Lecture 1 Sol

Provide the alma groups management with a quick

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Provide the Alma Group’s management with a quick estimate of the market value of Sitca’s equity. Carefully explain. Solution Use price-earnings (PE) ratios from similar publicly-traded firms to estimate the market value of Sitca’s equity, under the assumption that the stock market correctly prices existing public firms and that those firms are similar to Sitca. Specifically, let E S by Sitca’s equity value which we want to estimate. We could write its (unknown) PE ratio as: PE S = E S / NI S = E S / 10M. So we get E S = PE S x 10M. If we knew PE S then we can estimate E S . We estimate PE S as the average of the PEs of similar publicly-traded firms: Telex’s PE = 500M/8M = 62.5 and Rarex’s PE = 600M/12M = 50. The average PE of similar traded firms is 56.25 and thus E S = 56.25 x 10M = \$562.5M. Note: PE = equity value / NI = [equity value / #shrs] / [NI / \$shrs] = share price / EPS. Question 8. Write down the expressions for the following financial ratios and explain what they measure: a) Book leverage, market leverage, interest coverage, and fraction of debt which is long term (maturity more than 1 year). b) Current ratio and quick ratio. c) Net profit margin, ROA, and ROE. d) Payout ratio and retention ratio. e) Price-earnings ratio, market to book equity ratio, and dividend yield. f) Productivity of fixed assets and productivity of labor.

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COMM 370 – Elena Simintzi 16 Solution to question 8. a) Book leverage, market leverage, interest coverage, and fraction of debt which is long term (maturity more than 1 year). Book leverage = Book Value of Debt / Book Value of Assets Market leverage = Book Value of Debt / (Book Value of Debt + Market Value of Equity) Interest Coverage= (EBIT + Depreciation) / Interest Payments % of Debt that is Long Term = Book Value of Long Term Debt / Book Value of Debt The two leverage measures capture the amount of debt financing in the firm’s capital structure. The book measure is not affected by stock prices and the market measure is affected by stock prices. High leverage is associated with more financial risk. Interest coverage is really another measure of financial leverage, but it literally captures the # of times the firm could pay its current interest expenses using its current cash flow. The % of debt that is long term measures the debt’s maturity structure. When most debt is long term, there is little risk of immediate default, but when most debt is due within one year financial risk is higher as these payments are coming up soon. b) Current ratio and quick ratio. Current Ratio = Current Assets / Current Liabilities Quick Ratio = (Cash & Equivalents + Accounts Receivable) / Current Liabilities Both measures short-term solvency, i.e., the firm’s ability to repay its current liability by liquidating its current assets. The quick ratio ignores inventory, as it is typically hard to convert it into cash fast.
• Winter '12
• VincentGregoire
• Balance Sheet, Financial Ratio, Elena Simintzi

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