Consider the following sets of financial statements and answer the questions tha
ID: 2715737 • Letter: C
Question
Consider the following sets of financial statements and answer the questions that follow:
a. Which firm is the most liquid? Why? (Justify your answer with at least two ratios).
b. Which firm is the most profitable? Why? (Justify your answer with at least two ratios).
c. Construct a Du Pont equation (use the extended, or modified version shown in the Week 1, chapters 2 & 3 lesson notes) for each firm and comment on the sources of each firm’s ROE as revealed by the equation.
Question 2: (Time Value of Money – Monthly Loan Payments) 5 points
Best Buy has a 65” 4K Ultra HD TV on sale for $1,999.99. If you could borrow that amount from First National Bank of St Louis at 4% for 1 year, what would be your monthly loan payments?
Question 3: (Time Value of Money – Present Value) 4 points
You have figured out that you will need $800,000 to finance your child’s college education when she turns 18, which will be 16 years from now, so you decide to invest in zero-coupon bonds, which will mature in 16 years and will pay off $800,000 at maturity. How much would you have to invest in zero-coupon bonds today to reach your goal, assuming the going rate on such bonds is currently 3.5% per year?
Question 4: (Risk & Return) 4 points
You hold a portfolio of stocks consisting of the following:
Stock Beta Current Value
Caterpillar 0.6 $20,000
CitiCorp 0.8 $21,000
Wendy’s 1.0 $22,000
Boeing… 1.2 $27,000
Total: $90,000
a. What is the beta of the portfolio?
b. You have decided to sell Boeing for $27,000 and to use the proceeds to buy $27,000 of Nike stock with a beta of 1.4. After the transaction is complete, what will be the new beta of the portfolio? (Disregard any commissions on the buy and sell transactions.)
Question 5: (Risk & Return) 3 points
a. Define the Capital Asset Pricing Model.
b. Explain what a stock's "beta" is.
c. If the risk-free rate is 1% and the expected rate of return on the stock market is 9%, what is the required rate of return per the CAPM for a stock that has a beta of 1.3?
Question 6: (Bond valuation) 8 points
a. Curley's Company's bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 4%. The bonds have a yield to maturity (YTM) of 5%. Given these conditions, what should be the current price of these bonds?
b. Larry's Company's bonds have 8 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 4%. The bonds have a current market price of $890. Given these conditions, what should be the yield to maturity (YTM) of these bonds?
Question 7: (Stock Valuation) 6 Points
a. Define the Efficient Markets Hypothesis.
b. Financial theorists generally define three forms of market efficiency: the weak-form, the semi-strong-form, and the strong-form. Explain these three forms.
FNANCIAL STATEMENTS, Tootsie Roin $000s) BALANCE SHEET, as of year-end 2014 NCOMESTATEMENT201 45.337 Admin and seling exp Other opeain ncome exp) Beluetax eamings 23,634 EPS (G0,3B0,000 shares) Average stock pice, 2014 Common stock (6030,000 shares) $41,157 Treasry stock and other Total bites and Eqy FNANCIAL STATEMENTS, Hershey's n $000s) BALANCE SHEET, as of year-end 2014 NCOMESTATEMENT201 Admin and seling exp mpa ment chaayes nterest income(expense] S1.805.3A!5 Beluetax eamings assets IAB LTES AND EQUITES EPS (220,870,000 shares) Average stock pice, 2014 ST & curent pution of LT Debt Common stock (220,870,000 shs)359,901Explanation / Answer
Answer (1 a)
Tootsie Roll
Hershey’s
Cash & Marketable Securities
121855
1118508
Accounts receivable
45337
477912
Inventory
61856
659541
Prepaid Expenses
5581
178862
Deferred Taxes
5482
52511
Total Current Assets (A)
240111
2487334
Current Assets – Inventory – Prepaid Expenses – Deferred Taxes (C)
167192
1596420
Total Current Liabilities (B)
60121
1408022
Current Ratio = A/B
= 240111/60121
= 3.9938
= 2487334/1408022
= 1.7665
Quick Ratio = C/B
=167192/60121
= 2.7809
= 1596420/1408022
= 1.1338
From the above it can be seen that the current ratio and quick ratio of Tootsie Roll are higher compared those of Hershey’s indicating Tootsie Roll is more liquid. Most of the current assets of Tootsie Roll are invested in cash or near cash equivalents while around 30% is locked in inventory, prepaid expenses and deferred taxes which are not as liquid as other current assets. For Hershey’s these less liquid current assets constitute around 35% of total current assets contributing to the lower liquidity position.
Answer (1-b)
Tootsie Roll
Hershey’s
Gross Profit (A)
191486
3280848
Net Income (B)
60849
820470
Total Revenue (C)
543383
7146079
Total Assets (D)
888409
5357488
Total Equity (E)
680305
1616052
Gross Profit Margin (A/C)*100
35.2396%
45.91116%
Net Profit Margin (B/C) * 100
11.1982%
11.4814%
Return on Assets (B/D) * 100
6.8492%
15.3145%
Return on Equity (B/E) * 100
8.9443%
50.7700%
Hershey’s is more profitable compared to Tootsie Roll on profitability front. The gross realisations of Hersheys are nearly 10% more than that of Tootsie Roll. Similarly, the return on assets of Hershey’s is nearly double that of Tootsie Roll indicating better capacity utilization. This coupled with better realizations has resulted in a higher return number of Hershey’s compared to Tootsie Roll.
Answer (1-c)
Tootsie Roll
Hershey’s
Net Income (A)
60849
820470
Total Revenue (B)
543383
7146079
Total Assets (C)
888409
5357488
Total Equity (D)
680305
1616052
Net Profit Margin (B/C) * 100
11.1982%
11.4814%
Return on Assets (B/D) * 100
6.8492%
15.3145%
Return on Equity (B/E) * 100
8.944%
50.7700%
Total Asset Turnover (B/C)
0.6116
1.3338
Equity Multiplier (C/D)
1.3059
3.3151
Dupont Equation of Tootsie Roll
ROE = Profit margin * Total Asset Turnover * Equity Multiplier
= (net income / total revenue) *(total revenue/total assets) * (total assets / equity)
= 11.1982% * 0.6116 * 1.3059
= 8.944%
Dupont Equation of Hershey’s
ROE = Profit margin * Total Asset Turnover * Equity Multiplier
= (net income / total revenue) *(total revenue/total assets) * (total assets / equity)
= 11.4814% * 1.3338 * 3.3151
= 50.77%
A look at the above equation shows that though the net profit margin of Hershey’s is marginally higher than that of Tootsie Roll, its return on equity is nearly 6.5 times due to the following factors
Answer (2)
Monthly instalment = $ 170.30
Loan Amount = $ 1999.99
Rate of interest = 4% pa (assuming monthly compounding)
monthly interest rate = 4%/12 = 0.33333%
Effective interest rate = (1.0033333^12 - 1) * 100 = 4.07%
Let A be the monthly instalment which can be calculated as
$ 1999.99 = A * [(1-(1/(1+0.003333)^12)/0.003333]
$ 1999.99 = A * (1-1/1.040741128)/0.003333]
$ 1999.99 = A * (1-0.9608537)/0.003333
$ 1999.99 = A * (0.039146265/0.0033333)
$ 1999.99 = A * 11.743891
A = $ 1999.99 /11.743891
A = $ 170.30
Answer (3)
Amount to be invested for a maturity value of $ 800000 = $ 461,364.73
Matuirty Value of Zero Coupon bonds = $ 800,000
Rate of return = 3.5%
Period of investment = 16 years
Amount to be invested now = $ 800,000/(1+0.035)^16 = $ 800000/1.733986
= $ 461,364.7293 or $ 461,364.73 (rounded off)
Answer (4)
Stock
Amount invested
Weight
= Amount invested / Total investment
Caterpillar
20000
0.2222
Citicorp
21000
0.2333
Wendy’s
22000
0.2445
Boeing
27000
0.30
Total
90000
Beta of the Portfolio = Sum ( beta of stock * weight of stock in portfolio)
= 0.6 * 0.2222 + 0.8 * 0.2333 + 1.0 * 0.2445 + 1.2 * 0.30
= 0.13332 + 0.18664 + 0.2445 + 0.36
= 0.92446 or 0.92 (rounded off)
b. If $ 27000 of Boeing is sold and $ 27000 worth stock of Nike with Beta 1.4 are bought, then after transaction beta of the portfolio will be
Beta of revised Portfolio = 0.92 - 0.3 * 1.2 + 0.3 * 1.4
= 0.92 – 0.36 + 0.42
= 0.98
Answer (5-a)
Capital Asset Pricing Model is a relationship between risk and expected return which is used in pricing risky assets. The model can be depicted as
Expected Return = risk free rate + Beta * (market return – risk free rate)
The model is based on the premise investors need to be compensated for the time value of money and risk. The time value of money is derived from risk-free rate which compensates the investor for investing the money in the security. The second part of the equation represents risk and calculates the additional compensation needed by the investor to invest in this particular security instead of market.
Answer (5-b)
Beta is a measure of volatility of a security compared to market as a whole. Beta represents the portion of volatility of returns which cannot be reduced / diversified away by adding more securities to a portfolio. This is determined by a characteristic line fitted to set of points representing the returns of a security vis-à-vis that of market. The slope of this characteristic line represents beta and represents the systematic risk.
Answer (5-c)
Risk-free rate rf = 1%
Expected return on stock market rm = 9%
Beta of stock = 1.3
Expected return of stock = rf + beta * (rm – rf)
Expected return of stock = 1% + 1.3 * (9% -1%)
= 11.4%
Answer (6-a)
Price of the Bond = $ 922.78
Par Value = $1000
Coupon Rate = 4% per annum
Coupon amount =$ 1000 * 4% = $ 40
Time to maturity = 10 years
Yield to maturity (YTM) = 5% or 0.05
Price of the bond = $ 40 * [(1-(1/(1+0.05)^10))/0.05] + $ 1000/(1+0.05)^10
= $ 40 * [(1-(1/1.6288946))/0.05] + $ 1000/1.6288946
= $ 40 * [(1-0.6139132)/0.05] + $ 1000 * 0.6139132
= $ 40 * (0.3860867/0.05) + $ 1000 * 0.6139132
= $ 40 * 7.7217349 + $ 1000 * 0.6139132
= $ 308.8694 + $ 613.9132
= $ 922.7826 or $ 922.78 (rounded off)
Answer (6-b)
YTM = 5.76%
Time remaining to maturity = 8 years
Par Value = $ 1000
Coupon rate = 4%
Annual Coupon amount = $ 40
Current market price = $ 890
Let r be the ytm of the bond, then
890 = $ 40 * [(1-(1/(1+r)^8))/r] + $ 1000/(1+r)^8
890 - $ 40 * [(1-(1/(1+r)^8))/r] - $ 1000/(1+r)^8 = 0
Let r = 5%, then LHS of equation will be
= 890 - $ 40 * [(1-(1/(1+0.05)^8))/0.05] - $ 1000/(1+0.05)^8
= 890 - 40 * [(1-(1/1.477455))/0.05] - 1000/1.477455
= 890 - 40 * (1-0.676839)/0.05 – 1000 * 0.676839
= 890 – 40 * (0.323161/0.05) – 1000 * 0.676839
= 890 – 40 * 6.463213 – 1000 * 0.676839
= -45.3679
Let r= 6%, then LHS of equation will be
= 890 - $ 40 * [(1-(1/(1+0.06)^8))/0.06] - $ 1000/(1+0.06)^8
= 890 - 40 * [(1-(1/1.593848))/0.06] - 1000/1.593848
= 890 - 40 * (1-0.627412)/0.06 – 1000 * 0.627412
= 890 – 40 * (0.372588/0.06) – 1000 * 0.627412
= 890 – 40 * 6.209794 – 1000 * 0.627412
= 14.19588
r =0.05 + (-45.3679 * (0.05-.06))/(14.19588-(-45.3679))
r = 0.05 + 0.453679/59.56378
r = 0.05 + 0.007617
r = 0.057617 or 5.76% (rounded off)
Answer (7-a)
Efficient Markets Hypothesis states that the asset prices fully reflect all available information. That is it is impossible to beat the market consistently as the stocks trade at their fair value. The fair value continuously reflects all available information about that stock and hence it is impossible to beat the market expectations consistently.
Answer (7-b)
weak-form efficiency
In this form, future prices cannot be predicted by analysis of past price trends. Excess returns cannot be earned continuously by using investment strategies based on historical share prices or other historical data. This means technical analysis will not be effective under this form of efficiency, though fundamental analysis may produce higher returns than market in the short run but cannot be sustained for long. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.
Semi-strong-form efficiency
Under this premise, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Hence both technical and fundamental analyses cannot reliably produce excess returns.
Strong-form efficiency
Under this form, share prices reflect all information, public and private, and no one can earn excess returns. However, If there are legal barriers to private information becoming public which is the norm in real world as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
Tootsie Roll
Hershey’s
Cash & Marketable Securities
121855
1118508
Accounts receivable
45337
477912
Inventory
61856
659541
Prepaid Expenses
5581
178862
Deferred Taxes
5482
52511
Total Current Assets (A)
240111
2487334
Current Assets – Inventory – Prepaid Expenses – Deferred Taxes (C)
167192
1596420
Total Current Liabilities (B)
60121
1408022
Current Ratio = A/B
= 240111/60121
= 3.9938
= 2487334/1408022
= 1.7665
Quick Ratio = C/B
=167192/60121
= 2.7809
= 1596420/1408022
= 1.1338