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**Unformatted text preview: **BADM 115 – Section 11 Prof. Isabelle Bajeux‐Besnainou Fall 2008 Form A QUIZ #9 1. (5 points) Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $68 million in assets, $12.5 million of EBIT, and is in the 35 percent federal‐ plus‐state tax bracket. Firm HL, however, has a debt ratio (D/A) of 60 percent and pays 10.5 percent interest on its debt, whereas LL has a 35 percent debt ratio and pays only 8.5 percent interest on its debt. a. Calculate the rate of return on equity (ROE) for each firm b. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 35 to 70 percent, even though that would increase LL’s interest rate on all debt to 13.5 percent. Calculate the new ROE for LL. ANSWER: a. b. LL: D/TA = 35%. EBIT $12,500,000 Interest ($23,800,000 x 0.085) 2,023,000 EBT $10,477,000 Tax (35%) 3,666,950 Net income $ 6,810,050 Return on equity = $6,810,050/$44,200,000 = 15.41%. HL: D/TA = 60%. EBIT $12,500,000 Interest ($40,800,000 x 0.105) 4,284,000 EBT $ 8,216,000 Tax (35%) 2,875,600 Net income $ 5,340,400 Return on equity = $5,340,400/$27,200,000 = 19.63%. LL: D/TA = 70%. EBIT $12,500,000 Interest ($47,600,000 x 0.135) 6,426,000 EBT $ 6,074,000 Tax (35%) 2,125,900 Net income $ 3,948,100 Return on equity = $3,948,100/$20,400,000 = 19.35%. Although LL’s return on equity is higher than it was at the 35% leverage ratio, it is lower than the 19.63% return of HL. A ‐ 1 Initially, as leverage is increased, the return on equity also increases. But, the interest rate rises when leverage is increased. Therefore, the return on equity will reach a maximum and then decline. 2. (3 points) The Zocco Corporation has an inventory conversion period of 55 days, and average collection period of 42 days, and payables deferral period of 25 days. a. What is the length of the cash conversion cycle? b. If Zocco’s annual sales are $2,153,644 and all sales are on credit, what is the investment in accounts receivables? c. How many times per year does Zocco turn over its inventory? ANSWER: a. conversion cycle Cash = conversion collection deferral period period period Inventory Receivables Payables = 55 + 42 – 25 = 72 days. b. Average sales per day = $2,153,644/365 = $5,900. Investment in receivables = $5,900 x 42 = $247,817. c. Inventory turnover = 365/55 = 6.64x. 3. (2 points) Carter Corporation’s sales are expected to increase from $1.2 million in 2007 to $1.8 million in 2008, or by 50 percent. Its assets totaled $4 million at the end of 2007. Carter is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2007, current liabilities are $2 million, consisting of $850,000 of accounts payable, $750,000 of notes payable, and $400,000 of accrued liabilities. The after‐tax profit margin is forecasted to be 8 percent, and the forecasted retention ratio is 45 percent. Use the AFN equation to forecast carter’s additional funds needed for the coming year. ANSWER: AFN = (A*/S0)ΔS – (L*/ S0)ΔS – MS1(RR) = ($4,000,000/$1,200,000)$600,000 – ($1,250,000/$1,200,000)$600,000 – 0.08($1,800,000)(0.45) = $1,310,200. A ‐ 2 ...

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