Here is a simplified balance sheet for Locust Farming: Locust Farming Balance Sheet ($ in millions) Current assets Long-term assets Total $ 42,524 46,832 $ 89,356 Current liabilities Long-term debt Other liabilities Equity Total $ 29,755 27,752 14,317 17,532 $ 89,356 Locust has 657 million shares outstanding with a market price of $83 a share. a. Calculate the company’s market value added. Market value = 657 million × $83 = $54,531 million Market value added = $54,531 – $17,532 = $36,999 million b. Calculate the market-to-book ratio. Market value / Book value = $54,531 / $17,532 = 3.11 c. How much value has the company created for its shareholders? Yes. The company has increased the value of the equity investment by 311%. Home Depot’s common stock closed fiscal 2014 at a price of $114.75 per share. There were 1,307 million shares outstanding, At the end of 2014, the book value of Home Depot’s equity was $9,322 million. Suppose the broad stock market falls 20% in a year and Home Depot’s stock price falls by 10%. c. Calculate the market value added, if the stock market were unchanged and Home Depot’s stock fell by 10%. Market value = 1,307 million × $114.75 = $149,978 million The market value added for Home Depot = $149,978 − $9,322 = $140,656 million Assuming the stock price drops 10%, the market value is now $149,978 × .90 = $134,980 Market value added = $134,980 – $9,322 = $125,658 Here are simplified financial statements for Watervan Corporation: INCOME STATEMENT (Figures in $ millions) Net sales Cost of goods sold Depreciation Earnings before interest and taxes (EBIT) Interest expense Income before tax Taxes Net income $ 881 741 31 $ 109 12 $ 97 34 $ 63 BALANCE SHEET (Figures in $ millions) Assets Current assets End of Year Start of Year $ 369 $ 312 Long-term assets Total assets Liabilities and shareholders’ equity Current liabilities Long-term debt Shareholders’ equity Total liabilities and shareholders’ equity 258 $ 627 222 $ 534 $ 194 108 325 $ 157 121 256 $ 627 $ 534 The company’s cost of capital is 8.5%. a. Calculate Watervan’s economic value added (EVA). Economic value added = After-tax interest + Net income – (Cost of capital × Total capitalization) Economic value added = (1 – .35) × $12 + 63 – (.085 × [$256 + 121]) = $38.75 b. What is the company’s return on capital? (Use start-of-year rather than average capital.) (1 – .35) × $12 + 63 Return on capital = = .1878, or 18.78% $256 + 121 c. What is its return on equity? (Use start-of-year rather than average equity.) $63 Return on equity = = .2461, or 24.61% $256 d. Is the company creating value for its shareholders? Yes. The EVA indicates the firm is producing value in excess of the cost of capital. Thus, it is producing value. The ROC and ROE are also consistent with this conclusion. Home Depot entered fiscal 2014 with a total capitalization of $27,213 million. In 2014, debt investors received interest income of $830 million. Net income to shareholders was $6,345 million. (Assume a tax rate of 35%.) Calculate the economic value added assuming its cost of capital is 10%. Economic value added = After-tax interest + Net income – (Cost of capital × Total capitalization) Economic value added = (1 – .35) × $830 + 6,345 − (.10 × $27,213) = $4,163.20 Here are simplified financial statements for Phone Corporation in a recent year: INCOME STATEMENT (Figures in $ millions) Net sales Cost of goods sold Other expenses Depreciation Earnings before interest and taxes (EBIT) Interest expense Income before tax Taxes (at 35%) Net income Dividends BALANCE SHEET (Figures in $ millions) $ 13,193 4,060 4,049 2,518 $ 2,566 685 $ 1,881 658 $ 1,223 $ 856 Assets Cash and marketable securities Receivables Inventories Other current assets Total current assets Net property, plant, and equipment Other long-term assets Total assets Liabilities and shareholders’ equity Payables Short-term debt Other current liabilities Total current liabilities Long-term debt and leases Other long-term liabilities Shareholders’ equity Total liabilities and shareholders’ equity End of Year Start of Year $89 2,382 187 867 $3,525 $ 158 2,490 238 932 $ 3,818 19,973 19,915 4,216 3,770 $27,714 $27,503 $2,564 1,419 811 $4,794 7,018 6,178 9,724 $ 3,040 1,573 787 $ 5,400 6,833 6,149 9,121 $27,714 $27,503 a. $1,223 ($9,724 + 9,121) / 2 Return on equity = = .1298, or 12.98% b. Return on assets = $1,223 + 685 × (1 – .35) ($27,714 + 27,503) / 2 = .0604, or 6.04% c. Return on capital = $1,223 + 685 × (1 – .35) [($7,018 + 9,724) + ($6,833 + 9,121)] / 2 = .1020, or 10.20% d. Days in inventory = $238 $4,060 / 365 = 21.40 days e. Inventory turnover = $4,060 238 = 17.06 f. Average collection period = $2,490 $13,193 / 365 = 68.89 days g. Operating profit margin = $1,223 + 685 × (1 – .35) $13,193 = .1264, or 12.64% h. Long-term debt ratio = $7,018 $7,018 + 9,724 = .42 i. Total debt ratio = $4,794 + 7,018 + 6,178 $27,714 = .65 j. Times interest earned = $2,566 $685 = 3.75 k. $2,566 + 2,518 $685 Cash coverage ratio = = 7.42 l. $3,525 $4,794 Current ratio = = .74 m. $89 + 2,382 $4,794 Quick ratio = = .52 Consider this simplified balance sheet for Geomorph Trading: Current assets Long-term assets 10 $ 0 50 0 Current liabilities Long-term debt Other liabilities Equity 60 $ 0 $60 28 0 70 19 0 60 $ 0 a. Debt / Equity = $410 / $190 = 2.16 b. Total long-term debt / Total long-term capital = $280 / ($280 + 190) = .60 c. Net working capital = $100 – 60 = $40 d. Current ratio = $100 / $60 = 1.67 Chik’s Chickens has accounts receivable of $6,333. Sales for the year were $9,800. What is its average collection period? Average collection period equals average receivables divided by average daily sales: $6,333 Average collection period = = 235.87 days Salad Daze maintains an inventory of produce worth $400. Its total bill for produce over the course of the year was $73,000. How old on average is the lettuce it serves its customers? $400 Days sales in inventories = = 2 days $73,000 / 365 In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with book value of $1 million on which it pays an interest rate of 8%. What is the firm’s times interest earned ratio? EBIT = Revenues − COGS − Depreciation = $3,000,000 − 2,500,000 − 200,000 = $300,000 Interest = .08 × $1 million = $80,000 Times interest earned = $300,000 / $80,000 = 3.75 Lever Age pays an 8% rate of interest on $10 million of outstanding debt with face value $10 million. The firm’s EBIT was $1 million. a. What is its times interest earned? Interest expense = 0.08 × $10 million = $800,000 Times interest earned = $1,000,000 / $800,000 = 1.25 b. If depreciation is $200,000, what is its cash coverage ratio? $1,000,000 + 200,000 Cash coverage ratio = $800,000 = 1.5 Choose the correct definition for the following financial ratios. a. Long-term debt-equity ratio = Long-term debt / Equity b. Return on equity = Net income / Average equity c. Operating profit margin = (Net income + After-tax interest) / Sales d. Inventory turnover = Cost of goods sold / Inventory at start of year e. Current ratio = Current assets / Current liabilities f. Average collection period = Receivables at start of year / Average daily sales (Cash + Marketable securities + Receivables) / Current liabilities g. Quick ratio = Assume a firm’s inventory level of $10,000 represents 30 days' sales. What is the inventory turnover ratio? Annual cost of goods sold = $10,000 × 365 / 30 = $121,667 $121,667 Inventory turnover = = 12.17 times per year $10,000 The turnover rate can also be calculated as: Inventory turnover = Days in year / Days' sales in inventory = 365 / 30 = 12.17 A firm has a long-term debt-equity ratio of .4. Shareholders’ equity is $1 million. Current assets are $200,000, and the current ratio is 2. The only current liabilities are notes payable. What is the total debt ratio? Long-term debt-equity ratio Long-term debt = = = = Long-term debt / Equity Long-term debt-equity ratio × Equity 0.4 × $1,000,000 $400,000 Current ratio Current liabilities = Current assets / Current liabilities = Current assets / Current ratio = $200,000 / 2 = $100,000 Total liabilities = Current liabilities + Long-term debt = $100,000 + 400,000 = $500,000 Total assets = Total liabilities + Equity = $500,000 + 1,000,000 = $1,500,000 Total debt ratio = Total debt / Total assets = $500,000 / $1,500,000 = 0.33 A firm has a debt-to-equity ratio of .5 and a market-to-book ratio of 2. What is the ratio of the book value of debt to the market value of equity? Book debt / Book equity × [1 / (Market equity / Book equity)] = Book debt / Market equity 0.5 × (1 / 2) = 0.25 Would the following events increase/decrease a firm’s current ratio? a. Inventory is sold. No change b. The firm takes out a bank loan to pay its suppliers. Increase The firm arranges a line of credit with a bank that allows it to borrow at any time to pay its c. suppliers. No change d. A customer pays its overdue bills. No change e. The firm uses cash to buy additional inventory. No change State whether the following statements are true or false. a. A company’s debt-equity ratio is always less than 1. False b. The quick ratio is always less than the current ratio. False c. For a profitable company, the return on equity is always less than the return on assets. False Last year Electric Autos had sales of $100 million and assets at the start of the year of $150 million. If its return on start-ofyear assets was 15%, what was its operating profit margin? Sales ROA = × (Operating profit margin) Assets .15 = $100 million $150 million × (Operating profit margin) Operating profit margin = .2250, or 22.50% Torrid Romance Publishers has total receivables of $3,000, which represents 20 days’ sales. Total assets are $75,000. The firm’s operating profit margin is 5%. Find the firm's ROA and asset turnover ratio. Total sales = $3,000 × 365 / 20 = $54,750 Asset turnover ratio = $54,750 / $75,000 = 0.73 ROA = Asset turnover × Operating profit margin = 0.73 × 0.05 = 0.0365, or 3.65% Keller Cosmetics maintains an operating profit margin of 5% and asset turnover ratio of 3. a. What is its ROA? ROA = Asset turnover × Operating profit margin = 3 × .05 = .1500, or 15% b. If its debt-equity ratio is 1, its interest payments and taxes are each $8,000, and EBIT is $20,000, what is its ROE? If Debt / Equity = 1, then Debt = Equity, so total assets are twice equity. Net income = EBIT – Interest – Taxes = $20,000 – 8,000 – 8,000 = $4,000 Assets Net income ROE = × ROA × Equity After-tax operating income Tax rate = ROE = Taxes EBT 2 × ROA × 1 = $8,000 $20,000 – 8,000 $4,000 $4,000 + 8,000 × (1 – .67) = .6667, or 67% = .1807, or 18%