3.1. Which of the following statements is FALSE?

A. Financial ratios help compare over time companies of different sizes and industries, and
since not all sources calculate them the same way, managers should understand how they
are derived.
B. Asset utilization ratios describe how efficiently, or intensively, a firm uses its assets to
generate sales.
C. To a firms creditors, particularly short-term creditors such as suppliers, the higher the
current ratio is, the better.
D. Higher margin, turnover, leverage, and dividends all generally allow a firm to grow faster
over the long run.

3.2. Which of the following statements is FALSE?

A. The book value of equity rarely equals the market value of equity except when the
market-to-book ratio is 1.0.
B. The book value of equity is the residual difference between assets and liabilities.
C. The book value of equity increases when a company pays dividends.
D. The ultimate goal of financial managers is to maximize the current market value of the
companys existing equity.

3.C4. Which of the following statements is FALSE?

A. The current ratio provides a measure of the short-term solvency of the firm.
B. Price-earnings ratio reflects the book value per share per dollar of accounting earnings for
a firm.
C. Total asset turnover measures how much in sales is generated by each dollar of firm
assets.
D. Times interest earned, also known as the interest coverage ratio, provides a relative
measure of how well the firms operating earnings can cover current interest obligations.
3.KMC27. Suppose Miller Inc. is able somehow to reduce its fixed assets without affecting
the companys operations, sales, net income, or equity. This reduction will decrease which of the
following ratios?
A. Capital intensity ratio
B. Return on assets
C. Total asset turnover
D. Return on equity

3.HWQ3.F13. New Century Products is a company that was founded last year. While the outlook
for the company is positive, it currently has negative earnings. If you wanted to measure the
progress of this firm, which one of the following ratios would probably be best to monitor given
the firm's current situation?
A. Price-sales ratio
B. Market-to-book ratio
C. Profit margin

D. ROE
3.F12. Which of the following statements is FALSE?
A. Market capitalization is the number of shares outstanding times the market price.
B. A company with a .05x interest coverage ratio would be at less risk of missing payments
on interest than a company with a 4.9x interest coverage ratio.
C. The DuPont Identity is an expression that breaks the return on equity into three parts that
measure operating efficiency, asset use efficiency, and financial leverage.
D. Sometimes book equity can become negative, and when that happens, positive ROE is
not a good sign.

3.Hwk9. Which of the following will increase the sustainable rate of growth for a firm?
A. Decreasing the profit margin
B. Increasing the dividend payout ratio
C. Decreasing the asset turnover
D. Increasing the target debt-equity ratio

3.F15.23. Which one of the following statements is true concerning the price-earnings (PE) ratio?
A. A high PE ratio typically indicates that a firm is expected to grow significantly.
B. A PE ratio of 16 indicates that investors are willing to pay $1 for every $16 of current earnings.
C. PE ratios are unaffected by the accounting methods employed by a firm.

D. The PE ratio is classified as a profitability ratio.

Q3. (16 points) Using the 2010 data only, calculate the ROE and three components of its DuPont
decomposition. Briefly describe, discuss, or interpret each of these 4 in a short sentence or phrase
(merely restating the definition of each is not sufficient).

ROE = Net Income / Book Equity = 65 / 1080 = 6.0% measures overall profitability to owners.
Profit Margin = NI / Sales = 65 / 500 = 13% measures cost control in generating sales.
Asset Turnover = Sales / Assets = 500 / 1710 = 29.2% measures asset use efficiency.
Equity Multiplier = Assets / Book Equity = 1710 / 1080 = 1.583
or 1 + Leverage Ratio = 1 + (Total Liabs / Book Equity) = 1 + ((210+420) / 1080) = 1.583
This measures how the capital is levered, which can indicate long-term solvency problems if it is
particularly high.
Ch3.P13. (15 points) Based on the information below, calculate the sustainable growth rate for
Southern Lights Co. Briefly discuss whether you believe this growth rate is actually sustainable.
Profit Margin = 8.4%
Capital Intensity Ratio = 0.45
Leverage Ratio = Liabilities / Equity = 0.60 (described in the RWJ text as the Debt-Equity Ratio)
Net Income = $95,000
Dividends = $40,000

Asset Turnover = 1 / Capital Intensity Ratio = 1 / 0.45 = 2.22

Equity Multiplier = 1 + Leverage Ratio = 1.60
ROE = Profit Margin * Asset Turnover * Equity Multiplier = (0.084)(1/0.45)(1+0.60) = 29.9%
b = Plowback Ratio = (Net Income Dividends) / Net Income = (95,000 40,000) / 95,000 =
0.58
or b = 1 Payout Ratio = 1 Dividends/Net Income = 1 (40,000/95,000) = 0.58

Sustainable growth rate = [ROE*b] / [1 ROE*b] = [0.299(0.58)] / [1 0.299(0.58)] = 20.9%

Surely, 20.9% growth rate is not sustainable in the long run. The reason why that is unbelievably
high is likely because the current 29.9% ROE is exceptional and not likely to continue forever.
Ch3. (12 points) The following data are from the most recent market sources and annual
financial statements for M Co. and N Co.

a) Calculate the Market-to-Book ratio for each company. Briefly translate it or describe in words
what it means.

Book Value per Share = Book Equity / n = $7,425.0m/222.8m = $33.33for M Co.

and = $3,094.2m/342.0m = $9.05 for N Co.
Market-to-Book = P / Book Value per Share = 42.44 / (7,425.0/222.8) = 1.3x for M Co.
[Or Market-to-Book = Market Cap / Book Equity = ($42.44*222.8m) / $7,425.0m = 1.3x for M
Co.]
Market-to-Book = $56.78 / ($3,094.2m/342.0m) = ($56.78*342.0m) / $3,094.2m = 6.3x for N
Co.

Investors value M Co.s equity 1.3 times its book value. Investors are willing to pay 6.3 times N
Co.s book value based on the historical cost of the difference between its assets and liabilities.

b) Calculate the Price-to-Earnings multiple for each company. Briefly translate it or describe in
words what it means.

EPS = Net Income / n = $722.4m/222.8m = $3.24 for M Co.

= $312.8m/342.0m = $0.91 for N Co.
PE = P / EPS = $42.44 / ($722.4m/222.8m) = 13.1x for M Co.
= $56.78 / ($312.8m/342.0m) = 62.1x for N Co.
Or PE = Market Cap / Net Income = ($42.44*222.8m) / $722.4m = 13.1x for M Co.
= ($56.78*342.0m) / $312.8m = 62.1x for N Co.

Investors value M Co.s shares at 13.1 times its earnings. Investors are willing to pay 62.1 times
their proportionate ownership in N Co.s net income.

c) If these ratios are typical for M and N, which one would investment analysts more likely
categorize as a growth company, and which one as a value company? Briefly discuss.

Value companies typically have low Market-to-Book ratios and low PE multiples, like M Co.
Investors place a high price on growth companies, when compared to their current earnings or
existing book values, believing that these have high future growth prospects, like N Co.
Q3. (14 points) This firm has 20 million shares outstanding, which are priced on Nasdaq today
(in 2013) at $37 per share. Using the 2013 data only, calculate its (a) current ratio, (b) price-to-
earnings ratio, and (c) internal growth rate (assuming it never borrows more). Briefly describe or
discuss each.

Current Ratio = Current Assets / Current Liabilities

= $194m/$319m = .608x or 60.8%
Given that Current Assets are below Current Liabilities by a significant amount, red flags are
raised about this companys short-term solvency: receipts within the next year could be smaller
than anticipated payments in the next year. Yet this company has positive EBIT and has been
able to reduce its debt from 2012 to 2013, suggesting that it might have a strong ability to borrow
more if needed.

EPS = NI / n = $13m / 20m = $0.65 per share

P/E = $37 / $0.65 = 56.9x
Given that the historical average PE ratio for the S&P500 is about 17x, this ratio is extremely
high and typically indicates a company with high growth prospects. Despite the observation that
is assets have declined in 2013, investors might be willing to pay more per dollar of earnings if
those earnings are expected to grow substantially in the future. Or perhaps 2013 was a bad year
for its earnings, and this companys performance is expected to recover.

Profit Margin = NI / Sales = 13 / 842 = 1.54% measures cost control in generating sales.
Asset Turnover = Sales / Assets = 842 / 636 = 1.32x measures asset use efficiency.
ROA = Net Income / Assets = 13 / 636 = 2.04% measures overall profitability to assets, not
owners.
ROA = Profit Margin * Asset Turnover = 1.54% * 1.32x = 2.04%
That seems a bit low, but could be simply due to the current years data, as distinct from long-run
possibilities.

Plowback ratio b = 1 Payout Ratio = 1 Dividends/Net Income = 1 (2/13) = 84.6%

Internal growth rate = [ROA*b] / [1 ROA*b] = [.0204(0.846)] / [1 0.0204(0.846)] = 1.76%
Growth at a 1.76% rate is sustainable in the long run. Yet that is not consistent with the large PE
multiple: the market price indicates that this companys growth is substantially higher than
average.

3.T98.b. (6 points) A firm has adopted a policy whereby it will not seek any additional external
financing. Given this, what is the maximum growth rate for the firm if it has net income of
$12,100, total equity of $94,000, total assets of $156,000, and a 60 percent dividend payout
ratio?

Without additional financing, the firms growth is limited to its internal growth rate, assuming
the Return on Assets and Retention Ratio are constant over time.
ROA = $12,100 / $156,000 = 7.76%
Retention Ratio or plowback = 1 Dividend Payout Ratio = 1 .60 = .40 or 40%
Internal growth rate = .0776 * .40 / (1 - [.0776 * .40]) = 3.20%

Ch2&3.81. (20 points) Just this past year, the KC Bakeries had depreciation expense of $89m,
taxes paid of $216m, and an operating cash flow of $785m. A partial listing of its balance sheet
accounts is as follows:
Beginning Balance Ending Balance
Current Assets $1,417m $1,385m
Net Fixed Assets $6,878m $7,034m
Current Liabilities $873m $915m
Long-Term Debt $2,670m $2,480m
a) What was its Free Cash Flow? Discuss it and its components.

The firms existing assets generated $785m in operating cash flow last year.

CapEx = NFA + Depreciation = (7,034 6,878) + 89 = +$245m

The firm invested $245m in additional fixed assets during 2013, which was $156m above and
beyond its depreciation.

NWA = CA CL = (1,385 1,417) (915 873) = $74m

The firm recovered $74m in net working capital, since its current assets actually fell, while its
current liabilities climbed, and both reduced the cash that the firm required for operations.
Combined, the firms operating investments in capital expenditures and net working capital
totaled 245 + (74) = $171m.

FCF = OCF (CapEx + NWA) = 785 171 = +$614m

The firms operating cash flow from existing assets exceeded its in operating investments in
additional assets by $614m, which is the amount available to be paid to investors.

b) How did this companys Current Ratio change over the year? Discuss one type of stakeholder
which might be particularly interested this change, and whether they are relieved or concerned?

Beginning Ending
Current Ratio = CA/CL 1,417/873 = 1.62x 1,385/915 = 1.51x

Reductions in the Current Ratio mean improved operating capital usage, creating higher Free
Cash Flows, to the advantage of residual claimants like equity.
Other stakeholders with higher priority may be concerned by this drop in the Current Ratio: the
companys short-term solvency has been reduced, and customers with warranties, wage earners,
suppliers, and short-term lenders may become increasingly concerned.

Q3.F15.100. (8 points) Chess Pawns has a market-to-book ratio of 3.2x, a total asset turnover
ratio of 1.2x, a profit margin of 5%, a target retention ratio of 80%, total assets of $120,000, and
an equity multiplier of 1.4x.
a) What is its sustainable growth rate?

ROE = 5% * 1.2x * 1.4x = 8.4%

Sustainable growth rate = [.084 * .80] / [1 (.084 * .80)] = .072 or 7.2%

b) Could Chess Pawns change its dividend payout policy to achieve a sustainable growth rate of
10%? Explain why or why not?

The least that can be paid out of net income is 0% dividends, and thus retain the maximum
100%.
With that, the sustainable growth rate = [.084 * 1.00] / [ 1 (.084 * 1.00)] = .092 or 9.2%
Or note that the implied retention ratio to reach 10% growth is
b = g / [ROE * (1 + g)] = .10 / [.084 * (1+.10)] = 108% which is not feasible.
So, it is not possible for Chess Pawns to reach 10% growth by simply changing its dividend
policy.
To get to 10% growth, some combination of the following would be required:
Less dividends and, thus, higher retention
Raising cash through additional equity, such as issuing more shares
Higher profit margin
Improved asset turnover
Increased leverage