pratt_8e_chapter_5_solns - CHAPTER 5 USING FINANCIAL...

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CHAPTER 5 USING FINANCIAL STATEMENT INFORMATION BRIEF EXERCISE BE5–1 Coke Pepsi (a) ROE = Net Income/Average Stockholders Equity 27.3% 34.8% ROA = (Net Income +[Interest Expense (1-Tax Rate)])/ Average Total Assets 14.7% 15.2% Common Equity Leverage = Net Income/(Net Income + [Interest Expense(1-Tax Rate)]) 94.4% 95.5% Capital Structure Leverage = Average Total Assets/ Average Stockholders’ Equity 1.97 2.39 Return on Sales = Net Income + [Interest Expense (1- Tax Rate)]/Net Sales 19.3% 12.4% Asset Turnover = Sales/Average Total Assets .76 1.22 Pepsi earns considerably more relative to its equity base and slightly more relative to its assets. Coke, however, has a higher return on sales (profits relative to sales). Pepsi shows higher use of leverage (Capital Structure Leverage ratio) and is much more efficient generating sales from its asset base (Asset Turnover ratio). (b) ROA x Common Equity Leverage x Capital Structure Leverage = ROE Coke: .147 x .944 x 1.97 = .273 Pepsi: .152 x .955 x 2.39 = .347 (rounding) (c) Return on Sales x Asset Turnover = ROA Coke: .193 x .76 = .147 Pepsi: .124 x 1.22 = .151 (rounding) (d) Pepsi’s advantage in producing a return for shareholders’ equity investment is driven by more aggressive use of leverage and better returns from its asset base (ROA). Pepsi’s advantage in ROA is driven by its ability to generate sales from its assets; Pepsi’s lower return on sales is offset by higher sales volume. Given the higher returns on equity and the companies’ respective costs of capital, both companies are creating value for their shareholders. BE5–2 1
(a) With $24.6 billion in 2008 revenues, J & J’s pharmaceutical business is the largest. From 2006 to 2008, the consumer division showed the largest percentage growth at 64.25%. (b) 2006 2007 2008 55.8% 53.1% 50.7% (c) Based on 2008 results, the consumer division generated the highest percentage of sales outside the U.S. at 56.8% (with medical devices next at 54.4%). EXERCISES E5–1 Profitability Ratios: Return on Equity = Net Income ÷ Average Stockholders’ Equity 2008: $6,134 ÷ 36,500 = .168 2007: $8,052 ÷ 32,916.5 = .245 Return on Sales = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales 2008: ($6,134 + [346 x (1 - .20)]) ÷ $29,131 = .220 2007: ($8,052 + [319 x (1 - .20)]) ÷ $33,099 = .251 Solvency Ratios: Current Ratio = Current Assets ÷ Current Liabilities 2008: $ 44,177 ÷ $13,655 = 3.24 2007: $ 35,699 ÷ $13,858 = 2.58 Leverage Ratios: Capital Structure Leverage Ratio = Average Total Assets ÷ Average Total Stockholders’ Equity 2008: $63,431 ÷ $36,500 = 1.74 2007: $56,037 ÷ $32,916.5 = 1.70 Overall, by examining the above computed ratios, it appears that Cisco would be a good investment. Profitability declined but still remained strong, while solvency improved. Leverage is up only slightly. 2
E5–2 Profitability Ratios: Return on Equity = Net Income ÷ Average Stockholders’ Equity 2008: $5,292 ÷ 40,925 = .129 2007: $6,976 ÷ 39,757 = .176 Return on Sales = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales 2008: ($5,292 + [8 x (1 - .31)]) ÷ $37,586 = .141 2007: ($6,976 + [15 x (1 - .31)]) ÷ $38,334 = .182 Solvency Ratios: Current Ratio = Current Assets ÷ Current Liabilities 2008: $19,871 ÷ $7,818 = 2.54 2007: $23,885 ÷ $8,571 = 2.79 Leverage Ratios: Capital Structure Leverage Ratio = Average Total Assets ÷ Average Total Stockholders’ Equity 2008: $53,183 ÷ $40,925 = 1.30 2007: $52,009.5 ÷ $39,757 = 1.31 Profitability numbers are down significantly, solvency is down slightly and leverage is steady. The trends are due to the economic environment of 2008; the company is still quite strong and would

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