1.

On its 2010 balance sheet, Bangrover Books showed $510 million of retained earnings,
and exactly that same amount was shown the following year. Assuming that no
earnings restatements were issued, which of the following statements is CORRECT?
a. If the company lost money in 2010, they must have paid dividends.
b. The company must have had zero net income in 2010.
c. The company must have paid out half of its earnings as dividends.
d. The company must have paid no dividends in 2010.
e. Dividends could have been paid in 2010, but they would have had to equal the earnings
for the year.

2. Analysts who follow Howe Industries recently noted that, relative to the previous year,
the company’s operating net cash flow increased, yet cash as reported on the balance
sheet decreased. Which of the following factors could explain this situation?
a. The company cut its dividend.
b. The company made a large investment in a profitable new plant.
c. The company sold a division and received cash in return.
d. The company issued new common stock.
e. The company issued new long-term debt.

3. Aubrey Aircraft recently announced that its net income increased sharply from the
previous year, yet its net cash flow from operations declined. Which of the following
could explain this performance?
a. The company’s operating income declined.
b. The company’s expenditures on fixed assets declined.
c. The company’s cost of goods sold increased.
d. The company’s depreciation and amortization expenses declined.
e. The company’s interest expense increased.

4. A firm wants to strengthen its financial position. Which of the following actions would
increase its quick ratio?
a. Offer price reductions along with generous credit terms that would (1) enable the firm to sell
some of its excess inventory and (2)lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.
e. Issue new common stock and use the proceeds to acquire additional fixed assets.

5. Amram Company’s current ratio is 1.9. Considered alone, which of the following
actions would reduce the company’s current ratio?
a. Borrow using short-term notes payable and use the proceeds to reduce accruals.
b. Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
c. Use cash to reduce accruals.
d. Use cash to reduce short-term notes payable.
e. Use cash to reduce accounts payable.

6. Which of the following statements is CORRECT?

a. If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the
industry average and was also increasing and trending still higher, this would be
interpreted as a sign of strength.
b. If a firm increases its sales while holding its accounts receivable constant, then, other
things held constant, its days’ sales outstanding (DSO) will increase.
c. There is no relationship between the days’ sales outstanding (DSO) and the average
collection period (ACP). These ratios measure entirely different things.
d. A reduction in accounts receivable would have no effect on the current ratio, but it would
lead to an increase in the quick ratio.
e. If a firm increases its sales while holding its accounts receivable constant, then, other
things held constant, its days’ sales outstanding will decline.
 7. You observe that a firm’s ROE is above the industry average, but its profit margin and
debt ratio are both below the industry average. Which of the following statements is
CORRECT?
a. Its total assets turnover must be above the industry average.
b. Its return on assets must equal the industry average.
c. Its TIE ratio must be below the industry average.
d. Its total assets turnover must be below the industry average.
e. Its total assets turnover must equal the industry average.

8. Companies HD and LD are both profitable, and they have the same total assets (TA),
Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has
the higher debt ratio. Which of the following statements is CORRECT?
a. Company HD has a lower total assets turnover than Company LD.
b. Company HD has a lower equity multiplier than Company LD.
c. Company HD has a higher fixed assets turnover than Company B.
d. Company HD has a higher ROE than Company LD.
e. Company HD has a lower operating income (EBIT) than Company LD.

9. Taggart Technologies is considering issuing new common stock and using the proceeds
to reduce its outstanding debt. The stock issue would have no effect on total assets, the
interest rate Taggart pays, EBIT, or the tax rate. Which of the following is likely to occur
if the company goes ahead with the stock issue?
a. The ROA will decline.
b. Taxable income will decrease.
c. The tax bill will increase.
d. Net income will decrease.
e. The times interest earned ratio will decrease.

10. Which of the following statements is CORRECT?

a. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations
than is either the DSO or the inventory turnover ratio.
b. If two firms have the same ROA, the firm with the most debt can be expected to have the
lower ROE.
c. An increase in the DSO, other things held constant, could be expected to increase the total
assets turnover ratio.
d. An increase in the DSO, other things held constant, could be expected to increase the ROE.
e. An increase in a firm’s debt ratio, with no changes in its sales or operating costs, could be
expected to lower the profit margin.

11. Other things held constant, which of the following alternatives would increase a
company’s cash flow for the current year?
a. Increase the number of years over which fixed assets are depreciated for tax purposes.
b. Pay down the accounts payables.
c. Reduce the days’ sales outstanding (DSO) without affecting sales or operating costs.
d. Pay workers more frequently to decrease the accrued wages balance.
e. Reduce the inventory turnover ratio without affecting sales or operating costs.

12. Companies HD and LD have the same sales, tax rate, interest rate on their debt,
total assets, and basic earning power. Both companies have positive net incomes.
Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of
the following statements is CORRECT?
a. Company HD pays less in taxes.
b. Company HD has a lower equity multiplier.
c. Company HD has a higher ROA.
d. Company HD has a higher times interest earned (TIE) ratio.
e. Company HD has more net income.
 13. Companies HD and LD have the same tax rate, sales, total assets, and basic
earning power. Both companies have positive net incomes. Company HD has a higher
debt ratio and, therefore, a higher interest expense. Which of the following statements is
CORRECT?
a. Company HD has a lower equity multiplier.
b. Company HD has more net income.
c. Company HD pays more in taxes.
d. Company HD has a lower ROE.
e. Company HD has a lower times interest earned (TIE) ratio.

14. 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.

15. Van Buren Company has a current ratio = 1.9. Which of the following actions will increase
the company’s current ratio?
a. Use cash to reduce short-term notes payable.
b. Use cash to reduce accounts payable.
c. Issue long-term bonds to repay short-term notes payable.
d. All of the statements above are correct.
e. Statements b and c are correct.

16. Which of the following actions can a firm take to increase its current ratio?
a. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity of more than
one year.
b. Reduce the company’s days sales outstanding to the industry average and use the resulting cash
savings to purchase plant and equipment.
c. Use cash to purchase additional inventory.
d. Statements a and b are correct.
e. None of the statements above is correct.

17. Drysdale Financial Company and Commerce Financial Company have the same total
assets, the same total assets turnover, and the same return on equity. However, Drysdale has a
higher return on assets than Commerce. Which of the following can explain these ratios?
a. Drysdale has a higher profit margin and a higher debt ratio than Commerce.
b. Drysdale has a lower profit margin and a lower debt ratio than Commerce.
c. Drysdale has a higher profit margin and a lower debt ratio than Commerce.
d. Drysdale has lower net income but more common equity than Commerce.
e. Drysdale has a lower price earnings ratio than Commerce.

18. Which of the following statements is most correct?

a. A firm with financial leverage has a larger equity multiplier than an otherwise identical firm with no
debt in its capital structure.
b. The use of debt in a company’s capital structure results in tax benefits to the investors who purchase
the company’s bonds.
c. All else equal, a firm with a higher debt ratio will have a lower basic earning power ratio.
d. All of the statements above are correct.
e. Statements a and c are correct.
 19. Which of the following statements is most correct?
a. An increase in a firm’s debt ratio, with no changes in its sales and operating costs, could be expected
to lower its profit margin on sales.
b. An increase in the DSO, other things held constant, would generally lead to an increase in the total
assets turnover ratio.
c. An increase in the DSO, other things held constant, would generally lead to an increase in the ROE.
d. In a competitive economy, where all firms earn similar returns on equity, one would expect to find
lower profit margins for airlines, which require a lot of fixed assets relative to sales, than for fresh fish
markets.
e. It is more important to adjust the debt ratio than the inventory turnover ratio to account for seasonal
fluctuations.

20. Harte Motors and Mills Automotive each have the same total assets, the same level of sales,
and the same return on equity (ROE). Harte Motors, however, has less equity and a higher debt
ratio than does Mills Automotive. Which of the following statements is most correct?
a. Mills Automotive has a higher net income than Harte Motors.
b. Mills Automotive has a higher profit margin than Harte Motors.
c. Mills Automotive has a higher return on assets (ROA) than Harte Motors.
d. All of the statements above are correct.
e. None of the statements above is correct.

21. Company A and Company B have the same total assets, tax rate, and net income. Company
A, however, has a lower profit margin than Company B. Company A also has a higher debt ratio
and, therefore, higher interest expense than Company B. Which of the following statements is most
correct?
a. Company A has a higher total assets turnover.
b. Company A has a higher return on equity.
c. Company A has a higher basic earning power ratio.
d. Statements a and b are correct.
e. All of the statements above are correct.

22. Company A and Company B have the same tax rate, total assets, and basic earning power.
Both companies have positive net incomes. Company A has a higher debt ratio, and therefore,
higher interest expense than Company B. Which of the following statements is true?
a. Company A has a higher ROA than Company B.
b. Company A has a higher times interest earned (TIE) ratio than Company B
c. Company A has a higher net income than Company B.
d. Company A pays less in taxes than Company B.
e. Company A has a lower equity multiplier than Company B.

23. You observe that a firm’s profit margin is below the industry average, while its return on
equity and debt ratio exceed the industry average. What can you conclude?
a. Return on assets must be above the industry average.
b. Total assets turnover must be above the industry average.
c. Total assets turnover must be below the industry average.
d. Statements a and b are correct.
e. None of the statements above is correct.

24. Which of the following statements is most correct?

a. If Firms A and B have the same earnings per share and market to book ratio, they must have the
same price earnings ratio.
b. Firms A and B have the same net income, taxes paid, and total assets. If Firm A has a higher interest
expense, its basic earnings power ratio (BEP) must be greater than that of Firm B.
c. Firms A and B have the same net income. If Firm A has a higher interest expense, its return on
equity (ROE) must be greater than that of Firm B.
d. All of the statements above are correct.
e. None of the statements above is correct.
 25. Reeves Corporation forecasts that its operating income (EBIT) and total assets will remain
the same as last year, but that the company’s debt ratio will increase this year. What can you
conclude about the company’s financial ratios? (Assume that there will be no change in the
company’s tax rate.)
a. The company’s basic earning power (BEP) will fall.
b. The company’s return on assets (ROA) will fall.
c. The company’s equity multiplier (EM) will increase.
d. All of the statements above are correct.
e. Statements b and c are correct.

26. Company X has a higher ROE than Company Y, but Company Y has a higher ROA than
Company X. Company X also has a higher total assets turnover ratio than Company Y; however,
the two companies have the same total assets. Which of the following statements is most correct?
a. Company X has a lower debt ratio than Company Y.
b. Company X has a lower profit margin than Company Y.
c. Company X has a lower net income than Company Y.
d. Statements b and c are correct.
e. All of the statements above are correct.

27. Stennett Corp.’s CFO has proposed that the company issue new debt and use the proceeds
to buy back common stock. Which of the following are likely to occur if this proposal is adopted?
(Assume that the proposal would have no effect on the company’s operating income.)
a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.
e. None of the statements above is correct.

28. Amazon Electric wants to increase its debt ratio, which will also increase its interest
expense. Assume that the higher debt ratio will have no effect on the company’s operating income,
total assets, or tax rate. Also, assume that the basic earning power ratio exceeds the before-tax cost
of debt financing. Which of the following will occur if the company increases its debt ratio?
a. Its ROA will fall.
b. Its ROE will increase.
c. Its basic earning power (BEP) will stay unchanged.
d. Statements a and c are correct.
e. All of the statements above are correct.

29. Bedford Hotels and Breezewood Hotels both have $100 million in total assets and a 10
percent return on assets (ROA). Each company has a 40 percent tax rate. Bedford, however, has a
higher debt ratio and higher interest expense. Which of the following statements is most correct?
a. The two companies have the same basic earning power (BEP).
b. Bedford has a higher return on equity (ROE).
c. Bedford has a lower level of operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.

30. Company J and Company K each recently reported the same earnings per share (EPS).
Company J’s stock, however, trades at a higher price. Which of the following statements is most
correct?
a. Company J must have a higher P/E ratio.
b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
e. All of the statements above are correct.
 31. Company A’s ROE is 20 percent, while Company B’s ROE is 15 percent. Which of the
following statements is most correct?
a. Company A must have a higher ROA than Company B.
b. Company A must have a higher EVA than Company B.
c. Company A must have a higher net income than Company B.
d. All of the statements above are correct.
e. None of the statements above is correct.

32. Company A and Company B have the same total assets, return on assets (ROA), and profit
margin. However, Company A has a higher debt ratio and interest expense than Company B.
Which of the following statements is most correct?
a. Company A has a higher ROE (return on equity) than Company B.
b. Company A has a higher total assets turnover than Company B.
c. Company A has a higher operating income (EBIT) than Company B.
d. Statements a and b are correct.
e. Statements a and c are correct.

33. Nelson Company is thinking about issuing new common stock. The proceeds from the
stock issue will be used to reduce the company’s outstanding debt and interest expense. The stock
issue will have no effect on the company’s total assets, EBIT, or tax rate. Which of the following is
likely to occur if the company goes ahead with the stock issue?
a. The company’s net income will increase.
b. The company’s times interest earned ratio will increase.
c. The company’s ROA will increase.
d. All of the above statements are correct.
e. None of the above statements is correct.

34. Companies A and B have the same profit margin and debt ratio. However, Company A has
a higher return on assets and a higher return on equity than Company B. Which of the following
can explain these observed ratios?
a. Company A must have a higher total assets turnover than Company B.
b. Company A must have a higher equity multiplier than Company B.
c. Company A must have a higher current ratio than Company B.
d. Statements b and c are correct.
e. All of the statements above are correct.

35. Bichette Furniture Company recently issued new common stock and used the proceeds to
reduce its short-term notes payable and accounts payable. This action had no effect on the
company’s total assets or operating income. Which of the following effects did occur as a result of
this action?
a. The company’s current ratio decreased.
b. The company’s basic earning power ratio increased.
c. The company’s time interest earned ratio decreased.
d. The company’s debt ratio increased.
e. The company’s equity multiplier decreased.

Fama’s French Bakery has a return on assets (ROA) of 10 percent and a return on equity (ROE) of 14
percent. Fama’s total assets equal total debt plus common equity (that is, there is no preferred stock).
Furthermore, we know that the firm’s total assets turnover is 5.
1. What is Fama’s debt ratio?

Fama’s French Bakery has a return on assets (ROA) of 10 percent and a return on equity (ROE) of 14
percent. Fama’s total assets equal total debt plus common equity (that is, there is no preferred stock).
Furthermore, we know that the firm’s total assets turnover is 5.
2. What is Fama’s profit margin?
3. Miller Technologies is always looking for ways to expand their business. A plan has been proposed
that would entail issuing $300 million in notes payable to purchase new fixed assets (for this
problem, ignore depreciation). If this plan were carried out, what would Miller’s current ratio be
immediately following the transaction?
4. When reviewing the company’s performance for 2002, its CFO observed that the company’s
inventory turnover ratio was below the industry average inventory turnover ratio of 6.0. In addition,
the company’s DSO (days sales outstanding, calculated on a 365-day basis) was less than the industry
average of 50 (that is, DSO < 50). On the basis of this information, what is the most likely estimate of
the company’s sales (in millions of dollars) for 2002?
5. During 2002, Kewell’s days sales outstanding (DSO) was 40 days. The industry average DSO was
30 days. Assume instead that in 2002, Kewell had been able to achieve the industry-average DSO
without reducing its sales, and that the freed-up cash would have been used to reduce accounts
payable. If this reduction in DSO had successfully occurred, what would have been Kewell’s new
current ratio in 2002? (Assume Kewell uses a 365-day accounting year.)

6. The Wilson Corporation has the following relationships:

Sales/Total assets 2.0
Return on assets (ROA) 4.0%
Return on equity (ROE) 6.0%
What is Wilson’s profit margin and debt ratio?

7. The Charleston Company is a relatively small, privately owned firm. Last year the company had net
income of $15,000 and 10,000 shares were outstanding. The owners were trying to determine the
equilibrium market value for the stock prior to taking the company public. A similar firm that is
publicly traded had a price/earnings ratio of 5.0. Using only the information given, estimate the
market value of one share of Charleston’s stock.

8. Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000,
and its P/E is 8. What is the company’s stock price?

9. Iken Berry Farms has $5 million in current assets, $3 million in current liabilities, and its initial
inventory level is $1 million. The company plans to increase its inventory, and it will raise
additional short-term debt (that will show up as notes payable on the balance sheet) to purchase
the inventory. Assume that the value of the remaining current assets will not change. The
company’s bond covenants require it to maintain a current ratio that is greater than or equal to 1.5.
What is the maximum amount that the company can increase its inventory before it is restricted
by these covenants?

10. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent. The
company recently reported that its basic earning power (BEP) ratio was 15 percent and its return on
assets (ROA) was 9 percent. What was the company’s interest expense?

11. You are given the following information: Stockholders’ equity = $1,250; price/earnings ratio
= 5; shares outstanding = 25; and market/book ratio = 1.5. Calculate the market price of a share of the
company’s stock

12. Given the following information, calculate the market price per share of WAM Inc.:
Net income $200,000.00
Earnings per share $2.00
Stockholders’ equity $2,000,000.00
Market/Book ratio 0.20

13. Meyersdale Office Supplies has common equity of $40 million. The company’s stock price is
$80 per share and its market/book ratio is 4.0. How many shares of stock does the company have
outstanding?
 14. Strack Houseware Supplies Inc. has $2 billion in total assets. The other side of its balance sheet
consists of $0.2 billion in current liabilities, $0.6 billion in long-term debt, and $1.2 billion in common
equity. The company has 300 million shares of common stock outstanding, and its stock price is $20
per share. What is Strack’s market/book ratio?

15. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of
$7,500,000, total assets of $22,500,000, and an after-tax interest cost on total debt of 5 percent, what is
the firm’s ROA?

1. (3.2) Balance sheet Answer: e MEDIUM

2. (2.6) Net cash flow Answer: b MEDIUM
3. (2.6) Net cash flow and net income Answer: d MEDIUM
4. (3.2) Quick ratio Answer: a MEDIUM
5. (3.2) Current ratio Answer: b MEDIUM
a would leave the CR unchanged.
b would indeed reduce the CR.
c is false, given that the initial CR > 1.0.
d is false, given that the initial CR > 1.0.
e is false, given that the initial CR > 1.0.
Original New
CA/CL Minus .5 CA/CL Old CR New CR
1.9/1 0/0.5 1.9/1.5 1.90 1.27 CR falls if initial CR is greater than 1.0
6. (3.3) Accounts receivable Answer: e MEDIUM
7. (3.8) Du Pont analysis Answer: a MEDIUM
PM  TATO  Eq mult. = ROE
Old 9% 1.0 1.666667 15%
New 10% 0.9 2.5 23%
We see that a is true, thus b must be false.
We can also see that c, d, and e are all false.
8. (3.8) Du Pont analysis Answer: d MEDIUM
Rule out all answers except d because they are false.
Alternative answer explanation using the Du Pont equation:
ROE = PM  TATO  Eq mult.
ROE = NI/S  S/TA  TA/Equity

The first two terms are the same, but HD has higher equity multiplier, hence higher ROE.
9. (Comp: 3.4,3.5) FSA Answer: c MEDIUM
a is false because reducing debt will lower
interest, raise income, and thus raise ROA.
b is false for the above reason.
c is true for the above reason.
d is false.
The TIE will increase, not decrease.
10. (Comp: 3.3-3.5) FSA Answer: e MEDIUM
a. Sales fluctuations would have more effects on the DSO and S/Inventory ratios.
b. ROE = ROA  Equity multiplier, so more debt, higher ROE for given ROA.
c. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean an
increase in receivables, hence a decline, not a rise, in the TATO.
d. An increase in the DSO might increase or decrease ROE, depending on how it affected
sales and costs.
e. ore debt would mean more interest, hence a lower NI, given a constant EBIT. This would
lower the profit margin = NI/Sales.
 11. (Comp: 3.2,3.3) Cash flows Answer: c MEDIUM
a. Lengthening depreciable lives would lower depreciation, increase taxable income and
taxes, and thus lower cash flow.
b. Paying down accounts payable would use cash and thus reduce cash flow.
c. Reducing the DSO would require collecting receivables faster, which would indeed
increase cash flow.
d. Decreasing accruals would lower cash flow.
e. Reducing inventory turnover would mean increasing inventories, which would use cash.
12. (Comp: 3.4,3.5,3.8) Leverage, taxes, and ratios Answer: a
Under the stated conditions, HD would have more interest charges, thus lower taxable income
and taxes. Thus, a is correct. All of the other statements are incorrect.
13. (Comp: 3.4,3.5,3.8) Leverage, taxes, and ratios Answer: e
HD has higher interest charges. Basic earning power equals EBIT/Assets, and since
assets are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, HD's higher
interest charges means that its TIE must be lower. Thus, e is correct. All of the other
statements are incorrect.
14. (3.2) Current ratio Answer: a MEDIUM
The key here is to recognize that if the CR is less than 1.0, then a given increase in both
current assets and
current liabilities would lead to an increase in the CR. The reverse would hold if the
initial CR were greater than 1.0. Here the initial CR is less than 1.0, so borrowing on a
short-term basis to build inventories would increase the CR. For example:
Original New
CA/CL Plus $1 CA/CL Old CR New CR
1/2 1/1 2/3 0.50 0.67 CR rises if initial CR is less than
1.0
All of the other statements are incorrect, although b, c, and d would be correct if the initial CR had
been >1.0.
15. Current ratio Answer: d Diff: M
Statement d is the correct answer. For statements a and b a reduction in the numerator and
denominator by the same amount will increase the current ratio because the current ratio is greater
than 1. In statement c only the denominator goes down (long-term bonds are not in the current
ratio), so the current ratio will increase.
16. Current ratio Answer: e Diff: M
17. Ratio analysis Answer: c Diff: M N
TAD = TAC.
TATOD = TATOC so, S/TAD = S/TAC.
ROED = ROEC.
ROAD > ROAC.
Since TATO is the same for both, and since TA is the same for both, sales must be the same for both (since
TATO = Sales/TA). Remember the Du Pont equation: ROE = PM  TATO  EM. Drysdale and Commerce
have the same TATO. So, if Drysdale has a higher PM and a higher EM (if the debt ratio is higher, the EM is
higher), then its ROE must be higher. However, the problem states that the companies have the same ROE.
Therefore, statement a is incorrect. If Drysdale’s PM and debt ratio are lower than Commerce’s and both have
the same TATO, Drysdale would have a lower ROE. The problem states that the companies have the same
ROE, so statement b is incorrect. Looking again at the Du Pont equation: ROE = PM  TATO  EM. If the
ROEs are the same and the TATOs are the same, then (PM  EM) must be the same for the two companies. If
Drysdale has a higher PM and a lower EM, then (PM  EM) could be the same for both. Therefore, statement
c could explain the ratios in the problem. If Drysdale has lower NI and more common equity (higher TE), then
its ROE would be lower. Therefore, statement d is incorrect. The P/E ratio is irrelevant. The stock price cannot
explain what is going on with the two companies’ ratios.
18. Effects of leverage Answer: a Diff: M
Statement a is correct. The other statements are false. The use of debt provides tax benefits to the
corporations that issue debt, not to the investors who purchase debt (in the form of bonds). The basic earning
power ratio would be the same if the only thing that differed between the firms were their debt ratios.
19. Financial statement analysis Answer: a Diff: M
Statement a is true because, if a firm takes on more debt, its interest expense will rise, and this will lower its
profit margin. Of course, there will be less equity than there would have been, hence the ROE might rise
even though the profit margin declined.
20. Financial statement analysis Answer: d Diff: M N
The correct answer is statement d. Start with the Du Pont equation: NI/S  S/TA  TA/E = ROE. We know
S/TA and ROE are the same for both. Since the equity of Mills is higher than Harte, its NI must also
be higher to keep ROE the same. So, statement a is correct. The other statements are then also true.
Given Mills’ higher net income, both the profit margin and the ROA for Mills are also higher than
Harte’s.

21. Leverage and financial ratios Answer: e Diff: M

TATO = Sales/TA. Both companies have the same total assets. However, since A has a lower profit margin
than B and its net income is the same as B’s, it must have higher sales; thus, A has a higher total assets
turnover ratio than B. Therefore, statement a is true. ROE = NI/Equity. Both companies have the same total
assets and net income, but A has more debt and thus less equity than B. Therefore, A has a higher ROE than
B. Therefore, statement b is true. BEP = EBIT/TA. We know that A has higher interest payments than B but
the same net income as B. Therefore, A must have a higher EBIT than B to cover this extra interest. Thus, A
must have a higher basic earning power ratio than B. Therefore, statement c is true. Since statements a, b,
and c are true, the correct choice is statement e.
22. Leverage and financial ratios Answer: d Diff: M N
If BEP and total assets are equal, we know that EBIT is equal. Company A has a higher debt ratio and higher
interest expense than Company B.
Since Company A has lower net income, it must have a lower ROA (since total assets are the same). If EBIT
is the same for both A and B and Company A has higher interest expense, Company A must have a lower
TIE ratio than Company B. Company A has a lower EBT and lower net income than Company B. If A has
lower EBT, then Company A pays less in taxes than Company B. There is a positive relationship between
the debt ratio and the equity multiplier, which means that Company A has a higher equity multiplier than
B because A’s debt ratio is higher than B’s. Therefore, the correct choice is statement d.
23. Du Pont equation Answer: b Diff: M R
The Du Pont equation: ROE = (PM)(TATO)(EM). ROE is above average. PM is below average. EM is
above average because a high debt ratio implies a high EM. Therefore, TATO must be higher for the
equation to hold. Note that the firm’s ROA does not have to be higher than the industry ROA for this
equation to hold.
24. Miscellaneous ratios Answer: b Diff: M
Statement b is correct. EBIT = EBT + Interest. Statement c is incorrect because higher interest expense doesn’t
necessarily imply greater debt. For this statement to be correct, A’s amount of debt would have to be greater
than B’s.
25. Miscellaneous ratios Answer: e Diff: M
Statements b and c are correct. ROA = NI/TA. An increase in the debt ratio will result in an increase in interest
expense, and a reduction in NI. Thus ROA will fall. EM = Assets/Equity. As debt increases, the amount of
equity in the denominator decreases, thus causing the equity multiplier (EM) to increase. Therefore, statement
e is the correct choice.
26. Miscellaneous ratios Answer: d Diff: M
Since X has a lower ROA (NI/TA) than Y and both firms have the same assets, X must have a lower net
income than Y. So statement c is correct. X has a higher ROE (NI/EQ) than Y, even though its net income is
lower. Consequently, X must have less equity than Y, and therefore, more debt than Y. So statement a is
false. Since X has a higher total assets turnover ratio (Sales/TA) than Y and both firms have the same assets,
X’s sales must be higher than Y’s. This fact, combined with X’s lower net income, means that X must have a
lower profit margin (NI/Sales) than Y, so statement b is correct. Thus, statements b and c are both correct.
So, the correct choice is statement d.
27. Leverage and financial ratios Answer: d Diff: E
Statements a and c are correct. The increase in debt payments will reduce net income and hence reduce
ROA. Also, higher debt payments will result in lower taxable income and less tax. Therefore, statement d
is the best choice.
28. Leverage and profitability ratios Answer: e Diff: E
Statement a is true; higher debt will increase interest expense and net income will decline, resulting in a
lower ROA than before. Statement b is true; both net income and equity are going to decline, but net income
will decline less because the basic earning power exceeds the cost of debt, so ROE will actually rise.
Statement c is true; both EBIT and total assets remain the same. Therefore, statement e is the best choice.
29. Ratio analysis Answer: b Diff: E
Bedford = D; Breezewood = Z.
TAD = TAZ; ROAD = ROAZ; TD = TZ; D/AD > D/AZ; INTD > INTZ; ROA = NI/TA.
If both companies have the same ROA and total assets, then they must both have the same net incomes.
Therefore, NID = NIZ.
First, compare BEPs. BEP = EBIT/TA. Work backward up the income statement. If both companies have the
same NI and tax rate, then they must both have the same EBT. However, Bedford has higher interest
payments, so its EBIT must be higher than Breezewood’s. (Remember: EBT + I = EBIT.) Therefore, statement
c is false. In addition, Bedford’s BEP is higher than Breezewood’s, so statements a, d, and e are all false.
Statement b must be true for the following reason. Compare ROEs. ROE =
 1
ROA  EM and EM = .
1  D/A
Bedford has a higher D/A ratio than Breezewood; therefore, it has a higher EM than Breezewood. If its EM
is higher and its ROA is the same, then Bedford’s ROE must be higher than Breezewood’s.
30. Financial statement analysis Answer: a Diff: E
31. Financial statement analysis Answer: e Diff: E
ROE = NI/Equity; ROA = NI/TA; EVA = NI - ks  Equity.
We know nothing about the debt ratio or equity multiplier of either company. Remember, ROA = ROE/EM
(EM = equity multiplier). Since we don’t have EM, we don’t have enough information to say anything about
ROA. Therefore, statement a is false. We don’t know anything about the ks or the amount of equity of either
company. Therefore, we don’t know enough to determine which company’s EVA is higher. Therefore,
statement b is false. We know that A’s ROE is higher than B’s. However, we don’t know how much equity
either one has, so we cannot say which one has a higher net income. Therefore, statement c is false. Since
statements a, b, and c are false, the correct choice must be statement e.
32. Financial statement analysis Answer: e Diff: E
From the first sentence, both firms have the same net income, sales, and assets. Since A has more debt, it
must have less equity. Thus, its ROE (calculated as Net income/Equity) is higher than B’s. So statement a is
correct. Since the two firms have the same total assets and sales, their total assets turnover ratios must be
the same. So statement b is false. If A has higher interest expense than B but the same net income, this means
that A must have higher operating income (EBIT) than B. Therefore statement c is correct. Since statements
a and c are correct, the correct choice is statement e.
33. Financial statement analysis Answer: d Diff: E N
The correct answer is statement d. Although EBIT is unchanged, interest expense will go down, so NI will
increase. Therefore, statement a is correct. If EBIT is unchanged, but interest expense goes down, the TIE
ratio (EBIT/INT) will increase. Therefore, statement b is correct. If the stock issue has no effect on the
company’s total assets, but NI has increased (see statement a), then ROA (NI/TA) will increase. Therefore,
statement c is also correct.
34. Miscellaneous ratios Answer: a Diff: E
The Du Pont equation states: ROE = PM  TATO  EM.
The firms have the same profit margin and equity multiplier. The equity multiplier is the same because both
companies have the same debt ratio. If Company A has a higher ROE than B, then from the Du Pont equation
Company A also has a higher total assets turnover ratio than B. The current ratio does not explain the ratios
discussed. Therefore, only statement a explains the observed ratios.
35. Miscellaneous ratios Answer: e Diff: E R
Current ratio = Current assets/Current liabilities. This transaction will reduce current liabilities, which
results in a higher current ratio. So statement a is false. The basic earning power ratio = EBIT/TA. Since
neither the firm’s operating income (EBIT) or total assets have changed, its BEP ratio remains unchanged.
So statement b is false. TIE = EBIT/Interest. EBIT will be unaffected, but we may see interest costs fall due
to the firm having less debt. This will result in an increase in the TIE ratio. So statement c is false. Statement
d is also false for the same reasons as statements a and b. Total debt is reduced but total assets remain the
same. The firm now has more equity, so the equity multiplier (Assets/Equity) will decrease, so statement e
is correct.

1. The Du Pont analysis of return on equity gives us:

ROE = ROA  EM
14% = 10%  EM
1.4 = EM.
From the equity multiplier (A/E), we can calculate the debt ratio:
1.4 = A/E
E/A = 1/1.4
E/A = 0.7143.
D/A = 1 – E/A
D/A = 1 – 0.7143
D/A = 0.2857 = 28.57%.
2. Using the Du Pont analysis again, we can calculate the profit margin.
ROE = PM  TATO  EM
14% = PM  5  1.4
14% = PM  7
2% = PM.
3. Recall the current ratio is CA/CL = $900,000,000/$800,000,000 = 1.125.

The plan looks like this: Debit Fixed assets $300,000,000

Credit Notes payable $300,000,000

So, current liabilities increase by $300 million, while current assets do not change.
 So, the new current ratio is $900,000,000/($800,000,000 + $300,000,000) = $900,000,000/$1,100,000,000
= 0.818.

4. Step 1: One of our initial conditions is that inventory turnover (S/Inv.) < 6.0, hence:
Sales/Inventory < 6.0
Sales/$850,000,000 < 6.0
Sales < $5,100,000,000.

Step 2: Our second initial condition is that DSO < 50, hence:
AR/(Sales/365) < 50.0
$450,000,000/(Sales/365) < 50.0
[($450,000,000)(365)]/Sales < 50.0
($450,000,000)365 < 50(Sales)
[($450,000,000)(365)]/50 < Sales
Sales > $3,285,000,000.

So, the most likely estimate of the firm’s 2002 sales would fall between $3,285,000,000 and $5,100,000,000.
Only statement b meets this requirement.

5. Step 1: Determine actual 2002 sales:

DSO = AR/(Sales/365)
40 = $432,000/(Sales/365)
40(Sales)/365 = $432,000
40(Sales) = $157,680,000
Sales = $3,942,000.

Step 2: Determine new accounts receivable balance if DSO = 30 and sales remain the same:
30 = AR/($3,942,000/365)
30 = AR/$10,800
AR = $324,000.

Step 3: Determine the amount of freed-up cash and the new level of accounts payable.
Freed-up cash = $432,000 - $324,000 = $108,000.
New AP = $700,000 - $108,000 = $592,000.

Step 4: Determine the new current ratio:

CR = ($100,000 + $324,000 + $1,000,000)/($592,000 + $800,000)
= $1,424,000/$1,392,000
= 1.023.

6. First, calculate the profit margin, which equals NI/Sales:

ROA = NI/TA = 0.04.
Sales/Total assets = S/TA = 2.
PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02. [TA/S = 1/2 = 0.5.]

Next, find the debt ratio by finding the equity ratio:

E/TA = (E/NI)(NI/TA). [ROE = NI/E and ROA = NI/TA.]
E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity.
Therefore, D/TA must be 0.333 = 33.3%.

7. EPS = $15,000/10,000 = $1.50.

P/E = 5.0 = P/$1.50.
P = $7.50.

8. EPS = $750,000/100,000 = $7.50.

P/E = Price/EPS = 8.
Thus, Price = 8  $7.50 = $60.00.

9. With the numbers provided, we can see that Iken Berry Farms has a current ratio of 1.67 (CA/CL =
$5/$3 = 1.67). If notes payable are going to be raised to buy inventories, both the numerator and the
denominator of the ratio will increase. We can increase current liabilities $1 million before the
current ratio reaches 1.5.
 CA  X
 1.5
CL  X
$5,000,000  X
 1.5
$3,000,000  X
$5,000,000  X  $4,500,000  1.5X
$500,000  0.5X
$1,000,000  X
X  $1,000,000.
10. BEP = EBIT/TA
0.15 = EBIT/$100,000,000
EBIT = $15,000,000.

ROA = NI/TA
0.09 = NI/$100,000,000
NI = $9,000,000.
EBT = NI/(1 - T)
EBT = $9,000,000/0.6
EBT = $15,000,000.

Therefore interest expense = $0.

11. Total market value = $1,250(1.5) = $1,875.
Market value per share = $1,875/25 = $75.
Alternative solution:
Book value per share = $1,250/25 = $50.
Market value per share = $50(1.5) = $75.

12. Number of shares = $200,000/$2.00 = 100,000.

Book value per share = $2,000,000/100,000 = $20.
Market value = 0.2(Book value) = 0.2($20) = $4.00 per share.

13.

14. TA = $2,000,000,000; CL = $200,000,000; LT debt = $600,000,000; CE = $1,200,000,000; Shares

outstanding = 300,000,000; P0 = $20; M/B = ?

$1,200,000,000
Book value = = $4.00.
300,000,000

$20.00
M/B = = 5x
$4.00
15. Net income = 0.15($20,000,000) = $3,000,000.
ROA = $3,000,000/$22,500,000 = 13.3%.