Chapter 10 HW Solutions

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CHAPTER 10

Analysis of Financing Activities

THINKING BEYOND THE QUESTION

How do we finance our business?

Financial leverage is appropriate when it is likely that a company will beable to meet its principal and interest requirements. A company with sta-ble profits and cash flows usually is in a better position to use a largeamount of financial leverage than a company with volatile profits andcash flows. Companies with predictable revenues and expenses often

use a lot of financial leverage. Examples include regulated utilities thatcan predict revenues, based on approved rate charges, and expensesbased on well defined customer groups and demand. Many manufactur-ing companies also have stable demand for mature products. Expensesare relatively stable because they are linked to stable sales and produc-tion processes. Companies with large amounts of plant assets also areable to borrow large amounts of money because their physical assets canbe used as collateral for the loans.

QUESTIONS

Q10-1 Capital structure is the way a company chooses to finance its assets andoperating activities. A corporations capital structure includes commonstock and retained earnings. In addition, it may include preferred stock,long-term debt, and short-term obligations. Capital structures differbecause the transformation processes of companies differ. Somecompanies require large investments in plant assets. They may borrow tofinance these investments. Capital structures also differ because thefinancial performances of companies vary. Highly profitable companiesoften accumulate large proportions of retained earnings. If they are ableto generate net cash inflows from their operating activities, they may

have little need to borrow money. Companies that cannot generatesufficient cash flows from operating activities often issue long-term debtand preferred stock. Companies with stable revenues and earnings oftencan support relatively more debt in their capital structures than othercompanies. Steady cash flows reduce the chance a company will beunable to service its debt.

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12 Chapter 10

Q10-2 The primary benefit of return on equity is that it allows investors (andothers) to make reliable comparisons across many different companies.Return on equity measures the earning power of each dollar ofstockholders equity. In other words, it measures how hard each dollar ofstockholders equity is working. Computing the number of pennies ofreturn per dollar of equity invested establishes a common denominator

that can be used to make comparisons across many companies ofvarying sizes. Note that earning comparisons across companies ofdifferent sizes cannot be made reliably when net income is used as themeasure. One company may have twice the net income of another, buthave taken four times as much equity investment to generate that profit.Therefore, the investor would be better off owning shares of the companywith the smaller net income.

Q10-3 The most likely situation is that the two firms operate in very differentenvironments and that the choice management has made in each case ismost appropriate to that firm. For example, Company X may operate in a

mature industry where revenues and expenses are highly stable. Growthis steady, but not fast, and demand for the companys product isrelatively immune to changes in economic conditions. Given the stabilitydescribed, the firm would be smart to employ a capital structure heavilydependent on debt. On the other hand, Company Y may be in a morerapidly developing industry where technology changes daily. Innovationmay render yesterdays highly profitable market winner obsolete andunsalable today. Further, the demand for Company Ys products may behighly sensitive to changes in economic conditions. Clearly, Company Yoperates in a riskier environment and would be expected to employ a lowlevel (or no level) of leverage.

Q10-4 Both return on assets and return on equity are measures of companyperformance. Return on equity, however, is more directly related to theinterests of stockholders. Equity is their ownership interest in the firmand it is the return on their ownership that interests them most. While thereturn earned on assets is interesting to stockholders, it doesnt reveal tothem how well (or poorly) their investment is doing. In fact, depending onthe firms use of financial leverage, the return on assets may be a poormeasure of how the stockholders investment is doing. If financialleverage is high, and the company is profitable, the return on assets maygrossly understate the return earned by stockholders on their investment.

Q10-5 The use of financial leverage in the capital structure of a firm causes anadditional liability to arise each period in the form of interest payable.Until it is paid, the interest payable increases current liabilities which, inturn, reduces the current ratio. When the interest payment is made, thecash account is reduced, which reduces current assets. This in turnreduces the current ratio.


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Analysis of Financing Activities 13

Q10-6Holders of common stock have the potential to receive a return oninvestment in two different ways. One way is through dividends, andmany companies pay dividends regularly. The stockholder may alsoreceive a return from increases in the market value of the stock price.This is the case with Tommy Hilfiger, whose investors believe thecompany can invest its profits at a higher rate of return than they could

individually.

Q10-7 With the information given there is no way to determine which company ismore highly leveraged. Financial leverage is based on the relativeamounts of debt employed in the capital structure, not on the absoluteamount. Therefore, the fact that Beta Company has five times the amountof debt as Alpha Company does not mean that it is more highlyleveraged. Instead, one or more ratios should be computed. Among themwould be debt to equity, debt to assets, and assets to equity. In eachcase, larger values indicate a higher degree of financial leverage in use.

Q10-8 The debt to equity ratio is 0.25. Use the balance sheet equation of A = L + Eto solve this question. Note that the only liability is the long-term debt of$20 million. Therefore, if the debt to assets ratio is 0.20, assets must befive times as large as liabilities for a total of $100 (debt to assets = $20 x = 0.20;x = $100). If assets = $100 and liabilities = $20, then equity = $80.Therefore, debt to equity = $20 $80 = 0.25.

Q10-9Financial leverage does not always have a favorable impact. Financialleverage merely magnifies what the underlying financial results were. So,if a company earns a positive return on assets, financial leveragemagnifies that return and benefits the stockholders. On the other hand, if

the return on assets is negative, financial leverage magnifies thisnegative result and makes the return (loss) to stockholders even worse.

Q10-10 Financial leverage magnifies a companys results. If the company isprofitable to begin with, financial leverage increases the degree ofprofitability. If the company is unprofitable, financial leverage magnifiesthat loss. Therefore, the range of possible outcomes is greater and thecompany is riskier. Also, the use of financial leverage requires that acompany take on fixed interest payments that it would not otherwisehave. This increases the risk that a company, in some given year, may notbe able to meet its obligations as they come due. When a companycannot make its interest or principal payments when due, it is oftenforced into bankruptcy. Because of the extra risk, however, the companyhas a greater potential reward. Investors will only take on this extra risk ifthey believe that the potential increased reward is commensurate with theadditional risk.


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Q10-11 Restrictions protect creditors by limiting the amount of new debt acompany can issue and by limiting payments that can be made tostockholders. As the amount of debt in a companys capital structureincreases, the risk of default on principal and interest payments alsoincreases. Also, when cash is paid out as dividends, less cash isavailable for payment of debt. Therefore, restrictions protect creditors by

limiting the amount of debt and cash outflow for payments for purposesother than debt payments.

Q10-12 Issuing debt and equity is not necessarily a sign of poor financialcondition. A high-growth company with excellent opportunities forexpansion of products or markets will often need to raise new capital tofinance those opportunities. Cash flow from operating activities may notbe sufficient to permit a company to take advantage of all its availableopportunities. How a company uses its cash is important. When acompany is unable to produce sufficient cash flow to meet its currentobligations, it may attempt to borrow additional cash. Also, it may sell

existing assets to create cash. This type of company is not growing.Thus, an evaluation of performance should consider the amount of cashflow, changes in cash flow over time, and how the cash flow is beingused.

Q10-13 The amount of dividends a company pays depends partially on itsinvestment opportunities. Companies with good investment opportunitiesare likely to pay lower dividends. They use their cash instead to acquireadditional assets. These companies usually are high-growth companies.More stable companies with fewer investment opportunities often paylarge dividends. Therefore, low dividend payout companies are likely to

be high-value companies that also are risky relative to high payoutcompanies. Care should be used, however, in this analysis becausecompanies with poor cash flows and poor performance also may pay lowamounts of dividends. These companies cannot afford to pay high levelsof dividends. An investor should decide on the amount of risk he or sheis willing to accept and whether the investment is for growth and higherfuture income or for current cash flow. Also, an investor should comparethe amount of the expected dividend relative to the current price of thestock. (This ratio is the dividend yield.)

Q10-14 The market-to-book-value ratio reveals the difference between the cost ofa companys net assets (assets minus liabilities) and the market valueattached to them by the securities market. In a way, this ratio reveals thevalue added by management. If management has deployed thecompanys resources effectively and efficiently in generating profits, themarket will reward that behavior with a high stock price that results in ahigh market-to-book-value ratio. If, on the other hand, management hasmade a series of blunders in acquiring its assets and liabilities, the


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market will offer only a low stock price, which results in a low market-to-book-value ratio. In the case here, investors believe that the decisionsand strategies of Bravo Company have been much better than those ofApplause Company. In essence, the market is willing to pay $3.40 for adollar of Bravos net assets; it is willing to pay only 75 for a dollar ofApplauses net assets. The market wont pay as much for Applauses

assets as management did.

Q10-15 There is not necessarily a relationship between the level of financialleverage used by a company and its market-to-book-value ratio. A high-leverage company might have a high market-to-book-value ratio or a lowone. Similarly, a low-leverage company might have a high market-to-book-value ratio or a low one. One value does not drive the other.Instead, the circumstances and environment of the firm determinewhether it is smart for management to use high or low amounts ofleverage. In stable industries with dependable cash flows, high levels offinancial leverage are appropriate and the securities market would

probably reward such a strategy. Similarly, if the industry is less stableand demand is sensitive to fluctuations in economic conditions, it wouldbe smart to employ less leverage and the securities market wouldprobably look favorably on that decision. If the securities marketbelieved, however, that management had adopted a financial leveragestrategy that did not fit its circumstance, it would likely respondnegatively by assigning a lower stock price (and market-to-book-valueratio) to the firm.

EXERCISES

E10-1 Definitions of all terms are listed in the glossary.

E10-2 a. Increases the equity portion.b. Increases the long-term liability portion.c. No effect on capital structure.d. Increases the short-term liability portion.e. Decreases the equity portion.f. Increases the long-term liability portion.g. Decreases the equity portion and increases the short-term liability

portion.

h. Decreases the short-term liability portion.

E10-3 a. The companys capital structure is comprised of approximately 66%debt and 34% equity. Total debt is $39,100 out of $59,500 of totalcapital ($39,100 $59,500 = 66%). Equity represents $20,400 of the$59,500 of total capital ($20,400 $59,500 = 34%). The debt-to-equityratio is 1.92 to 1 ($39,100 $20,400).


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(continued)


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b. If the company had issued stock instead of bonds, the capitalstructure would be 10% debt and 90% equity. Total debt would be$6,100 out of $59,500 = 10%. Equity would be $53,400 out of $59,500of total capital ($53,400 $59,500 = 90%). The debt-to-equity ratiowould be 0.11 to 1 ($6,100 $53,400).

E10-5 a. The income statement information appears positive. Sales areincreasing each period as is net income. Based on the incomestatement results alone, the company appears as if it might be anattractive investment.

b. 2006 = 25.0% $3 net income $12 stockholders equity2007 = 18.5% $5 net income $27 stockholders equity2008 = 12.7% $7 net income $55 stockholders equity

c. Based on the new information, the company does not seem soattractive. Even though net sales and net income have beenincreasing, the return to stockholders (return on equity) has been

decreasing. Each dollar of stockholders equity has been earning asmaller and smaller return each year. In 2006, for example, each dollarof stockholders equity earned 25 cents. By 2008, each dollar wasearning only 12.7 cents. The stockholders investment is beingemployed less and less efficiently.

d. An evaluation cannot focus on just one factor. For example, its easyto focus only on net income because it is readily available. If onedigs a little and makes some computations, such as return on equity,the result is a richer understanding of the company underconsideration.


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E10-6 Leverage is the use of long-term debt in the capital structure. A companyusually has some combination of both long-term debt and equity in itscapital structure. The larger the proportion of long-term debt, the greateris its leverage. Leverage can have either a positive effect or a negativeeffect on a companys return on equity. If the firm is able to earn a greaterreturn on borrowed funds than the price of renting those funds (interest

expense), the firms return on equity will be magnified. If, however, thecompany must pay more for funds than it is able to earn on those funds,the firms return on equity will be reduced. Two measures of leverage arethe debt-to-equity ratio (total long-term debt total stockholders equity)and debt-to-assets ratio (total long-term debt total assets). The higherthe value of either measure, the greater is the degree of leverage beingemployed by the firm. If a company has low debt-to-equity and debt-to-asset ratios, the company is not using much leverage and may be able totake on more. More leverage results in more risk to creditors, though, sothere is a limit to the amount of leverage that a company can employ. Ifleverage gets too high, given the companys circumstances, creditors will

refuse to lend more capital until the degree of leverage is reduced.

E10-7 2007 return on equity = 22.2% Net income stockholders equity($4 million $18 million = 22.2%)

2007 return on equity if bonds had ($3.79 million $14.54 millionbeen sold = 26.1% = 26.1%)

E10-8

All EquityFinancing

Some DebtFinancing

Total assetsTotal liabilitiesTotal stockholders equity

$25,000,000(0 )

$25,000,000

$25,000,000(10,000,000 )

$15,000,000

Income before interest and taxesInterest expensePretax incomeIncome tax expense (28.6%)Net income

$ 7,000,000

0

$ 7,000,000(2,002,000 )

$ 4,998,000

$ 7,000,000(900,000 )

$ 6,100,000(1,744,600 )

$ 4,355,400

Return on equity 20% 29%

Return on equity = $5 million $25 million for equity financing and

$4,355,400 $15 million for debt financing.


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E10-9 One approach to this exercise is to compute the expected net income andreturn on equity under each option.

Projected results with additional financing:

Earnings before interest and taxes

Interest expense

$ 5,000,000

3,800,000

$ 8,000,000

3,800,000

$15,000,000

3,800,000

Pretax incomeIncome tax (30%)

$ 1,200,000360,000

$ 4,200,0001,260,000

$11,200,0003,360,000

Net income $ 840,000 $ 2,940,000 $ 7,840,000

Stockholders equity $75,000,000 $75,000,000 $75,000,000

Return on equity 1.12% 3.92% 10.45%

Projected results without additional financing:

Earnings before interest and taxes

Interest expense

$ 5,000,000

800,000

$ 8,000,000

800,000

$ 15,000,000

800,000

Pretax income

Income tax (30%)

$ 4,200,000

1,260,000

$ 7,200,000

2,160,000

$ 14,200,000

4,260,000

Net income $ 2,940,000 $ 5,040,000 $ 9,940,000

Stockholders equity $100,000,000 $100,000,000 $100,000,000

Return on equity 2.94% 5.04% 9.94%

At average or below average levels of activity, net income and return onequity would be less if the new financing option is adopted. Further, theadditional debt increases the risk of losses and bankruptcy if the compa-ny earnings (before interest and taxes) fall below the projected amounts.Therefore, based on the available information, issuing the additional debt

probably is not a wise decision unless the likelihood of high-end earn-ings is great.

E10-10 Linfield should consider its investment opportunities. If the company hasthe opportunity to invest in new projects that are expected to yieldreturns in excess of its cost to raise capital, it should considerexpansion. Low interest costs and high stock prices provide anopportunity to finance new projects at relatively low costs. The companymight also consider refinancing a portion of its existing debt. Becausethe debt is callable, the company could issue new debt or stock toreplace existing debt. New debt would require lower interest payments. If

the company wishes to restructure its capital, it could issue new stock topay off existing debt. All of these decisions should take into account theeffect of financing on expected cash flows available for commonstockholders and the companys risk. Additional debt could increasecash flows but would probably increase risk as well. Refinancing existingdebt with new debt would increase cash flows by decreasing interestpayments. Refinancing existing debt with new stock or financing newassets with new stock should increase cash flows and reduce risk.


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However, current shareholder ownership would be diluted andearnings and cash flow per share could decrease because of theadditional shares.

E10-11 Information useful for evaluating the effects of Georgia-Pacifics capitalstructure on profitability, cash flow, and risk includes the following:

(In millions) 2004 2003 2002

(a) Total assets $23,072 $24,405 $24,629

(b) Total stockholders equity 6,225 5,394 4,560

(c) Total debt (a b) 16,847 19,011 20,069

(d) Net income (loss) 623 254 735

(e) Debt to equity ratio (c b) 2.71 3.52 4.40

(f) Debt to assets ratio (c a) 0.73 0.78 0.81

(g) Return on assets (d a) 0.03 0.01 0.03

(h) Leverage factor (a b) 3.71 4.52 5.40

(i) Return on equity (g h) 0.10 0.05 0.16

Note: ROE calculated as (g h) may differ from ROE calculated as (d b)because of rounding to two decimal places in Excel.

The debt-to-equity ratio, debt-to-assets ratio, and the leverage factor allpoint out that Georgia-Pacific was highly leveraged over the three-yearperiod, but the amount of leverage decreased each year. For example, thepercentage of assets financed with debt ranged from 73% to 81% over theperiod. This meant that the companys profits or losses were magnifiedover the amount it would have reported if it had little or no debt. The mag-nification factor (leverage factor) ranged from 3.7 to 5.4. In the companysmost profitable year (2004), this converted a 3% return on assets into a10% return on equity. In the companys least profitable year (2002), itturned a 3% return on assets into a 16% return on equity.

The high levels of debt were a drain on cash flow from operationseach year. Large interest payments had to be made even though (in someyears) there was little (or no) net income. The companys risk was highduring the period as observed by the volatility of net income and cashflow. The high debt-to-equity ratios, high debt-to-asset ratios, and highleverage factors all indicate high risk. The probability the company wouldbe unable to meet interest payments was higher than it otherwise wouldbe because of the high proportion of debt in the capital structure.


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E10-12 a. Return on equity = 44.7% (proof below)b. Return on equity = 36.4% (proof below)

(a.) (b.)With Without

Preferred Stock Preferred StockNet income $ 8,000,000 $ 8,000,000

Preferred dividends 400,000 0Income available for common $ 7,600,000 $ 8,000,000Common equity $17,000,000 $22,000,000Return on equity ($7.6 $17) 44.7%

($8 $22) 36.4%This does not appear to be a good idea. Return on common equity wouldhave been reduced from 44.7% to 36.4% for 2008. Similar results would belikely in future years.

E10-13 It is likely that the financial market will respond negatively to theproposed issue of bonds. The liquidity of the firm has decreased

significantly over the previous four years. The current ratio for the fouryears has been as follows:

2008 2007 2006 2005

Current ratio 1.14 1.38 1.78 2.00

During the same period, both net income and cash flow from operationshave also decreased significantly. This is not a favorable situation inwhich to issue debt. In the face of decreasing net income and cash flow,the firm would nearly quadruple its required interest payments (from $6million or $8 million per year to $24 million or $26 million per year).

It is also helpful to look at the projected effect on the capital structure ascompared to the existing and past capital structure. The year 2009 dataholds everything constant from year 2008 except for the issuance of $200million of new bonds.

Pro-forma2009 2008 2007 2006 2005

Total liabilitiesto total assets

44.6%($322 $722)

23.4%($122 $522)

23.3%($116 $498)

23.9%($118 $494)

23.1%($102 $442)

Total equity

to total assets 55.4% 76.6% 76.7% 76.1% 76.9%

The table above shows that the capital structure will swing heavily to-ward additional debt, which will increase the risk to all creditors. Giventhe recent years deterioration in liquidity, net income, and cash flow, andthe proposed huge increase in leverage, bond investors are likely to re-spond unfavorably to this offering of securities.


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E10-14 Debt to Debt to Financial CurrentEquity Assets Leverage Ratio

a. decrease decrease decrease increaseb. increase increase increase increasec. increase increase increase decreased decrease decrease decrease increase

e. decrease decrease decrease decreasef. no effect no effect no effect decrease*g. increase increase increase decrease

*If stock investment is long-term; if short-term, then no effect

E10-15 Intels capital structure consists of liabilities and common stockholdersequity. The debt-to-equity and debt-to-assets ratios can be used to showthe relationship of the two. Before computation, however, decisions mustbe made as to which aspects of debt to include. Several alternativecomputations of the two ratios are shown below. They differ only in whatis included in the term debt.

Long-TermDebt Only

All Long-TermLiabilities

AllLiabilities

Debt-to-equity ratio 0.018 0.040 0.248

Debt-to-assets ratio 0.015 0.032 0.199

Long-term debt 703All long-term liabilities 1,558All liabilities 9,564Equity 38,579Assets (All liabilities + Equity) 48,143

Which items to include in debt is somewhat a matter of the analysts per-sonal preference. The most important issue is that it be computed thesame way for all periods or for all companies being compared. Use oflong-term debt is often preferred because it limits the definition of debt toobligations incurred purely for financing reasons. This excludes otheritems such as deferred taxes that arise as a result of prior operating ac-tivities. Exclusion of current liabilities (other than the current portion oflong-term debt) also has the effect of excluding debt arising from operat-ing activities (e.g., accounts payable, wages payable, etc.).

Regardless of the formulation used, the proportion of debt in Intels capitalstructure is rather low. It relies mostly on equity to finance its activities.


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E10-16 a.

EastmanChemical Microsoft Formula

i. Return on assetsii. Total assets to

total equity

iii. Return on equityiv. Long-term debt to

equityv. Long-term debt to

assets

2.9%4.96 times

14.4%174.1%1

35.1%2

8.8%1.23 times

10.9%0%

0%

NI total assetsTotal assets stockholders equity

NI stockholders equityLT debt to stockholdersequityLT debt to total assets

1Total debt to equity: Eastman 396%; Microsoft 23.5%2Total debt to assets: Eastman 79.8%; Microsoft 19%

b. The financing strategies of the two firms have been very different.Eastman Chemical has adopted a strategy of using a significant

amount of long-term debt in the capital structure, whereas Microsofthas used none. This is shown most directly by the difference indegree of leverage: 4.96 for Eastman Chemical versus 1.23 forMicrosoft. (Microsofts small amount of leverage comes from currentliabilitiesrelated to operating activitiesand other long-termdebt that could also be related to operating activities, probablydeferred taxes.) The effect of different financing decisions onstockholders shows up when comparing the return on assets to thereturn on equity. Eastman Chemical earns a 2.9% return on assetsand magnifies that return through leverage to 14.4%. Microsoft earnsa higher return on assets of 8.8%, but the small leverage of 1.23

results in a return on equity of 10.9%.

E10-17 The overall impression from reviewing the financial ratios of Wal-Mart isthat the companys financial structure is very stable. For example, thelong-term debt to equity and long-term debt to assets ratios are identicalfor 2003 and 2004. The company reported a slight increase in both ROEand ROA. Current assets declined slightly from 2003 to 2004. A keyindicator of financial structure, financial leverage, remains virtuallyunchanged between 2003 and 2004.


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E10-18 a. Giffin Co. Good Co.Long-term debt- 2 to 1 0.14 to 1

to-equity ratio1 ($60,000 $30,000) ($10,000 $70,000)Long-term 60% 10%

debt/assets2 ($60,000 $100,000) ($10,000 $100,000)

Giffins use of debt is more extensive than Goods.1Total debt to equity: Giffin Co. 2.33 to 1 ($70,000 $30,000); GoodCo. 42.9 to 1 ($30,000 $70,000)

2Total debt to assets: Giffin Co. 70% ($70,000 $100,000); Good Co.30% ($30,000 $100,000)

b. Giffin Co. Good Co.Operating income $40,000 $40,000Interest expense (10%) 6,000 1,000Pretax income $34,000 $39,000Income tax (40%) 13,600 15,600Net income $ 20,400 $ 23,400Earnings per share $8.16 $3.90

($20,400 2,500) ($23,400 6,000)

Giffen Co. has used leverage to increase its earnings per share to $8.16.Both companies have the same amount of assets ($100,000) and thesame operating income ($40,000) but the company with greater debt (Gif-fin Co.) has greater earnings per share in this case.

E10-19 a. ROA = $7,700 $50,500 = 15%ROE = $7,700 $35,400 = 22%

b. ROA* = $7,700 $50,500 = 15%

ROE* = $7,700 $17,400 = 44%

c. ROA* = $7,700 $50,500 = 15%ROE* = $7,700 $47,400 = 16%

d. Financial leverage does not affect ROA because the total assetamount is not affected by the source of financing for those assets.An increase in the financial leverage (shown in part b) increases theROE, while a decrease in the financial leverage (shown in part c)decreases the ROE.

*While this exercise does not provide the monetary impact of theincrease or decrease in debt, it is important to recognize the effectsuch changes have on net income. Increasing (decreasing) debt almostalways means an increase (decrease) in interest expense, which thenmeans a decrease (increase) in net income and equity.


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E10-20 It is helpful to compute the two companies dividend payout ratios(dividends net income).

Dividend payout ratio 2004 2003 2002

General Mills 39.1% 44.3% 78.2%

Wal-Mart 17.3% 16.7% 18.9%

Both Wal-Mart and General Mills increased their earnings over the peri-ods shown. Also, each company paid out more total cash for dividendseach year than the year before. Wal-Marts dividend payout ratio is moresteady than General Mills. It seems that General Mills earnings grew at afaster rate than did dividend payments. We may conclude that both com-panies are likely to continue paying dividends in the future. If earningscontinue to grow, we may expect growth in dividend payments, as well.

E10-21 a. The market-to-book-value ratio is a measure of how favorably

investors view the company and its prospects. If investors haveconfidence in the management and future of a firm, they will bid upthe price of the companys common stock because they expectfuture profits and cash flows to grow. If investors have lowconfidence in management and the future of the firm, the stock pricewill fall as investors perceive future profits and cash flows to bemore risky.

b.

J.C. PenneyCompany Wal-Mart

i. Market value per share $42 $55ii. Number of common shares (mil-lions) 271 4,311

iii. Market value of stockholders eq-uity (i ii) $11,382 $237,105

iv. Common stockholders equity $4,856 $43,623

v. Ratio of market value to book val-ue of stockholders equity(iii iv) 2.34 5.44

c. A dollar of stockholders equity in Wal-Mart is valued more highly by

the financial markets than a dollar of stockholders equity in J.C.Penney Company. Every dollar of Wal-Marts stockholders equitysells for $5.44. A dollar of Penneys stockholders equity sells for$2.34. The financial markets are expressing greater confidence in theability of Wal-Mart and its management to generate future profits andcash flows than they are in J.C. Penney Company and itsmanagement.


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E10-22 a. Ratio 2008 2007Long-term debt/assets* 0.41 ($862 $2,103) 0.45 ($815 $1,810)Assets/stk. equity 3.00 ($2,103 $700) 3.48 ($1,810 $520)Return on assets 0.05 ($115 $2,103) 0.05 ($91 $1,810)Return on equity 0.16 ($115 $700) 0.18 ($91 $520)Current ratio 1.36 ($736 $541) 1.35 ($643 $475)

Dividend payout 0.30 ($34 $115) 0.30 ($27 $91)Market to book value 1.56 ($1,093 $700) 1.67 ($870 520)

*Total debt/assets: 2008: ($541 + $862) $2,103 = 0.67; 2004: ($475 +$815) $1,810 = 0.71

b. Registers primary financing activities in 2008 consisted of issuingadditional debt ($31 million more than it repaid), issuing $85 millionof stock, and paying $34 million of dividends. The companysperformance was strong. Its net income and operating cash flowswere positive and increased from 2007 to 2008. Additional financingactivities were used to support investing activities. Additional assetswere acquired in 2007 and 2008, indicating growth.

c. Registers financial leverage decreased during 2008. Therefore,though its return on assets was the same in 2007 and 2008, its returnon equity decreased. Thus, because the company was performingwell, stockholders would have benefited from an increase in financialleverage. The decrease in financial leverage reduced stockholderreturn (return on equity). The lower return on equity wasaccompanied by a decrease in company value (market to bookvalue). Both profitability and capital structure affect company value.

PROBLEMS

P10-1

A. 2007 actual return on equity = $46 $460 = 10%

B. 2007 revised return on equity = $40 $310 = 12.9%

Proof: Revised 2007 income statement (in millions):Sales $893Cost of goods sold (552)Operating expenses (267 )Operating income $ 74Interest expense ($8 + $9) (17 )Pretax income $ 57Income taxes (30%) (17 )Net income $ 40

(continued)


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Revised year-end 2007 balance sheet (in millions):Assets:

Current assets $252Plant assets 505Total assets $ 757

Liabilities:

Current liabilities $197Long-term debt 250Total liabilities $447

Stockholders equity: 310Total liabilities andstockholders equity $ 757

Return on equity = $40 $310 = 12.9%

C. Issuing additional debt reduces net income because of the additionalinterest expense. However, stockholders equity is reduced as wellbecause the additional debt was used to repurchase stock.

Therefore, return on equity would be higher if the debt were issued(increasing from 10% to 12.9%). Based on this information,increasing financial leverage is a good decision for this company.Whether it will continue to be a good decision in the future dependsupon whether the company continues to be profitable.

P10-2

A. There was a significant change in capital structure during 2008. Theportion of capital provided by equity (1) was decreased and theportion provided by long-term debt (2) was increased.

Equity Assets 2008 2007(1) $57,300 $85,600 66.9%

$40,800 $98,800 41.3%

LT debt Assets(2) $16,400 $85,600 19.2%

$46,000 $98,800 46.6%

B. 2007 debt-to-equity ratio = 28.6% $16,400 ($34,000 + $26,400 $3,100)2008 debt-to-equity ratio = 112.7% $46,000 ($34,000 + $34,800 $28,000)

2007 debt-to-assets ratio = 19.2% $16,400 $85,6002008 debt-to-assets ratio = 46.6% $46,000 $98,800

C. 2007 return on assets = 8.5% $7,300 $85,6002007 return on equity = 12.7% $7,300 ($34,000 + $26,400 $3,100)

D. 2008 return on assets = 8.5% $8,400 $98,8002008 return on equity = 20.6% $8,400 ($34,000 + $34,800 $28,000)


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28 Chapter 10

E. The change in capital structure increased financial leverage by asignificant amount. In 2007 the leverage factor was 1.49 ($85,600 $57,300). At the end of 2008 the leverage factor had increased to 2.42($98,800 $40,800). While the change in capital structure (andfinancial leverage) had no effect on return on assets, it had a greateffect on return on equity.

P10-3 A. The following measures (only three were required) can be used tocompare capital structure among companies. Their values, using thedata given, are as follows:

Ratio Calculation Intel PG&E

Total debt to totalassets

(All liabilities + treat preferred stockas debt) 1 19.9% 75.0%

Long-term debt tototal assets Long-term debt 2 1.5% 21.2%Total debt tocommon stockequity

(All liabilities + treat preferred stockas debt) 3 24.8% 300.1%

Long-term debt tocommon stockequity

Long-term debt equity4 1.8% 84.8%Leverage Total assets common stock

equity51.25

times4.0

times

1($8,006 + $703 + $855 + $0) $48,143 = 19.9%($6,918 + $7,323 + $11,380 + $286) $34,540 = 75.0%

2($703 $48,143) = 1.5%($7,323 $34,540) = 21.2%

3($8,006 + $703 + $855 + $0) $38,579 = 24.8%($6,918 + $7,323 + $11,380 + $286) $8,633 = 300.1%

4($703 $38,579) = 1.8%($7,323 $8,633) = 84.8%

5($48,143 $38,579) = 1.25 times($34,540 $8,633) = 4.0 times

B. There are big differences in all four measures. All indicate that PacificGas & Electric employs much more debt capital than does Intel.Perhaps the most striking difference is in their relative usage of

leverage. Pacific Gas & Electric uses 3.2 times the amount of leverageas does Intel (4.0 versus 1.25). By all measures it is clear that Inteluses a capital structure heavily oriented toward equity, whereasPacific Gas & Electric has a capital structure heavily oriented towarddebt.

C. The companies are in very different industries. Pacific Gas & Electricis in a stable, somewhat regulated industry. A fairly stable source ofrevenues permits it to support a high amount of financial leverage.


19/37


(continued)

Intel, however, is in a high-technology field that changes rapidly. Theindustry is inherently more risky. Therefore, the company dependsprimarily on common stock to finance its investment and operatingactivities. The demand for its products could change much morequickly than for a utility. Lower demand would reduce cash flows

and could make it difficult for the company to survive if it werehighly leveraged. A capital structure that is suitable for one type ofcompany often is not suitable for another.

P10-4 Baker Mountain CompanyPro Forma Income Statement

Dollars in thousands Equity Debt

Operating income $386,679 $386,679Interest expense 55,528 90,5281

Income before taxes $331,151 $296,151

Income taxes (40%) 132,460 118,460

Net income $ 198,691 $ 177,691

Return on assets2 5.23% 4.68%

Return on equity3 9.08% 10.52%

1 New debt = $ 500,000Interest rate on debt = 7%

Interest on new debt = $ 35,000Total interest after new debt: $35,000 + $55,528 = $ 90,5282 $198,691 ($3,297,390 + $500,000) = 5.23%

$177,691 ($3,297,390 + $500,000) = 4.68%3 $198,691 ($1,689,209 + $500,000) = 9.08%

$177,691 $1,689,209 = 10.52%

If new stock were sold, the return on assets would be greater than if newdebt were sold (5.23% versus 4.68%). The preferable measure, however,is return on equity. Because of increased leverage from selling new debt,the return on equity would be greater than if new stock were sold (9.08%versus 10.52%). But when leverage increases, the risk of being unable to

make required interest payments also increases. Management (and in-vestors) need to assess the stability of earnings and whether it is wise totake on the increased risk. If the company can sell new debt on the termsdescribed, and the company remains profitable, the stockholders will bebetter off if new debt is issued.


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30 Chapter 10

P10-5 A. and B Pro Forma Income StatementsEquity Debt

Financing FinancingSales revenue $ 429,600 $429,600Cost of sales (272,400 ) (272,400 )Gross margin $ 157,200 $157,200

Interest expense (same as 2007) (5,000)($5,000 plus $200,000 6%) (17,000)Other fixed expenses (70,000 ) (70,000 )

$ 82,200 $ 70,200Taxes (40%) (32,880 ) (28,080 )Net income $ 49,320 $ 42,120

C.

Net incomeStockholders

equityReturn on

equityActual 2007 results $33,600 $102,000 32.94%

Pro-forma 2008(equity financing) $49,320 $351,320a 14.04%Pro-forma 2008(debt financing) $42,120 $144,120b 29.23%

a($61,000 + $41,000 + $200,000 + $49,320)b($61,000 + $41,000 + $42,120)

Financing the acquisition of new equipment with equity has the ef-fect of cutting 2008s return on equity by more than one-half (from32.94% to 14.04%). Even financing with debt, however, will dilute thereturn on equity somewhat (from 32.94% to 29.23%). Of the two op-

tions, debt financing is clearly the better choice if managementwants to maintain an ROE close to its current level. At the same time,such financing raises the risk of the company. Currently, its manda-tory interest payments are only $5,000 per year. The debt financingoption raises required interest payments to $17,000 per year. If thecompany hits a period of economic difficulty it may not be able toservice its debt.

Students may question why a company would choose debt financ-ing, which results in more risk (having to meet interest payments)and less income than the equity financing option. One way to look at

it is that there may be less income under debt financing, but thereare also fewer stockholders (under debt financing) that share thegood results. In the long run, the financial leverage will magnify anypositive ROA the company can attain.


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P10-6 A. The following ratio values might be helpful in identifying the firmscapital structure.

Ratio Computation 2004 2003

Long-term debt to total assets a c 0.17 0.17

Total debt to total assets b c 0.40 0.49Long-term debt to equity a d 0.29 0.34

Total debt to equity b d 0.67 0.94

Leverage factor c d 1.67 1.94

a. Long-term debt $ 350,080 $ 350,280b. Total debt 826,970 984,776c. Total assets 2,053,406 2,028,151d. Equity 1,226,436 1,043,375e. Current assets 929,658 915,532

f. Current liabilities 240,613 404,922

Overall, financial leverage is an important part of the firms capitalstructure. For example, creditors financed 40% and 49% of the com-panys assets in 2004 and 2003, respectively.

B.

Current Ratio 2004 2003

Current assets Current liabilities 3.86 2.26

If a current ratio of 1.84 is considered the industry benchmark, it

would appear that the company has a very favorable current ratio. Ithas a strong ability to meet current obligations as they become due.

P10-7 A. Return on equity = net income stockholders equity

2004 = 52.2% ($4,504 $8,633)2003 = 10.0% ($420 $4,215)

B. Leverage = total assets stk. equity

2004 leveragefactor = 4.0 times ($34,540 $8,633)

2003 leveragefactor = 7.2 times ($30,175 $4,215)

In 2003, financial leverage magnified the return on equity by a factorof 7.2 times over return on assets. This means that the 2003 returnon assets must have been 1.39% (ROE of 10% financial leverage


22/37

32 Chapter 10

factor of 7.2). In 2004, the return on assets must have been 13.1%(ROE of 52.2% financial leverage factor of 4.0).

C. The payoff of long-term debt would have reduced leveragesignificantly. Therefore, the magnification factor would have beenless in both years.

P10-8 Primary alternatives for raising additional capital include long-term debt,preferred stock, and common stock. Risk issues that should beconsidered include the risk of default and bankruptcy and the risk of lossof control. Return issues include the cost of debt, payment of preferreddividends, and dilution of earnings available for common stockholders.

Liabilities already account for 80% of the companys total finances.Therefore, the company is already highly leveraged. Financial leveragehas a positive effect on earnings available to stockholders if a companycan earn a return on investment higher than the cost of debt. Leverage in-creases risk, however, because of the possibility a company will not be

able to meet principal and interest requirements. If a company defaults onits debt, it can be forced into bankruptcy. The owners could lose controland their investments.

Preferred stock is less risky to the company than debt because divi-dends can be skipped without a company being forced into bankruptcy.Also, preferred stock normally does not have voting rights. Therefore,current owners could retain control of the company. Dividends paid onpreferred stock reduce the earnings and cash flows available for commonstockholders. But preferred stockholders do not necessarily participatein earnings to the same extent as common stockholders. Therefore, thefamily would have greater control over the transfer of resources to non-

family investors. Unlike interest, dividends are not tax deductible. Also,investors would have to be offered sufficient incentives to interest themin investing in the stock.

Common stock is the least risky alternative for raising new capital be-cause resources are transferred to stockholders only when managementdeems it appropriate. Dividends typically are paid if the company is prof-itable and has sufficient cash to make dividend payments. Loss of con-trol is a major problem, however. Common stockholders normally havevoting rights. A major sale of common stock could result in the transferof control to nonfamily members. Common stockholders participate in acompanys earnings. Thus, nonfamily members would have a claim to a

portion of the companys earnings, diluting earnings for family members.


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P10-9 A. Debt to EquityClipper Company: 2008 2007 2006

$3,273 2,727 1.20$4,014 1,486 2.70$3,750 1,250 3.00

Battle Company:

$5,333 1,667 3.20$4,286 1,714 2.50$3,333 1,667 2.00

For Clipper Company, the debt/equity ratio is declining and thereforeover the three years debt is becoming a smaller part of Clipperscapital structure. For Battle Company, debt is increasing relative tothe stockholders equity.

B. Return on Equity:Clipper Company: 2008 2007 2006

$300 2,727 11%$200 1,486 13.5%$100 1,250 8%

Battle Company:$300 1,667 18%$200 1,714 11.7%$100 1,667 6%

Return on Assets:Clipper Company: 2008 2007 2006

$300 6,000 = 5.0%$200 5,500 = 3.6%$100 5,000 = 2.0%

Battle Company:$300 7,000 = 4.3%$200 6,000 = 3.3%$100 5,000 = 2.0%

Financial Leverage:Clipper Company: 2008 2007 2006

$6,000 2,727 2.20$5,500 1,486 3.70$5,000 1,250 4.00

Battle Company:$7,000 1,667 4.20$6,000 1,714 3.50$5,000 1,667 3.00

Clipper Company had a greater increase in ROA over the three yearsthan did Battle Company. However, Battle Company has had anincrease in financial leverage over the years, while Clipper Company


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34 Chapter 10

had a decrease in financial leverage. Therefore, Battle Company hashad a dramatic increase in ROE while Clipper Companys increase inROE has been more modest.

C. Dividend Payout Ratio:Clipper Company: 2008 2007 2006

$75 300 25%$50 200 25%$25 100 25%

Battle Company:$150 300 50%$100 200 50%$50 100 50%

Battle Company pays out half its income in dividends every year,while Clipper Company pays out one-fourth of its income in divi-dends.

D. Students may point out that each company has had the same income

each year so that the investment decision might be based solely onthe dividends paid out. Some investors may prefer a higher dividenddistribution, while others may prefer investing in companies thatretain their earnings and cash to reinvest in the company. Otherstudents may be indifferent to dividends and base the decisionsolely on ROE. They might prefer the ROE trend of Battle Companyto that of Clipper. Another factor to consider, though, is that BattleCompany has more debt and greater financial leverage. This meansit also has greater risk, and if net income declines or losses occur,Battle Company not only may not distribute as much to stockholdersvia dividends but may not even be able to meet its interest

payments.

P10-10 A.Halyard Company Spinnaker Company

i. Debt-to-equity ratio 33.3% 300.0%ii. Debt-to-assets ratio 25.0% 75.0%

Debt to equity: The debt-to-equity ratio is a measure of the amount ofdebt financing in use. It reveals the relative sizes of debt and equity.When the percentage is small, it means that there is not very much lever-age. When it is large, the opposite is true. Here, Halyard Company has a

small ratio and a small amount of leverage. Debt is only about 1/3 theamount of equity. Spinnaker Company has very different results. Spin-naker Company has a large ratio and a large amount of leverage. There isthree times as much debt as equity.

Debt to assets: The debt-to-assets ratio also measures the amount ofdebt financing in use. It reveals the portion of assets that are financed bydebt. When the percentage is small, it means that there is not very much


25/37


leverage. When the percentage is large, the opposite is true. Here, Hal-yard Company is financing only 25% of its assets via debt. SpinnakerCompany, on the other hand, is financing 75% of its assets with debt. Hal-yard Company is using a small amount of leverage; Spinnaker Companyis using a large amount of leverage.

B. Halyard Company Spinnaker Company

BadYear

NormalYear

GoodYear

BadYear

NormalYear

GoodYear

i. Return on assets (3.13) 9.38 21.88 (3.13) 9.38 21.88

ii. Financial leverage 1.33 1.33 1.33 4.00 4.00 4.00

iii. Return on equity (4.17) 12.50 29.17 (12.50) 37.50 87.50

C. The use of financial leverage makes Spinnaker Company a riskierfirm than Halyard Company. The return on equity has wider swingsfor Spinnaker Company than for Halyard Company. Halyard

Company swings between 4.17% and 29.17% return on equitydepending on economic circumstances. Spinnaker Company swingsbetween 12.50% and 87.50% return on equity. The greater the rangeof possible outcome, the riskier the firm.

P10-11 A. James Company 2008 2007 2006Debt/Equity 150% 150% 150%Debt/Assets 60% 60% 60%ROA 33.3% 25% 25%

Leverage 2.5 2.5 2.5ROE 83.3% 62.5% 62.5%

Joyce Company 2008 2007 2006Debt/Equity 150% 150% 150%Debt/Assets 60% 60% 60%ROA (13.3%) (10%) 30%Leverage 2.5 2.5 2.5ROE (33.3%) (25%) 75%


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36 Chapter 10

B.

2006 2007 2008

In the year 2006, when Joyce Company had a higher net income thanJames Company, the existence of financial leverage magnifiedJoyces ROA (which was already better than James ROA) to pro-duce an ROE for Joyce that was much better than James ROE. Thenext year, Joyces ROA became negative and the financial leveragemade the ROE even more negative. In the third year, when JamesCompanys net income increased again and Joyce Companys net in-come declined further, the disparity between the companys ROAs

was magnified by the leverage factor to produce an even greater dis-parity in the two companies ROEs.

C. James Company 2008 2007 2006Debt/Equity 66.7% 66.7% 66.7%Debt/Assets 40% 40% 40%ROA 33.3% 25% 25%Leverage 1.67 1.67 1.67ROE 55.6% 41.7% 41.7%

Joyce Company 2008 2007 2006Debt/Equity 66.7% 66.7% 66.7%

Debt/Assets 40% 40% 40%ROA (13.3%) (10%) 30%Leverage 1.67 1.67 1.67ROE (22.2%) (16.7%) 50%

(continued)

-40

-20

0

20

40

60

80

100

Joyce ROA

James ROA

Joyce ROE

James ROE


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2006 2007 2008

The change did not affect the ROA for any of the three years for thetwo companies. However, the change did produce a capital structurethat included less debt and as a result, there was less difference be-tween ROA and ROE results in part C than in part A.

P10-12 A. Return on equity (as reported) = 8.04% ($74 net income $920 S.E.)

B. Return on equity (revised) = 8.92% ($62 net income $695 S.E.)

Proof: Revised financial statements after issuing $225 million of debt

and repurchasing $225 million of stock would be as follows.

Revised Income Statement Revised Year-End(in millions) Balance Sheet (in millions)

Operating income $122 Total assets $ 1,514Interest expense ($16 + $18) (34 ) Liabilities:Pretax income 88 Current liabilities $ 394Income taxes ($88 0.30) (26 ) Long-term debt 425Net income $ 62 Total liabilities $ 819

Stockholders equity 695Total liabilities and

stockholders equity $ 1,514

C. Higher financial leverage increases risk. If a net loss occurs, causingreturn on assets to be negative, financial leverage reduces return onequity. If net income and return on assets are positive, financialleverage increases return on equity. Consequently, financial leveragemay increase or decrease return. In either case, it increases risk.Louisianas return on equity increases from 8.04% to 8.92% if the

-30

-20

-10

0

10

20

30

40

50

60

Joyce RO

James R

Joyce RO

James R


28/37

38 Chapter 10

additional debt is issued. However, uncertainty about future netincome and return on equity increases because of the increase infinancial leverage. If Louisiana can continue to earn a profit, theadditional debt should result in a higher return on equity in the futurethan if the debt were not issued.

P10-13 A. An analysis of profit performance would include computation of thereturn on assets and return on equity for the periods underconsideration.

2004 2003 2002

Return on assets(Net income Total assets) 0.08 0.01 0.08

Return on equity(Net income Stockholders equity) 0.21 0.04 0.23

Net income $ 705 $ 99 $ 570Total assets 8,652 7,694 7,367Stockholders equity 3,422 2,730 2,521

The company experienced a significant dip in ROA and ROE during2003. A closer examination of the income statement reveals an in-creasing amount of earnings from continuing operations during theperiods presented. However, in 2003, the company had a major lossresulting from discontinuing an operation. Each year ROE exceedsROA because Best Buy, Inc., employs financial leverage.

B.

2004 2003 2002

Financial leverage(Total assets Stockholders equity) 2.53 2.82 2.92

When profitable, the companys stockholders benefit a great dealfrom financial leverage. The use of financial leverage is a two-edgedsword, however. Should the company hit a rough spot, perhaps asignificant recession where sales drop precipitously, or fail to identi-fy a rapid shift in consumer product preferences, the benefit of finan-cial leverage could shift in the opposite direction. That is, if the com-pany begins to show a negative return on assets, leverage will mag-nify that into a negative return on equity by approximately 2 to 3times.


29/37


P10-14 Johnson & Johnson does not appear to be facing financial problems. Ithas used cash to pay dividends, repurchase stock, and pay off both long-term and short-term debt. These activities suggest the company hassufficient cash to meet its needs. By repurchasing stock, the companyshould be able to earn higher returns for remaining stockholders.

During 2003 and 2004, Johnson & Johnsons financing activities re-sulted in an increase in financial leverage. As shown below, the total ofactions that increased financial leverage was larger than the actions thatdecreased financial leverage. Overall, then, financing activities increasedfinancial leverage.

Increased DecreasedFinancial Financial

Financing activity Leverage LeveragePayment of dividend ($2,746 + $3,251) $ 5,997Repurchase of common stock ($1,183 + $1,384) 2,567

Issue short-term debt ($3,062 + $514) 3,576Retire short-term debt ($4,134 + $1,291) $5,425Issue long-term debt ($1,023 + $17) 1,040Retire long-term debt ($196 + $395) 591Proceeds from stock options ($311 + $642) 953

Totals $ 13 ,180 $6 ,969

P10-15 M E M O R A N D U M

DATE: (todays date)TO: Wellington Smythe

FROM: (students name)SUBJECT: Credit worthiness of Sunny Meadow Enterprises

I am responding to your concerns about the recent net loss of SunnyMeadow Enterprises and the implications of the loss for the companysability to make its principal and interest payments. While not favorable,the loss this period does not necessarily mean that principal and interestpayments are at risk. Principal and interest payments are not made withnet income. They are made with cash flow. Therefore, inspection of thecompanys cash flow situation is necessary.

Even with the net loss for the year, cash flow from operations waspositive . . . though just barely. At $6.8 million, this represents a substan-tial decrease from the prior years $144.2 million. Note that cash flowfrom operations of $6.8 million is measured after meeting this years in-terest payments of $65.9 million. From that perspective, it appears thatthe interest payments were just barely able to be made from operatingcash flows.


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40 Chapter 10

Also worrisome is the current portion of long-term debt that comesdue in this next year. While last years cash flow from operations of$144.2 million was more than sufficient to meet last years then-currentportion of long-term debt of $31.6 million, this is not the case now. If nextyears cash flow from operations is about the same as this year (i.e., $6.8million or so), the company will not be able to pay off its current portion

of long-term debt then due ($27.7 million). Somewhat encouraging is thatthe current ratio has strengthened marginally from last year at 1.82 to thisyear at 1.95. This suggests a small strengthening in the firms ability tomeet its short-term obligations. Unless cash flow from operations is dra-matically higher next year, the company will need additional financing tomeet its principal and interest payments. Given the loss incurred thisyear, the cost of that financing (either debt or equity) will be high. Thecompany may even have to sell off assets next year to raise cash.

P10-16 A. A leveraged buyout involves the massive issuance of debt and useof the proceeds to buy back the outstanding common stock of the

firm. This is typically carried out by the firms managers to gaincontrol of the company. At other times, an outside group will buy thecommon stock, gain control of the company, and then issue debt toliquidate the common stock the outside group (but now inside)owns.

B. Whenever bonds are issued with a nominal rate less than the marketrate, the bonds will sell at a discount. In each year, amortization ofdiscount will cause interest expense on the bonds to exceed thecash paid for interest. The deeper the discount at issue, the greaterwill be the excess of interest expense over cash paid for interest.

Here, the bonds must have been issued at a deep discount.C. When a company increases its debt and decreases its equity, it

becomes more highly leveraged. The greater the leverage, thegreater the risk to owners and suppliers of debt capital. An LBOmakes a firm more risky.

D. The reversal of net income to net loss is not encouraging. Still, theimmediate issue is whether the company can make the interestpayments on its huge debt. In this case, operating income (ameasurement before subtracting interest expense) is about the sameas before. Also, cash from operations (a measurement after

deducting cash interest paid) continues at about the same level.Apparently the company is able to continue making its interestpayments even though those payments are much higher than before.Whether this will continue is uncertain. If the economy weakens, andsales decline, the situation will deteriorate. Because of higherleverage, any deterioration will be magnified even more.


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P10-17 A. Financing Cash Flows:During the three-year period, the company issued debt, paid off debt,and issued stock resulting from the exercise of stock options. Thecompany generated cash from operating activities sufficient to fundtheir investing activities in each of the three years shown. In 2003and 2004 the companys operating activities also produced signifi-

cant amounts of cash used for debt reduction.

B. Dividend Policy:Inspection of the cash flow statement (financing activities section)reveals that the company does not pay dividends. If they did, itwould be reported there. This dividend policy is confirmed by thequotation from the annual report.

C. Company value:Market to book value = (Price of stock number of shares outstand-

ing) stockholders equity

Year 2004 2003Highpoints:*($17.41 per share 91,307 shares) $1,226,436 = 1.30($7.44 per share 90,579 shares) $1,043,375 = 0.65

Lowpoints:($12.73 per share 91,307 shares) $1,226,436 = 0.95($5.61 per share 90,579 shares) $1,043,375 = 0.49

During the fourth quarter of 2003, the market valued each $1 investedby stockholders at a low of $0.48 and a high of $0.65. In the fourthquarter of 2004, the value of the company ranged from a low of $0.95to a high of $1.30 for each $1 invested by stockholders. Even at thehigh point, the market did not value the stock much better than thebook value.

*Share data are shown in thousands.

P10-18 There are at least two unethical activities in this case. First, the companyis intentionally hiding debt from interested parties. The only reason thepartnerships are established is to make Endruns financial statementslook better than they really are. The intent to deceive and thereby gainadvantage is called fraud. Creditors, for example, are unaware of the truerisk associated with loans they make because they do not have accurate

information as to the extent of loans already in existence and guaranteedby Endrun.

Second, a corporate officer owes allegiance to his employer. In this case,the CFO has a conflict of interest. After setting up the partnership, theCFO then negotiates the terms of its activities with Endrun (his employer)on behalf of the partnership (which he partially owns). Further, he often isnegotiating with Endrun employees who work for him. How forcefully can


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42 Chapter 10

those employees negotiate on behalf of Endrun when they report to theperson with whom they are negotiating? Every dollar Randy earns fromhis partial ownership of the partnerships is a dollar less that Endrunearns from the business activities of the partnership. To whom will Randybe most loyal? To his employer, or to his own interest, which conflictswith that of his employer?

P10-19 A.

Ratio Formula Computation

TodaysRatioValue

Current ratioCurrent assets

Current liabilities11,200 + 15,000 + 10,000

18,550 + 39,5500.62

LT debt toequity

LT debtStk. equity

100,000319,200

0.31

LT debt toassets

LT debtTotal assets

100,000477,300

0.21

Assets to equity Total assetsEquity

477,300319,200

1.50

B. Comparison toRatio Todays Value Industry BenchmarksCurrent ratio 0.62 (incredibly) WeakLong-term debt to equity 0.31 StrongLong-term debt to assets 0.21 StrongAssets to equity 1.50 Strong

C. Option #1: Obtain short-term bank loan

Ratio Formula ComputationNewRatio

ChangeFromToday

Currentratio

Current assetsCurrent liabilities

11,200 + 15,000 + 10,000 + 90,00018,550 + 39,550 + 90,000 0.85 Better

LT debtto equity

LT debtStk. equity

100,000319,200 0.31 Same

LT debtto assets

LT debtTotal assets

100,000477,300 + 90,000 0.18 Better

Assetsto equity

Total assetsEquity

477,300 + 90,000319,200 1.78 Worse

(continued)


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Option #2: Sell new shares of common stock


ChangeFromToday

Current

ratio

Current assets

Current liabilities

11,200 + 15,000 + 10,000 + 90,000

18,550 + 39,550 2.17 Better

LT debtto equity

LT debtStk. Equity

100,000319,200 + 90,000 0.24 Better

LT debtto assets

LT debtTotal assets

100,000477,300 + 90,000 0.18 Better

Assets toequity

Total assetsEquity

477,300 + 90,000319,200 + 90,000 1.39 Better

Option #3: Issue long-term bonds payable


Change

FromToday

Currentratio

Current assetsCurrent liabilities

11,200 + 15,000 + 10,000 + 90,00018,550 + 39,550 2.17 Better

LT debt toequity

LT debtStk. Equity

100,000 + 90,000319,200 0.60 Worse

LT debt toassets

LT debtTotal assets

100,000 + 90,000477,300 + 90,000 0.33 Worse

Assets to

equity

Total assets

Equity

477,300 + 90,000

319,200 1.78 WorseD. Option #2 Only Option #2 improves all four ratios. The other ratios

improve some ratios but not all. For example, Option #1improves the current ratio and the long-term debt-to-assets ratio, but has no effect on the long-term debt-to-equity ratio. Further, under Option #1 the assets-to-equity ratio gets worse. Under Option #3, the currentratio improves but the other three ratios get worse.


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44 Chapter 10

P10-20

High Income Low Income

Current Less Debt More Debt Current Less Debt More Debt

Operating income $ 647,585 $ 647,585 $ 647,585 $ 200,000 $ 200,000 $ 200,000

Total assets 5,623,107 5,623,107 5,623,107 5,623,107 5,623,107 5,623,107

Long-term debt 2,097,416 1,097,416 3,097,416 2,097,416 1,097,416 3,097,416Stockholders equity 3,370,241 4,370,241 2,370,241 3,370,241 4,370,241 2,370,241

Interest expense 188,767 98,767 278,767 188,767 98,767 278,767

Pretax income 458,818 548,818 368,818 11,233 101,233 (78,767)

Income taxes 160,586 192,086 129,086 3,931 35,431 (27,568)

Net income 298,232 356,731 239,732 7,302 65,802 (51,199)

Return on assets 5.30% 6.34% 4.26% 0.13% 1.17% 0.91%

Financial leverage 1.67 1.29 2.37 1.67 1.29 2.37

Return on equity 8.85% 8.16% 10.11% 0.22% 1.51% 2.16%

Note: Students may observe slight rounding errors between their solutions and the solutionspresented here. Rounding errors typically occur because of the number of significant digitsExcel uses in its calculations.

P10-21

1 2 3 4 5 6 7 8 9 10

a d c b c c c b c d

Effect of Financial Leverage on Return

(0.04)

(0.02)

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.0 0.5 1.0 1.5 2.0 2.5

Financial Leverage

ReturnonEquity


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CASES

C10-1 At the end of 2007, Terabyte Technologys capital structure consisted of48.7% equity ($4,257 $8,742) and 51.3% debt. Long-term debt accountedfor 9.1% ($792 $8,742) of the capital structure. At the end of 2008, thecapital structure consisted of 49.4% ($4,630 $9,375) equity and 50.6%

debt. Long-term debt accounted for 10.2% ($954 $9,375) of the capitalstructure. The primary cause of the changes was the increase in long-term debt to pay off the current portion of other long-term debt.Stockholders equity also increased as a result of reinvested net incomeand a small increase in common stock.

Terabyte Technologys primary source of cash in 2008 was its operat-ing activities. Cash used in investing activities was provided primarily byoperating activities. A sufficient amount of cash was available from oper-ating activities to meet investing needs after paying debt principal anddividends. As a result, relatively little change occurred in the companyscapital structure in 2008.

Though its net income decreased from 2007, Terabyte Technologyscash from operating activities increased. Overall, the companys financialcondition remained relatively stable. It was able to continue paying divi-dends at the same amount in 2008 as in 2007. It had no difficulty in pay-ing interest and principal on its debt. No indication existed of any majorfinancial problems.

C10-2 Summary of actual results and projected results of the events noted in thecase (dollar amounts in millions)

Actual

Results

Event A Event B Event C

Netincome

$3 $3.45 $2 $3.8

Returnonassets

11.5%($3 $26)

13.0%($3.45 $26.45)

8.0%($2 $25)

10.9%($3.8 $34.8)

Returnonequity*

16.1%($3 $18.6)

14.3%($3.45 $24.05)

11.4%($2 $17.6)

19.6%($3.8 $19.4)

*Assumes preferred stock is part of equity

A. The substitution of common stock for existing bonds would havecaused interest expense to decrease by $450,000 ($5,000,000 9%).This would have raised net income from $3 million to $3.45 million.At year-end 2007, therefore, the capital structure of the firm wouldhave been as follows:


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46 Chapter 10

Current liabilities $ 2,400,000 no changeLong-term debt (9% bonds) 0 all bonds repurchasedPreferred stock, $100 par 1,000,000 no changeCommon stock, no par value 20,000,000 new stock soldRetained earnings 3,050,000 $450,000 extra NITotal liabilities and equity $26,450,000

At year-end 2007, total assets would also equal $26,450,000. There-fore, return on assets increases from 11.5% to 13.0%, but return onequity decreases from 16.1% to 14.3%. The return on equity decreaseis caused by the substitution of equity for debt. The de-leveragingeffect of substituting equity for debt reduces risk and return.

B. The reduction of net income by $1 million would leave it at $2million. Capital structure would be changed only by the amount ofnet income. At year-end 2007, therefore, the capital structure of thefirm would be as follows:

Current liabilities $ 2,400,000 no changeLong-term debt (9% bonds) 5,000,000 no changePreferred stock, $100 par 1,000,000 no changeCommon stock, no par value 15,000,000 no changeRetained earnings 1,600,000 $1 million less NITotal liabilities and equity $25,000,000

At year-end 2007, total assets would also equal $25,000,000. There-fore, return on assets would be reduced (from 11.5% to 8.0%) and re-turn on equity would be reduced (from 16.1% to 11.4%). Risk has in-creased on the bonds because there is less cushion available fromnet income with which to make required interest payments. Similarly,

the reduction in net income, coupled with continuing required inter-est payments, negatively affects the risk of the common stock. Asnet income goes down, holding all other factors constant, the risk ofdefault on the debt goes up.

C. The purchase of $8 million of new assets would increase net incomeby $1.6 million before allowing for $800,000 of additional interest ($8million 10%). New net income will be $3.8 million ($3 + $1.6 $0.8).At year-end 2007, therefore, the capital structure of the firm would beas follows:

Current liabilities $ 2,400,000 no change

Long-term debt (9% bonds) 13,000,000 sale of new bondsPreferred stock, $100 par 1,000,000 no changeCommon stock, no par value 15,000,000 no changeRetained earnings 3,400,000 $800,000 million more NITotal liabilities and equity $34,800,000

(continued)


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At year-end 2007, total assets would also equal $34,800,000. There-fore, the return on assets decreases from 11.5% to 10.9% becausethe profits earned on the new assets are not quite as great as profitsearned on the previous assets. The additional leverage, however,more than makes up for the reduced return on assets. Return on eq-uity increases from 16.1% to 19.6%. Issuance of new bonds (an in-

crease in leverage) makes both the existing bonds and the commonstock more risky because there is a greater risk that required interestpayments cannot be made and that the company might have to de-fault.

C10-3 Students will have their own ideas and their own way of weighing thevarious considerations. Here is a brief outline of factors that studentsmay consider:

I. Factors in the decision to lend money to Sporty Footware, Inc.a. Debt is a small part of the companys capital structure and there-

fore it should not have any trouble meeting reasonable debtcovenants.

b. There is no other long-term debt, therefore no interest paymentsand no default risk currently.

c. The company seems to be making enough cash from operationsto meet any future payments of interest and debt.

d. The current ratio seems pretty high, indicating the ability to makeinterest payments.

II. Factors in the decision to invest in the stock of Sporty Footware, Inc.a. According to the cash flow statement, cash from operations has

increased each of the three years presented here, indicating suc-

cess.b. Cash is being invested, so it looks as if the company is growing.c. Dividends are not paid out but are used instead to reinvest in the

business.d. The market-to-book value has declined from 2006 to 2007 (poten-

tial drawback to the investing decision).e. Financial leverage is being used to advantage somewhat, but

probably could be used to a greater advantage since the ROAseems to be increasing (indicates that the company has room forimprovement).

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