4-(Question 4 is composed of two parts.) The DuPont Formula defines the net return on shareholders ‘Equity as a function of the following components:
Operating Margin A
Asset Turnover
Interest Burden
Financial Leverage
Income Tax Rate
Using only the data in the table below:
a. Calculate 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 2010 to 2014.
Income State Data 2010 2014
Revenues $542 $979
Operating Income $38 $76
Depreciation and Amortization $3 $9
Interest Expense $3 $0
Pretax Income $32 $67
Income Taxes $13 $37
Net Income After Tax $19 $30
Balance Sheet Data 2010 2014
Fixed Assets $41 $70
Total Assets $245 $291
Workign Capital $123 $157
Total Debt $16 $0
Total Shareholders’ Equity $159 $220
5- David Wright CEA. An analyst with River Investment is considering buying a Montrose Cable Company corporate bond. He has collect the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10 He has also calculated the three ratios shown in EXHIBIT 10.11. Which indicate that the bond is currently rated “A” according to the firm’s internal bond rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance –sheet items in his credit analysis, as shown in Exhibit 10.12. Specifically. Wright wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Exhibit 10.11.
a. Calculate the combined effect of the three of balance sheet items in the Exhibit 10.12 on each of the following three financial ratios shown in Exhibit 10.11
1-EBITDA/interest expense.
2- Long-term debt/equity.
3-Current assets/current liabilities.
The bond is currently trading at the credit premium of 25 basis points. Using the internal bond-rating criteria in Exhibit 10.13, Wright wants to evaluate whether or not the credit yield premium incorporates the effect 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 internal bond-rating criteria found in Exhibit 10.13.
Exhibit 10.10 Montrose Cable Company Year Ended March 31, 2011 {Use Thousands}
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’s equity 33,460
Total liabilities and Shareholder’s equity 47,960
Income Statement .
Revenue $18,500
Operating and administrative expenses $14,050
Operating income $4,450
Depreciation and amortization $1,675
Internet expense $942
Income before income taxes $1,833
Taxes $641
Net income $1,192
Exhibit 10.11 Selected Ratios and Credit Yield Premium Data for Montrose .
EBITDA/interest expense 4.72
Long-term debt/equity 0.30
Current assets/ Current liabilities 1.05
Credit yield premium over U.S. Treasuries 55 basis points
Exhibit 10.12 Montrose off-balance-sheet items
· Montrose has guaranteed the long-term debt (principal only0 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 transmission equipment. The discount 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
Credit Yield
Interest Coverage Current Ratio premium over
{EBITDA/interest Leverage Long[Current assets/ U.S. Treasuries
Bond Rating Expense} -term debtequityCurrent liabilities] 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 t0 1.00 100bps
BB 2.00 to 3.00 0.50 to 0.60 0.75 to .090 125bvps
6- . Over the long run, you expect dividends for BBC in Problem 4 to grow at 8 percent and you require 11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?
7- The Shamrock Dogfood Company (SDC) has consistently paid out 40 percent of its earnings in divi- dends. The company’s return on equity is 16 percent. What would you estimate as its dividendgrowth rate?
8-– What P/E ratio would you apply if you learned that SDC had decided to increase its payout to50 percent? (Hint: This change in payout has multiple effects.)
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