HHH Inc.

reported $12,500 of sales and $7,025 of operating costs (including

depreciation). The company had $18,750 of investor-supplied operating assets
(or capital), the weighted average cost of that capital (the WACC) was 9.5%,
and the federal-plus-state income tax rate was 40%. What was HHH's Economic
Value Added (EVA), i.e., how much value did management add to stockholders'
wealth during the year?

Solution:
Sales $12,500
Operating costs $7,025
Operating income (EBIT) $5,475
WACC 9.5%
Tax rate 40%
Investor-supplied capital $18,750

EVA = EBIT(1 – T) – Investor Capital  WACC

EVA = $3,285.00 – $1,781.25
EVA = $1,503.75

Wells Water Systems recently reported $8,250 of sales, $4,500 of operating

costs other than depreciation, and $950 of depreciation. The company’s
federal-plus-state income tax rate was 35%. In order to sustain its
operations and thus generate sales and cash flows in the future, the firm
was required to spend $750 to buy new fixed assets and to invest $250 in net
operating working capital. How much free cash flow did Wells generate?

Solution:

Tax rate 35%

Required addition to net operating working capital $250.00
Required capital expenditures (fixed assets) $750.00

Sales $8,250.00
Operating costs excluding depr'n $4,500.00
Depreciation $950.00
Operating income (EBIT) $2,800.00

FCF = EBIT(1 – T) + Depr'n – Cap Ex – Δ Net Op WC

FCF = $1,820 + $950 – $750 – $250
FCF = $1,770.00
A new firm is developing its business plan. It will require $565,000 of
assets, and it projects $452,800 of sales and $354,300 of operating costs for
the first year. Management is quite sure of these numbers because of
contracts with its customers and suppliers. It can borrow at a rate of 7.5%,
but the bank requires it to have a TIE of at least 4.0, and if the TIE falls
below this level the bank will call in the loan and the firm will go
bankrupt. What is the maximum debt ratio the firm can use?

Solution:

Sales $452,800
Operating costs 354,300
Operating income (EBIT) $ 98,500

TIE =EBIT/Interest 4.00

Maximum interest expense = EBIT/TIE $24,625

Interest rate 7.50%

Max. debt = Max interest/Interest rate $328,333

Assets $565,000 (Given)

Maximum debt ratio = Debt/Assets 58.11%

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

Solution:
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.

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)?

Solution:
Equity Ratio: (1 - D/A)= (1 - 0.4)= 0.6
Equity multiplier = 1/Equity Ratio = 1/0.6 = 1.67.
ROE = ROA  Equity multiplier
18% = (ROA)(1.67)
ROA = 10.8%.
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?

Solution:

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.

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.

We can increase current liabilities $1 million before the current ratio

reaches 1.5.

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.

Solution:
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.
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.

Solution:

DSO = A/R/ Sales per day

(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%.

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?

Solution:

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.

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.

Solution:

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.

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?

Solution:
Write down equations with given data, then find unknowns:
NI
Profit margin = S = 0.06.
D D
Debt ratio = A = $100,000 = 0.4; D = $40,000.
S S
TA turnover = A = 3.0 = $100,000 = 3; S = $300,000.

Now plug sales into profit margin ratio to find NI:

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

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

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?

Solution:
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.
Complete the balance sheet and sales information in the table that follows for Isberg Industries using the
following financial data:
Debt ratio: 50%
Quick ratio: 0.80X
Total assets turnover: 1.5X
Days sales outstanding: 36.5 days
Gross profit margin on sales: (Sales - Cost of goods sold)/Sales = 25%
Inventory turnover ratio: 5.0X

Solution:

(1) Total liabilities and equity = Total assets = $300,000.

(2) Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

(3) Accounts payable = Debt ─ Longterm debt = $150,000 ─ $60,000 = $90,000.

(4) Common stock = Total liabilities and equity – Debt – Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500

(5) Sales = 1.5 x Total assets = 1.5 x $300,000 = $450,000

(6) Cost of goods sold = Sales(1 - 0.25) = $450,000(.75) = $337,500

(7) Inventory = (CGS)/5 = $337,500/5 = $67,500.

(8) Accounts receivable = (Sales/360)(DSO) = ($450,000/360)(36) = $45,000.

(9) (Cash + Accounts receivable)/(Accounts payable) = 0.80x

Cash + Accounts receivable = (0.80)(Accts payable)
Cash + $45,000 =(0.80)($90,000)
Cash = $72,000 ─ $45,000 = $27,000.

(10) Fixed assets = Total assets ─ (Cash + Accts Rec. + Inventories)

= $300,000 ─ ($27,000 + $45,000 + $67,500) = $160,500.