I just got through reading the FSA material, and I made a note of a few items along the way that weren’t clear to me. I figured you guys can probably help me out: 1. Why is the contributed capital subtracted from assets in order to get to ending retained earnings? Shouldn’t it be added, as it is an asset the firm has? The formula is: ending retained earnings = assets - contributed capital - liabilities. Similarly, why is one of the formula for liabilities: liabilities = assets - contributed capital - ending retained earnings. And in that vein…why are contributions from owners not counted in income, and distributions to owners not counted in expenses? -------------------------------------------------- 2. The 2008 Schweser notes state on Pg. 89: “Inventory is reported at the lower of cost or net realizable value. Net realizable value is the selling price of the inventory less the estimated cost of completion and disposal costs. For a manufacturer, inventory cost includes direct materials, direct labor, and overhead. Inventory cost excludes the following: • Abnormal amounts of wasted materials, labor, and overhead. • Storage costs beyond the production process. • Administrative overhead. • Disposal (selling) costs.” Are disposal costs included as part of the selling price of inventory or not? The notes first state that it is, and a few lines later claims that they are not. Same deal with overhead! This may sound like a very small thing to be asking a question about, but this sounds like something that could end up as one of the trivial pursuit-type questions on the exam…so I thought I’d ask. --------------------------------- 3. While talking about how to convert an indirect statement into a direct statement when it comes to cash payments to suppliers, the notes on Pg. 120 state: “Subtract an inventory write-off that occurred during the period. An inventory write-off, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the write-off.” I can understand how an inventory write-off would reduce inventory, but why would COGS increase? Or do they mean, COGS will increase as a percentage of total inventory? ---------------------------------- 4. “For purposes of analysis, market values may be more appropriate than book values. For example, firms that issue debt when interest rates are low are relatively better off when interest rates increase. This increase should be reflected in a higher value of equity and a lower value of debt. Adjusting the firm’s debt down to market value will reduce it to the amount the firm would currently have to pay to retire the debt, and will decrease the debt-to-equity ratio. If interest rates decrease, adjusting the debt to market value will have the opposite effects.” Pg. 237 Schweser. Why would the equity level of a firm be higher and its debt level lower if interest rates rise after a bond is issued? The firm still has to pay the coupon rate specified based on the par value of the bond - their debt obligation really hasn’t changed! Also, doesn’t the firm have to “retire” the debt at par value? I don’t get the line about how if interest rates go up after issuance, you should adjust the value of the debt down to market value and thus decrease the debt-to-equity ratio. Similarly - “A firm may choose to retire debt because interest rates have fallen, because it has generated a surplus of operating cash flow, or because funds from the issuance of equity make it possible (and desirable). When debt is retired prior to maturity at its book value, no gain or loss is reported on the transaction. When the payment to retire the debt is greater than or less than its book value, a gain or loss is recorded. Unless the debt retirement specifically qualifies for treatment as an extraordinary item, the gains and losses recorded affect income from continuing operations, which is the typical treatment.” Pg. 238. When the payment to retire the debt is greater then the book value, the firm would have a LOSS, wouldn’t they? The wording makes it seem like they would have a gain. ---------------------------------------- 5. Use the following information for RGB, Inc. - EBIT/sales = 10% - Tax Retention Rate = 60% - Sales/assets = 1.8 times - Current Ratio = 2 times - Interest/assets = 2% - Assets/equity = 1.9 times. RGB’s ROE is closest to: A) 10.50% B) 11.32% C) 12.16% D) 18.24% Answer: D Another similar question: Paragon Co. has an operating profit margin (EBIT/S) of 11%, an asset turnover (S/A) of 1.2, a financial leverage multiplier (A/E) of 1.5 times, an average tax rate of 35%, and an interest expense (I/A) of 4%. The ROE is: A) 9% B) 10% C) 11% D) 12% In both of these questions, the formula used is ROE = (EBIT/S)(S/A)-(I/A)(1-t). Why is the first part of the equation [(EBIT/S)(S/A)-(I/A)] as opposed to [(EBIT/S)(S/A)(I/A)]? There is no mention of subtracting I/A anywhere in the chapter. Why would you multiply the “interest burden” (EBT/EBIT) against the rest of the equation to get the ROE, but subtract out the “interest expense” (I/A)? It seems like a simple thing that might trip me up on the exam! ------------------------------------- Thanks a lot for your help, I can’t afford the Shweser/Stalla packages yet so I have no other place to ask questions other then here!
wow that is a long post - - I think I have seen this before though “[(EBIT/S)(S/A)-(I/A)]” in L1 threads, try searching “ROE”
^ Yeah, they seem long because I had to write out a lot of the text from the notes, but they’re not particularly difficult questions…I think…haha! Thanks for the ROE tip, I’ll check that out and see if i find anything.
Answer to question 5 should be D Suppose Equity is 100 Assets = 1.9 * Equity =190 Sales = 1.8 * Assets =342 EBIT = 10% * Sales =34.2 Interest = 2% * Assets =3.8 EBT = EBIT – Interest = 30.4 Tax = 40% *EBT = 12.16 NI = EBT – Tax =18.24 ROE = 18.24/100 =18.24%
sameeragarwal Wrote: ------------------------------------------------------- > Answer to question 5 should be D > Suppose Equity is 100 > Assets = 1.9 * Equity =190 > Sales = 1.8 * Assets =342 > EBIT = 10% * Sales =34.2 > Interest = 2% * Assets =3.8 > EBT = EBIT – Interest = 30.4 > Tax = 40% *EBT = 12.16 > NI = EBT – Tax =18.24 > ROE = 18.24/100 =18.24% I can follow your logic in the above calculation, but where did you get that from? That method of calculating ROE isn’t in the notes
brafique Wrote: ------------------------------------------------------- > > In both of these questions, the formula used is > ROE = (EBIT/S)(S/A)-(I/A)(1-t). Why is the > first part of the equation [(EBIT/S)(S/A)-(I/A)] > as opposed to [(EBIT/S)(S/A)(I/A)]? > > There is no mention of subtracting I/A anywhere in > the chapter. Why would you multiply the “interest > burden” (EBT/EBIT) against the rest of the > equation to get the ROE, but subtract out the > “interest expense” (I/A)? It seems like a simple > thing that might trip me up on the exam! > > ------------------------------------- I may have an engineering-type bias in approaching your question, but hopefully it helps. The easiest way I can see to explain why it is not [(EBIT/S)(S/A)(I/A)] is just to look at the math. By multipling by I/A, you end up with EBIT * Interest / Assets^2 which is meaningless. By calculating [(EBIT/S)(S/A)-(I/A)] you are getting EarningsBIT/Assets - Interest/Assets which is equivalently EarningsBT/Assets. Then the multiplication by Assets/Equity takes you to EaringsBT/Equity, and finally multipling by (1-t) takes you to Earnings/Equity. Hope this makes sense… hard to explain my type of thinking in words.
For the equation: NI = (EBIT-Int)(1-T) <= does that look familiar? ROE = NI / CE So = (EBIT - Int ) (1-T) / CE = (EBIT-Int) / TA * TA/CE * (1-T) = [(EBIT/S)(S/TA) - Int/TA] * TA/CE * (1-T) or in Long form [Operating Profit Margin * Total Asset Turnover - Int Coverage] * Financial Leverage * Tax Burden
Answer to your Q1: A = L + E. Now, think what E (Equity) is made off? E is a sum of RE and CS (Contr. Surplus) A = L + (RE + CS). Mathematically, RE = A - L - CS Similarly, L = A - RE - CS. CS is not the same as Income. CS is capital from shareholders, NI is a result of operational, financial or investing activities. Distribution to owners is not an Expense – it can take a form of dividends (taxable or non-taxable, i.e. Capital Dividends) or Loans to Shareholders. :)))
i just assume the lowest of the figures to be 100 and try to arrive at the rest of the figures, i m bad at memorizing formulas, thats why this long approach