Question

Question 5. (Profitability and capital structure analysis) In the year that just ended, Callaway Lighting had sales of $5,470,000 and incurred cost of goods sold equal to $4,460,000. The firm's operating expenses were $128,000 and its increase in retained earnings was $42,000 for the year. There are currently 99,000 common stock shares outstanding and the firm pays a $4.770 dividend per share. The firm has $1,180,000 in interest-bearing debt on which it pays 7.7 percent interest. The firm's earnings are taxed at 35%, construct the firm's income statement.

Income Statement Revenues $ 5,470,000

Cost of Goods Sold (4,460,000)

Gross Profit $ 1,010,000

Operating Expenses (128,000)

Net Operating Income $ 882,000

Interest Expense (90,860)

Earnings before Taxes $ 791,140

Income Taxes (276,900)

Net Income $ 514,240

The operating profit margin is 16.1 %

The net income margin is 9.4 %

The times interest earned ratio is 9.71 %

***What does this tell you about Callaway's ability to pay its interest expense? (Fill in the blank with the times interest earned ratio from above and select the best choice.)

1) Callaway's operating income can fall as much as 9.71 times the interest expense and the company would still be able to service its debt.

2) Callaway's interest expense is _______ times higher than its competitors.

3) Callaway's gross profit can fall as much as ______ times and still be able to service its debt.

4) Callaway's operating income can fall as much as ______ times and still be able to repay its debt.

Answer:

***What is the firm's return on equity? (Select the best choice.)

1) The firm's return on equity is the same as the net profit margin, 9.4%.

2) The firm's return on equity is the sum of the operating profit margin and the net profit margin, 25.5%.

3) There is not enough information to answer this question.

4) The firm's return on equity is the same as the operating profit margin, 16.1%.

Answer:

Answer 1

Times Interest Earned Ratio is also called as Interest Coverage ratio. It is also considered as solvency ratio because it measures a firm's ability to make interest and debt service payments.

The times interest earned ratio(TIE) is calculated by dividing income before interest and income taxes(EBIT) by the interest expense.(TIE ratio = EBIT/interest expense)

In above case, Interest expense = 1,180,000 * 7.7% = 90,860

EBIT (Operating income)= $882,000

Times interest earned ratio = $882,000/90,860 = 9.4%

As per definition of Times interest earned ratio, Callaway's operating income can fall as much as 9.71 times the interest expense and the company would still be able to service its debt.

2) Return on Equity = Net Income / Average Shareholder's equity

To find the Shareholder's equity, we should have the par value of each common stock share. However it was not provided.

So there is no enough information to calculate ROE.