Chapter 2

PROBLEM 1 Solution:

Source(+)
2009 2008 or Use(-)?
Cash $ 400 $ 500 +
Accounts receivable 250 300 +
Inventory 450 400 –
Current assets 1,100 1,200
Net property & equipment 1,000 950 –*
Total assets $2,100 $2,150

Accounts payable $ 200 $ 400 –

Accruals 300 250 +
Notes payable 400 200 +
Current liabilities 900 850
Long-term debt 800 900 –
Total liabilities 1,700 1,750
Common stock 250 300 –
Retained earnings 150 100 +
Total equity 400 400
Total liabilities and equity $2,100 $2,150
*
The book value of property and equipment is stated net of depreciation. Because the book value
of fixed assets increased, and depreciation is an adjustment that reduces the account balance,
Batelan must have purchased addition fixed assets. But, without more information we cannot
determine the amount of the purchase.

The retained earning balance increased in 2009, so Batelan must have generated a positive net
income. But, without additional information (i.e. the amount of net income), we cannot tell
whether dividends were paid in 2009.
Problem 5 Solution
Lloyd Lumber Company
Balance Sheet, 2009
($ millions)

Jan. 1 Dec. 31 Source Use

Cash $ 7 $ 15 $ 8
Marketable securities 0 11 11
Net receivables 30 22 $ 8
Inventories 53 75 22
Total current assets $ 90 $123

Gross fixed assets $ 75 $125 50

Less: depreciation 25 35 10*
Net fixed assets $ 50 $ 90
Total assets $140 $213

Accounts payable $ 18 $ 15 3
Notes payable 3 15 12
Other current liabilities 15 7 8
Long-term debt 8 24 16
Common stock 29 57 28
Retained earnings 67 95 28
Total liabilities and equity $140 $213 $102 $102

*Depreciation is not a source of cash, but it affects cash in the form of taxes on the income
statement
b. Lloyd Lumber Company
Statement of Cash Flows, 2009
($ millions)

Operating Activities:
Net income $ 33

Other additions (sources of cash):

Depreciation $ 10
Decrease in accounts receivable 8

Subtractions (uses of cash):

Increase in inventories ($22)
Decrease in accounts payable ( 3)
Decrease in other current liabilities ( 8)
Net cash flow from operations $ 18

Long-term Investing Activities:

Acquisition of fixed assets ($ 50)

Financing Activities:
Increase in notes payable $ 12
Sale of long-term debt 16
Sale of common stock 28
Payment of dividends ( 5)
Net cash flow from financing $ 51
Net increase in cash and marketable securities $ 19
Cash and marketable securities at beginning of year 7
Cash and marketable securities at end of year $ 26

c. Investments were made in plant and inventories. Funds were also utilized to reduce
accounts payable and other current liabilities and to increase the cash and marketable
securities accounts. Most funds were obtained by increasing long-term debt, selling
common stock, and retaining earnings. The remainder was obtained from increasing notes
payable and reducing receivables.
PROBLEM 3 Solution
(1) Operating cash flow = NOI (1 – Tax rate) + Depreciation
= 120,000(1-.40)+25,000
=72,000+25,000 = 97,000.
(2) Free cash flow = Operating cash flow – Investment
= 97,000 – 150,000
= - 53,000

PROBLEM 4 Solution:
a. NI = (Sales – Operating costs – Interest expense)(1-T)
$650,000 = (Sales - $1,500,000 - $300,000 – 0)(1 – 0.35)

$650,000
Sales   ($1,500,000  $300,000 )  $2,800,000
0.65

b. Net cash flow = $650,000 + $300,000 = $950,000

c. Operating cash flow = $950,000

PROBLEM 5 Solution:
EVA = $150,000(1 – 0.4) – 0.10($1,100,000) = -$20,000

Problem#6
Solution:
EVA = $150,000(1 – 0.4) – 0.10($1,100,000) = -$20,000

Problem#7
Wolken Corporation has $500,000 of debt outstanding, and it pays an interest rate of 10 percent
annually. Wolken’s annual sales are $2 million, its average tax rate is 20 percent, and its net profit margin
is 5 percent. If the company does not maintain a TIE ratio of at least 5, its bank will refuse to renew the
loan, and bankruptcy will result. What is Wolken’s TIE ratio?

Solution:
TIE = EBIT/INT, so find EBIT and INT

Interest = $500,000 x 0.1 = $50,000

Net income = $2,000,000 x 0.05 = $100,000

 Taxable income (EBT) = $100,000/(1 - T) = $100,000/0.8 = $125,000

EBIT = $125,000 + $50,000 = $175,000

TIE = $175,000/$50,000 = 3.5 x

Problem#8
Coastal Packaging’s ROE last year was only 3 percent, but its management has developed a new
operating plan designed to improve things. The new plan calls for a total debt ratio of 60 percent, which
will result in interest charges of $300 per year. Management projects an EBIT of $1,000 on sales of
$10,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the average
tax rate will be 30 percent. If the changes are made, what return on equity (ROE) will Coastal earn?
What is the ROA?

Solution:
ROE = NI/Equity
Now we need to determine the inputs for the equation from the data that were given. On the left we set up
an income statement, and we put numbers in it on the right:
Sales (given) $10,000
- Cost na
EBIT (given) $ 1,000
- INT (given) ( 300)
EBT $ 700
- Taxes (30%) ( 210)
NI $ 490

Now we can use some ratios to get some more data:

Total assets turnover = 2.0 = Sales/TA; TA = Sales/2 = $10,000/2 = $5,000

Debt/TA = 60%; so Equity/TA = 40%; therefore, Equity = TA x Equity/TA

= $5,000 x 0.40 = $2,000

Alternatively, Debt = TA x Debt/TA = $5,000 x 0.6 = $3,000; Equity = TA – Debt = $5,000 - $3,000 =
$2,000
ROE = NI/E = $490/$2,000 = 24.5%, and ROA = NI/TA = $490/$5,000 = 9.8%

Problem#9
Complete the balance sheet and sales information in the table that follows for Isberg Industries using the
following financial data:
Debt ratio: 50%
Quick ratio: 0.80X
Total assets turnover: 1.5X
Days sales outstanding: 36.5 days
Gross profit margin on sales: (Sales - Cost of goods sold)/Sales = 25%
Inventory turnover ratio: 5.0X
(1) Total liabilities and equity = Total assets = $300,000.

(2) Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

(3) Accounts payable = Debt ─ Long-term debt = $150,000 ─ $60,000 = $90,000.

(4) Common stock = Total liabilities and equity – Debt – Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500

(5) Sales = 1.5 x Total assets = 1.5 x $300,000 = $450,000

(6) Cost of goods sold = Sales(1 - 0.25) = $450,000(.75) = $337,500

(7) Inventory = (CGS)/5 = $337,500/5 = $67,500.

(8) Accounts receivable = (Sales/360)(DSO) = ($450,000/360)(36) = $45,000.

(9) (Cash + Accounts receivable)/(Accounts payable) = 0.80x

Cash + Accounts receivable = (0.80)(Accts payable)
Cash + $45,000 =(0.80)($90,000)
Cash = $72,000 ─ $45,000 = $27,000.

(10) Fixed assets = Total assets ─ (Cash + Accts Rec. + Inventories)

= $300,000 ─ ($27,000 + $45,000 + $67,500) = $160,500.
Problem#10

Solution: (For calculation look at the attached excel file)

a. Here are Cary's base case ratios and other data as compared to the industry:

Cary Industry Comment

Quick 0.85x 1.0x Weak
Current 2.33x 2.7x Weak
Inventory turnover 4.0x 5.8x Poor
Days sales outstanding 36.8 days 32.0 days Poor
Fixed assets turnover 10.0x 13.0x Poor
Total assets turnover 2.3x 2.6x Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1% 18.2% Bad
Debt ratio 54.8% 50.0% High
Profit margin on sales 2.5% 3.5% Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0x 6.0x Poor
M/B ratio 0.65 n.a. --

Cary appears to be poorly managed—all of its ratios are worse than the industry averages, and the
result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The company needs to do
something to improve.

b. A decrease in the inventory level would improve the inventory turnover, total assets turnover, and
ROA, all of which are too low. It would have some impact on the current ratio, but it is difficult to
say precisely how that ratio would be affected. If the lower inventory level allowed Cary to reduce
its current liabilities, then the current ratio would improve. The lower cost of goods sold would
improve all of the profitability ratios and, if dividends were not increased, would lower the debt
ratio through increased retained earnings. All of this should lead to a higher market/book ratio and
a higher stock price.