IRFAN GAFFAR ADNAN

436681

Exercise 8-1
a. Firstalternative:
 NOPAT = $6,000,000 * 10% = $600,000
 Net income = $600,000 –
[$1,000,000*12%](1-.40) = $528,000
Second alternative:
NOPAT = $6,000,000 * 10% = $600,000
 Net income = $600,000 – [$2,000,000*12%](1-.40) =
$456,000
b. Firstalternative:
 ROCE = $528,000 / $5,000,000 = 10.56% Second alternative:
 ROCE = $456,000
/ $4,000,000 = 11.40%
c. Firstalternative:
 Assets-to-Equity = $6,000,000 / $5,000,000 = 1.2 Second alternative:
 Assets-to-
Equity = $6,000,000 / $4,000,000 = 1.5
d. First,let’scomputereturnonassets(RNOA): First alternative: $600,000 / $6,000,000 = 10% Second
alternative: $600,000 / $6,000,000 = 10%
e. Second, notice that the interest rate is 12% on the debt (bonds). More importantly, the after-tax interest
rate is 7.2% (12% x (1-0.40)), which is less than RNOA. Hence, the company earns more on its assets
than it pays for debt on an after-tax basis. That is, it can successfully trade on the equity—use
bondholders’ funds to earn additional profits. Finally, since the second alternative uses more debt, as
reflected in the assets-to-equity ratio in c, the second alternative is probably preferred. The shareholders
would take on additional risk with the second alternative, but the expected returns are greater as evidenced
from computations in

Exercise 8-2
a. NOPAT=Netincome=$10,000,000x10%=$1,000,000
b. Firstalternative:
 NOPAT = $1,000,000 + $6,000,000*10% = $1,600,000
 Net income = $1,600,000
– ($2,000,000 × 5% x [1-.40]) = $1,540,000
Second alternative:
NOPAT = $1,000,000 + $6,000,000*10% = $1,600,000
 Net income = $1,600,000 – ($6,000,000 × 6%
x [1-.40]) = $1,384,000
c. Firstalternative:ROCE=$1,540,000/($10,000,000+$4,000,000)=11% Second alternative: ROCE =
$1,384,000 / ($10,000,000 + $0) = 13.84%
d. ROCEishigherunderthesecondalternativeduetosuccessfuluseofleverage— that is, successfully trading
on the equity. [Note: Asset-to-Equity is 1.14=$16 mil./$14 mil. (1.60=$16 mil./$10 mil.) under the first
(second) alternative.] The company should pursue the second alternative in the interest of shareholders
(assuming projected returns are consistent with current performance levels).

Exercise 8-3
a. RNOA =2x5%=10%

b. ROCE = 10% + 1.786 x 4.4% = 17.86%
c. RNOA
 Leverage advantage
Return on equity
10.00% 7.86% 17.86%
Exercise 8-5
a. RNOA=3x7%=21%
b. ROCE=RNOA+LEVxSpread=21%+(1.667x8.4%)=35%
c. Netleverageadvantagetocommonequity
 Return on net operating assets .................................. 21%
Leverage advantage .................................................... 14% Return on common equity (rounding
difference) ..... 35%
Exercise 8-6
a. Atthepresentlevelofdebt,ROCE=$157,500/$1,125,000=14%.
In the absence of leverage, the noncurrent liabilities would be substituted with equity. Accordingly, there
would be no interest expense with all-equity financing. Consequently, in this case, net income would be
as follows:
ROCE without leverage = $184,500 / $1,800,000 = 10.25%.
 This means that leverage is beneficial to
Rose's shareholders since ROCE is 14% with leverage but only 10.25% without leverage.
b. NOPAT=$157,500+[$675,000x8%x(1-.50)]=$184,500 RNOA = $184,500 / ($2,000,000-$200,000) =
10.25% 

c. The company is utilizing borrowed funds in its capital structure. Since the ROCE is greater than RNOA,
the use of financial leverage is beneficial to stockholders. Specifically, the after cost of debt is 4%
and the financial leverage (NFO/Equity) is $675,000 / $1,125,000 = 60%. Therefore, 
 ROCE =
RNOA + LEV x Spread = 10.25% + 0.60 x (10.25% - 4%) = 14%, as before. The favorable effect
of financial leverage is given by the term [0.60 x (10.25% - 4%)] = 3.75%.


Exercise 8-5
a. RNOA=3x7%=21%

b. ROCE=RNOA+LEVxSpread=21%+(1.667x8.4%)=35%
c. Netleverageadvantagetocommonequity
 Return on net operating assets .................................. 21%
Leverage advantage .................................................... 14% Return on common equity (rounding
difference) ..... 35%

Exercise 8-6
a. Atthepresentlevelofdebt,ROCE=$157,500/$1,125,000=14%.
In the absence of leverage, the noncurrent liabilities would be substituted with equity. Accordingly, there
would be no interest expense with all-equity financing. Consequently, in this case, net income would be
as follows:
ROCE without leverage = $184,500 / $1,800,000 = 10.25%.
 This means that leverage is beneficial to
Rose's shareholders since ROCE is 14% with leverage but only 10.25% without leverage.
NOPAT=$157,500+[$675,000x8%x(1-.50)]=$184,500 RNOA = $184,500 / ($2,000,000-$200,000) =
10.25% 

The company is utilizing borrowed funds in its capital structure. Since the ROCE is greater than RNOA,
the use of financial leverage is beneficial to stockholders. Specifically, the after cost of debt is 4% and
the financial leverage (NFO/Equity) is $675,000 / $1,125,000 = 60%. Therefore, 
 ROCE = RNOA +
LEV x Spread = 10.25% + 0.60 x (10.25% - 4%) = 14%, as before. The favorable effect of financial
leverage is given by the term [0.60 x (10.25% - 4%)] = 3.75%.
Exercise 9–4

Lyon Corporation
Cash Forecast For
July, Year 6

Beginning cash balance...................................................... $ 20

Cash collections
Beginning accounts receivable ............................... $ 20
Sales for month ......................................................... 150
170
Less: Ending accounts receivable .......................... 21 149
Cash available ...................................................................... $169
Cash disbursements

Beginning accounts payable ................................... 18

Purchases (note a) .................................................... 115
133
Ending accounts payable (25% of purchases)....... 29 104
Miscellaneous outlays .............................................. 11
Cash balance ............................................................. $ 54
Minimum cash balance desired ............................... 30
Excess cash .............................................................. $ 24

[a] Ending inventory$ 15

.......................................................................................................
Cost of goods sold (5/6 of sales)125
.............................................................................
140
Less beginning inventory 25
.........................................................................................
Purchases $115
..................................................................................................................
Problem 9-2 — continued

Year 3
Statement of Cash Flows Estimate
Net income 425
Depreciation 304
Accounts receivable -71
Inventories -401
Accounts payable 561
Income taxes 9
Net cash flow from operations 827
CAPEX -1,262
Net cash flow from investing activities -1,262
Long term debt -114
Additional paid in capital 0
Dividends 0
Net cash flow from financing activities -114

Net change in cash -550

Beginning cash 746
Ending cash 196

b. Based on our projection, it appears that Best Buy will require about $550 Million of external
financing to yield a cash balance of approximately $750 million. Analysts must allocate this
external financing between debt and equity so as to preserve the financial leverage level presently
used by Best Buy.