Ch_05

Ch_05 - CHAPTER 5 INTRODUCTION TO FINANCIAL STATEMENT...

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5-1 Solutions CHAPTER 5 INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS Questions, Short Exercises, Exercises, Problems, and Cases: Answers and Solutions 5.1 See the text or the glossary at the end of the book. 5. 21 .T he firm may have changed its methods of accounting over time. 2. The firm may have changed its product lines, production techniques, investment or financing strategies, or even its managerial personnel. 5. 31 . The firms may use different methods of accounting. 2. The firms may pursue different operating, investing, or financing strategies, so that they have different technologies, production techniques, and selling strategies. 5.4 The adjustment in the numerator of rate of return on assets is for the incremental effect on net income of having versus not having interest expense. Because interest expense reduces taxable income and, therefore, income taxes otherwise payable, the tax savings from interest expense incrementally affect net income. The computation of the numerator must, therefore, incorporate this tax effect. 5.5 The first company apparently has a relatively small profit margin and must rely on turnover to generate a satisfactory rate of return. A discount department 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 first company to generate a satisfactory rate of return. 5.6 Management strives to keep its inventories at a level that is neither too low so that it loses sales nor too high so that it incurs high storage costs. Thus, there is an optimal level of inventory for a particular firm in a particular period and an optimal inventory turnover ratio. 5.7 The rate of return on common shareholders’ equity exceeds the rate of return on assets when the latter rate exceeds the return required by creditors 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 the return on assets when the latter rate is less than the return required by creditors and preferred shareholders. This situation generally occurs during periods of very poor earnings performance.
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Solutions 5-2 5.8 This statement suggests that the difference between the rate of return on assets and the aftertax cost of debt is positive but small. Increasing the amount of debt will require a higher interest rate that will eliminate this positive difference and financial leverage will work to the disadvantage of the common shareholders. 5.9 Financial leverage involves using debt capital that has a smaller aftertax cost than the return a firm can generate from investing the capital in various assets. The excess return belongs to the common shareholders. A firm cannot continually increase the amount of debt in the capital structure without limit.
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This note was uploaded on 04/23/2010 for the course B 101 taught by Professor Mcafee during the Winter '10 term at UMBC.

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Ch_05 - CHAPTER 5 INTRODUCTION TO FINANCIAL STATEMENT...

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