Running head: TOOLS 1

Portfolio Project

Ashley Moss

MGMT 575 Financial Analysis II

3 November 2012

Southwestern College Professional Studies

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Table of Contents

1. Valuation and Characteristics of Stock & Payout Policy CH 16

Vocabulary

Three step valuation process for preferred stock

Stock Exchange

Valuing Preferred Stock

Rate of return on shareholders’ investment

Growth rate of future earnings and common stockholders’ investment

2. Cost of Capital & Debt

Vocabulary

Interest expenses are deductible

Economic Value Added (EVA)

Floatation Cost

Cost of Debt is calculated in TI-83 Calculator

Cost of Preferred Stock

Calculate Common Stock Investors Required Rate of Return

Capital Asset Pricing Model (CAPM)

Weighted Average Cost of Capital (WACC)

Market Value of each security

3. Financing Mix & Risk

Vocabulary

Times Interest earned Ratio

Business Risk

Financial Risk

Implementation of the breakeven model

EBIT

Financial Leverage

4. Ratios

Liquidity

Profitability

Debt or Equity

Return on Equity (ROE)

Shareholder Value

Note:

NPV & IRR, Time Value of Money Calculations are in the portfolio from Financial Analysis I.

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My Tool Box

Valuation and Characteristics of Stock & Payout Policy

Financial Slack is most valuable to companies’ that are interested in keeping project

opportunities and company growth easily funded through options. These options include

“…having cash, marketable securities, readily salable real estate, and ready access to debt

markets or to bank financing” (Brealey, Myers & Allen, 2011, p.463). The most profitable firms

have historically had the most financial slack that enables them to quickly finance positive NPV

growth opportunities (good investments).

Are there situations in which financial slack should be reduced by barrowing and paying out the

proceeds to the stock holders? If there is too much financial slack, it “…may encourage

managers to take it easy, expand their perks, or empire-build with cash that should be paid back

to stockholders” (Brealey, Myers & Allen, 2011, p.464).

Preferred Stocks / Hybrid stocks

1. have no fixed maturity date

2. failure to pay dividends does not bring on bankruptcy

3. dividends are not tax deductible

Features of preferred stocks

1. Multiple series each with possible different rights or protective features and/or risk.

2. Preferred stocks come before common stocks but after creditors.

3. Preferred stock can have cumulative dividends as common stock does not.

4. Protective Provisions

5. Convertible Preferred Stock is convertible at the investor’s discretion to trade in

preferred shares for a predetermined amount of common stock shares.

6. Retirement features in the form of a call provision or shinking fund.

Call Provision entitles a company to repurchase its preferred stock from their holders at stated

prices over a given time period. The SEC discourages preferred stock without a call provision.

Shrinking Fund Provision requires the firm to periodically to set aside an amount of money for

the retirement of its preferred stock.

Three step valuation process for preferred stock

1. Estimate the amount and timing of the receipt of the future cash flows the preferred stock

is expected to provide.

2. Evaluate the riskiness of the preferred stock’s future dividends and determine the

investors required rate of return.

3. Calculate the economic or intrinsic value of the share of preferred stock, which is the

present value of the expected dividends discounted at the investor’s required rate of

return.

Stock Exchange

YTD = year to date and indicates the price has +/- value from one yr ago.

52 week high or low indicates the high and low during the past year.

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Stock (SYM) = abbreviated corporate name and ticker symbol.

Div. = the dividends paid to common stock holders in the last year.

Yld% = Example 2.5 is the stock dividend yield – the amount of the dividend divided by the

days closing price ($88/ $35.23) = 2.4978… or 2.5.

PE (23) = gives the current market price (35.23) divided by the firms earnings per share.

VOL 100S = the amount of firm stock traded on that day of the stock quote.

The previous days price is subtracted from the previous days price (last) of for example. 35.23

for Jan 14, 2005 for a net change (Net Chg) of -0.45

Valuing Preferred Stock equation

Value = dividend in yr 1 / (1+ required rate of return) + dividend in yr 2 / (1+ required rate of

return) + …

Valuing Preferred Stock

Example, if a preferred stock pays 4% on its par or stated value of $100 and your required rate

of return is 7%, what is the stock worth to me.

Value = dividend / required rate of return = (0.04x100) / 0.07 = $57.14

Common Stock is a certificate that indicates ownership in a corporation. Its value is based is

equal to the present value of all future cash flows expected to be received by the stockholder as

(dividends or the total firms total value less outstanding debt equaling to firms free cash flow).

Growth is realized through the infusion of new capital (making more money).

Company Growth = borrowing money to invest in new projects, acquiring another company

adding assets.

Rate of return on shareholders’ investment

Return on Equity = net income / (common stock + retained earnings)

Growth rate of future earnings and common stockholders’ investment

Example. g = ROE x r with a 16% return on equity and 25% of the profits / retained

withheld the stockholders investment and firm’s stock price would grow 4%.

g = .16 x 0.25 = .04 or 4% expected growth.

g = the growth rate of future earnings and common stockholders’ investment in the firm.

ROE = Return on Equity (net income / common book value).

r = the company percentage of profits retained, called the profit return rate 6.

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Internal Growth management retains some or all of the firm’s profits for reinvestment resulting

in the growth of future earnings and hopefully company stock.

Proxy gives a designated party the temporary power of attorney to vote for the signee at the

corporation’s annual meetings.

Proxy Fights – are battles between rival groups for proxy votes.

Majority Voting, each share of stock allows the shareholder one vote and each position on the

board of directors is voted on separately. The majority share holders can elect the entire board.

Cumulative Voting, each share of stock allows the stockholder a number of votes equal to the

number of directors being elected. All votes can be used on one candidate or split between all of

the candidates.

Preemptive right entitles the common shareholder to maintain a proportionate share of

ownership in the firm.

Rights are certificates issued to shareholders giving them the option to purchase a stated number

of new shares of stock at a specified price during a 2-10 wk period.

Limited Liability in the case of bankruptcy is limited to the amount of the investment.

Operating Income

1. + depreciation and amortization

2. – tax expenses

3. = after-tax cash flows from operations

4. – the investment (increase) in the firm’s assets, both net working capital and capital

expenditures in plant and equipment.

Competitive-advantage period represents the number of years management believes it can

sustain a competitive advantage, given the present strategies.

Residual value is the value at the end of the competitive-advantage period.

Cost of Capital & Debt

Required Rate of Return is simply the return that creditors demand on new borrowing.

Cost of Capital is the hurdle rate that must be achieved by an investment before it will increase

share holder wealth (The Riskiness of a project being evaluated).

Cost of a particular source of capital is equal to the investor’s required rate of return after

adjusting for the effects of both flotation costs and corporate taxes.

Often interchangeable with the required rate of return, it is the discount rate for evaluating a new

investment and a firm’s opportunity cost of funds. But there are two differences, 1 taxes and 2

flotation cost.

Interest expenses are deductible for federal income tax calculations.

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A firm borrows at 9% and then deducts interest expenses from revenues before paying taxes at

34%. For every dollar in interest paid the firm reduces it’s taxes by $0.34.

Consequently the actual cost of borrowing is only

(.09-(.34x.09) = 5.94% or .09(1-.34) = .0594 = 5.94%

Economic Value Added (EVA)

Economic value is created by earning a return greater than investors required rate of return and is

destroyed by earning a return less than they require.

EVA encourages management to make business decisions that create economic value through

improved operating efficiency, asset utilization, and growth that generates returns that exceed the

cost of capital. EVA compensation incentives for participants are directly linked to improvement

and efficiency of EVA operations aliening corporations and investor interests.

Opportunity Cost equals the return on the investor’s next best investment.

Investors required rate of return or the minimum rate necessary to attract an investor to

purchase or hold a security with consideration of the opportunity cost of an investment.

Floatation Cost is any transaction costs incurred when the firm raises funds by issuing a

particular type of security. Fees paid to investment bankers and sales commissions for securities.

A firm sells new shares for $25 ea, with a transaction cost of $5 per share, then the cost of capital

has increased. Assume the investors required rate of return is 15% for each $25 share. So .15 x

$25 = $3.75 must be earned EACH YEAR to satisfy the investors required return. However the

firm only has $20 to invest…

Cost of Capital is calculated as the rate of return that must be earned

$20k = $25 x .15 = $3.75

K = $3.75/ $20.00 = .1875 or 18.75%

Of the $20, cost of capital (k) is calculated as the rate of return that must be earned on the $20

net proceeds that will produce a dollar return of $3.75.

Financial Policy, that is the policies regarding the source of finances it plans to use and the

particular mix (proportions) in which they will be used – governs its use and equity financing.

Cost of Debt is calculated in TI-83 Calculator

N: 20*1=20

I: ? I = 9.73%

PV: $908.32 - $58.32 = $850 Adjustment to After Tax Cost of Debt Capital

PMT: $80 9.73% (1 - .34) = 6.422%

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FV: $1,000 = 6.42%

P/Y: 1 period per year

PMT: End of Month (EOM)

$58.32 Floatation Cost Per Bond

$1,000 Investors Required Rate of Return and Bond Face Value

$908.32 - $58.32 = $850 Net Proceeds Per Bond

9.73% Before-Tax Cost of Debt

9.73% (1 - .34) = 6.422% After-Tax Cost of Debt

34% Corporate Tax-Rate

8% x $1,000 = $80 Coupon Rate x Bond Face Value = Interest Paid Per Year

$908.32 Current Cost of Debt Capital or Investor Bond Cost. The Cost of Preferred Stock (Note: incurs flotation costs)

Stock Current Market Price = Preferred Stock Dividend / Stockholder Required Rate of

Return

Stockholder Required Rate of Return = Preferred Stock Dividend / Stock Current Market

Price

Cost of Preferred Stock = Preferred Stock Dividend / Net Proceeds Per Preferred Share

$4.25/ ($58.50 - $1.375) = .0744 or 7.44%

$4.25 Annual dividend paid per share

$58.50 Stock closing price on November 23, 2004

$1.375 Floatation costs per share Note: there are no tax adjustments because preferred dividends are not tax deductible.

Cost of Common Equity

Firms do not incur any flotation costs when they use retained earnings but they do when they

issue new common stock shares.

Calculate Common Stock Investors Required Rate of Return

($2.20 / $50.00) + .10 = .144 or 14.4%

$2.20 Shareholders anticipated dividend next year

$50.00 Current Market Price per Share

.10 Anticipated yearly growth rate of (10%)

.144 or 14.4% Common Stock Investors Required Rate of Return Cost of capital to the firm is 14.4%

Issue New Common Stock with a $7.50 flotation cost per share or 15% of the current stock price.

$50.00 x .15 = $7.50

The resulting cost of new common stock equity capital would be...

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( ($2.20 / ( $50.00- $7.50) )+ .10 = .1517647059 = 15.18%

New common stock issue the corresponding cost is 15.18%

Capital Asset Pricing Model (CAPM) pg 192, 219-221 provides a basis for determining the

investor’s expected or required rate of return from investing in common stock.

The model depends on three things

1. The risk free rate

2. The systematic risk of the common stock returns relative to the market as a whole, or the

stocks Beta coefficient.

3. The market risk premium, which is equal to the difference in the expected rate of return

for the market as a whole, that is, the expected rate of return for the “average security”

minus the risk free rate.

1.40 Firm common stock Beta coefficient

3.75% Risk Free Rate

12% Expected Rate of Return on market portfolio .0375 + 1.40 (.12 - .0375) = .153 or 15.3%

Note: the required rate of return is the cost of internal common equity because no

transaction costs are considered.

Weighted Average Cost of Capital (WACC) is the weighted average of the after tax costs of

each of the sources of capital used by a firm to finance a project, where the weights reflect the

proportion of the total financing raised from each source.

The weighted average cost of capital is the return rate that a firm must earn on its investments so

it can pay investors and creditors (pg 339 & examples pg 341).

Example WACC = (.06 x .5) + (.10 x .5) = .08 or 8%

(borrows 6% after taxes x .5 equal portions) + (pays10% in equity x .5 equal portions)

Capital Structure refers to the proportions of each source of financing used by the firm.

(after tax cost of debt x proportions of debt financing) + (cost of equity x proportion of

equity financing) = WACC

% of portfolio debt

30% x 6% = 1.8%

50% x 8% = 4.0%

20% x 10% = 2.0%

=100% = WACC = 7.8%

Cost of Equity Capital (Coca-Cola Company).

Market Value Added (MVA) represents the difference in the current market value of the firm

and the SUM of all the funds that are invested in the firm.

Total Market Value of the firm – Invested Capital = MVA

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Total Market Value of the firm is equal to the value of all the claims or securities the firm has

issued; that is…

Market

Value of

the Firm

= Market Value of the

Firms Outstanding

Debt

+ Market Value of the

Firms Preferred

Stock

+ Market Value of

the Firms Common

Stock

Market Value of each security = number of securities x market price

Economic Profit is used to measure the performance of a firm over a specific time period such

as a year.

Net Operating Profit After Taxes (NOPAT) is the deduction of the return to the firms invested capital.

Invested Capital is the total dollars investment made in the firm by its creditors and

owners.

Cost of Capital constitutes a change in capital and is not an accounting expense. Economic

Profit

= ( Net Operating

Profit After

Taxes

(NOPAT)

) – ( Invested Capital x Cost of Capital )

$568.979M = ( $950M ) – ( $19,727M x .0770)

$950M Net Operating Profit After Taxes (NOPAT)

$19,727M Invested Capital

.0770 Cost of Capital

Financing Mix & Risk

Times Interest earned Ratio

$698.2 million in Earnings Before Interest and Taxes (EBIT)

$24.8 million Incurred Interest Expense (i.e, $698.2 / $24.8) = 28.2

Which means the company in an adverse year; EBIT could slip to about one-twenty-eight and

still meet its contractual interest debt obligations.

Risk is the likely variability associated with the expected revenue or income streams.

Income variations separate into two parts

1. The companies exposure to business risk

2. The decision to incur financial risk

Business Risk refers to the relative dispersion (variability) in the firms expected earnings before

interest and taxes (EBIT). Company cost structure, product demand characteristics, and

competitive market position (a direct result of investment decisions). The asset structure gives

rise to variability in operating profits.

Coefficient of Variation

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Expected EBIT of $100,000 with an associated standard deviation of $20,000

Coefficient of Variation = Expected EBIT of $100,000 / Standard Deviation of $20,000

Coefficient of Variation = $20,000 / $100,000 = .20

This means the larger the “Coefficient of Variation” when comparing to other companies the

larger the amount of business risk that is being taken.

Financial Risk is a direct result of the chosen financing mix chosen and applies to

The additional variability in the earnings (EBIT) available to the firms common shareholders

The additional chance of insolvency borne by the common shareholder cased by the

firm’s financial leverage.

Financial Leverage means financing a portion of the firm’s assets with securities bearing a fixed

(limited) rate of return in hope of increasing the ultimate return to the common stockholders. The

variability of EIBT is magnified by the firm’s use of financial leverage, which causes variability

in earnings per share of stock for shareholders. Financial Leverage should be used to produce a

certain effect.

Operating Leverage refers to the incurrence of fixed operating costs in the firm’s income

stream. Operating leverage depends a great deal on cost-volume-profit analysis, or breakeven

analysis. Responsiveness in EBIT to sales

Breakeven analysis determines the breakeven quantity of output by studying the relationships

among the firms cost structure, volume of output, and profit.

Cover costs and determine product prices to continue.

Breakeven Quantity of Output is the quantity of output denominated in units, which results in

an EBIT level equal to zero. It enables companies to…

1. Determine quantity of output required to cover all operating costs.

2. Calculate the EBIT that will be achieved at various levels of outputs.

To do this analysis one must speculate production costs in two mutually exclusive categories

fixed costs and variable costs.

Fixed Costs also referred to as indirect costs; do not vary with the total amount of sales volume

or the quantity of output changes. Do not include interest charges,they are constant .

Administrative salaries

Depreciation

Insurance

Lump sums paid for advertising

Property taxes

Rent

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Variable Costs are sometimes referred to as direct costs, that are fixed per unit of output but

vary in totals as output changes. Variable Costs are computed by taking the variable cost per

unit and multiplying it by the quantity produced and sold.

From manufacturing some examples are…

Direct labor

Direct materials

Energy costs (fuel, electricity, natural gas) associated with the production area

Freight costs for products leaving the plant

Sales commissions Note:

Costs can be termed a mix between Semi-variable and Semi-fixed.

Implementation of the breakeven model is an adaptation of the income statement that

identifies…in an analytical format.

1. The most relevant output range for planning purposes.

2. The approximate costs effect of semi variable items over a specified range of time

separating fixed and variable costs.

Sales – (total variable cost + total fixed cost) = profit

On a unit of production basis it is necessary to introduce

Each unit price

Variable cost per unit of output

Setting the EBIT to Zero

(Sales)

price per

unit

(units)

sold

- [(variable cost)

per unit

(units)

sold

+ (total fixed) ]

costs

= EIBT

of 0

Now one must find the number of units that must be produced or sold to satisfy the equation that

is to get the EIBT to zero.

Contribution-Margin is the difference between the unit selling price and the variable cost as

follows…

Unit Sales Price $10

- Unit Variable Cost - 6

= Unit Contribution Margin $ 4

Breakeven Quantity of Output

If the annual fixed costs of $100,000 are divided by the unit contribution-margin of $4 we find

the breakeven quantity of output is 25,000 units. $100,000 / $4 = 25,000 units

Breakeven Point in Sales Dollars from annual report information (analytical income statement).

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Analytical Income Statement

Sales $300,000

Less Variable Costs $180,000

Revenue Before

Fixed Costs

$120,000

Less Total Fixed Costs $100,000

= EBIT $20,000

Break Even Sales can be computed by…

Sales – (total variable cost + total fixed cost ) = EBIT

$300,000 – ($180,000 + $100,000) = $20,000

Ratio of total variable costs to sales , VC/S is a constant for any level of sales which allows the

previous equation to be rewritten as…

VC = variable costs

S = sales

VC/S = ratio of total variable cost to sales

F= total fixed costs

D = Revenue Before Fixed Costs

S* Break even level of sales

S-((VC/S) S)–F = EBIT

$300,000-(($180,000/$300,000) - $300,000) - $100,000 = $20,000

OR

S (1-(VC/S))-F = EBIT

$300,000(1-($180,000/$300,000)) - $100,000 = $20,000

At the breakeven level of sales we have

S (1-(VC/S))-F = 0

$300,000(1-($180,000/$300,000) )- $100,000 = 0

Revenue before Fixed Costs

S(1-(VC/S)) = D

$300,000(1-($180,000/$300,000)) = $120,000

Break even level of sales

S= F/ (1-(VC/ S))

S=$100,000/ (1-(180,000/$300,000)) = $250,000

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Operating Leverage arises from a firm’s use of fixed operating costs.

Question: How will a 20% positive change in sales effect the EBIT

Item Base Sales Forecast Sales

Sales = $300,000 x .20 $360,000

Less Variable

Costs

= $180,000 x .20 $216,000

Revenue

Before

Fixed

Costs

= $120,000 $144,000

Less Total

Fixed

Costs

= $100,000 $100,000

= EBIT = $20,000 $44,000

EBIT is $44,000 at the end of the planning period.

Percentage Change in EBIT = (EBIT 1- EIBT 2) / EIBT 1

Percentage Change in EBIT = ($44,000-$20,000) / $20,000 = 1.2 or 120%

Percentage Change in Sales = (Sales 2 – Sales 1) / Sales 1

Percentage Change in Sales = ($360,000 - $300,000) / $300,000 =.20 or 20%

Degree of Operating Leverage from sales level (DOL)

DOL= Percentage Change in EIBT / Percentage Change in Sales

DOL= 120% / 20% = 6 times as great

Managers have less control over the operating cost structure and almost complete control over a

firm’s financial structure.

The greater the sales level, the lower the degree of operating leverage.

If operating leverage exists it will exceed 1.00

Percentage change in EIBT / Percentage Change in Sales = DOL is will exceed 1.00

This means the more operating leverage that is computed, the more profits will vary within

a given percentage change in sales.

Financial Leverage

Prospective owners calculate, $200,000 will be required to purchase specific assets required to

conduct business.

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In plan A: has zero debt and no financial risk is assumed.

Total Assets $200,00 Total Debt $0

Common Equity $200,000

Total Liabilities & Equity $200,000

Earnings per share rise 100%

In plan B: has 25% debt at 8% interest.

Total Assets $200,00 Total Debt $50,000

Common Equity $150,000

Total Liabilities & Equity $200,000

Earnings per share rise 125%

In plan C: has 40% debt at 8% interest.

Total Assets $200,00 Total Debt $80,000

Common Equity $120,000

Total Liabilities & Equity $200,000

Plan C uses the most financial leverage with 40% of assets financed with debt.

Earnings per share rise 147%

The firm is exposing its owners to risk when the following situation exists:

Percentage change in earnings per share / Percentage change in EIBT = >1.00 DFL

Note the EIBT drop of 10% between plans A-C below and can be quantified.

Degree of Financial Leverage (DFL) from the base EBIT level

Plan A DFL = DFL $20,000 = 100% / 100% = 1.00 time

Degree of Financial Leverage (DFL) from the base EBIT level

Plan A DFL = DFL $20,000 = ($20,000 / ($20,000-0)) = 1.00 time

Plan B DFL = DFL $20,000 = 125% / 100% = 1.25 time

Plan B DFL = DFL $20,000 = ($20,000 / ($20,000-$4,000)) = 1.25 time

Plan C DFL = DFL $20,000 = 147% / 100% = 1.47 time

Plan C DFL = DFL $20,000 = ($20,000 / ($20,000-$6,400)) = 1.47 time

Note: the degree of combined leverage is actually the product (not the simple sum) of the two

independent leverage measures. Thus we have pg 384.

(DOL) x (DFLEBIT) = DCL

(6) x (1.25) = 7.50 times

The degree of combined leverage with out percent fluctuations

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Percentage change in earnings per share divided by the percentage change in sales; or revenue

before fixed costs divided by EBT

DCL = sales ( WHAT IS THE FORMULA)

DCL $300,000 = $30,000 ($10 - $6) = 7.5 times

$30,000 ($10-$6) - $100,000 -$4,000

Ratios

Question 1 How Liquid is a Firm?

Liquidity is a businesses ability to convert assets into cash. How is Liquidity measured?

Two ways to measure (pg. 106).

Method 1 is used to measure short term solvency, Measuring “liquidity” assets that should be

converted into cash within the next 12 months against the debt (liabilities) that is coming due

within 12 months.

current ratio = current assets / current liabilities

current ratio 1.73 = current assets $922M / $533M current liabilities

This means $1.73 in current assets for every $1 in short-term debt.

(good to compare with competitors in the same market)

Acid-test or Quick Ratio (more stringent test of liquidity).

acid-test ratio = (cash + accounts receivable) / current liabilities

.84 Acid-test ratio = ($350M cash + $114M accounts receivable) / $553M current liabilities. This

means $0.84 in cash and accounts receivables per $1 in current debt.

Method 2a measures liquidity by examining a firm’s ability to convert accounts receivable

and inventory into cash on a timely basis.

Average collection period = accounts receivable / (annual credit sales/ 365 days)

Average collection period = accounts receivable $114M/( annual credit sales $611M/365days)

Average collection period = accounts receivable / daily credit sales)

Average collection period = $114M / ($1.67M/1day)

68.1 Days = 114/(611/365) = 68.1 days to collect on accounts receivable.

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Average collection period =68.1 Days

This means it takes 68.1 days to convert accounts receivable into cash.

Method 2b The same conclusion can be reached by measuring how many times accounts

receivable are “rolled over” during a year using the accounts receivable turnover ratio.

Accounts receivable turnover = annual credit sales / accounts receivable

5.36 = 365 days / 68.1 days

This means accounts are collected 5.36 times a year.

5.36 accounts receivable turnover ratio

Converting Inventories into Cash

Inventory turnover ratio is how many times a year a company is turning over inventories.

Inventory turnover = cost of goods sold / inventory

9.38 = $3,207M / $342M

9.38 = 3207 / 342

Inventory turnover ratio of 9.38 means the company turning its inventory 9.38 times a year, or

9.38 % of their inventory sitting on the shelves.

Companies look at the cost of materials being shipped out to the value of the inventory.

Inventory sitting on the shelves.

Cost of good sold/ inventory = % of inventory still sitting on the shelves.

3207/342 = 9.38 % of inventory sitting on the shelves.

Days of inventory tells a business how many days of inventory it has before back orders must be

taken.

Days of inventory = (inventory / cost of good sold) * 365

(342/3207)*365 = 38.9 days of inventory

Operating Cycle (is how long it takes a product to sell and then receivables to be collected).

Days of inventory + Days Receivable = Operating Cycle

Question 2 (profitability) is management generating profits on the firm’s assets?

What profits have been generated on the total assets?

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Note. Operating profit is the same as operating income and earnings before interest and taxes

(EBIT). To examine the level of operating profit relative to the total assets, we used the

operating return on assets (OROA).

Operating return on assets = operating profit / total assets

$436M / $2672M = 0.1632 or 16.32%

This means the operating return on assets is, 16.3 cents for every $1 of assets.

The product of two ratio is how the return on assets are calculated between asset management

and operations management?

Operations return on assets = Operations Management operating profit margin * Asset

Management total asset turn over… which is calculated as follows:

Part 1 of 3 the operating profit margin (effectiveness in managing operations).

operating return on assets = (operating profits / sales) * (sales / total assets)

operating return on assets 0.107 or 10.7% = (operating profits 436 / sales 4076)

436/4076= 0.107 or 10.7% operating return on assets

Part 2 of 3 total assets turn over (how well the firm manages assets or asset efficiency).

total asset turn over = sales / total assets

total asset turn over 1.53 = sales 4076 / total assets 2672

4076/2672= 1.53 total asset turn over

Part 3 of 3 fixed asset turn over (how well the firm manages fixed assets).

fixed asset turnover = sales / net fixed assets

fixed asset turnover 2.33 = sales 4076/ net fixed assets 1750

4076/1750 = 2.33 fixed asset turnover (lower the turnover the better)

Question 3 how is a firm financing its assets (either debt or equity)?

What percentage of the firms assets are financed by debt both short-term and long-term,

realizing the remainder percentage must be financed by equity? Liabilities are the debt.

Debt Ratio

debt ratio = total debt / total assets

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debt ratio 0.221 or 22.1% = total debt 591 / total assets 2672

591 / 2672 = debt ratio 0.221 or 22.1%

This means 22.1% of assets are financed with debt and 77.9 with equity.

Times Interest Earned Ratio (number of times we are earning our interest).

Stated as a ratio, compares the amount of operating income that is available to pay the interest

with the amount of interest that is to be paid.

times interest earned = operating profits / interest expense

times interest earned 145.3= operating profits 436/ interest expense 3

times interest earned 145.3 = 436 / 3

436/3 = 145.3x interest earned.

This means it can pay its interest of 3 million 145.3 times and is less than 1% of its operating

profits.

Question 4 Is Management providing a good return on the capital provided by shareholders?

Return on Equity (ROE) is the accounting return on the common stock holders investment (the

higher the percentage the better).

Return on equity = net income / common equity = net income / (common stock + retained

earnings)

Return on equity 0.129 or 12.9% = 268 net income / 2081common equity

268/2081=0.129 or 12.9% return on equity

Note a higher return on asset will result in a higher return on equity. Also the less debt a firm

uses the lower the return on equity will be provided return on assets is greater than the interest

rate on its debt. More Debt also means more financial risk for the company and its shareholders.

Question 5 Is the Management team creating shareholder value?

Earnings per Share Ratio or Price/Earnings Ratio (PE) indicates how much investors are

willing to pay for $1 of earnings. The higher the ratio the more optimistic investors are about the

company’s future. Note 268 million net income / 391 million shares = $0.69

Price / earnings ratio = market price of one share of stock / earnings per share

PE 50.57x = market price of one share of stock $35.00 / earnings per share $0.69

TOOLS 19

35/0.69 = 50.57x price earnings ratio

50.57 times price earnings ratio

Price/Book Ratio (compares the market value of a stock to the book value per share of the firms

reported total [both common stock and retained earnings] equity in the balance sheet). Book

value per share is $5.32 so ($5.32=$2081 million book equity value / 391 million shares) Note

price/book>1 shareholder value was created. Or price/book<1 share holder value was destroyed.

Price/ Book Ratio = price per stock share / equity book value per share

Price/Book Ratio 6.58x = price per stock share $35.00/ equity book value per share $5.32

35/5.32 = 6.58 times Price/ Book Ratio

$6.58 for each dollar of book value and is much greater than 1.

Economic Value Added (EVA) is an attempt to measure a firm’s economic profit rather than

accounting profits in a given year. Economic profits assign a cost to the equity capital (the

opportunity cost of funds provided by shareholders) in addition to the interest cost on the firm’s

debt.

Example

EVA = (operating return on assets –cost of all capital) * total assets

EVA = (0.16 – 0.11) * $1,000 = $50

Cash Invested not Profit

PB=1/ACF or 10yrs = 1000/100

10 years to get money back

Payback (In Years) = Investment / Annual cash flows

(Assumes that the annual cash flow stays the same).

PB = 5yrs PB = 5yrs

Yr1 Yr3

2-3 (-) loss 2-3 (-) loss

4-5 (+) gain 4-5 (+) gain

The boss gets promoted about every 5yrs so think about if his time of promotion might be around

year 3 and put him at a loss yr3+ yr2-3 (-) loss. The quicker a profit/return can be made the

better the value of the deal.

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References

Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance. (10 ed.). New

York, NY: McGraw-Hill