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Chapter 2 - Assignment 03 Solution

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27 views

Chapter 2 - Assignment 03 Solution

Uploaded by

hikari.5e4
Copyright
© © All Rights Reserved
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Assignment -3

Problem#1

Wolken Corporation has $500,000 of debt outstanding, and it pays an interest rate of 10 percent
annually. Wolken’s annual sales are $2 million, its average tax rate is 20 percent, and its net profit margin
is 5 percent. If the company does not maintain a TIE ratio of at least 5, its bank will refuse to renew the
loan, and bankruptcy will result. What is Wolken’s TIE ratio?

Solution:
TIE = EBIT/INT, so find EBIT and INT

Interest = $500,000 x 0.1 = $50,000

Net income = $2,000,000 x 0.05 = $100,000

Taxable income (EBT) = $100,000/(1 - T) = $100,000/0.8 = $125,000

EBIT = $125,000 + $50,000 = $175,000

TIE = $175,000/$50,000 = 3.5 x

Problem#2
Coastal Packaging’s ROE last year was only 3 percent, but its management has developed a new
operating plan designed to improve things. The new plan calls for a total debt ratio of 60 percent, which
will result in interest charges of $300 per year. Management projects an EBIT of $1,000 on sales of
$10,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the average
tax rate will be 30 percent. If the changes are made, what return on equity (ROE) will Coastal earn?
What is the ROA?

Solution:
ROE = NI/Equity
Now we need to determine the inputs for the equation from the data that were given. On the left we set up
an income statement, and we put numbers in it on the right:
Sales (given) $10,000
- Cost na
EBIT (given) $ 1,000
- INT (given) ( 300)
EBT $ 700
- Taxes (30%) ( 210)
NI $ 490

Now we can use some ratios to get some more data:


Total assets turnover = 2.0 = Sales/TA; TA = Sales/2 = $10,000/2 = $5,000

Debt/TA = 60%; so Equity/TA = 40%; therefore, Equity = TA x Equity/TA


= $5,000 x 0.40 = $2,000

Alternatively, Debt = TA x Debt/TA = $5,000 x 0.6 = $3,000; Equity = TA – Debt = $5,000 - $3,000 =
$2,000
ROE = NI/E = $490/$2,000 = 24.5%, and ROA = NI/TA = $490/$5,000 = 9.8%
Problem#3

Star Lakes, Inc., has a total debt ratio of .29. What is its debt–equity ratio? What is its equity
multiplier?

Total debt ratio = 0.29 = TD / TA


So, equity ratio = 1- debt ratio

Solving this equation yields:


ER = 1- 0,29 = 0.71
Debt/equity ratio = DR / ER = 0.29 / 0.71 = 0.41

Equity multiplier = 1 + D/E = 1.41

Problem#4
Assume you are given the following relationships for Zumwalt Corporation:

Calculate Zumwalt’s net profit margin and debt ratio.

We are given ROA = 3% and Sales/Total assets = 1.5x

From DuPont equation: ROA = Profit margin x Total assets turnover


3% = Profit margin (1.5)
Profit margin = 3%/1.5 = 2%.

We can also calculate Zumwalt’s debt ratio in a similar manner, given the facts of the problem.
We are given ROA, which is NI/A and ROE, which is NI/Equity; if we use the reciprocal of
ROE we have the following equation:

Equity NI Equity 1
=  = 3.0%  = 0.60 = 60%
A ssets A ssets NI 0.05

Debt/Assets = 1 - Equity/Assets = 1 - 0.60 = 0.40 = 40.0%

Thus, Zumwalt's profit margin = 2% and its debt ratio = 40%.


Problem#5
Solution: (For calculation look at the attached excel file)

a. Here are Cary's base case ratios and other data as compared to the industry:

Cary Industry Comment


Quick 0.85x 1.0x Weak
Current 2.33x 2.7x Weak
Inventory turnover 4.0x 5.8x Poor
Days sales outstanding 36.8 days 32.0 days Poor
Fixed assets turnover 10.0x 13.0x Poor
Total assets turnover 2.3x 2.6x Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1% 18.2% Bad
Debt ratio 54.8% 50.0% High
Profit margin on sales 2.5% 3.5% Bad
EPS $4.71 n.a.
Stock Price $23.57 n.a.
P/E ratio 5.0x 6.0x Poor
M/B ratio 0.65 n.a.

Cary appears to be poorly managed—all of its ratios are worse than the industry averages, and the
result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The company needs to do
something to improve.

b. A decrease in the inventory level would improve the inventory turnover, total assets turnover, and
ROA, all of which are too low. It would have some impact on the current ratio, but it is difficult to
say precisely how that ratio would be affected. If the lower inventory level allowed Cary to reduce
its current liabilities, then the current ratio would improve. The lower cost of goods sold would
improve all of the profitability ratios and, if dividends were not increased, would lower the debt
ratio through increased retained earnings. All of this should lead to a higher market/book ratio and
a higher stock price.

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