Question

1. Company A has a current ratio of 2, PE ratio of 12, debt ratio of 25% and ROE of 8%. Its basic earnings power (EBIT/TA) is 20%. The company net income is $8000, and the tax rate is 40%. Find ROA and Time Interest Earned (EBIT/Interest) Ratio.

2. If company B uses cash to pay down the account payable, what will happen to its current ratio? (Please use numerical examples to illustrate)

3. Company C adopts a new operation system and improves its asset turnover ratio (Sales/Total Assets) from 0.8 last year to 1.8 this year. During this year, its asset grows by 30% from last year. How much does the sales have to grow in percentage this year so that the total asset turnover ratio is 1.8?

4. Company D has no debt now and is considering borrowing $200 million at a market interest rate of 5%. The loan is a balloon payment loan for 20 years, and the company faces a 30% marginal tax rate, what is the value of the tax benefits that the company will get just from the loan?

5. Currently, company E has a 20% debt ratio, a marginal tax rate of 40% and its beta is 1.3. The risk-free rate is 3% and the equity risk premium is 7%. What will happen to the cost of equity, if the firm moves to a 50% debt ratio?

6. Company F has 5 million shares, trading at $40/share and it has $30 million in debt. The manager believes that the value of the company will increase by 20% if it borrows another $30 million and buys back stock. Assuming investors are rational, what would the company expect to pay, per share, on the stock buyback?

7. Company G has 100 million shares outstanding, trading at $20/share and $900 million in debt outstanding. If the marginal tax rate for the firm is 30%, the cost of bankruptcy is 20% of current firm value and the probability of bankruptcy at the current debt level is 30%, what is the unlevered value of the firm?

8. Firm H has equity with a market value of $600 million and a current debt ratio of 20%. If the company has an optimal debt ratio of 50% and would like to borrow money and buy back stock right now, how much additional debt will the firm have to issue?

9. Company I operates in a market where investors pay a 30% tax rate on dividends and only 10% in capital gains. The company’s stock trades at $30/share today and has an annual dividend of $2/share. If the ex-dividend day is tomorrow, what would you expect the stock price to be at the end of today?

10. Mark Cuban is a household name due to his involvement on the hit reality show "Shark Tank," but Cuban is also a billionaire and owner of NBA basketball team the Dallas Mavericks. He's also got his hands in several other ventures, including a TV network. Cuban is an outspoken critic of the NBA and has long preferred investing directly into companies instead of the stock market. However, when he does invest in stocks, he sees dividends as a requirement rather than a bonus. Do you agree with him? Please elaborate your answers.

7. Company G has 100 million shares outstanding, trading at $20/share and $900 million in debt outstanding. If the marginal tax rate for the firm is 30%, the cost of bankruptcy is 20% of current firm value and the probability of bankruptcy at the current debt level is 30%, what is the unlevered value of the firm?

8. Firm H has equity with a market value of $600 million and a current debt ratio of 20%. If the company has an optimal debt ratio of 50% and would like to borrow money and buy back stock right now, how much additional debt will the firm have to issue?

9. Company I operates in a market where investors pay a 30% tax rate on dividends and only 10% in capital gains. The company’s stock trades at $30/share today and has an annual dividend of $2/share. If the ex-dividend day is tomorrow, what would you expect the stock price to be at the end of today?

Answer 1

Answer to Question 1:

Return on Equity = Net Income / Total Equity
0.08 = $8,000 / Total Equity
Total Equity = $100,000

Equity Ratio = 1 - Debt Ratio
Equity Ratio = 1 - 0.25
Equity Ratio = 0.75

Equity Ratio = Total Equity / Total Assets
0.75 = $100,000 / Total Assets
Total Assets = $133,333.33

Basic Earnings Power = EBIT / Total Assets
0.20 = EBIT / $133,333.33
EBIT = $26,666.67

EBT = Net Income / (1 - Tax Rate)
EBT = $8,000 / (1 - 0.40)
EBT = $13,333.33

Interest Expense = EBIT - EBT
Interest Expense = $26,666.67 - $13,333.33
Interest Expense = $13,333.34

Return on Assets = Net Income / Total Assets
Return on Assets = $8,000 / $133,333.33
Return on Assets = 0.06 or 6.00%

Times Interest Earned = EBIT / Interest Expense
Times Interest Earned = $26,666.67 / $13,333.34
Times Interest Earned = 2.00

Answer to Question 2:

If company B uses cash to pay down the account payable, then its current ratio will increase.

Let assume that current assets are $50,000 and current liabilities are $25,000 before payment of accounts payable of $5,000

Before payment of accounts payable:

Current Ratio = Current Assets / Current Liabilities
Current Ratio = $50,000 / $25,000
Current Ratio = 2.00

After payment of accounts payable:

Current Assets = $50,000 - $5,000
Current Assets = $45,000

Current Liabilities = $25,000 - $5,000
Current Liabilities = $20,000

Current Ratio = Current Assets / Current Liabilities
Current Ratio = $45,000 / $20,000
Current Ratio = 2.25