chapter 5 - 5-1Odd-numbered SolutionsCHAPTER 5INTRODUCTION...

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Unformatted text preview: 5-1Odd-numbered SolutionsCHAPTER 5INTRODUCTION TO FINANCIAL STATEMENT ANALYSISQuestions, Short Exercises, Exercises, Problems, and Cases: Answers and Solutions5.1See the text or the glossary at the end of the book.5.31.The firms may use different methods of accounting.2.The firms may pursue different operating, investing, or financingstrategies, so that they have different technologies, productiontechniques, and selling strategies.5.5The first company apparently has a relatively small profit margin andmust rely on turnover to generate a satisfactory rate of return. A discountdepartment store is an example. The second company, on the other hand,has a larger profit margin and does not need as much turnover as the firstcompany to generate a satisfactory rate of return.5.7The rate of return on common shareholders equity exceeds the rate ofreturn on assets when the latter rate exceeds the return required bycreditors and preferred shareholders (net of tax effects). In this situation,financial leverage is working to the benefit of the common shareholders.The rate of return on common shareholders equity will be less than thereturn on assets when the latter rate is less than the return required bycreditors and preferred shareholders. This situation generally occurs duringperiods of very poor earnings performance.5.9Financial leverage involves using debt capital that has a smaller aftertaxcost than the return a firm can generate from investing the capital invarious assets. The excess return belongs to the common shareholders. Afirm cannot continually increase the amount of debt in the capital structurewithout limit. Increasing the debt level increases the risk to the commonshareholders. These shareholders will not tolerate risk levels that theyconsider too high. Also, the cost of borrowing increases as a firm assumeslarger proportions of debt. Sooner or later, the excess of the rate of returnon assets over the aftertax cost of borrowing approaches zero or evenbecomes negative. Financial leverage then works to the disadvantage ofthe common shareholders.Odd-numbered Solutions5-25.11(Cracker Barrel Old Country Store and Outback Steakhouse; calculatingand disaggregating rate of return on assets.)a.Cracker Barrel: $106,529 + (1 .35)($8,892)$1,295,077= 8.7 percent.Outback: $91,273 + (1 .35)($2,489)$531,312= 12.1 percent.b.TotalAssetRate of Return on Assets=Profit Margin for ROAXTurnoverRatioCracker Barrel:$106,529 + (1 .35)($8,892)$1,295,077= $106,529 + (1 .35)($8,892)$2,198,182X$2,198,182$1,295,0778.7 percent= 5.1 percentX1.70Outback:$170,206 + (1 .35)($1,810)$1,413,810=$170,206 + (1 .35)($1,810)$2,724,600X$2,724,600$1,413,81012.1 percent= 6.3 percentX1.93c.Outback has a higher ROA, the result of a higher profit margin for ROAand a higher total assets turnover. Outbacks higher profit margin forROA likely results from its serving primarily the dinner meal, whereasCracker Barrel serves meals all day. The profit margins on breakfastCracker Barrel serves meals all day....
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This note was uploaded on 05/31/2008 for the course ORIE 310 taught by Professor Callister during the Fall '07 term at Cornell University (Engineering School).

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chapter 5 - 5-1Odd-numbered SolutionsCHAPTER 5INTRODUCTION...

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