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