Investments Ch 10 Flashcards

Question

Answer 1

DAYS SALES OUTSTANDING Days Sales Outstanding Ratio * Reflects how long it takes a company on average to collect cash from sales on credit * Also referred to as Average Collection Period Receivables Receivables Days Sales Outstanding =--------------------------------- = ------------------------- Average Sales per Day nnual Sales / 365

Answer 2

FINANCIAL LEVERAGE RATIOS Financial Leverage Ratio * Provide an indication of the long-term solvency of the firm. * They measure the extent to which the firm is using long-term debt. Debt Ratio * The ratio of total debt to total assets * Includes all current liabilities and long-term debt * Creditors prefer low debt ratios because it means lower risk. Total Debt Debt Ratio = ------------------------ Total Assets

Answer 3

PROFITABILITY RATIOS Gross Profit Margin _____________________________ * Measure the success of the firm at generating profits Sales - Cost of Goods Sold Gross Profit Margin = ---------------------------------------------- Sales PROFIT MARGIN_________________ Profit Margin (or net profit margin) * Measures the percentage of each sale that results in net income Net Income Profit Margin = --------------------------- Sales

Answer 4

ROA AND ROE * Return on assets is a measure of how effectively the firm’s assets are being used to generate profits Net Income ROA = ------------------------------ Total Assets * Return on equity measures the profits earned for each dollar of common equity. Net Income ROE = ------------------------------- Shareholder Equity * A company’s sustainable growth rate is the maximum growth rate for a company, while maintaining its capital structure. Growth Rate = ROE x ( 1- Payout Ratio )

Answer 5

DUPONT FORMULA The DuPont formula disaggregates ROE into three basic components: * Profit margin * Total asset turnover * Financial leverage Net Income Sales Total Assets ROE = ------------------ x ----------------------x ---------------------- Sales Total Assets Equity

Answer 6

DEGREE OF LEVERAGE Degree of Opening Leverage ( DOL ) _________________ % change in EBIT DOL = ---------------------------- % change in Sales Degree of Financial Leverage ( DFL )__________________ % change in EPS DOL = ---------------------------- % change in EBIT Degree of total Leverage ( DTL )______________________ DTL = DOL x DFL

Answer 7

MARKET VALUE RATIOS * Give insight into how the market and other investors perceive a company’s risk and future prospects. PE Ratio * Expresses how much investors are willing to pay for a dollar of profits. Price per Share PE Ratio = ----------------------------------- Earnings per Share ( EPS )

Answer 8

OTHER MARKET VALUE RATIOS PEG Ratio * Compares a stock’s PE ratio to the expected growth of that stock’s earnings per share. PE Ratio PEG Ratio = ------------------------------ Expected EPS Growth

Answer 9

Price-to-Book Ratio * Expresses how much investors in the market are willing to pay for a dollar of book value (equity). Share Price Price to Book = ------------------------------ Book Value per Share Shareholders Equity Book Value per Share = --------------------------------- Shares Outstanding

Answer 10

DIVIDEND POLICY RATIOS DIVIDEND YIELD * Dividend yield is a company’s dividends relative to the stock price Dividends per share Dividend Yield = ------------------------------- Share Price PAYOUT RATIO * Payout ratio is the percentage of earnings paid out to the shareholders in the form of dividends. Dividends per Share Payout Ratio = ---------------------------------- Earnings per Share

Answer 11

TECHNICAL ANALYSIS * Technical analysis is another method that may help determine the price at which an investor should buy, sell, or hold an individual equity security. * Technical analysis largely ignores the fundamentals MARKET VOLUME The total number of shares traded each day: * Based upon supply and demand of securities * Indicator of investor sentiment * Provides insight as to the market's strength or weakness BREADTH OF THE MARKET * Measures the number of advancing stocks versus declining stocks * Technical analysts use this measure to assess the direction of the market ADVANCE-DECLINE LINE * A/D line is a graphical depiction of periodic changes in advancing and declining issues on an exchange. * Each point on the chart is determined by taking the difference between the number of advancing and declining stocks SHORT INTEREST * Measurement of the total number of shares currently sold short in a particular market * An increase in short selling may indicate negative sentiment regarding present market conditions. ODD LOT TRADING * A trade in any amount that is less than 100 shares, most made by individual investors * Sophisticated investors view the average individual investor as being unable to accurately time market trends. CHARTING * The Dow Theory premise is that trend behavior signals the end of both bear and bull markets. * Primary trends * Secondary movements * Ripples MOVING AVERAGE * A tool that smooths out minor, short-term variations in price changes * Is a useful indicator of long-term trends * Is an arithmetic mean of stock prices * The prices used in the calculation “move” or shift forward by one day each trading day

Answer 12

POINT AND FIGURE CHART

Answer 13

SUPPORT AND RESISTANCE LEVELS Support Levels * Indicate the floor price below which an asset is not expected to trade Resistance Levels * Represent a “ceiling” for the stock price trading range

Answer 14

Solution: The correct answer is B. Net Income Profit margin = ------------------ Sales OR Net Income = Sales x Profit margin = 2 mill x .08 = $ 2,080,000 Net income 2,080,000 EPS = ----------------------------- = --------------- = 1.04 EPS Shares outstanding 2,000,000 --------------------------------------------------------------------------------- Price PE = ---------------- EPS OR Stock Price = P/E x EPS 17.68 = P/E x 1.04 17.68 PE = ------------- = 17 1.04 Div per Share Payout Ratio = --------------------- or Div per Share = Payout Ratio X EPS EPS Div Yield= Div per share Payout Ratio x EPS -------------------- = --------------------------- Price Price .40 x 1.04 .416 so ---------------------- = -------------- -- = .0235 = 2.35 % $ 17.68 $ 17.68

Answer 15

Pay accounts payable from cash. Rationale The current ratio is equal to current assets divided by current liabilities and indicates a company’s ability to cover current liabilities. Cash and marketable securities are considered current assets, so a sale of marketable securities for cash would not increase current assets or the current ratio. Prepaying part of long-term debt would decrease the current ratio. Delaying payment of accounts payable will not change current cash or current liabilities. The payment of accounts payable with cash will decrease both balances (current assets and current liabilities), but because the old current ratio exceeds 1.0, the impact will be an increase in the new current ratio. If current assets = 125,000 and current liabilities = 100,000, the current ratio is 1.25. Payment of 25,000 in current liabilities reduces cash to 100,000 and liabilities to 75,000. The new current ratio equals 100,000/75,000 = 1.33. Though cash and payables decrease by the same amount, the new ratio goes up because it is greater than 1.0. Given a current ratio of less than 1, and the same set of circumstances, the new current ratio would be reduced.

Answer 16

2.3. Rationale % chg in EBIT (Total unitsx $ /unit) - (Total units x var cost/unit) DOL=---------------------= -------------------------------------------- % chg in Sales (the above figure ) - Fixed cost Q(P-V) DOL = ----------------- (Q(P-V)-F) 70 (15-1.5) ------------------------------- = 2.333 ( 70 (15-1.5 ) -540 )

Answer 17

40%. Rationale EBIT x DOL = EPS increase 20% increase in EBIT x 2.0 DOL = 40%: EPS increase

Answer 18

1.67. Rationale EPS increased by 100%. % change in EPS ?? DFL = ----------------------------- % change EBIT EPS -------------------------------- = DFL ( sales increase x DOL ) 100% .10 ----------------------- = ----------- = 1.67 ( 20% x 3.0 ) .06

Answer 19

Rationale Operating leverage magnifies EBIT and financial leverage magnifies EPS. Therefore, if sales increase by 20%, then EPS will increase by 90% (20% x 3.0 x 1.5). % change in EPS <<<<< want to solve for this DFL = ---------------------- % change in EBIT OR % change in EPS = % change in EBIT x DFL 1. What % change in EBIT ? % change in EBIT EBIT DOL =------------------------- or 3 = ----------- = .60 = 60 % % change in sales .20 so % change in EPS = % change in EBIT x DFL .60 x 1.5 = .90 = 90%

Answer 20

The variation in ROE and EPS is identical to the variation in EBIT if the firm is unleveraged. The variation in ROE and EPS is always greater than the variation in EBIT if the firm is leveraged. Financial risk is the additional variation in ROE and EPS arising from the use of debt. All of the above. Rationale All of the statements are correct.

Answer 21

Business risk. Rationale Business risk refers to the variability in earnings caused by the industry in which the company operates. Variability in income from operations can be caused by volatility in sales and higher than average fixed costs. Financial risk refers to the variability of returns to stockholders based on the introduction of long-term debt to the capital structure. Default risk is the risk that the company won’t be able to pay their debt, and systematic risk is market risk (nondiversifiable).

Answer 22

Both of the above. Rationale Both DOL and DFL will amplify EPS. DOL amplifies EBIT, which then amplifies EPS. DFL does not amplify EBIT, but amplifies EPS.

Answer 23

Must solve for DTL = DOL x DFL __________________________________________________________________ Sales - ( variable cost ) DOL = ------------------------------------------------ ( Sales - Variable cost) - Fixed cost ($50m - (0.2 x $50m)) 40 DOL= ----------------------------------------------= ------------- = 4 [($50m - (0.2 x $50m)) - $30m] 40 - 30 ( Sales - variable cost ) - Fixed cost ___________________________________________________________________ EBIT = ( Sales - Var cost ) - Fixed Cost EBIT = $50m - $10m VC - $30m FC = $10m ___________________________________________________________________ EBIT DFL = ---------------------------------------- EBIT - interest Expense Interest = $20 million x 6% = $1.2 million EBIT $10mill DFL =---------------------------------- = ---------------------------------- = 1.136 (EBIT – I) ($10 million - $1.2 million) __________________________________________________________________ DTL = DOL x DFL = 4 x 1.136 = 4.545

Answer 24

Use the information below to answer this question. ABC Corporation Selected Financial Statement Information for the Year Ended December 31 (In millions except per share data) BALANCE SHEET 20x1 (Beginning) 20x1 (Endings) Assets Cash 360 380 Marketable Securities 300 100 Receivables 1,100 130 Inventories 600 910 Other 1,900 660 Total Current Assets 4,260 2,180 Property, Plant & Equipment 5,230 3,400 Other Assets 2,300 1,000 Total Assets $11,790 $6,580 Liabilities and Shareholder's Equity Accounts Payable 2,800 1,300 Long-Term Debt 2,400 900 Other Liabilities 1,500 1,400 Total Liabilities 6,700 3,600 8% Preferred Stock 500 500 Common Stock 2,000 1,800 Retained Earnings 2,590 680 Total Liabilities & Shareholder's Equity $11,790 $6,580 Which of the following is the quick ratio for ABC Corporation (for this question, assume that the “other” current assets are additional inventory)? 0.47. Rationale Cash + Marketable Securities + Accts Receivable Quick Ratio= ------------------------------------------------------------------------ Current Liabilities 380 cash + 100 marketable + 130 receivables ----------------------------------------------------------------------------- = .4692 1300 ( only use Accounts Payable )

Answer 25

It determines the end of a bull or bear market. Rationale According to the Dow Theory once a primary trend is established asset prices tend to move in that direction. The primary trend will be supported by the same directional movement in both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). The primary trend will continue until the trend is reversed, as evidenced by both the DJIA and the DJTA.

Answer 26

Fixed costs. Rationale Operating leverage comes from low variable costs. Once fixed costs are covered, increases in sales drop to the bottom line.

Answer 27

EBIT increase is 20 % DFL = 2.5 What is the expected change in earnings per share (EPS) ? % change in EPS DFL = ----------------------- OR % change in EPS = DFL x % change EBIT % change in EBIT So EPS = DFL x % change EBIT 2.5 x 20 % = 50 %

Answer 28

The debt to equity ratio is closest to: 1.21 Rationale Total Debt 3600 ----------------- = ----------------- = 1.21 Total Assets 2,980

Answer 29

HIGH fixed cost & LOW variable cost. Rationale Operating leverage occurs with high fixed costs and low variable costs. Once breakeven has occurred, the majority of sales increases will also increase net income if the firm has low variable costs.

Answer 30

40,000. Rationale $540,000 -------------------------- = 40,000 ($15.00 - $1.50) Total Cost -------------------------------- ( total cost - variable cost )

Answer 31

TEST * Purpose of financial ratios − Insight into past performance − Allows for comparison across firms − Allows for comparison of firms with industry averages * Calculate − EPS − PE Ratio − Stock Price using PE − Relative PE ratio − PEG * Usefulness and meaning

Answer 32

TEST * Ratio analysis is the study of the relationships between financial statement accounts, and it provides a historical perspective. * May infer future performance based on historical perspective. * Understanding key ratios allow investor to better understand the connection between different elements of financial performance.

Answer 33

TEST * Dividend per Share = Annual Dividend / # of Common Shares Outstanding * Payout Ratio = Dividend per Share / Earnings per Share * g (growth rate) − one method of estimating the firm’s growth rate is: g = b x ROE b = retention rate ( which is 1 – dividend payout ratio ) ROE = return on equity

Answer 34

Lending at the prime rate of interest. Rationale The Federal Reserve Board operates in the open market, can change both the discount rate and excess reserve, but has no direct control over the prime lending rate.

Answer 35

Inflation would decrease. Rationale During a recession/contraction, there is a decline in demand. GDP is decreasing, inflation is decreasing, and unemployment is increasing. Since demand is decreasing, the supply of goods and services will also be decreasing. To stimulate economic growth, the money supply will likely increase, causing interest rates to decline.

Answer 36

High fixed costs and low variable cost.

Answer 37

Solution: The correct answer is B. DY = Dividend ÷ Stock Price = 1.80 ÷ 18.95 = .0949