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CHAPTER 10

QUESTION 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

·         Asset turnover

·         Interest burden

·         Financial leverage

·         Income tax rate

Using only the data in the table shown 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 STATEMENT 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

Working capital                                            123             157

Total debt                                                      16                 0

Total shareholders’ equity                            159             220

 

QUESTION 5

David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected 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 off-balance-sheet items in Exhibit 10.12 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 liabilities

The bond is currently trading at a credit premium of 55 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 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 internal bond-rating criteria found in Exhibit 10.13.

 

EXHIBIT 10.10 MONTROSE CABLE COMPANY YEAR ENDED MARCH 31, 2011

US$ 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

Shareholders’ equity                                             33,460

    Total liabilities & shareholders’ equity           $47,960        

Income Statement__________________________________

Revenue                                                               $18,500

Operating & administrative expenses                    14,050

Operating income                                                    4,450

Depreciation & amortization                                  1,675

Interest 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 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 transmission 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 YIELD PREMIUM DATA

Bond Rating

Interest Coverage (EBITDA/interest expense

Leverage (long-term debt/equity)

Current Ratio (current assets/current liabilities

Credit Yield Premium over US Treasuries (in basis points)

AA

A

BBB

BB

5.00 to 6.00

4.00 to 5.00

3.00 to 4.00

2.00 to 3.00

0.25 to .30

0.30 to 0.40

0.40 to 0.50

0.50 to 0.60

1.15 to 1.25

1.00 to 1.15

0.90 to 1.00

0.75 to 0.90

30 bps

50 bps

100 bps

125 bps

 

CHAPTER 11

QUESTION 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?

QUESTION 8

The Shamrock Dogfood Company (SDC) has consistently paid out 40 percent of its earnings in dividends. The company’s return on equity is 16 percent. What would you estimate as its dividend growth rate?

QUESTION 10

 

What P/E ratio would you apply if you learned that SDC had decided to increase its payout to 50 percent? (Hint: This change in payout has multiple effects.)

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