Midterm 1 Name __________________________

Practice Exam
Solutions

I. Multiple Choice

1. Nimoy Nautalytics has a return on sales of 9%, a total assets turnover ratio of 1.5, debt
of $4 million and assets of $14 million. What is the firm’s return on equity?

a. 16.3%
b. 18.9%
c. 31.2%
d. 33.2%
e. 36.0%

NI / E = 9 x 1.5 x (14 / (14-4)) = 18.9%

2. Last year, Shatner Shoes had negative cash flow from operations; however, cash on its
balance sheet increased. Which of the following could explain this?
a. The company repurchased some of its common stock.
b. The company had large depreciation and amortization expenses.
c. The company issued a large amount of long-term debt.
d. The company dramatically increased its capital expenditures.
e. All of the statements above are correct.

This is the only choice that would bring cash into the company (source of cash).

3. Simon Cybernetics has total interest charges of $50,000 per year, sales of $400,000, a
tax rate of 40 percent, and a profit margin of 30 percent. What is the firm’s times interest
earned ratio?

a. 5x
b. 6x
c. 8x
d. 9x
e. none of the above

NI = 0.30 x 400,000 = 120,000

EBT = 120,000 / (1 – 0.40) = 200,000
EBIT = 200,000 + 50,000 = 250,000
TIE = 250,000 / 50,000 = 5x
4. A fire has destroyed many of the financial records at Fortes Associates. You are
assigned to piece together information to prepare a financial report. You have found that
the firm’s return on equity is 24 percent and its debt ratio is .55. What is its return on
assets?

a. 4.90%
b. 8.40% 55
c. 10.80%
d. 12.80% 100
e. 15.60% 45

24 = NI /A x A/E
24 = NI/A x 100/45
NI/A = 24 / 2.222 = 10.80

5. At the beginning of the year, Cessna Corporation had $200,000 in cash. Looking at its
statement of cash flows, you see that the net cash provided by its operations was
$300,000 and the company’s investing activities required cash expenditures of $800,000.
The company’s cash position at the end of the year was $275,000. What was the net cash
provided by the company’s financing activities?

a. $400,000
b. $450,000
c. $500,000
d. $575,000
e. $700,000

(275 – 200) = 300 – 800 + CFF  CFF = 575

6. Consider the following balance sheet, for Games Inc. Because Games has $800,000 of
retained earnings, we know that the company would be able to pay cash to buy an asset
with a cost of $800,000.

Cash $50,000 Accounts payable $100,000

Inventory $200,000 Accruals $100,000
Accounts receivable $250,000 Total CL $200,000
Total CA $500,000 Long-term debt $200,000
Net fixed assets $900,000 Common stock $200,000
Retained earnings $800,000
Total assets $1,400,000 Total L & E $1,400,000

a. true
b. false
Retained earnings on the balance sheet is not cash. It is the financing provided by
stockholders over time through the retention of earnings. In this example, the cash
available to buy an asset is $50,000. See next question.

7. The retained earnings account on the balance sheet does not represent cash. Rather, it
represents part of the stockholders' claim against the firm's existing assets. Put another
way retained earnings are stockholders' reinvested earnings.

a. True
b. False

8. Interest paid by a corporation is a tax deduction for the paying corporation, but
dividends paid are not deductible. This treatment, other things held constant, tends to
encourage the use of debt financing by corporations.

a. True
b. False

The tax deductibility of interest on debt favors debt over equity financing since
dividends paid aren’t tax deductible.

9. Other things held constant, which of the following actions would increase the amount
of cash on a company's balance sheet?

a. The company repurchases common stock.

b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment.

When a company issues new stock, the investors pay the company cash. This
increases the amount of cash the company has on the balance sheet (until they
perhaps use the cash to buy an asset).

10. The Nantell Corporation just purchased an expensive piece of equipment. Assume
that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but
Congress then passed a provision that requires the company to depreciate the equipment
on a straight-line basis over 7 years. Other things held constant, which of the following
will occur as a result of this Congressional action? Assume that the company uses the
same depreciation method for tax and stockholder reporting purposes.

a. Nantell’s taxable income will be lower.

b. Nantell’s operating income (EBIT) will increase.
c. Nantell’s cash position will improve (increase).
d. Nantell’s reported net income for the year will be lower.
e. Nantell’s tax liability for the year will be lower.

Depreciation is an operating cost. So lower depreciation will increase operating

income, which will also increase taxable income and net income. However, the
company will have higher taxable income so will pay more taxes. This will require
higher cash payments.

11. Scranton Shipyards has $11.0 million in total invested operating capital, and its
WACC is 10%. Scranton has the following income statement:

Sales $10.0 million

Operating costs 6.0 million
Operating income (EBIT) $ 4.0 million
Interest expense 2.0 million
Earnings before taxes (EBT) $ 2.0 million
Taxes (40%) 0.8 million
Net income $ 1.2 million

What is Scranton’s approximate EVA?

a. $1,235,000
b. $1,040,000
c. $1,300,000
d. $975,000
e. $1,495,000

EVA = EBIT ( 1-t) – (WACC) (total invested capital)

EVA = 4.0 (1 – 0.40) – (0.10)(11.0) = 1.3 million

12. The days sales outstanding 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.

a. True
b. False

13. If a firm's ROE is equal to 9% and its ROA is equal to 6%, its equity multiplier must
be 1.5.

a. True
b. False
9 = 6 X a/e  A/E = 9/6 = 1.5
NI/E = NI/A x A/E
9 = 6 x A/E  A/E = 9 / 6 = 1.5

Use the following income statement for Lopez Laser to answer problems 14 through 16:

Sales $40,000,000
Operating costs excluding depreciation and amortization 25,000,000
EBITDA $15,000,000
Depreciation and amortization 8,000,000
Operating income (EBIT) $7,000,000
Interest expense 3,000,000
Taxable income (EBT) $ 4,000,000
Taxes (40%) 1,600,000
Net income $ 2,400,000

14. The net operating profit after tax is:

a. $1,800,000
b. $3,000,000
c. $4,200,000
d. $6,000,000
e. none of the above

7,000,000 (1 – 0.40) = 4,200,000

15. If Lopez has investor supplied capital of $30,000,000 and a weighted average cost of
capital of 11%, what is the firm’s economic value added (EVA)?

a. -$900,000
b. $700,000
c. $900,000
d. $3,700,000
e. $5,700,000

EVA = 4,200,000 – 0.11(30,000,000) = 900,000

16. If Lopez has 1,200,000 shares outstanding, a book value per share of $12.00, and a
stock price of $30.00, what is the P/E ratio if net income is $2,400,000?

a. 8
b. 15
c. 20
d. 30
e. 45

P / E = 30 / (2,400,000/1,200,000) = 15
II. Problems

2. (24 points) Complete the following balance sheet using the information provided
(assume a 365 day year). Round numbers to the nearest $1,000.

Current Ratio = 6.25 Total Asset Turnover = 1.52 X

Inventory Turnover = 7.6 X Days Sales Outstanding = 32.02 days
Total Debt Ratio = .38

Cash 250,000 Accounts Payable 200,000

Accounts Receivable 400,000 Long Term Debt $940,000
Inventory 600,000 Common Stock $960,000
Fixed Assets 1,750,000 Retained Earnings 900,000
Total Assets 3,000,000 Tot Liabilities & Equity $3,000,000

Sales 4,560,000

Total liabilities and equity = total assets  total assets = 3,000,000

Total asset turnover = 1.52 = Sales / 3,000,000  Sales = 4,560,000
Debt ratio = 0.38 = (Accts Payable + 940,000) / 3,000,000  Accts Payable = 200,000
Plug for retained earnings = 900,000
Days sales outstanding = 32.02 = AR / (4,560,000/365)  AR = 400,000
Inventory TO = 7.6 = Sales / Inventory = 4,560,000 / Inv  Inv = 600,000
Current ratio = 6.25 = (Cash + 400,000 + 600,000) / 200,000  Cash = 250,000
Plug for fixed assets = 1,750,000
3. In 2019 Juniper Corporation had sales of $1,440,000, net income of $101,120, and
24,000 shares outstanding. Their year-end balance sheet is as follows:

The 2019 income statement is as follows:

2019
Sales $1,440,000
Operating Costs $1,272,000
EBIT $168,000
Interest Expense $40,000
EBT $128,000
Taxes (21%) $26,880
Net Income $101,120

Fixed operating costs amount to $120,000 with the remainder of operating costs variable.
The firm’s tax rate is 21%.

a. (5 points) Perform a Dupont analysis for this company, breaking ROE up into three
components. Also calculate the firm’s EPS.

a
NI/Sales 101,120/1,440,000 0.0702
Sales/Assets 1,440,000/1,266,000 1.1374
Assets/Equity 1,266,000/600,000 2.1100
ROE = 0.1685
EPS = 101,120 / 24,000 $4.21

EPS ________
b. (10 points) Management plans to implement the following changes in 2020:

1. Through increased labor outsourcing and more efficient materials purchasing the
variable operating cost percentage (variable operating costs / sales) will be
reduced to 70% of sales from the current level 80%.

2. More efficient sales collection practices will lead to a reduction in DSO to the
industry average of 25.3473. The funds generated will be used to buy back stock
at $50 per share.

There will be no change in the firm’s sales, debt or interest expense.

Complete the income statement below for 2020 under the assumption that sales remain at
$1,440,000, fixed operating costs remain at $120,000, the variable operating cost
percentage is 70%, and interest expense remains at $40,000.

2020
Sales $1,440,000
Operating Costs 1,128,000 120,000 + (0.70)(1,440,000)
EBIT 312,000
Interest Expense 40,000
EBT 272,000
Taxes (21%) 57,120 (0.21) x (272,000)
Net Income $214,880

c. (10 points) Given the changes in part b, perform a Dupont Analysis for the company
for 2020 breaking ROE up into three components. Also calculate the firm’s EPS.

ROE ___________
EPS ____________

New AR $100,000 25.3473 x (1,440,000)/365

Reduction in AR $20,000 120,000 – 100,000
New Assets $1,246,000 1,266,000 – 20,000
New Equity $580,000 600,000 – 20,000
New Shares 23,600 24,000 – (20,000/50)
 NI/Sales 214,880/1,440,000 0.1492
Sales/Assets 1,440,000/1,246,000 1.1557
Assets/Equity 1,246,000/580,000 2.1483
ROE = 37.05%
EPS = $9.11

EPS = 214,880 / 23,600 = 9.11

d. (10 points) Using the Dupont framework, analyze the expected differences in performance from
2019 to 2020. Which ratios have changed and why?