

2002 2001
Cash $ 100,000 $ 85,000
Accounts receivable 432,000 350,000
Inventories 1,000,000 700,000
Total current assets $1,532,000 $1,135,000
Net fixed assets 3,000,000 2,800,000
Total assets $4,532,000 $3,935,000

Accounts payable $ 700,000 $ 545,000

Notes payable 800,000 900,000
Total current liabilities $1,500,000 $1,445,000
Long-term debt 1,200,000 1,200,000
Common stock 1,500,000 1,000,000
Retained earnings 332,000 290,000
Total common equity $1,832,000 $1,290,000
Total liabilities and equity $4,532,000 $3,935,000

Kewell Boomerangs has never paid a dividend on its common stock. Kewell
issued $1,200,000 of long-term debt in 1997. This debt was non-callable and
is scheduled to mature in 2027. As of the end of 2002, none of the principal
on this debt has been repaid. Assume that 2001 and 2002 sales were the same
in both years.

Chapter 3 - Page 38
Financial statement analysis Answer: a Diff: E N
97
. Which of the following statements is most correct?

a. Kewell’s current ratio in 2002 was higher than it was in 2001.

b. Kewell’s inventory turnover ratio in 2002 was higher than it was in
2001.
c. Kewell’s debt ratio in 2002 was higher than it was in 2001.
d. All of the statements above are correct.
e. None of the statements above is correct.

Current ratio Answer: c Diff: M N

98
. During 2002, Kewell’s days sales outstanding (DSO) was 40 days. The
industry average DSO was 30 days. Assume instead that in 2002, Kewell
had been able to achieve the industry-average DSO without reducing its
sales, and that the freed-up cash would have been used to reduce
accounts payable. If this reduction in DSO had successfully occurred,
what would have been Kewell’s new current ratio in 2002? (Assume Kewell
uses a 365-day accounting year.)

a. 1.018
b. 1.021
c. 1.023
d. 1.027
e. 1.033

Chapter 3 - Page 39
 CHAPTER 3
ANSWERS AND SOLUTIONS

Chapter 3 - Page 40
1. Current ratio Answer: a Diff: E

Remember, the current ratio is CA/CL. In order to increase the current

ratio, either current assets must increase, or current liabilities must
decrease. Accounts receivable are a current asset, and if they increase
the current ratio will increase. So, statement a is true. Accounts
payable are a current liability, so if they increase the current ratio
declines. So, statement b is false. Net fixed assets are long-term
assets, not current assets, so they will not affect the current ratio. So,
statement c is false.

2. Current ratio Answer: d Diff: E

Pepsi Corporation:
Before: Current ratio = $50/$100 = 0.50.
After: Current ratio = $150/$200 = 0.75.

Coke Company:
Before: Current ratio = $150/$100 = 1.50.
After: Current ratio = $250/$200 = 1.25.

3. Cash flows Answer: a Diff: E

Statement a is correct. The other statements are false. Increasing the

years over which fixed assets are depreciated results in smaller amounts
being depreciated each year. Given that depreciation is a non-cash
expense and is used to reduce taxable income, the change would result in
less depreciation expense and higher taxes for the year. Since taxes are
paid with cash, the company's cash flow would decrease. In addition,
decreasing accounts payable results in using cash to pay off the accounts
payable balance.

4. Leverage and financial ratios Answer: d Diff: E

Statements a and c are correct. The increase in debt payments will reduce
net income and hence reduce ROA. Also, higher debt payments will result
in lower taxable income and less tax. Therefore, statement d is the best
choice.

5. Leverage and profitability ratios Answer: e Diff: E

Statement a is true; higher debt will increase interest expense and net
income will decline, resulting in a lower ROA than before. Statement b is
true; both net income and equity are going to decline, but net income will
decline less because the basic earning power exceeds the cost of debt, so
ROE will actually rise. Statement c is true; both EBIT and total assets
remain the same. Therefore, statement e is the best choice.

6. EVA Answer: b Diff: E N

The correct answer is statement b. A company can have positive NI and

still have negative EVA. Look at the following formula:
EVA = NI - (Cost of Equity)(Amount of Equity Capital).

If the cost of equity times the amount of equity is greater than NI, EVA
could be negative. Just because a company has a positive NI does not mean
that it is earning enough to adequately compensate its shareholders.
Therefore, statement a is not correct.

For statement b, look at the following formula:

EVA = (ROE - k)(Equity).
 As long as ROE is greater than the cost of equity, EVA will be positive.
Therefore, statement b is correct.

From the formula above, you can see that a company can increase its EVA by
increasing its ROE, decreasing its cost of equity, or by increasing its
equity investment. Any of these three changes would increase EVA, not
just the increase in ROE. Therefore, statement c is incorrect.

7. ROE and EVA Answer: e Diff: E

EVA is the value added after both shareholders and debtholders have been
paid. Net income only takes payments to debtholders into account, not
shareholders. Therefore, statement a is false. EVA = (ROE - k) × Total
equity. So, if k is larger than ROE, EVA would be negative even if ROE is
positive. The shareholders are getting a return but not as much as they
require. Therefore, statement b is false. Statement c is exactly the
opposite of what is true, so it is false. EVA will be negative whenever
the cost of equity exceeds the ROE. Since statements a, b, and c are
false, the correct choice is statement e.

8. ROE and EVA Answer: b Diff: E

ROED > ROEB; EVAD < EVAB.

EVA can be calculated with 3 different equations:

 Total Investor-Supplied 
(1) EVA = EBIT(1 - T) - WACC ×  Operating Capital  .
  
(2) EVA = NI – (kS × Equity).
(3) EVA = (ROE - k S) × Equity.

Since Devon has a higher ROE, but its EVA is lower, the only things that
could explain this is if (1) its k s were higher or (2) its equity (or size)
were lower.

Since statement a would have the opposite effect (increasing Devon’s

EVA), statement a is false. If the k S were higher, then (ROE - k S) would
be lower, and EVA would be lower. Therefore, statement b is true. A
higher EBIT would lead to a higher EVA, so statement c is false.
9 . Ratio analysis

Answer: b Diff: E

Bedford = D; Breezewood = Z.
TAD = TAZ; ROAD = ROAZ; TD = TZ; D/AD > D/AZ; INTD > INTZ; ROA = NI/TA.
If both companies have the same ROA and total assets, then they must both
have the same net incomes. Therefore, NID = NIZ.

First, compare BEPs. BEP = EBIT/TA. Work backward up the income

statement. If both companies have the same NI and tax rate, then they
must both have the same EBT. However, Bedford has higher interest
payments, so its EBIT must be higher than Breezewood’s. (Remember: EBT +
I = EBIT.) Therefore, statement c is false. In addition, Bedford’s BEP is
higher than Breezewood’s, so statements a, d, and e are all false.
Statement b must be true for the following reason. Compare ROEs. ROE =
1
ROA × EM and EM = .
1 − D/A

Bedford has a higher D/A ratio than Breezewood; therefore, it has a higher
EM than Breezewood. If its EM is higher and its ROA is the same, then
 Bedford’s ROE must be higher than Breezewood’s.

10. Financial statement analysis Answer: a Diff: E

11. Financial statement analysis Answer: e Diff: E

ROE = NI/Equity; ROA = NI/TA; EVA = NI - k s × Equity.

We know nothing about the debt ratio or equity multiplier of either

company. Remember, ROA = ROE/EM (EM = equity multiplier). Since we don’t
have EM, we don’t have enough information to say anything about ROA.
Therefore, statement a is false. We don’t know anything about the k s or
the amount of equity of either company. Therefore, we don’t know enough
to determine which company’s EVA is higher. Therefore, statement b is
false. We know that A’s ROE is higher than B’s. However, we don’t know
how much equity either one has, so we cannot say which one has a higher
net income. Therefore, statement c is false. Since statements a, b, and
c are false, the correct choice must be statement e.

12. Financial statement analysis Answer: e Diff: E

From the first sentence, both firms have the same net income, sales, and
assets. Since A has more debt, it must have less equity. Thus, its ROE
(calculated as Net income/Equity) is higher than B’s. So statement a is
correct. Since the two firms have the same total assets and sales, their
total assets turnover ratios must be the same. So statement b is false. If
A has higher interest expense than B but the same net income, this means
that A must have higher operating income (EBIT) than B. Therefore
statement c is correct. Since statements a and c are correct, the correct
choice is statement e.

13. Financial statement analysis Answer: d Diff: E N

The correct answer is statement d. Although EBIT is unchanged, interest

expense will go down, so NI will increase. Therefore, statement a is
correct. If EBIT is unchanged, but interest expense goes down, the TIE
ratio (EBIT/INT) will increase. Therefore, statement b is correct. If the
stock issue has no effect on the company’s total assets, but NI has
increased (see statement a), then ROA (NI/TA) will increase. Therefore,
statement c is also correct.

14. Miscellaneous ratios Answer: a Diff: E

The Du Pont equation states: ROE = PM × TATO × EM.

The firms have the same profit margin and equity multiplier. The equity
multiplier is the same because both companies have the same debt ratio. If
Company A has a higher ROE than B, then from the Du Pont equation Company
A also has a higher total assets turnover ratio than B. The current ratio
does not explain the ratios discussed. Therefore, only statement a
explains the observed ratios.

15. Miscellaneous ratios Answer: e Diff: E R

Current ratio = Current assets/Current liabilities. This transaction will

reduce current liabilities, which results in a higher current ratio. So
statement a is false. The basic earning power ratio = EBIT/TA. Since
neither the firm’s operating income (EBIT) or total assets have changed,
its BEP ratio remains unchanged. So statement b is false. TIE =
 EBIT/Interest. EBIT will be unaffected, but we may see interest costs fall
due to the firm having less debt. This will result in an increase in the
TIE ratio. So statement c is false. Statement d is also false for the
same reasons as statements a and b. Total debt is reduced but total
assets remain the same. The firm now has more equity, so the equity
multiplier (Assets/Equity) will decrease, so statement e is correct.

16. Current ratio Answer: d Diff: M

Statement d is the correct answer. For statements a and b a reduction in

the numerator and denominator by the same amount will increase the current
ratio because the current ratio is greater than 1. In statement c only
the denominator goes down (long-term bonds are not in the current ratio),
so the current ratio will increase.

17. Current ratio Answer: e Diff: M

18. Ratio analysis Answer: c Diff: M

19. Ratio analysis Answer: c Diff: M N

TAD = TAC.
TATOD = TATOC so, S/TAD = S/TAC.
ROED = ROEC.
ROAD > ROAC.

Since TATO is the same for both, and since TA is the same for both, sales
must be the same for both (since TATO = Sales/TA). Remember the Du Pont
equation: ROE = PM × TATO × EM. Drysdale and Commerce have the same TATO.
So, if Drysdale has a higher PM and a higher EM (if the debt ratio is
higher, the EM is higher), then its ROE must be higher. However, the problem
states that the companies have the same ROE. Therefore, statement a is
incorrect. If Drysdale’s PM and debt ratio are lower than Commerce’s and
both have the same TATO, Drysdale would have a lower ROE. The problem states
that the companies have the same ROE, so statement b is incorrect. Looking
again at the Du Pont equation: ROE = PM × TATO × EM. If the ROEs are the
same and the TATOs are the same, then (PM × EM) must be the same for the two
companies. If Drysdale has a higher PM and a lower EM, then (PM × EM)
could be the same for both. Therefore, statement c could explain the
ratios in the problem. If Drysdale has lower NI and more common equity
(higher TE), then its ROE would be lower. Therefore, statement d is
incorrect. The P/E ratio is irrelevant. The stock price cannot explain
what is going on with the two companies’ ratios.

20. Ratio analysis Answer: a Diff: T

Statement a is correct; the others are false. If Company X has a higher

total assets turnover (Sales/TA) but the same total assets, it must have
higher sales than Y. If X has higher sales and also a higher profit margin
(NI/Sales) than Y, it must follow that X has a higher net income than Y.
Statement b is false. ROE = NI/EQ or ROE = ROA × Equity multiplier. In
either case we need to know the amount of equity that both firms have.
This is impossible to determine given the information in the question.
Therefore, we cannot say that X must have a higher ROE than Y. Statement c
is false. Remember from the Du Pont equation that ROA = Profit margin ×
 Total assets turnover = NI/S × S/TA. Since Company X has both a higher
profit margin and total assets turnover than Company Y, X’s ROA must also be
higher than Y’s.

21. Effects of leverage Answer: a Diff: M

Statement a is correct. The other statements are false. The use of debt
provides tax benefits to the corporations that issue debt, not to the
investors who purchase debt (in the form of bonds). The basic earning
power ratio would be the same if the only thing that differed between the
firms were their debt ratios.

22. Financial statement analysis Answer: a Diff: M

Statement a is true because, if a firm takes on more debt, its interest

expense will rise, and this will lower its profit margin. Of course, there
will be less equity than there would have been, hence the ROE might rise
even though the profit margin declined.

23 . Financial statement analysis

Answer: d Diff: M N

The correct answer is statement d. Start with the Du Pont equation:

NI/S × S/TA × TA/E = ROE. We know S/TA and ROE are the same for both.
Since the equity of Mills is higher than Harte, its NI must also be higher
to keep ROE the same. So, statement a is correct. The other statements
are then also true. Given Mills’ higher net income, both the profit
margin and the ROA for Mills are also higher than Harte’s.

24. Leverage and financial ratios Answer: e Diff: M

TATO = Sales/TA. Both companies have the same total assets. However,
since A has a lower profit margin than B and its net income is the same as
B’s, it must have higher sales; thus, A has a higher total assets turnover
ratio than B. Therefore, statement a is true. ROE = NI/Equity. Both
companies have the same total assets and net income, but A has more debt
and thus less equity than B. Therefore, A has a higher ROE than B.
Therefore, statement b is true. BEP = EBIT/TA. We know that A has higher
interest payments than B but the same net income as B. Therefore, A must
have a higher EBIT than B to cover this extra interest. Thus, A must have
a higher basic earning power ratio than B. Therefore, statement c is
true. Since statements a, b, and c are true, the correct choice is
statement e.

25. Leverage and financial ratios Answer: d Diff: M N

If BEP and total assets are equal, we know that EBIT is equal. Company A
has a higher debt ratio and higher interest expense than Company B.
Since Company A has lower net income, it must have a lower ROA (since
total assets are the same). If EBIT is the same for both A and B and
Company A has higher interest expense, Company A must have a lower TIE
ratio than Company B. Company A has a lower EBT and lower net income than
Company B. If A has lower EBT, then Company A pays less in taxes than
Company B. There is a positive relationship between the debt ratio and
the equity multiplier, which means that Company A has a higher equity
multiplier than B because A’s debt ratio is higher than B’s. Therefore,
 the correct choice is statement d.

26. Du Pont equation Answer: b Diff: M R

The Du Pont equation: ROE = (PM)(TATO)(EM). ROE is above average. PM is

below average. EM is above average because a high debt ratio implies a
high EM. Therefore, TATO must be higher for the equation to hold. Note
that the firm’s ROA does not have to be higher than the industry ROA for
this equation to hold.
27. ROE and EVA Answer: d Diff: M

EVA = NI – (ks × Equity). ks × Equity cannot be zero, therefore, net income

must be positive if EVA is zero. So statements a and b are false. ROA =
NI/TA. This equation really does not have anything to do with the EVA
calculation. Statement c is only correct if the firm has zero debt, which
we know not to be correct. (We are given information in the question
stating that the firm’s debt ratio is 40 percent.) Therefore, statement c
is also false. ROE = NI/Equity. Rewrite the EVA equation by substituting
into it EVA = 0, and you get: NI = k s × Equity. Divide both sides by
Equity and you obtain the following equation: NI/Equity = k s. Thus ROE =
14%. Statement e would give a negative EVA and the problem states that the
firm’s EVA is zero, so it is false.

28. ROE and EVA Answer: b Diff: M

Statement a is false; EVA depends upon the amount of equity invested,

which could be different for the two firms. Statement b is correct; for
positive EVA, the ROE must exceed the cost of equity. Statement c is
false; it is very plausible to have a firm with positive ROE and a higher
cost of equity, resulting in negative EVA.

29. Miscellaneous ratios Answer: b Diff: M

Statement b is correct. EBIT = EBT + Interest. Statement c is incorrect

because higher interest expense doesn’t necessarily imply greater debt.
For this statement to be correct, A’s amount of debt would have to be
greater than B’s.

30. Miscellaneous ratios Answer: e Diff: M

Statements b and c are correct. ROA = NI/TA. An increase in the debt ratio
will result in an increase in interest expense, and a reduction in NI. Thus
ROA will fall. EM = Assets/Equity. As debt increases, the amount of equity
in the denominator decreases, thus causing the equity multiplier (EM) to
increase. Therefore, statement e is the correct choice.

31. Miscellaneous ratios Answer: d Diff: M

Since X has a lower ROA (NI/TA) than Y and both firms have the same
assets, X must have a lower net income than Y. So statement c is correct.
X has a higher ROE (NI/EQ) than Y, even though its net income is lower.
Consequently, X must have less equity than Y, and therefore, more debt
than Y. So statement a is false. Since X has a higher total assets
turnover ratio (Sales/TA) than Y and both firms have the same assets, X’s
sales must be higher than Y’s. This fact, combined with X’s lower net
income, means that X must have a lower profit margin (NI/Sales) than Y, so
statement b is correct. Thus, statements b and c are both correct. So,
the correct choice is statement d.
32. ROE and EVA Answer: a Diff: T

The following formula will make this question much easier: EVA = (ROE - k s)
× Total equity. If Division A is riskier than Division B, then A’s cost of
equity capital will be higher than B’s. If k s is higher, EVA will be lower.
So, statement a is true. If A is larger than B in terms of equity, then the
term (ROE - k s) will be multiplied by a much larger number for Division A.
Since A’s ROE is also higher than B’s, then its EVA would be higher than
B’s. Therefore, statement b is false. If A has less debt, then its
interest payments will be lower than B’s, so its EBIT will be higher.
Another way to write the EVA formula is EVA = EBIT (1 – T) – [Cost of
capital × Investor-supplied capital employed]. So, a higher EBIT will lead
to a higher EVA. In addition, a lower level of debt will make A less risky
than B, so A’s cost of equity will be lower than B’s. From the other EVA
formula, we can see that this would cause a higher EVA, not a lower one.
So, statement c is false.

33. Ratio analysis Answer: d Diff: T

Statement d is correct; the others are false. ROA = NI/TA. Company C has
higher interest expense than Company D; therefore, it must have lower net
income. Since the two firms have the same total assets, ROA C < ROAD.
Statement a is false; we cannot tell what sales are. From the facts as
stated above, they could be the same or different. Statement b is false;
Company C must have lower equity than Company D, which could lead it to
have a higher ROE because its equity multiplier would be greater than
company D's. Statement c is false as TIE = EBIT/Interest, and C has
higher interest than D but the same EBIT; therefore, TIE C < TIED. Statement
e is false; they have the same BEP = EBIT/TA from the facts as given in
this problem.

34. Ratio analysis Answer: d Diff: T

We can conclude that X has a lower NI, because it has a lower EBIT and
higher interest than Y, but the same tax rate as Y. Sales for each
company are the same because they have the same total assets and the same
total assets turnover ratio (TATO = Sales/TA). Therefore, since X has a
lower NI and same sales as Y, it must follow that it has a lower profit
margin (NI/Sales).

35 . Ratio analysis and Du Pont equation

Answer: d Diff: T

ROAL = ROAY; S/TAL > S/TAY; EML > EMY, or A/EL > A/EY.

From the Du Pont equation we know that ROA = Profit margin × Total assets
turnover. If the 2 firms’ ROAs are equal, but Lancaster’s total assets
turnover is greater than York’s then Lancaster’s profit margin must be lower
than York’s. Therefore, statement a is true. The debt ratio is calculated
 as 1 - 1/Equity multiplier. So, if Lancaster has a higher equity multiplier
than York, its debt ratio must be higher too. So, statement b is false.
From the extended Du Pont equation we know that ROE = Profit margin × Total
assets turnover × Equity multiplier. We also know that ROA = Profit margin
× Total assets turnover. Since we know the
2 firms’ ROAs are equal and Lancaster has a higher equity multiplier it must
have a higher ROE too. Therefore, statement c is true. Since statements a
and c are true, the correct choice is statement d.

36. Leverage and financial ratios Answer: d Diff: T

The new income statement will be as follows:

Operating income (EBIT) $1,200,000 0.2 × $6,000,000
Interest expense 200,000
Earnings before taxes (EBT) $1,000,000
Taxes (40%) 400,000
Net income $ 600,000

NI $540,000 $600,000
ROAOld = = = 10.8% ; ROENew = = 10%.
Assets $5,000,000 $6,000,000
Therefore, ROA falls.

NI $540,000 $600,000
ROEOld = = = 13.5% ; ROENew = = 15.0%.
Equity $4,000,000 $4,000,000

Since net income increases, ROA falls and ROE increases, statement d is
the correct choice.

37. Miscellaneous ratios Answer: c Diff: T

Step 1: Use the ratios and data to arrive at alternative relationships to

answer the question:

TATO = Sales/TA
= NI/TA × S/NI
= ROA × 1/PM.

D/A = TD/TA
= (TA - EQ)/TA
= (TA/TA) - (EQ/TA)
= 1 - (EQ/NI) × (NI/TA)
= 1 - (ROA/ROE).
 ROA = NI/TA
NI = TA × ROA.

Step 2: Substitute the data given with the alternative relationships

obtained in Step 1:

Hemmingway Fitzgerald
TATO = ROA/PM = 0.09/0.04 = 0.08/0.03
= 2.25×. = 2.67×.
D/A = 1 - (ROA/ROE) = 1 - (0.09/0.18) = 1 - (0.08/0.24)
= 0.5. = 0.667.
NI = TA × ROA = 2 × 0.09 = 1.5 × 0.08
= $0.18 billion. = $0.12 billion.

From the calculations above, statement c is the correct choice.

38. Financial statement analysis Answer: a Diff: E

BEP = EBIT/TA
0.15 = EBIT/$100,000,000
EBIT = $15,000,000.

ROA = NI/TA
0.09 = NI/$100,000,000
NI = $9,000,000.

EBT = NI/(1 - T)
EBT = $9,000,000/0.6
EBT = $15,000,000.

Therefore interest expense = $0.

39. Market price per share Answer: b Diff: E

Total market value = $1,250(1.5) = $1,875.

Market value per share = $1,875/25 = $75.

Alternative solution:
Book value per share = $1,250/25 = $50.
Market value per share = $50(1.5) = $75.

40. Market price per share Answer: c Diff: E

Number of shares = $200,000/$2.00 = 100,000.

Book value per share = $2,000,000/100,000 = $20.
Market value = 0.2(Book value) = 0.2($20) = $4.00 per share.

41
. Market/book ratio Answer: c Diff: E
 M Price per share × shares
=
B BV
$80 × shares
4.0 =
$40,000,000
$160,000,000 = $80 × shares
2,000,000 = shares.

42. Market/book ratio Answer: e Diff: E N

TA = $2,000,000,000; CL = $200,000,000; LT debt = $600,000,000; CE =

$1,200,000,000; Shares outstanding = 300,000,000; P0 = $20; M/B = ?

$1,200,000,000
Book value = = $4.00.
300,000,000

$20.00
M/B = = 5.0.
$4.00

43. ROA Answer: d Diff: E

Net income = 0.15($20,000,000) = $3,000,000.

ROA = $3,000,000/$22,500,000 = 13.3%.

44. TIE ratio Answer: b Diff: E

TIE = EBIT/INT
7 = ($300 + INT)/INT
7INT = $300 + INT
6INT = $300
INT = $50.

45. ROE Answer: c Diff: E

Equity = 0.25($6,000) = $1,500.

NI $240
Current ROE = = = 16%.
E $1,500
$300
New ROE = = 0.20 = 20%.
$1,500
∆ROE = 20% - 16% = 4%.

46. Profit margin Answer: c Diff: E

S $10,000
Current inventory turnover = = = 2.
Inv $5,000
S S $10,000
New inventory turnover = = 5; Inv = = = $2,000.
Inv 5 5
Freed cash = $5,000 - $2,000 = $3,000.
Increase in NI = 0.07($3,000) = $210.
NI $240 + $210
New Profit margin = = = 0.0450 = 4.5%.
Sales $10,000

47. Du Pont equation Answer: a Diff: E

First, calculate the profit margin, which equals NI/Sales:

ROA = NI/TA = 0.04.
Sales/Total assets = S/TA = 2.
PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02. [TA/S = 1/2 = 0.5.]
 Next, find the debt ratio by finding the equity ratio:
E/TA = (E/NI)(NI/TA). [ROE = NI/E and ROA = NI/TA.]
E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity.
Therefore, D/TA must be 0.333 = 33.3%.

48. P/E ratio and stock price Answer: b Diff: E

EPS = $15,000/10,000 = $1.50.

P/E = 5.0 = P/$1.50.
P = $7.50.

49. P/E ratio and stock price Answer: e Diff: E

EPS = $750,000/100,000 = $7.50.

P/E = Price/EPS = 8.
Thus, Price = 8 × $7.50 = $60.00.

50. Current ratio and inventory Answer: b Diff: E N

With the numbers provided, we can see that Iken Berry Farms has a current
ratio of 1.67 (CA/CL = $5/$3 = 1.67). If notes payable are going to be
raised to buy inventories, both the numerator and the denominator of the
ratio will increase. We can increase current liabilities $1 million
before the current ratio reaches 1.5.

CA + X
≥ 1.5
CL + X
$5,000,000 + X
≥ 1.5
$3,000,000 + X
$5,000,000 + X ≥ $4,500,000 + 1.5X
$500,000 ≥ 0.5X
$1,000,000 ≥ X
X ≤ $1,000,000.

51. Accounts receivable increase Answer: b Diff: M R

DSO = $41,096/($250,000/365) = 60 days.

New A/R = [($250,000)(1.5)/(365)](60)(1.5) = $92,466.
Hence, increase in receivables = $92,466 - $41,096 = $51,370.

52. Accounts receivable Answer: a Diff: M R

First solve for current annual sales using the DSO equation as follows: 50
= $1,000,000/(Sales/365) to find annual sales equal to $7,300,000.
If sales fall by 10%, the new sales level will be $7,300,000(0.9) =
$6,570,000. Again, using the DSO equation, solve for the new accounts
receivable figure as follows: 32 = AR/($6,570,000/365) or AR = $576,000.

53. ROA Answer: a Diff: M

Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.4) = 1.67.

 ROE = ROA × Equity multiplier
18% = (ROA)(1.67)
ROA = 10.8%.

54. ROA Answer: e Diff: M

Step 1: We must find TA. We are given BEP and EBIT.

EBIT EBIT
BEP = and TA = .
TA BEP
Therefore, TA = $40,000,000/0.1, or $400 million.

Step 2: NI/TA = ROA, so now we need to find net income. Net income is
found by working through the income statement (in millions):

EBIT $40
Interest 5 (from TIE ratio: 8 = EBIT/Int)
EBT $35
Taxes (40%) 14
NI $21

Step 3: ROA = $21/$400 = 0.0525 = 5.25%.

55 . ROA

Answer: c Diff: M N

BEP = EBIT/TA = 0.10, so EBIT = 0.10 × $500,000 = $50,000.

TIE = EBIT/INT = 5, so INT = $50,000/5 = $10,000.

EBIT $50,000
Int -10,000
EBT $40,000
Taxes (40%) -16,000
NI $24,000

ROA = NI/TA = $24,000/$500,000 = 0.048, or 4.8%.

56. ROE Answer: c Diff: M R

(Sales per day)(DSO) = A/R

(Sales/365)(60) = $150,000
Sales = $912,500.

Profit margin = Net income/Sales.

Net income = 0.04($912,500) = $36,500.
Debt ratio = 0.64 = Total debt/$3,000,000.
Total debt = $1,920,000.
Total equity = $3,000,000 - $1,920,000 = $1,080,000.
ROE = $36,500/$1,080,000 = 3.38% ≈ 3.4%.
57. ROE Answer: b Diff: M

Total equity = ($5,000,000)(2) = $10,000,000.

Total assets = $5,000,000 + $10,000,000 = $15,000,000.
Net income = (0.06)($15,000,000) = $900,000.
ROE = $900,000/$10,000,000 = 9%.
ROE - ROA = 9% - 6% = 3%.

58. ROE Answer: d Diff: M

Profit margin = ($1,500(1 - 0.3))/$5,000 = 21%.

Equity multiplier = 1.0 since firm is 100% equity financed.

ROE = (Profit margin)(Assets turnover)(Equity multiplier)

= (21%)(2.0)(1.0) = 42%.

59. ROE Answer: c Diff: M

Calculate debt, equity, and EBIT:

Debt = D/A × TA = 0.35($1,000) = $350.
Equity = TA - Debt = $1,000 - $350 = $650.
EBIT = TA × BEP = $1,000(0.20) = $200.

Calculate net income and ROE:

Net income = (EBIT - I)(1 - T) = [$200 - 0.0457($350)](0.6) = $110.4.
ROE = $110.4/$650 = 16.99%.

60. Equity multiplier Answer: d Diff: M

Equity multiplier = 4.0 = Total assets/Total equity = 4/1.

Assets = Debt + Equity

4 = Debt + 1
Debt = 3.

Debt/Assets = 3/4 = 0.75.

61. TIE ratio Answer: e Diff: M

TIE = EBIT/I, so find EBIT and I.

Interest = $800,000 × 0.1 = $80,000.
Net income = $3,200,000 × 0.06 = $192,000.
Pre-tax income = $192,000/(1 - T) = $192,000/0.6 = $320,000.
EBIT = $320,000 + $80,000 = $400,000.
TIE = $400,000/$80,000 = 5.0×.
62. TIE ratio Answer: b Diff: M N

TA = $8,000,000,000; T = 40%; EBIT/TA = 12%; ROA = 3%; TIE ?

EBIT
= 0.12
$8,000,000,000
EBIT = $960,000,000.

NI
= 0.03
$8,000,000,000
NI = $240,000,000.

Now use the income statement format to determine interest so you can
calculate the firm’s TIE ratio.

INT = EBIT – EBT

EBIT $960,000,000 See above. = $960,000,000 - $400,000,000
INT 560,000,000
EBT $400,000,000 EBT = $240,000,000/0.6
Taxes (40%) 160,000,000
NI $240,000,000 See above.

TIE = EBIT/INT
= $960,000,000/$560,000,000
= 1.7143 ≈ 1.71.

63. TIE ratio Answer: b Diff: M

Remember, TIE = EBIT/Interest. We need to find EBIT and Interest.

TA = $20,000,000; BEP = 25%; ROA = 10%; T = 40%.

BEP = EBIT/TA
25% = EBIT/$20,000,000
$5,000,000 = EBIT.

ROA = NI/TA
10% = NI/$20,000,000
$2,000,000 = NI.

NI = (EBIT - I)(1 - T)
$2,000,000 = ($5,000,000 - I)(1 - 0.4)
$2,000,000 = ($5,000,000 - I)(0.6)
$3,333,333 = $5,000,000 - I
$1,666,667 = I.

Therefore, TIE = EBIT/I

= $5,000,000/$1,666,667
= 3.0×.

64. TIE ratio Answer: d Diff: M N

The times interest earned (TIE) ratio is calculated as the ratio of EBIT
and interest expense. We can find EBIT from the BEP ratio and total
assets given in the problem.
 EBIT
BEP =
TA
EBIT
25% =
$3,000,000
EBIT = $750,000.

Interest expense can be obtained from the income statement by simply

working your way up the income statement. To do this, however, we must
first calculate net income from the data given for ROA.

NI
ROA =
TA
NI
12% =
$3,000,000
NI = $360,000.

Solving for EBT and then interest, we find:

NI
EBT =
(1 - T)
$360,000
EBT =
(1 − 0.35)
EBT = $553,846.

EBIT – INT = EBT

$750,000 – INT = $553,846
INT = $196,154.

We can now calculate the TIE as follows:

EBIT
TIE =
INT
$750,000
TIE =
$196,154
TIE = 3.82×.

65. EBITDA coverage ratio Answer: a Diff: M N

TA = $9,000,000,000; EBIT/TA = 9%; TIE = 3; DA = $1,000,000,000; Lease

payments = $600,000,000; Principal payments = $300,000,000; EBITDA
coverage = ?

EBIT/$9,000,000,000 = 0.09
EBIT = $810,000,000.

3 = EBIT/INT
3 = $810,000,000/INT
INT = $270,000,000.

EBITDA = EBIT + DA
 = $810,000,000 + $1,000,000,000
= $1,810,000,000.

EBITDA + Lease payments

EBITDA coverage ratio =
INT + Princ. pmts + Lease pmts
$1,810,000,000 + $600,000,000
=
$270,000,000 + $300,000,000 + $600,000,000
$2,410,000,000
= = 2.0598 ≈ 2.06.
$1,170,000,000

66. Debt ratio Answer: c Diff: M

Debt ratio = Debt/Total assets.

Sales/Total assets = 6
Total assets = $24,000,000/6 = $4,000,000.

ROE = NI/Equity
Equity = NI/ROE = $400,000/0.15 = $2,666,667.

Debt = Total assets - Equity = $4,000,000 - $2,666,667 = $1,333,333.

Debt ratio = $1,333,333/$4,000,000 = 0.3333.

67. Profit margin Answer: a Diff: M

Equity multiplier = 1/(1 - 0.35) = 1.5385.

ROE = (Profit margin)(Assets utilization)(Equity multiplier)

15% = (PM)(2.8)(1.5385)
PM = 3.48%.

68. Financial statement analysis Answer: e Diff: M R

$1,000
Current DSO = = 36.5 days. Industry average DSO = 30 days.
$10,000/365
 $10,000 
Reduce receivables by (36.5 – 30)   = $178.08.
 365 
Debt = $400/0.10 = $4,000.
TD $4,000 - $178.08
= = 65.65%.
TA $6,000 - $178.08

69. Financial statement analysis Answer: b Diff: M R

First, find the amount of current assets:

Current ratio = Current assets/Current liabilities
Current assets = (Current liabilities)(Current ratio)
= $375,000(1.2) = $450,000.

Next, find the accounts receivables:

DSO = AR/(Sales/365)
AR = DSO(Sales)(1/365)
= (40)($1,200,000)(1/365) = $131,506.85.
 Next, find the inventories:
Inventory turnover = Sales/Inventory
Inventory = Sales/Inventory turnover
= $1,200,000/4.8 = $250,000.

Finally, find the amount of cash:

Cash = Current assets - AR - Inventory
= $450,000 - $131,506.85 - $250,000 = $68,493.15 ≈ $68,493.

70. Basic earning power Answer: d Diff: M

Given ROA = 10% and net income of $500,000, total assets must be $5,000,000.

NI
ROA =
A
$500,000
10% =
TA
TA = $5,000,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a

partial income statement:

EBIT $1,033,333 ($200,000 + $833,333)

Interest 200,000 (Given)
EBT $ 833,333 $500,000/0.6
Taxes (40%) 333,333
NI $ 500,000

EBIT
BEP =
TA
$1,033,333
=
$5,000,000
= 0.2067 = 20.67%.

71. P/E ratio and stock price Answer: e Diff: M

The current EPS is $1,500,000/300,000 shares or $5. The current P/E ratio
is then $60/$5 = 12. The new number of shares outstanding will be 400,000.
 Thus, the new EPS = $2,500,000/400,000 = $6.25. If the shares are selling
for 12 times EPS, then they must be selling for $6.25(12) = $75.

72 . Current ratio and DSO

Answer: a Diff: M

Step 1: Determine average daily sales using the old DSO.

Receivables
DSO = .
Average Daily Sales

If DSO changes while sales remain the same, then receivables must
change.
$400
40 =
Average Daily Sales
$10 = Average Daily Sales.

Step 2: Determine the new level of receivables required for Parcells to

achieve the industry average DSO.
Receivables
30 =
$10
$300 = Receivables.

Step 3: Calculate the new current ratio.

Receivables decline by $100, so current assets declined by $100.
Therefore, the new level of current assets is $800 - $100 = $700.
Since the $100 cash freed up is used to reduce long-term bonds, cur-
rent liabilities remain at $400. Current ratio = $700/$400 = 1.75.

73. Current ratio Answer: c Diff: M N

Currently:
DSO = AR/Average Daily Sales
= $250/$10
= 25 days.

Now, Cartwright wants to reduce DSO to 15. The firm needs to reduce
accounts receivable because it doesn’t want to reduce average daily sales.
So, we can calculate the new AR balance as follows:
DSO = AR/Average Daily Sales
 15 = AR/$10
$150 million = AR.

If the firm reduces its DSO to the industry average, its AR will be $150
million, reduced by $100 million. Therefore, there must be an equal
reduction on the right side of the balance sheet. Half of this $100
million of freed-up cash will be used to reduce notes payable, and the
other half will be used to reduce accounts payable. Therefore, notes
payable will fall by $50 million to $250 million, and accounts payable
will fall by $50 million to $250 million.

Therefore, we can now calculate the firm’s new current ratio:

Current Ratio = CA/CL
= (Cash + AR + Inv.)/(Notes Payable + Accounts Payable)
= ($250 + $150 + $250)/($250 + $250)
= $650/$500
= 1.30×.
74. Current ratio Answer: b Diff: M N

Step 1: Calculate the firm’s current inventory turnover.

Inv. turnover = Sales/Inv.
= $3,000,000/$500,000
= 6.0×.

New Inv. turnover = 10.0× (but sales stay the same).

Step 2: Calculate what the firm’s inventory balance should be if the firm
maintains the industry average inventory turnover.
Inv. turnover = Sales/Inv.
10× = $3 million/Inv.
$300,000 = Inv.

The new inventory level will be $300,000, so inventories will be reduced

by $200,000 from the old level. This means that current assets will
decrease by $200,000.

Step 3: Calculate the firm’s new current assets level.

CA = Cash + Inv. + A/R
= $100,000 + $300,000 + $200,000
= $600,000.

Half of the $200,000 that is freed up will be used to reduce notes payable,
and the other half will be used to reduce common equity. Therefore, notes
payable will be reduced by $100,000 to a new level of $100,000.

Step 4: Calculate the firm’s new liabilities level.

CL = A/P + Accruals + Notes payable
= $200,000 + $100,000 + $100,000
= $400,000.

Step 5: Calculate the firm’s new current ratio with the improved
inventory management.
CR = CA/CL
= $600,000/$400,000
= 1.5×.

75. Credit policy and ROE Answer: c Diff: M R

Use the DSO formula to calculate accounts receivable under the new policy
as 36 = AR/($730,000/365) or AR = $72,000. Thus, $125,000 - $72,000 =
$53,000 is the cash freed up by reducing DSO to 36 days. Retiring $53,000
 of long-term debt leaves $247,000 in long-term debt. Given a 10% interest
rate, interest expense is now $247,000(0.1) = $24,700. Thus, EBT = EBIT -
Interest = $70,000 - $24,700 = $45,300. Net income is $45,300(1 - 0.3) =
$31,710. Thus, ROE = $31,710/$200,000 = 15.86%.

76. Du Pont equation Answer: d Diff: M

Before: Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.5) = 2.0.

ROE = (PM)(Assets turnover)(EM) = (10%)(0.25)(2.0) = 5%.

After: [ROE = 2(5%) = 10%]:

10% = (12%)(0.25)(EM)
EM = 3.33 = A/E.

E/A = 1/3.33 = 0.3.

D/A = 1 – 0.3 = 0.7 = 70%.

77. Sales and extended Du Pont equation Answer: a Diff: M

NI/E = 15%; D/A = 40%; E/A = 60%; A/E = 1/0.6 = 1.6667; NI/S = 5%.

Step 1: Determine total assets turnover from the extended Du Pont

equation:
NI/S × S/TA × A/E = ROE
(5%)(S/TA)(1.6667) = 15%
0.0833 S/TA = 15%
S/TA = 1.8.

Step 2: Determine sales from the total assets turnover ratio:

S/TA = 1.8
S/$800 = 1.8
S = $1,440 million.

78. Net income and Du Pont equation Answer: c Diff: M N

Step 1: Calculate total assets from information given.

Sales = $10 million.

3.5× = Sales/TA
$10,000,000
3.5× =
Assets
Assets = $2,857,142.8571.

Step 2: Calculate net income.

There is no debt, so Assets = Equity = $2,857,142.8571.

ROE = NI/S × S/TA × TA/E

0.15 = NI/$10,000,000 × 3.5 × 1
3.5NI
0.15 =
$10,000,000
$1,500,000 = 3.5NI
$428,571.4286 = NI.
79. ROE Answer: c Diff: T

Given: New D/A = 0.55 Interest = $7,000

EBIT = $25,000 Tax rate = 40%
Sales = $270,000 TATO = 3.0

Recall the Du Pont equation: ROE = (PM)(TATO)(EM).

ROE = (ROA)(EM).
ROE = NI/Equity.
EBIT $25,000
Interest 7,000 (Given)
EBT $18,000
Taxes (40%) 7,200 ($18,000 × 40%)
NI $10,800

TATO = Sales/Total assets

Total assets = Sales/TATO = $270,000/3 = $90,000.

Equity = [1 - (D/A)](Total assets)

Equity = [1 - 0.55](Total assets)
Equity = 0.45($90,000) = $40,500.

ROE = NI/Equity = $10,800/$40,500 = 26.67%.

80. ROE Answer: d Diff: T

Industry average inventory turnover = 6 = Sales/Inventories.

To match this level: Inventories = Sales/6
$3,000,000/6 = $500,000.

Current inventories = $1,000,000. Reduction in inventories = $1,000,000 -

$500,000 = $500,000. This $500,000 is to be used to reduce debt.

New debt level = $4,000,000 - $500,000 = $3,500,000.

Interest on this level of debt = $3,500,000 × 0.1 = $350,000.

Look at the income statement to determine net income:

EBIT $1,400,000
Interest 350,000
EBT $1,050,000
Taxes (40%) 420,000
NI $ 630,000

ROE = Net income/Equity = $630,000/$2,000,000 = 0.3150 or 31.50%.

81. ROE and financing Answer: a Diff: T

The firm is not using its “free” trade credit (that is, accounts payable
(A/P)) to the same extent as other companies. Since it is financing part
of its assets with 10% notes payable, its interest expense is higher than
necessary.
 Calculate the increase in payables:
Current (A/P)/Inventories ratio = $100/$500 = 0.20.
Target A/P = 0.60(Inventories) = 0.60($500) = $300.
Increase in A/P = $300 - $100 = $200.

Since the current ratio and total assets remain constant, total
liabilities and equity must be unchanged. The increase in accounts
payable must be matched by an equal decrease in interest-bearing notes
payable. Notes payable decline by $200. Interest expense decreases by
$200 × 0.10 = $20.
Construct comparative Income Statements:
Old New
Sales $2,000 $2,000
Operating costs 1,843 1,843
EBIT $ 157 $ 157
Interest 37 17
EBT $ 120 $ 140
Taxes (40%) 48 56
Net income (NI) $ 72 $ 84

ROE = NI/Equity = $72/$800 = 9%. $84/$800 = 10.5%.

New ROE = 10.5%.

82. ROE and refinancing Answer: d Diff: T

Relevant information: Old ROE = NI/Equity = 0.06 = 6%.

Sales = $300,000; EBIT = 0.11(Sales) = 0.11($300,000) = $33,000.
Debt = $200,000; D/A = 0.80 = 80%.
Tax rate = 40%.
Interest rate change: Old bonds 14%; new bonds 10%.

Calculate total assets and equity amounts:

Since debt = $200,000, total assets = $200,000/0.80 = $250,000.
Equity = 1 - D/A = 1 - 0.80 = 0.20.
Equity = E/TA × TA = 0.20 × $250,000 = $50,000.

Construct comparative Income Statements from EBIT, and calculate new ROE:
Old New
EBIT $33,000 $33,000
Interest 28,000 20,000
EBT $ 5,000 $13,000
Taxes (40%) 2,000 5,200
Net income $ 3,000 $ 7,800

New ROE = NI/Equity = $7,800/$50,000 = 0.1560 = 15.6%.

83. TIE ratio Answer: d Diff: T

EBIT
TIE = = ?
I
TA Turnover = S/A = 2
S/$10,000 = 2
S = $20,000.

TD
= 0.6;
TA
TD = 0.6($10,000)
Debt = $6,000.

I = $6,000(0.1) = $600.
 NI
PM = = 3%
S
NI
PM = = 0.03
$20,000
NI = $600.

$600
EBT = = $1,000.
(1 - 0.4)

EBIT $1,600
Interest 600
EBT $1,000
Taxes (40%) 400
NI $ 600

TIE = $1,600/$600 = 2.67.

84. Current ratio Answer: e Diff: T

Old DSO = 40; CA = $2,500,000; CA/CL = 1.5; AR = $1,600,000.

Step 1: Calculate average daily sales:

DSO = AR/Average daily sales
40 = $1,600,000/Average daily sales
$40,000 = Average daily sales.

Step 2: Calculate the new level of accounts receivable when DSO = 30:
30 = AR/$40,000
$1,200,000 = AR.
So, the change in receivables will be $1,600,000 – $1,200,000 =
$400,000.

Step 3: Calculate the old level of current liabilities:

Current ratio = CA/CL
1.5 = $2,500,000/CL
$1,666,667 = CL.

Step 4: Calculate the new current ratio:

 The change in receivables will cause a reduction in current assets
of $400,000 and a reduction in current liabilities of $400,000.
CA new = $2,500,000 - $400,000 = $2,100,000.
CL new = $1,666,667 - $400,000 = $1,266,667.
CR new = $2,100,000/$1,266,667 = 1.66.

85. P/E ratio and stock price Answer: b Diff: T

Here are some data on the initial situation:

EPS = $50/20 = $2.50.
Stock price = $2.50(8) = $20.
If XYZ had the industry average inventory turnover, its inventory balance
would be:
Sales $1,000
Turnover = 5 = =
Inv Inv
Inv = $1,000/5 = $200.
Therefore, inventories would decline by $100.
The income statement would remain at the initial level. However, the
company could now repurchase and retire 5 shares of stock:
Funds available $100
= = 5 shares.
Price/share $20

Thus, the new EPS would be:

Net income $50
New EPS = = = $3.33.
Shares outstanding 20 - 5

The new stock price would be:

New price = New EPS(P/E) = $3.33(8) = $26.67.
Stock price increase = $26.67 - $20.00 = $6.67.
86. Du Pont equation and debt ratio Answer: e Diff: T

NI S A
× × = ROE.
S A EQ

Data for A:
NI $1,000 $500
× × = 0.15
$1,000 $500 0.7($500)
NI
= 0.15 = NI = $52.50.
0.7($500)
NI $52.50
∴ROE = = = 0.0525 = 5.25%.
S $1,000

Data for B:
NI S A
× × = 0.30
S A EQ
$500
0.0525 × 2 × = 0.30
EQ
$500
0.1050 × = 0.30
EQ
$500
= 2.8571
EQ
Equity = $175.

Debt = $500 - $175 = $325.

Therefore, D/A = $325/$500 = 0.65 or 65%.

87. Financial statement analysis Answer: a Diff: T

 Sales $15,000
Cost of goods sold _______
EBIT $ 1,065
Interest 465
EBT $ 600
Taxes (35%) 210
NI $ 390

EBIT EBIT
BEP = = = 0.133125; EBIT = $1,065.
TA $8,000

Now fill in: EBIT = $1,065.

Interest = EBIT - EBT = $1,065 - $600 = $465.

D D
= = 0.45; D = 0.45($8,000) = $3,600.
A $8,000
Interest $465
Interest rate = = = 0.1292 = 12.92%.
Debt $3,600

88. EBIT Answer: e Diff: T

Write down equations with given data, then find unknowns:

NI
Profit margin = = 0.06.
S
D D
Debt ratio = = = 0.4; D = $40,000.
A $100,000
S S
TA turnover = = 3.0 = = 3; S = $300,000.
A $100,000

Now plug sales into profit margin ratio to find NI:

NI
= 0.06; NI = $18,000.
$300,000

Now set up an income statement:

Sales $300,000
Cost of goods sold ________
EBIT $ 33,200 (EBIT = EBT + Interest)
Interest 3,200 ($40,000(0.08) = $3,200)
EBT $ 30,000 (EBT = $18,000/(1 - T) = $30,000)
Taxes (40%) 12,000
NI $ 18,000

89. Sales increase needed Answer: b Diff: T N

You need to work backwards through the income statement to solve this
problem.

The new NI will be: ($1,800,000)(1.25) = $2,250,000.

Now find EBT:

(EBT)(1 - T) = NI
EBT = NI/(1 - T)
= $2,250,000/(1 - 0.4)
= $3,750,000.

Now find EBIT:

EBIT - I = EBT
EBIT = EBT + I
 EBIT = $3,750,000 + $1,500,000
= $5,250,000.

Now find Sales:

(Sales)(Operating Margin) = EBIT
Sales = EBIT/Operating Margin
= $5,250,000/0.4
= $13,125,000.

Therefore, sales need to rise to $13,125,000. How much of an increase is

this?

$13,125,000/$12,000,000 = 1.09375. Therefore, sales have gone up by

9.375% (rounded to 9.38%).
90. Debt ratio and Du Pont analysis Answer: c Diff: M N

The Du Pont analysis of return on equity gives us:

ROE = ROA × EM
14% = 10% × EM
1.4 = EM.

From the equity multiplier (A/E), we can calculate the debt ratio:

1.4 = A/E
E/A = 1/1.4
E/A = 0.7143.

D/A = 1 – E/A
D/A = 1 – 0.7143
D/A = 0.2857 = 28.57%.

91. Profit margin and Du Pont analysis Answer: a Diff: E N

Using the Du Pont analysis again, we can calculate the profit margin.

ROE = PM × TATO × EM
14% = PM × 5 × 1.4
14% = PM × 7
2% = PM.

92. ROA Answer: d Diff: M N

ROA = NI/Assets. Total assets = $3,200,000,000 (from the balance sheet).

We, know ROE = NI/Common equity = 0.20, with Common equity = $900,000,000
(from the balance sheet).

0.20 = NI/$900,000,000
NI = $180,000,000.

So, ROA = $180,000,000/$3,200,000,000 = 0.05625, or 5.625%.

93. Current ratio Answer: b Diff: M N

Recall the current ratio is CA/CL = $900,000,000/$800,000,000 = 1.125.

The plan looks like this: Debit Fixed assets $300,000,000

Credit Notes payable $300,000,000

So, current liabilities increase by $300 million, while current assets do

not change.
 So, the new current ratio is $900,000,000/($800,000,000 + $300,000,000) =
$900,000,000/$1,100,000,000 = 0.818.

94. Miscellaneous concepts Answer: e Diff: E N

The correct answer is statement e. The current ratio in 2002 was 1.77, while
the current ratio in 2001 was 1.64. Hence, the current ratio was higher in
2002. The debt ratio was 0.4773 in 2002 and 0.5250 in 2001, so the debt
ratio decreased from 2001 to 2002. The firm issued $300 million in new
common stock in 2002.

95. Net income Answer: b Diff: E N

To determine 2002 net income, use the following equation:

Ending retained earnings = Beginning RE + NI – Dividends paid
$800,000,000 = $700,000,000 + NI – $50,000,000
$150,000,000 = NI.

96. Sales, DSO, and inventory turnover Answer: b Diff: M N

Step 1: One of our initial conditions is that inventory turnover (S/Inv.)

< 6.0, hence:
Sales/Inventory < 6.0
Sales/$850,000,000 < 6.0
Sales < $5,100,000,000.

Step 2: Our second initial condition is that DSO < 50, hence:
AR/(Sales/365) < 50.0
$450,000,000/(Sales/365) < 50.0
[($450,000,000)(365)]/Sales < 50.0
($450,000,000)365 < 50(Sales)
[($450,000,000)(365)]/50 < Sales
Sales > $3,285,000,000.

So, the most likely estimate of the firm’s 2002 sales would fall between
$3,285,000,000 and $5,100,000,000. Only statement b meets this requirement.

97 . Financial statement analysis

Answer: a Diff: E N

The correct answer is statement a. The current ratio in 2002 is 1.02,

while in 2001 it is 0.785. So, statement a is correct. For statement b,
assume that sales are X. The inventory turnover ratio for 2002 is X/
$1,000,000 and X/$700,000 in 2001. So, the inventory turnover ratio for
2001 is higher than in 2002. (If that’s not clear, try X = $500,000 or
any other number.) Thus, statement b is incorrect. The debt ratio in
2002 is 0.596, while in 2001 it’s 0.672, so statement c is incorrect.
98 . Current ratio

Answer: c Diff: M N

Step 1: Determine actual 2002 sales:

DSO = AR/(Sales/365)
40 = $432,000/(Sales/365)
40(Sales)/365 = $432,000
40(Sales) = $157,680,000
Sales = $3,942,000.

Step 2: Determine new accounts receivable balance if DSO = 30 and sales

remain the same:
30 = AR/($3,942,000/365)
30 = AR/$10,800
AR = $324,000.

Step 3: Determine the amount of freed-up cash and the new level of
accounts payable.
Freed-up cash = $432,000 - $324,000 = $108,000.
New AP = $700,000 - $108,000 = $592,000.
Step 4: Determine the new current ratio:
CR = ($100,000 + $324,000 + $1,000,000)/($592,000 + $800,000)
= $1,424,000/$1,392,000
= 1.023.