ECN 134 Solution Key to Problem Set Financial Economics Prof Farshid Mojaver Part A Problem 1 Cash Flows at WARF Computers Inc Angus has asked you to prepare the financial statement of each flows and the accounting statement of cash flows He has also asked you to answer the following questions 1 How would you describe Wart Computer s cash flows 2 Which cash flow statement more accurately describes the cash flows at the company 3 In light of your previous answers comment on Nick s expansion plans Answer The operating cash flow for the company is NOTE All numbers are in thousands of dollars OCF EBIT Depreciation Current taxes OCF 1 332 159 386 1 105 To calculate the cash flow from assets we need to find the capital spending and change in net working capital The capital spending for the year was Capital spending Ending net fixed assets 2 280 Beginning net fixed assets 1 792 Depreciation 159 Net capital spending 647 And the change in net working capital was Change in net working capital Ending NWC Beginning NWC Change in NWC So the cash flow from assets was Cash flow from assets Operating cash flow Net capital spending Change in NWC Cash flow from assets The cash flow to creditors was Cash flow to creditors Interest paid Net New Borrowing Cash flow to Creditors The cash flow to stockholders was 728 586 142 1 105 647 142 316 95 20 75 Cash flow to stockholders 1 Dividends paid Net new equity raised Cash flow to Stockholders 212 29 241 The accounting cash flow statement of cash flows for the year was Statement of Cash Flows Operations Net income Depreciation Deferred taxes Changes in assets and liabilities Accounts receivable Inventories Accounts payable Accrued expenses Other Total cash flow from operations Investing activities Acquisition of fixed assets Sale of fixed assets Total cash flow from investing activities Financing activities Retirement of debt Proceeds of long term debt Notes payable Dividends Repurchase of stock Proceeds from new stock issues Total cash flow from financing activities Change in cash on balance sheet 742 159 109 31 14 17 99 9 902 786 139 547 98 118 5 212 40 11 216 39 Answers to questions 1 The firm had positive earnings in an accounting sense NI 0 and had positive cash flow from operations and a positive cash flow from assets The firm invested 142 in new net working capital and 647 in new fixed assets The firm was able to return 241 to its stockholders and 75 to creditors 2 The financial cash flows present a more accurate picture of the company since it accurately reflects interest cash flows as a financing decision rather than an operating decision 3 The expansion plans look like they are probably a good idea The company was able to return a significant amount of cash to its shareholders during the year but a better use of these cash flows 2 may have been to retain them for the expansion This decision will be discussed in more detail later in the book Problem 2 Financial Ratio Analysis A financial ratio by itself tells us little about a company because financial ratios vary great deal across industries There are two basic methods for analyzing financial ratios for a company Time trend analysis and per group analysis In time trend analysis you find the ratios for the company over some period say five years and examine how each ratio has changed over this period In peer group analysis you compare a company s financial ratios to those of its peers Why might each of these analysis methods be useful What does each tell you about the company s financial health Answer Time trend analysis gives a picture of changes in the company s financial situation over time Comparing a firm to itself over time allows the financial manager to evaluate whether some aspects of the firm s operations finances or investment activities have changed Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm s operations finances or investment activities are out of line with the norm thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate Both allow an investigation into what is different about a company from a financial perspective but neither method gives an indication of whether the difference is positive or negative For example suppose a company s current ratio is increasing over time It could mean that the company had been facing liquidity problems in the past and is rectifying those problems or it could mean the company has become less efficient in managing its current accounts Similar arguments could be made for a peer group comparison A company with a current ratio lower than its peers could be more efficient at managing its current accounts or it could be facing liquidity problems Neither analysis method tells us whether a ratio is good or bad both simply show that something is different and tells us where to look Problem 3 Du Pont Identity If Roten Inc has an equity multiplier of 1 35 total asset turn over of 2 15 and profit margin of 5 8 percent what is its ROE Answer ROE PM TAT EM ROE 058 2 15 1 35 1683 or 16 83 Problem 4 Using Du Pont Identity Y3K Inc has sales of 3 100 total assets of 1 580 and a debt equity ratio of 1 20 If its return on equity is 16 percent what is its net income Answer 3 This is a multi step problem involving several ratios The ratios given are all part of the Du Pont Identity The only Du Pont Identity ratio not given is the profit margin If we know the profit margin we can find the net income since sales are given So we begin with the Du Pont Identity ROE 0 16 PM TAT EM PM S TA 1 D E Solving the Du Pont Identity for profit margin we get PM ROE TA 1 D E S PM 0 16 1 1580 1 1 20 3 100 0371 Now that we have the profit margin we can use this number and the given sales figure to solve for net income PM 0371 NI S NI 0371 3 100 114 91 Problem 5 EFN The most recent financial statement for Martin Inc are shown here Income Statement Balance Sheet Sales 25 800 Assets 113 000 Debt 20 500 Costs Taxable income Taxes 34 Net income 16 500 9 300 3 162 6 138 Equity Total 113 000 Total 92 500 113 000 Assets and costs are proportional to sales Debt and equity are not A dividend of 1 841 was paid and Martin wishes to maintain a constant payout ratio Next year s sales are projected to be 30 960 What external