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MIDDLE EAST TECHNICAL UNIVERSITY SPRING 2012

DEPARTMENT OF BUSINESS ADMINISTRATION

BA 5802 – FINANCIAL MANAGEMENT

Dr. Danışoğlu

Recitation #1

Monday, March 5, 2012, 13:15 – 14:30

Q1. Georgia Electric reported the following income statement and balance sheet for the previous year:

Balance sheet:

Assets Liabilities & Equity

Cash $ 100,000

Inventory 1,000,000

Accounts receivable 500,000

Current assets $1,600,000

Total debt $4,000,000

Net fixed assets 4,400,000 Total equity 2,000,000

Total assets $6,000,000 Total claims $6,000,000

Income Statement:

Sales $3,000,000

Operating costs 1,600,000

Operating income (EBIT) $1,400,000

Interest expense 400,000

Taxable income (EBT) $1,000,000

Taxes (40%) 400,000

Net income $ 600,000

The company’s interest cost is 10 percent, so the company’s interest expense each year is 10 percent of its total debt.

While the company’s financial performance is quite strong, its CFO (Chief Financial Officer) is always looking for ways to improve. The CFO has noticed that the company’s inventory turnover ratio is considerably weaker than the industry average which is 6.0. As an exercise, the CFO asks what the company’s ROE would have been last year if the following had occurred:

(1) The company maintained the same level of sales, but was able to reduce inventory enough to achieve the industry average inventory turnover ratio.

(2) The cash that was generated from the reduction in inventory was used to reduce part of the company’s outstanding debt. So, the company’s total debt would have been $4 million less the cash freed up from the improvement in inventory policy. The company’s interest expense would have been 10...