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Bodie10ce SM CH19
Bodie10ce SM CH19
PROBLEM SETS
1. a.
d.
e.
f.
g.
i.
j.
k.
3. Earnings management should not matter in a truly efficient market, where all
publicly available information is reflected in the price of a share of stock. Investors
can see through attempts to manage earnings so that they can determine a
company’s true profitability and, hence, the intrinsic value of a share of stock.
However, if firms do engage in earnings management, then the clear implication is
that managers do not view financial markets as efficient.
4. Both credit rating agencies and stock market analysts are likely to be interested in
all of the ratios discussed in this chapter (as well as many other ratios and forms of
analysis). Since the Moody’s and Standard and Poor’s ratings assess bond default
risk, these agencies are most interested in leverage ratios. A stock market analyst
would be most interested in profitability and market price ratios.
Bodie et al. Investments 10th Canadian Edition Solutions Manual
© 2022 McGraw-Hill Ryerson Ltd.
19-2
5. ROA = ROS ATO
The only way that Crusty Pie can have an ROS (return on sales) higher than the
industry average and an ROA equal to the industry average is for its ATO to be
lower than the industry average.
7.
ROEA > ROEB
Firms A and B have the same ROA. Assuming the same tax rate and assuming
that ROA > interest rate, then Firm A must have either a lower interest rate or a
higher debt ratio.
8.
= Net profit margin Asset turnover Leverage ratio
= 5.5% 2.0 2.2 = 24.2%
b. Lower bad debt expense will have no effect on operating cash flow until
Galaxy actually collects receivables.
10. A. Certain GAAP rules can be exploited by companies to achieve specific goals,
while remaining within the letter of the law. Aggressive assumptions, such as
lengthening the depreciable life of an asset (which are utilized to boost earnings)
result in a lower quality of earnings.
13.
14.
15.
a. Cash flows from investing activities
Sale of old equipment $72,000
Purchase of bus (33,000)
Net cash provided by investing activities 39,000
16. a. The total capital of the firms must first be calculated by adding their respective
debt and equity together. The total capital for Acme is 100 + 50 = 150, and the total
capital for Apex is 450 + 150 = 600. The economic value added will be the spread
between the ROC and cost of capital multiplied by the total capital of the firm. Acme’s
EVA thus equals (17% − 9%) × 150 = 12 (million). Apex’s EVA equals (15% − 10%) ×
Bodie et al. Investments 10th Canadian Edition Solutions Manual
© 2022 McGraw-Hill Ryerson Ltd.
19-4
600 = 30 (mil). Notice that even though Apex’s spread is smaller, their larger capital
stock allows them more economic value added.
b. However, since Apex has a larger capital stock, it’s EVA per dollar invested in
capital is smaller at 30/600 = .05 compared to Acme’s 12/150 = .08
CFA PROBLEMS
For 2021:
4. a. QuickBrush has had higher sales and earnings growth (per share) than
SmileWhite. Margins are also higher. But this does not mean that QuickBrush
is necessarily a better investment. SmileWhite has a higher ROE, which has
been stable, while QuickBrush’s ROE has been declining. We can see the
source of the difference in ROE using DuPont analysis:
Component Definition QuickBrush SmileWhite
Tax burden (1 – t) Net profits/pretax profits 67.4% 66.0%
Interest burden Pretax profits/EBIT 1.000 0.955
Profit margin EBIT/Sales 8.5% 6.5%
Asset turnover Sales/Assets 1.42 3.55
Leverage Assets/Equity 1.47 1.48
ROE Net profits/Equity 12.0% 21.4%
While tax burden, interest burden, and leverage are similar, profit margin and
asset turnover differ. Although SmileWhite has a lower profit margin, it has a
far higher asset turnover.
b. QuickBrush’s recent EPS growth has been achieved by increasing book value
per share, not by achieving greater profits per dollar of equity. A firm can
increase EPS even if ROE is declining as is true of QuickBrush. QuickBrush’s
book value per share has more than doubled in the last two years.
Book value per share can increase either by retaining earnings or by issuing new
stock at a market price greater than book value. QuickBrush has been retaining
b. The differences in the components of ROE for Eastover and Southampton are:
Profit margin EO has a higher margin.
Interest burden EO has a higher interest burden because its pretax profits are
a lower percentage of EBIT.
Asset turnover EO is more efficient at turning over its assets.
Leverage EO has higher financial leverage.
Tax burden No major difference here between the two companies ROE.
EO has a higher ROE than SHC, but this is only in part due
to higher margins and a better asset turnover. Greater
financial leverage also plays a part.
c. The sustainable growth rate can be calculated as ROE times plowback ratio.
The sustainable growth rates for Eastover and Southampton are as follows:
Plowback Sustainable
ROE Ratio* Growth Rate
Eastover 10.2% 0.36 3.7%
Southampton 7.8 0.58 4.5
*Plowback = (1 – Payout ratio)
EO: Plowback = (1 – 0.64) = 0.36
SHC: Plowback = (1 – 0.42) = 0.58
For Eastover:
This compares with the current stock price of $28. On this basis, it appears
that Eastover is undervalued.
b. The formula for the two-stage discounted dividend model is
This approach makes Eastover appear even more undervalued than was the
case using the constant growth approach.
b. Disadvantages of the relative P/E model include: (1) the relative P/E measures
only relative, rather than absolute, value; (2) the accounting earnings estimate
for the next year may not equal sustainable earnings; (3) accounting practices
may not be standardized; (4) changing accounting standards may make
historical comparisons difficult.
Disadvantages of the relative P/B model include: (1) book value may be
understated or overstated, particularly for a company like Eastover, which has
valuable assets on its books carried at low historical cost; (2) book value may
not be representative of earning power or future growth potential; (3) changing
accounting standards make historical comparisons difficult.
8. The following table summarizes the valuation and ROE for Eastover and Southampton:
Eastover Southampton
Stock price $28.00 $48.00
Constant-growth model $43.20 $29.00
2-stage growth model $48.03 $35.50
Current P/E 17.50 16.00
9. a. Net income can increase even while cash flow from operations decreases. This
can occur if there is a buildup in net working capital—for example, increases
in accounts receivable or inventories, or reductions in accounts payable.
Lower depreciation expense will also increase net income but can reduce cash
flow through the impact on taxes owed.
10. $1,200
Cash flow from operations = Sales – Cash expenses – Increase in A/R
Ignore depreciation because it is a noncash item and its impact on taxes is already
accounted for.
11. Both current assets and current liabilities will decrease by equal amounts. But this is
a larger percentage decrease for current liabilities because the initial current ratio is
above 1.0. So the current ratio increases. Total assets are lower, so turnover
increases.
12. Considering the components of after-tax ROE, there are several possible explanations
for a stable after-tax ROE despite declining operating income:
1. Declining operating income could have been offset by an increase in nonoperating
income (i.e., from discontinued operations, extraordinary gains, gains from changes in
accounting policies) because both are components of profit margin (net income/sales).
2. Another offset to declining operating income could have been declining interest rates
on any interest rate obligations, which would have decreased interest expense while
allowing pretax margins to remain stable.
3. Leverage could have increased as a result of a decline in equity from: (a) writing
down an equity investment; (b) stock repurchases, (c) losses; or (d) selling new debt.
The effect of the increased leverage could have offset a decline in operating income.
4. An increase in asset turnover could also offset a decline in operating income. Asset
turnover could increase as a result of a sales growth rate that exceeds the asset growth
rate, or from the sale or write-off of assets.
5. If the effective tax rate declined, the resulting increase in earnings after tax could
offset a decline in operating income. The decline in effective tax rates could result
from increased tax credits, the use of tax loss carry-forwards, or a decline in the
statutory tax rate.
b. Asset turnover measures the ability of a company to minimize the level of assets
(current or fixed) to support its level of sales. The asset turnover increased
substantially over the period, thus contributing to an increase in the ROE.
Financial leverage measures the amount of financing other than equity, including
short- and long-term debt. Financial leverage declined over the period, thus
adversely affecting the ROE. Since asset turnover rose substantially more than
financial leverage declined, the net effect was an increase in ROE.