1.The DuPont formula defines the net return on shareholder's equity as a function of the following components:
- Operating margin
- Asset turnover
- Interest burden
- Financial leverage
- Income tax rate
Using only the data in the following table shown below:
a. Calculate each of the five components listed above for 2010 and 2014, and calculate the return on equity (ROE) for 2010 and 2014, using all of the five components. Show calculations.
b. Briefly discuss the impact of the changes in asset turnoverand financial leverage on the change in ROE from 2010 to 2014.
Income Statement Data 2010 2014
Revenues $542 $979
Operating income 38 76
Depreciation and amortization 3 9
Interest expense 3 0
Pretax income 32 67
Income taxes 13 37
Net income after tax 1 9 30
Balance Sheet Data 2010 2014
Fixed assets $41 $70
Total assets 245 291
Working capital 123 157
Total debt 16 0
Total shareholder's equity 159 220
2. David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10. He has also calculated the three ratios shown in Exhibit 10.11, which indicate the bond that is currently rated "A" according to the firm's internal bond-rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance sheet items in his credit analysis, as the off-balance sheet items on each of the ratios found in Exhibit 10.11.
a. Calculate the combined effect of the three off-balance sheet items in Exhibit 10.12 on each of the following three financial ratios shown in Exhibit 10.11.
i. EBITDA/interest expense
ii. Long/term debt/equity
iii. Current assets/current liabilities
The bond is currently trading at a credit premium off 55 basis points. Using the internal credit yield premium incorporates the effect of the off-balance sheet items.
b. State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the internal-bond rating criteria found in Exhibit 10.13.
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Exhibit 10.10 Montrose Cable Company Year Ended March 31, 2011
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(US$ Thousands)
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Balance Sheet
Current assets $4,735
Fixed assets 43,225
Total assets $47,960
Current liabilities $4,500
Long-term debt 10,000
Total liabilities $14,500
Shareholder's equity 33,460
Total liabilities and shareholder's equity $47,960
Income Statement
Revenue $18,500
Operating and administrative expenses 14,050
Operating income $4,450
Depreciation and amortization 1,675
Interest expense 942
Income before income taxes $1,833
Taxes 641
Net Income $1,192
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Exhibit 10.11 Selected Ratios and Credit Yield Premium Data for Montrose
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EBITDA/interest expense 4.72
Long-term debt/equity 0.30
Current assets/current liabilities 1.05
Credit yield premium over U.S. Treasuries 55 basis points
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Exhibit 10.12 Montrose Off
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Balance
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Sheet Items
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- Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000.
- Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent
- Montrose is a lessee in a new noncancelable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,144,000 using an interest rate of 10 percent. The annual payment will be 1,000,000.
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Exhibit 10.13 Blue River Investments: Internal Bond
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Rating Criteria and Credit Yield Premium Data
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Bond Rating
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Interest Coverage
(EBITDA/interest expense)
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Leverage
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Current Ratio (Current assets/current liabilities)
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Credit Yield Premiumover U.S. Treasuries
(in basis points)
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AA 5.00 to 6.00 0.25 to 0.30 1.15 to 1.25 30 bps
A 4.00 to 5.00 0.30 to 0.40 1.00 to 1.15 50bps
BBB 3.00 to 4.00 0.40 to 0.50 0.90 to 1.00 100bps
BB 2.00 to 3.00 0.50 to 0.60 0.75 to 0.90 125bps