solution manual for 《investment analysis and portfolio management》 ch10.doc

chapter 10analysis of financial statementsanswers to questions1.the kind of decisions that require the analysis of financial statements include whether to lend money to a firm, whether to invest in the preferred or the common stock of a firm, and whether to acquire a firm. to properly make such decisions, it is necessary to understand what financial statements are available, what information is included in the different types of statements, and how to analyze this financial information to arrive at a rational decision.2.analysts employ financial ratios simply because numbers in isolation are typically of little value. for example, a net income of $100,000 has little meaning unless analysts know the sales figure that generated the income and the assets or capital employed in generating these sales or this income. therefore, ratios are used to provide meaningful relationships between individual values in the financial statements. ratios also allow analysts to compare firms of different sizes.3.a major problem with comparing a firm to its industry is that you may not feel comfortable with the measure of central tendency for the industry. specifically, you may feel that the average value is not a very useful measure because of the wide dispersion of values for the individual firms within the industry. alternatively, you might feel that the firm being analyzed is not “typical,” that it has a strong “unique” component. in either case, it might be preferable to compare the firm to one or several other individual firms within the industry that are considered comparable to the firm being analyzed in terms of size or clientele. for example, within the computer industry it might be optimal to compare ibm to burroughs and/or control data rather than to some total industry data that might include numerous small firms.4.in general, jewelry stores have very high profit margins but low asset turnover. it could take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be tremendous. on the other hand, grocery stores usually have very low profit margins but very high asset turnover. assuming both business risk and financial risk of the firms are equal, the roes should likewise be equal.5. business risk is measured by the relative variability (i.e., the coefficient of variation) of operating earnings for a firm over time. in turn, the variability of operating earnings is a function of sales volatility and the amount of operating leverage (i.e., fixed costs of production) employed by the firm. sales variability is the prime determinant of earnings volatility. in addition, the greater the firms operating leverage, the more variable the operating earnings series will be relative to the sales variability.6.the steel company would be expected to have greater business risk. as discussed in question #5, sales variability and operating leverage are the two components of business risk. while both the steel and the retail food chain will have high operating leverage, the steel firm is more sensitive to the business cycle than the retail food chain. that is, the steel firm will have a very volatile sales pattern over the business cycle. therefore, the steel firm should have higher business risk than the retail food chain.7.when examining a firms financial structure, we would also be concerned with its business risk. since financial risk is the additional uncertainty of returns faced by equity holders because the firm uses fixed-obligation debt securities, the acceptable level of financial risk usually depends on the firms business risk. for a firm with low business risks, investors are willing to accept higher financial risk. on the other hand, if the firm has very high business risk, investors probably would not feel comfortable with high financial risk also.8. the total debt/total asset ratio is a balance sheet ratio that indicates the stock of debt as compared to the stock of equity. while the total debt/total asset ratio is a common measure of financial risk, many analysts prefer to employ the fixed charge coverage ratio, which reflects the flow of funds from earnings that are available to meet fixed-payment debt obligations.a cash flow ratio represents the cash available to service the debt issue, whereas a proportion of debt ratio simply indicates the amount of debt outstanding. for example, a large amount of debt (i.e. high proportion of debt indicating greater financial risk) could be issued with a low coupon rate, thereby requiring only a small amount of cash to service the debt. generally, when these two types of debt ratios diverge, one should concentrate on the cash flow ratios since they represent the firms ability to make its debt obligations.9.growth analysis is important to common stockholders because the future value of the firm is heavily dependent on future growth in earnings and dividends. the present value of a firm with perpetual dividends payment is:therefore, an estimation of expected growth of earnings and dividends on the basis of the variables that influence growth is obviously crucial. growth analysis is also important to debt-investors because the major determinant of the firms ability to pay an obligation is the firms future success which, in turn, is influenced by its growth.9. the rate of growth of any economic unit depends on the amount of resources retained and reinvested in the entity and the rate of return earned on the resources retained. the more reinvested, the greater the potential for growth. in general:growth = retention rate x return on equity11.assuming the risk of the firm is not abnormally high, a 24% roe is quite high and probably exceeds the return that the equity investor could earn on the funds. therefore, the firm should retain their earnings and invest them at this rate.12.this does not mean that orange company is better than blue company. in order to make this judgment, we have to know what factors (components) caused the extra four points of roe. if it comes from either the profit margin or the total asset turnover component of the roe, we can comfortably claim that equity holders of orange company are better off than equity holders of blue company. on the other hand, it would not be so if the extra four points is because the orange company has higher financial leverage, since this extra return is simply a compensation to its equity holders for the higher financial risk they bear. finally, we are not told anything about the business risks of the two firms.13.external market liquidity is the ability to buy or sell an asset quickly with little change in price (from prior transaction), assuming no new information has been obtained. the two components of external market liquidity are: (1) the time it takes to sell (or buy) the asset, (2) the selling (or buying) price as compared to recent selling (buying) prices.real estate is considered an illiquid asset because it can take months to find a buyer (or seller), and the price can vary substantially from the last transaction or comparable transactions.14.some internal corporate variables such as the total market value of outstanding securities and the number of security owners are good indicators of market liquidity. if the firm has a fairly large number of stockholders, it would be very likely that, at any point in time, some of these investors will be buying or selling for a variety of purposes. therefore, the firms security would enjoy a liquid secondary market. on the other hand, a small number of security holders would probably indicate an illiquid secondary market. the ultimate indicator is the volume of trading in the security either in absolute terms or relative turnover (shares traded as a percent of outstanding shares).15.student exercisechapter 10answers to problems1(a).1(b).growth rate= (retention rate) x (return on equity)= (1 - 160,000/400,000) x .345= (1 - .40) x .345= .60 x .345= 20.7%1(c).1(d).growth rate = .60 x .207 = 12.42%if dividends were $40,000, then rr= (1 - $40,000/400,000)= 1 - .10 = .90then growth rate = .90 x .207 = 18.63%2(a).roe = total asset turnover x total assets/equity x net profit margincompany k: roe= 2.2 x 2.4 x .04 = .21company l: roe= 2.0 x 2.2 x .06 = .26company m: roe= 1.4 x 1.5 x .10 = .212(b).growth rate= retention rate x roe= (1 - payout rate) x roecompany k: growth rate= (1 - 1.25/2.75) x .21= .55 x .21 = .1155company l: growth rate= (1 - 1.00/3.00) x .26= .67 x .26 = .1742company m: growth rate= (1 - 1.00/4.50) x .21= .78 x .21 = .16383.current ratio = 650/350 = 1.857quick ratio = 320/350 = 0.914receivables turnover = 3500/195 = 17.95xaverage collection period = 365/17.95 = 20.33 daystotal asset turnover = 3500/2182.5 = 1.60xinventory turnover = 2135/280 = 7.625xfixed asset turnover = 3500/1462.5 = 2.39xequity turnover = 3500/1035 = 3.382xgross profit margin = (3500 - 2135)/3500 = .39operating profit margin = 258/3500 = .074return on capital (129 + 62)/2182.5 = .088return on equity = 129/1185 = .109return on common equity = 114/1035 = .110debt/equity ratio = 625/1225 = .51debt/total capital ratio = 625/1850 = .338interest coverage = 258/62 = 4.16xfixed charge coverage = 258/62 + (15/.66) = 3.045xcash flow/long-term debt = (129 + 125 + 20)/625 = .438cash flow/total debt = (129 + 125 + 20)/975 = .281retention rate = 1 - (40/114) = .65eddies current performance appears in line with its historical performance and the industry average except in the areas of profitability (measured by return on capital and return on equity) and leverage (debt/equity and debt/total capital ratios).4.cfa examination i (1990)199920034(a).operating margin = (operating income depreciation)/sales= (38 - 3)/542 = 6.46%= (76 - 9)/979 = 6.84%asset turnover = sales/total assets= 542/245 = 2.21x= 979/291 = 3.36xinterest burden = interest expense/total assets= 3/245 = 1.22%= 0/291 = 0%financial leverage = total assets/common shareholders equity= 245/159 = 1.54x= 291/220 = 1.32xtax rate = income taxes/pre-tax income= 13/32 = 40.63%= 37/67 = 55.22%the recommended formula i