PRACTICE EXERCISES

1. Below is the common equity section (in millions) of Timeless Technology’s

last two year-end balance sheets:

2011 2010
Common stock $2,000 $1,000
Retained earnings 2,000 2,340
Total common equity $4,000 $3,340

The firm has never paid a dividend to its common stockholders. Which of
the following statements is CORRECT?

a. The company’s net income in 2011 was higher than in 2010.

b. The firm issued common stock in 2011.
c. The market price of the firm's stock doubled in 2011.
d. The firm had positive net income in both 2010 and 2011, but its net
income in 2011 was lower than it was in 2010.
e. The company has more equity than debt on its balance sheet.

i2. Which of the following factors could explain why Michigan Energy's cash
balance increased even though it had a negative cash flow last year?

a. The company sold a new issue of bonds.

b. The company made a large investment in new plant and equipment.
c. The company paid a large dividend.
d. The company had high depreciation expenses.
e. The company repurchased 20% of its common stock.
i

3. Suppose all firms follow similar financing policies, face similar risks, have
equal access to capital, and operate in competitive product and capital markets.
However, firms face different operating conditions because, for example, the grocery
store industry is different from the airline industry. Under these conditions,
firms with high profit margins will tend to have high asset turnover ratios, and
firms with low profit margins will tend to have low turnover ratios.

a.True
b. False

4. Determining whether a firm's financial position is improving or deteriorating

requires analyzing more than the ratios for a given year. Trend analysis is one
method of examining changes in a firm's performance over time.

a. True
b. False

5. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio
might exceed that of A. However, if A's quick ratio exceeds B's, then we can be
certain that A's current ratio is also larger than B's.

a. True
b. False

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6. Firms A and B have the same current ratio, 0.75, the same amount of sales, and
the same amount of current liabilities. However, Firm A has a higher inventory
turnover ratio than B. Therefore, we can conclude that A's quick ratio must be
smaller than B's.

a. True
b. False

7. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of
its debt, the interest rate on that debt, the applicable tax rate, and its operating
costs. With this information, the firm can calculate the amount of sales required
to achieve its target TIE ratio.

a. True
b. False

8. Suppose Firms A and B have the same amount of assets, pay the same interest rate
on their debt, have the same basic earning power (BEP), and have the same tax rate.
However, Firm A has a higher debt ratio. If BEP is greater than the interest rate
on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

a. True
b. False

9. If a firm finances with only debt and common equity, and if its equity multiplier
is 3.0, then its debt ratio must be 0.667.

a. True
 b. False

10. One problem with ratio analysis is that relationships can sometimes be
manipulated. For example, if our current ratio is greater than 1.5, then borrowing
on a short-term basis and using the funds to build up our cash account would cause
the current ratio to INCREASE.

a. True
b. False
11. One problem with ratio analysis is that relationships can be manipulated. For
example, we know that if our current ratio is less than 1.0, then using some of our
cash to pay off some of our current liabilities would cause the current ratio to
increase and thus make the firm look stronger.

a. True
b. False

12. Assume that Besley Golf Equipment commenced operations on January 1, 2011, and
it was granted permission to use the same depreciation calculations for
shareholder reporting and income tax purposes. The company planned to
depreciate its fixed assets over 15 years, but in December 2011 management
realized that the assets would last for only 10 years. The firm's
accountants plan to report the 2011 financial statements based on this new
information. How would the new depreciation assumption affect the company’s
financial statements?

a. The firm’s reported net fixed assets would increase.

b. The firm’s EBIT would increase.
c. The firm's reported 2011 earnings per share would increase.
d. The firm's cash position in 2011 and 2012 would increase.
e. The provision will increase the company's tax payments.

14. A start-up firm is making an initial investment in new plant and equipment.
Assume that currently its equipment must be depreciated on a straight-line basis
over 10 years, but Congress is considering legislation that would require the firm
to depreciate the equipment over 7 years. If the legislation becomes law, which of
the following would occur in the year following the change?

a. The firm’s operating income (EBIT) would increase.

b. The firm’s taxable income would increase.
c. The firm’s cash flow would increase.
d. The firm’s tax payments would increase.
e. The firm’s reported net income would increase.

15. For managerial purposes, i.e., making decisions regarding the firm's
operations, the standard financial statements as prepared by accountants under
generally accepted accounting principles (GAAP) are often modified and used to
create alternative data and metrics that provide a somewhat different picture of a
firm's operations. Related to these modifications, which of the following
statements is CORRECT?

a. The standard statements make adjustments to reflect the effects of

inflation on asset values, and these adjustments are normally carried into
any adjustment that managers make to the standard statements.
b. The standard statements focus on accounting income for the entire
corporation, not cash flows, and the two can be quite different during any
 given accounting period. However, the firm's value is based on its future
cash flows. After all, future cash flows tells us how much the firm can
distribute to its investors.
c. The standard statements provide useful information on the firm’s
individual operating units, but management needs more information on the
firm’s overall operations than the standard statements provide.
d. The standard statements focus on cash flows, but managers should be less
concerned with cash flows than with accounting income as defined by GAAP.
e. The best feature of standard statements is that, if they are prepared
under GAAP, the data are always consistent from firm to firm. Thus, under
GAAP, there is no room for accountants to “adjust” the results to make
earnings look better.
16. The CFO of Daves Industries plans to have the company issue $300 million of new
common stock and use the proceeds to pay off some of its outstanding bonds that
carry a 7% interest rate. Assume that the company, which does not pay any
dividends, takes this action, and that total assets, operating income (EBIT), and
its tax rate all remain constant. Which of the following would occur?

a. The company’s taxable income would fall.

b. The company’s interest expense would remain constant.
c. The company would have less common equity than before.
d. The company’s net income would increase.
e. The company would have to pay less taxes.

17. Last year Besset Company’s operations provided a negative cash flow, yet the
cash shown on its balance sheet increased. Which of the following statements could
explain the increase in cash, assuming the company’s financial statements were
prepared under generally accepted accounting principles (GAAP)?

a. The company repurchased some of its common stock.

b. The company dramatically increased its capital expenditures.
c. The company retired a large amount of its long-term debt.
d. The company sold some of its fixed assets.
e. The company had high depreciation expenses.

18. Which of the following statements is CORRECT?

a. If a firm has high current and quick ratios, this always indicate that the
firm is managing its liquidity position well.
b. If a firm sold some inventory for cash and left the funds in its bank
account, its current ratio would probably not change much, but its quick
ratio would decline.
c. If a firm sold some inventory on credit, its current ratio would probably
not change much, but its quick ratio would decline.
d. If a firm sold some inventory on credit as opposed to cash, there is no
reason to think that either its current or quick ratio would change.
e. The inventory turnover ratio and days sales outstanding (DSO) are two
ratios that are used to assess how effectively a firm is managing its
current assets.

19. Which of the following statements is CORRECT?

a. A decline in a firm's inventory turnover ratio suggests that it is

improving both its inventory management and its liquidity position, i.e.,
that it is becoming more liquid.
b. In general, it's better to have a low inventory turnover ratio than a high
one, as a low one indicates that the firm has an adequate stock of
 inventory relative to sales and thus will not lose sales as a result of
running out of stock.
c. If a firm's fixed assets turnover ratio is significantly lower than its
industry average, this could indicate that it uses its fixed assets very
efficiently or is operating at over capacity and should probably add fixed
assets.
d. The more conservative a firm's management is, the higher its debt ratio is
likely to be.
e. The days sales outstanding ratio tells us how long it takes, on average,
to collect after a sale is made. The DSO can be compared with the firm's
credit terms to get an idea of whether customers are paying on time.

20. Walter Industries’ current ratio is 0.5. Considered alone, which of the
following actions would increase the company’s current ratio?

a. Borrow using short-term notes payable and use the cash to increase
inventories.
b. Use cash to reduce accruals.
c. Use cash to reduce accounts payable.
d. Use cash to reduce short-term notes payable.
e. Use cash to reduce long-term bonds outstanding.

21. Safeco’s current assets total to $20 million versus $10 million of current
liabilities, while Risco’s current assets are $10 million versus $20 million of
current liabilities. Both firms would like to “window dress” their end-of-year
financial statements, and to do so they tentatively plan to borrow $10 million on a
short-term basis and to then hold the borrowed funds in their cash accounts. Which
of the statements below best describes the results of these transactions?

a. The transactions would improve Safeco’s financial strength as measured by

its current ratio but lower Risco’s current ratio.
b. The transactions would lower Safeco’s financial strength as measured by
its current ratio but raise Risco’s current ratio.
c. The transactions would have no effect on the firm’ financial strength as
measured by their current ratios.
d. The transactions would lower both firm’ financial strength as measured by
their current ratios.
e. The transactions would improve both firms’ financial strength as measured
by their current ratios.

22. Wie Corp's sales last year were $315,000, and its year-end total assets were
$355,000. The average firm in the industry has a total assets turnover ratio
(TATO) of 2.4. The firm's new CFO believes the firm has excess assets that can be
sold so as to bring the TATO down to the industry average without affecting sales.
By how much must the assets be reduced to bring the TATO to the industry average,
holding sales constant? 246,667$

23. Chang Corp. has $375,000 of assets, and it uses only common equity capital
(zero debt). Its sales for the last year were $595,000, and its net income was
$25,000. Stockholders recently voted in a new management team that has promised to
lower costs and get the return on equity up to 15.0%. What profit margin would the
firm need in order to achieve the 15% ROE, holding everything else constant? 9.45%

24. Jordan Inc has the following balance sheet and income statement data:

Cash $ 14,000 Accounts payable $ 42,000

Receivables 70,000 Other current liab. 28,000
Inventories 280,000 Total CL $ 70,000
Total CA $364,000 Long-term debt 140,000
Net fixed assets 126,000 Common equity 280,000
Total assets $490,000 Total liab. and equity $490,000
Sales $280,000
Net income $21,000

The new CFO thinks that inventories are excessive and could be lowered
sufficiently to cause the current ratio to equal the industry average, 2.75,
without affecting either sales or net income. Assuming that inventories are
sold off and not replaced to get the current ratio to the target level, and
that the funds generated are used to buy back common stock at book value, by
how much would the ROE change? 24.08%

25. Multiple Part:

(The following information applies to Problems 110 through 127.)

The balance sheet and income statement shown below are for Koski Inc. Note that
the firm has no amortization charges, it does not lease any assets, none of its
debt must be retired during the next 5 years, and the notes payable will be rolled
over.

Balance Sheet (Millions of $)

Assets 2010 
Cash and securities $ 2,500
Accounts receivable 11,500
Inventories 16,000
Total current assets $30,000
Net plant and equipment $20,000
Total assets $50,000
Liabilities and Equity
Accounts payable $ 9,500
Notes payable 7,000
Accruals 5,500
Total current liabilities $22,000
Long-term bonds $15,000
Total debt $37,000
Common stock $ 2,000
Retained earnings 11,000
Total common equity $13,000
Total liabilities and equity $50,000

Income Statement (Millions of $) 2010 

Net sales $87,500
Operating costs except depreciation 81,813
Depreciation 1,531
Earnings bef interest and taxes (EBIT) $ 4,156
Less interest 1,375
Earnings before taxes (EBT) $ 2,781
Taxes 973
Net income $ 1,808
Other data:
Shares outstanding (millions) 500.00
Common dividends $632.73
Int rate on notes payable & L-T bonds 6.25%
Federal plus state income tax rate 35%
Year-end stock price $43.39

Required:
a. What is the firm's current ratio? 1.09

b. What is the firm's quick ratio?0.55

c. What is the firm's days sales outstanding? Assume a 365-day year for this
calculation. 65.18

d. What is the firm's total assets turnover? 1.40

e. What is the firm's inventory turnover ratio?

f. What is the firm's TIE?

4.67

g. What is the firm's debt/assets ratio? 45.45%

h. What is the firm's ROA?

i. What is the firm's ROE?

j. What is the firm's BEP?

k. What is the firm's profit margin?

l. What is the firm's operating margin?

m. What is the firm's dividends per share?

n. What is the firm's EPS?

o. What is the firm's P/E ratio?

p. What is the firm's book value per share?

q. What is the firm's market-to-book ratio?