© studocu Exercises on Ch.9 - SolutionsExercises on Ch. 9 4” Level FRA 1) The ratio percentage of earnings retained is the same as that termed: a. dividend yield b. dividend payout ¢. this year's retained earnings to net income d. return on common equity e. book value 2) The earnings per share is computed for: 4. common stock b. non-redeemable preferred c. redeemable preferred d. common stock and non-redeemable preferred stock e. common stock and fully diluted preferred stock 3) In 2008, ABC Company reported earnings per share of $2.00 for 10,000 shares. In 2009, there was a 2-for-1 stock split, for which 2009 earnings per share were reported at $2.10. The appropriate earnings per share presentation for a 2-year comparative analysis would be: 2009. 2008 a. $2.10 $2.00 b. $1.05 $2.00 ©. $1.05 $2.00 . $2.10 $1.00 ¢. none of the answers are correct, When the company made a stock split, we adjust the EPS of the prior years. The company made a 2-for-1 stock split in 2009. Therefore, we adjust the EPS of 2008 ($2.00/2 = $1.00). 4) Interest expense creates magnification of earnings through financial leverage because: a, the interest rate is variable b. interest accompanies debt financing c. the use of interest causes higher earnings d. interest costs are cheaper than the required rate of return to equity owners ¢. while earnings available to pay interest rise, earnings to residual owners rise faster 5) What is the effect of the exercise of stock options? a. They generate cash to the issuing firm and therefore increase profit per share. b. They are an expense at the time of exercise. This lowers net income. c. They increase debt and lower borrowing capacity but have no effect on profit d. They increase the number of shares outstanding. c. They have no immediate effect on profitability. 6) Using financial leverage is a good financial strategy from the viewpoint of stockholders of companies having: a. a high debt ratio b. cyclical highs and lows ¢. steady or rising profits d. a steadily declining current ratio e. none of the answers are correct x 4 po ccsmnnalbinctctoaaon Oy Studocu Downloaded by VIVAL GARG (vimalg.garg@amall.com)Exercises on Ch. 9 - Solutions 4” Level 7) A summarized income statement for Leveraged Inc. is presented below. Sales $1,000,000 Cost of Sales 600,000 Gross Profit $ 400,000 Operating Expenses 250,000 Operating Income $ 150,000 Interest Expense 30,000 Earnings Before Tax $ 120,000 Income Tax 40,000 Net Income $80,000 The degree of financial leverage is: a, $150,000/$30,000 . $150,000/5 120,000 c. $1,000,000/8400,000 4. $150,000/$80,000 e. $400,000/120,000 EBT 120,000 120,000 8) Dawn Alive reported the following for 2008. Ending market price $40.75 Earnings per share: Basic 2.50 Diluted 2.08 Dividends per share 1.10 ‘The price/earnings ratio and dividend payout were: a. 19.59 and 52.88% b, 16.30 and 52.88% ©. 16.30 and 44.00% d. 19.59 and 44.00% €. 37.04 and 52.88% Price/earnings ratio Dividend payout = 1.10 _ 2.08 9) The best dividend payout ratio: a. approximates 50% b. continues at the same level as was historically paid c. is similar to the industry average d. is higher than that of competitors ¢. does not follow any rule of thumb for dividend payout 2 Downloaded by VIMAL GARG (vimala.gara@amall.com)Exercises on Ch. 9 - Solutions 4” Level FRA a1 10) The following data were gathered from the annual report of Desk Products. Market price per share $30.00 Number of common shares 10,000 Preferred stock, 5%, $100 par ‘$10,000 Common equity $140,000 The book value per share is: a, $30.00 b, $15.00 ¢. $14.00 4, $13.75 €. none of the answers are correct $140,000 _ 10,000 11) Which of the following is not a reason to interpret book value with caution? a, Land may be worth more than it cost. b. Depreciable assets may be held. c. Investments may be worth more than their purchase price. d. Patents may have a high market value. e. All of the answers are correct. 12) Which of the following is not a true statement regarding stock options? a. They may cause dilution of earnings per share. b. They generally allow the purchase of common stock at favorable terms. c. They involve a compensation expense. d. Exercise improves the short-term liquidity and debt position of the issuing firm. e. The potential dilution can be disregarded in financial analysis. 13) A firm has a degree of financial leverage of 1.20. If earnings before interest and tax increase by 20%, then net income: a, will not necessarily change b. will increase by 20% c. will decrease by 24% d. will decrease by 20% ¢. none of the answers are correct 1 increase by 24% (20% x 1.20) 14) The price/eamings ratio: a, measures the past earning ability of the firm b. relates price to total net income ¢. is a gauge of future earning power as seen by investors d, relates price to dividends e. all of the answers are correct 15) Stable dividend policy would most commonly imply: a. a high price/earnings ratio b. a stable dividend yield ¢. stable dividends per share d, stable earnings per share e. increasing dividends per share x 4 po csrnnlbinctctoaaon Oy Studocu Downloaded by VIVAL GARG (vimala.garg@amall.com)Exercises on Ch. 9 - Solutions 4” Level FRA a1 16) Book value per share may not approximate market value per share because: a. the book value is after tax b. book values are based on replacement costs rather than market values ¢. book value is related to book figures and market value is related to the future potential as seen by investors d. investors do not understand book value e. book value is not related to dividends. 17) Which of the following ratios represents dividends per common share in relation to market price per common share? a. dividend payout b, dividend yield c. price/earnings d. book value per share e. percentage of earnings retained 18) Which of the following ratios usually reflects investors opinions of the future prospects for the firm? a. dividend yield b. book value per share ¢. price/earnings ratio d. earnings per share e. dividend payout 19) Smith reported the following for 2008. Beginning market price $20.00 Average market price 24.00 Ending market price 26.00 Eamings per share: Basic 1.80 Diluted 1.60 Cash dividends per share 1.00 The price earnings ratio and dividend payout were: a. 16.25 and 62.50% b. 16.25 and 65.00% c. 17.00 and 62.50% d. 15.00 and 62.50% e. 15.00 and 60.00% . . . $26.00 Price/earnings ratio = = 16.25 1.60 1.00 Di od ividend payout = = 20) The earnings per share ratio is computed for a. Convertible bonds. b, Redeemable preferred stock. ¢. Common stock. d. Nonredeemable preferred stock. e. None of the above. ™ mn Downloaded by VIMAL GARG (vimala.gara@amall.com)Exercises on Ch. 9 - Solutions 4” Level 21) In 2009 and 2010, Zoret Company reported earnings per share of $0.80 and $1.00, respectively. In 2011, Zoret Company declared a 4-for-I stock split. For the year 2011, Zoret Company reported earnings of $0.30 per share. The appropriate earnings per share presentation for a three-year comparative analysis that includes 2009, 2010, and 2011 would be 201 2010 2009 a. $0.30 $0.25 $0.80 b. $0.30 $4.00 $3.20 & $0.30 $0.25 d $1.20 $0.25 $0.20 e $1.20 $4.00 $3.20 EPS (2009) = $0.80/4 = $0.20 EPS (2010) = $1.00/4 = $0.25 EPS (2011) = $0.30 22) The degree of financial leverage for Zorro Company was 1.50 when EBIT was reported at $1,000,000. If EBIT goes to $2,000,000, the accompanying change in net income will be a, $2,500,000. b. $3,000,000. c. $2,000,000. . $1,500,000. e. $1,000,000. Change in NI = Change in EBIT x Degree of financial leverage Change in NI = (2,000,000 — 1,000,000) x 1.50 = 1,500,000 23) In 2012, Zello Company declared a 10% stock dividend. In 2011, earnings per share was $1.00. When the 2011 earnings per share is disclosed in the 2012 annual report, it will be disclosed at a, $1.00. b. $1.10. c. $1.20. d. $0.91. e. $0.81. EPS (2011) = $1.00 / 110% = $0.91 24) Which of the following ratios usually reflects investors’ opinions of the future prospects for the firm? a. Dividend yield b. Book value per share ¢. Price/earnings ratio d. Earnings per share e. Dividend payout 25) Which of the following ratios gives a perspective on risk in the capital structure? a, Book value per share b. Dividend yield c. Dividend payout d. Degree of financial leverage _¢. Price/earnings ratio 26) Increasing financial leverage can be a risky strategy from the viewpoint of stockholders of companies having a. Steady and high profits. b. Low and falling profits. c. Relatively high and increasing profits. d. A low debt/equity ratio and relatively high profits. ¢. None of the above. 5 Downloaded by VIVAL GARG (vimala.garg@amall.com)Exercises on Ch. 9 - Solutions 4” Level FRA 4 27) A firm has a degree of financial leverage of 1.3. If earnings before interest and tax increase by 10%, then net income 4. Will increase by 13.0%. b. Will increase by 13. c. Will decrease by 13.0%. d. Will decrease by 13. e. None of the above. Increase in NI = Increase in EBIT x Degree of financial leverage ~ 10% x 1.3 = 13% 28) The ratio that represents dividends per common share in relation to market price per common share is a, Dividend payout. b. Dividend yield. c. Price/earings. d. Book value per share. e. Percentage of earnings retained. 29) Book value per share may not approximate market value per share because a, Investments may have a market value substantially above the original cost. b, Land may have substantially increased in value. c. Market value reflects future potential earning power. 4. The firm owns patents that have substantial value. ¢. All of the abor — SS 7 N x 4 mn Downloaded by VIMAL GARG (vimala.gara@amall.com)Exercises on Ch. 9 - Solutions 4” Level (1) A firm has camings before interest and tax of $1,000,000, interest of $200,000, and net income of $400,000 in Year 1. Required: a. Calculate the degree of financial leverage in base Year 1. b. If earnings before interest and tax increase by 10% in Year 2, what will be the new level of earnings, assuming the same tax rate as in Year 1? c. If earnings before interest and tax decrease to $800,000 in Year 2, what will be the new level of earnings, assuming the same tax rate as in Year 1? Earnings Before Interest and Tax . Di f Fi ial Li a. Degree of Financial Leverage Tamings Before Tax $1,000,000 $800,000 5 b. Earnings will increase by 12.5% (10% x 1.25) to $450,000 ($400,000 x 112.5% = $450,000) c, If EBIT decrease by 20%, earnings will decrease by 25% (20% x 1.25) to $300,000 ($400,000 x 75% = $300,000) 7 Downloaded by VIVAL GARG (vimala.garg@amall.com)Exercises on Ch. 9 - Solutions 4” Level (2) McDonald Company shows the following condensed income statement information for the current year: Revenue from sales $ 3,500,000 Cost of products sold (1,700,000) Gross profit 1,800,000 Operating expenses: Selling expenses $ 425,000 General expenses 350,000 (775,000) Operating income 1,025,000 Other income 20,000 Interest (70,000) Operating income before income taxes 975,000 Taxes related to operations (335,000) Income from operations 640,000 Extraordinary loss (less applicable income taxes of $40,000) (80,000) Income before noncontrolling interest 560,000 Noncontrolling interest (loss) (50,000) Net income 510,000 Required: Calculate the degree of financial leverage. Degree of Financial = Earnings Before Interest and Tax Leverage Earnings Before Tax $975,000 + $70,000 _ $1,045,000 _ 1.07 $975,000 $975,000 . 8 Downloaded by VIMAL GARG (vimala.gara@amall.com)Exercises on Ch. 9 - Solutions 4” Level (3) The following information was in the annual report of Rover Company: 2011 2010 2009 Earnings per share $ 112 $§ 120 $ 127 Cash dividends per share (common) § 0.90 $ 0.85 $ 0.82 Market price per share $ 12.80 $ 14.00 $ 16.30 Total common dividends $ 21,700,000 $ 19,500,000 $18,360,000 Shares outstanding, end of year 24,280,000 23,100,000 22,500,000 Total assets $1,280,100,000 $1,267,200,000 $1,260,400,000 Total liabilities $ 800,400,000 — $ 808,500,000 $_ 799,200,000 Nonredeemable preferred stock $ 15,300,000 $ 15,300,000 $15,300,000 Preferred dividends $ 910,000 $ — 910,000 $ 910,000 Net income $ 31,200,000 $ 30,600,000 $ 29,800,000 Requ a. Based on these data, compute the following for 2011, 2010, and 2009: 1. Percentage of earnings retained 2. Price/earnings ratio 3. Dividend payout 4, Dividend yield 5. Book value per share b. Discuss your findings from the viewpoint of a potential investor. Net Income before nonrecurring items a. 1, Percentage of Earnings Retained = ~ All Dividends Net Income before nonrecurring items 2007 2006 2005 Net income (A) $ 31,200,000 $30,600,000 $ 29,800,000 Less: Common dividend (21,700,000) (19,500,000) (18,360,000) Less: Preferred dividend (910,000) (910,000) (910,000) NI ~All Dividends (B) 8,590,000 10,190,000 10,530,000 % of Earnings Retained (B + A) 2153% 35.34% Market Price Per Share 2. Price/Earnings Rati lac, << ve =r Tieebamings Ratio Fully Diluted Earnings Per Share 2007 2006 2005 $12.80 $14.00 $16.30 $1.12 $1.20 $1.27 =11430 =11.67 = 12. Downloaded by VIVAL GARG (vimala.garg@amall.com)Exercises on Ch. 9 - Solutions 4” Level Dividends Per Common Share 3. Dividend Payout = Fy Diluted Eamings Per Share 2007 2006 2005 $0.90 $0.85 $0.82 $1.12 $1.20 $1.27 =80,36% =70.83% = 64.57% Dividends Per Common Share 4. Dividend Yield = + ferket Price Per Common Share 2007 2006 2005 $0.90 $0.85 $0.82 $12.80 $14.00 $16.30 = 7.03 = 6.07Y = 5.03% Total Stockholders’ Equity ~ Preferred Stock Equity 5. Book Value Per Share = Number of Common Shares Outstanding 2007 2006 2005, Total assets: $ 1,280,100,000 — $ 1,267,200,000 —$_1,260,400,000 Less: Liabilities (800,400,000) (808,500,000) (799,200,000) Stockholders’ Equity 479,700,000 458,700,000 461,200,000 Less: Nonredeemable preferred stock (15,300,000) (15,300,000) (15,300,000) Common stock equity $ $464,400,000 $ $443,400,000 $ $445,900,000 ~ Shares outstanding 24,280,000 23,100,000 22,500,000 Book Value per Share $ $19.13 § $19.19 b. The percentage of earnings retained is decreasing. The related ratio, dividend payout, is therefore increasing. The price/earnings ratio has been relatively stable. The dividend yield has increased and is relatively high. The market price per share is substantially below the book value. It appears that this stock is being purchased for the relatively high dividend and not for growth potential. 10 Downloaded by VIMAL GARG (vimala.gara@amall.com)