CHAPTER 10: (Question 4 is composed of two parts) The DuPont formula defines the net return on shareholders’ equity as a function of the components:
Operating margin
Asset turnover
Interest burden
Financial leverage
Income tax rate
Using only the date in the table shown below:
a. Calculatete each of the five components listed above for 2010 and 2014, and calculate the return on equity (ROE) for 2010 and 2014, using all of the five components. Show calculations.
b. Briefly discuss the impact of the changes in asset turnover and financial leverage on the change in ROE from 010 to 2014
Income Statement Date 2010 2014
Revenues $ 542 $ 979
Operating income 38 76
Depreciation and amortization 3 9
Interest exprense 3 0
Pretax income 32 67
Income taxes 13 37
Net income after tax 19 30
Balance Sheet Date 2010 2014
Fixes assets $ 41 $ 70
Total assets 245 291
Working capital 123 157
Total debt 16 0
Total shareholders’ quity 159 220
Problem 5: David, CFA, an analys with Blue River Investment, is condidering buying a Montrose Cable Company cororate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhbit 10.10. He has also calculated the three ratios shown in Exhbit 10:11, which indicate that the bond is cyrrently rated “A” according to the firm’s internal bond-rating criteria shown in Exhibit 10-13 Wrigh has decided to consider some off-balance-sheet items in his credit analysis, as shown in Exhibit 10-12. Specialy, Wright wishes to evaluate the impact of each of the off-balance -sheey items on each of the ratios found in Exhibt 10:11
a . Calsuclate the conbined effects of the three off- balance-sheet items in Exhibit on each of the following three financial ratios shown in Exhibit 10.11
i. EBITDA/interest expense
ii. Long-term debt/equity
iii Current assets/current liabilites
The bond is current trading at at credit premium of 55 bass points. Using the internalbond-rating criterie in Exhibit 10.13, Wright wants to evaluate whether or not the cridit yield premium incorporates the effect of the off-balance-sheet items.
b. State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the inrnal bond-ratinf criteria found in Exhibit 1013
Exhibit 10-10 Montroses Cable Company Year Ended March 31, 2011
Balance Sheet
Current assets $ 4,735
Fixed assets 43, 225
total assets 47,960
Current liabilities $ 4,500
Long-term debt 10,000
Total liabilities $ 14,500
Shareholder’ equity $ 33,460
Total liabilities and shareholders’ equity $ 47,960
Income Statement:
Revenue $ 18,500
Operating and administrative expenses $ 14,050
Operating income $ 4, 450
Depreciation and amoritzation $ 1,675
Interest expense $ 942
Income before taxes $ 1,833
Taxes $ 641
Net income $ 1,192
Exhibit 10.11 Selected Ratios and Credit Yeld Premium Date for Montrose.
EBITDA/interest expense 4-72
Long-term debt/equity 0.30
Current assets/current liabilities 1.05
Credit yield primium over U.S. Treasuries 55 basis points
Exhibit 10.12 Montrose Off-Balance-Sheet Items.
Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $ 995,000
Montrose has sold $ 500,000 of accounts receivable with recourse at a yield of 8 percent.
Montrose is a lessee in a new noncancelable operating leasing agreement to finance transmision equipment. The discounted present value of the lease payments is $ 6,144,000 using an interest rate of 10 percent. The annual payment will be $ 1,000,000
Exhibit 10.13 Blue River Investments: Internal Bond-Rating Criteria and Credit Yeld Premium Data
Bond Rating Interest Coverage Leaverage Current Ratio (current/ Credit Yield Premium
(EBITDA/interest expense) (Long-term debt/equity) asset/current liabilities) over U.S. Treasuries
(in basis points)
AA 5.00 to 6.00 0.25 to 0.30 1.15 to 1.25 30 bps
A 4.00 to 5.00 0.30 to 0.40 1.00 to 1.15 50 bps
BBB 3.00 to 4.00 0.40 to 0.50 0.90 to 1.00 100 bps
BB 2.00 to 3.00 0.50 to 0.60 0.75 to 0.90 125 bps
