Chapter 11, Problem 11.6EYCT

DECISION MAKING ACROSS THE ORGANIZATION

During a recent period, the fast-food drain Wendy’s International purchased many treasury shares. This caused the number of shares outstanding to fall from 124 million to 105 million. The following information was drawn from the company’s financial statements (in millions).

  Instructions

  Use the information provided to answer the following questions.

  (a) Compute earnings per share, return on common stockholders’ equity and return on assets for both years. Discuss the change in the company’s profitability over this period.

  (b) Compute the dividend payout ratio. Also compute the average cash dividend paid per share of common stock (dividends paid divided by the average number of common shares outstanding). Discuss any change in these ratios during this period and the implications for the company’s dividend policy.

  (c) Compute the debt to assets ratio and limes interest earned. Discuss the change in the company’s solvency.

  (d) Based on your findings in (a) and (c), discuss to what extent any change in lie return on common stockholders’ equity was tire result of increased reliance on debt.

  (e) Does it appear that the purchase of treasury stock and the shift toward more reliance on debt were wise strategic moves?

To determine

Financial Ratios: Financial ratios are the metrics used to evaluate the overall financial performance of a company during a specific period of time.

To compute: the earnings per share for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Calculate the earnings per share for W International.

For year ended after purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Earnings }\\ \text{per share}\end{array}\}\text{ = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average number of shares outstanding}}\\ \text{=}\frac{\text{\$193}\text{.6–\$0}}{\text{109}\text{.70 shares}}\\ \text{= \$1}\text{.76 per share}\end{array}$

For year ended before purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Earnings }\\ \text{per share}\end{array}\}\text{ = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average number of shares outstanding}}\\ \text{=}\frac{\text{\$123}\text{.4–\$0}}{\text{119}\text{.9 shares}}\\ \text{= \$1}\text{.03 per share}\end{array}$

Explanation of Solution

Earnings per share (EPS) refers to the share of earnings earned by the shareholder on each owned. The formula to calculate the earnings per share is as follows:

  $\begin{array}{l}\text{Earnings }\\ \text{per share}\end{array}\}\text{ = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average number of shares outstanding}}$

Conclusion

Therefore, the earnings per share for year ended after purchase of treasury stock is $1.76 per share and for year ended before purchase of treasury stock is $1.03 per share.

To determine

To Compute: the return on common stockholders’ equity for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Compute the return on common stockholders’ equity for W International:

For year ended after purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income–Preferred dividends}}{\text{Average}\text{Common stockholders' equity}}\times 100\\ =\frac{\$193.6–\$0}{\text{\$1,078}}\times 100\\ =18\%\end{array}$

For year ended before purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income–Preferred dividends}}{\text{Average}\text{Common stockholders' equity}}\times 100\\ =\frac{\$123.4–\$0}{\text{\$1,126}\text{.2}}\times 100\\ =11\%\end{array}$

Explanation of Solution

Return on common stockholders’ equity ratio: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on common stockholders’ equity is as follows:

  $\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income–Preferred dividends}}{\text{Average common stockholders' equity}}\times 100$

Conclusion

Therefore, the Return on Common Stockholders’ equity for year ended after purchase of treasury stock is 18% and, for year ended before purchase of treasury stock is 11%.

To determine

To Compute: the return on assets ratio for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Compute the return on assets ratio:

For year ended after purchase of treasury stock.

  $\begin{array}{c}\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100\\ =\frac{\$193.6}{\$2,016.9}\times 100\\ =9.6\%\end{array}$

For year ended before purchase of treasury stock.

  $\begin{array}{c}\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100\\ =\frac{\$123.4}{\$1,889.6}\times 100\\ =6.5\%\end{array}$

Explanation of Solution

Return on assets is used to measure the overall earning ability of the company. Thus, it shows the relationship between the net income and the average total assets.

The formula to calculate the return on assets ratio is as follows:

  $\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100$

Conclusion

Therefore, the Return on assets for year ended after purchase of treasury stock is 9.6% and, for year ended before purchase of treasury stock is 6.5%.

To determine

To discuss: the change in the company’s profitability over this period.

Explanation of Solution

The change in the company’s profitability over this period is discussed below:

• The purchase of treasury stock increased the earnings per share from $1.03 per share to $1.76 per share thereby reducing the number of outstanding shares in the for the year ended after the purchase of treasury stock.
• The return on common stockholders’ equity increased from 11% to 18% after the purchase of treasury stock due to increased return on assets from 6.5% to 9.6%. This implies that the company is able to earn more on the money invested on assets than interest paying on its borrowings.
• Thus, the above explanations imply that the purchase of treasury stock has increased the profitability of W International.

To determine

To Compute: the payout ratio for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Compute the payout ratio for W International:

For year ended after purchase of treasury stock

  $\begin{array}{c}\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100\\ \text{=}\frac{\text{\$26}\text{.8}}{\text{\$193}\text{.6}}\text{×100}\\ \text{=13}\text{.8\%}\end{array}$

For year ended after purchase of treasury stock

  $\begin{array}{c}\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100\\ \text{=}\frac{\text{\$31}\text{.0}}{\text{\$123}\text{.4}}\text{×100}\\ \text{=25}\text{.1\%}\end{array}$

Explanation of Solution

Payout Ratio: It refers to a measure that evaluates the amount of dividends paid to the shareholders out of the net income earned by a corporation. It is generally expressed as a percentage. The formula to calculate the payout ratio is as follows:

  $\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100$

Conclusion

Therefore, the Payout ratio for year ended after purchase of treasury stock is 13.8% and, for year ended before purchase of treasury stock is 25.1%.

To determine

To Compute: the average cash dividend paid per share for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Compute the average cash dividend paid per share for W International:

For year ended after purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Average}\text{cash}\text{dividend}\\ \text{paid}\text{per}\text{share}\end{array}]\text{ = }\frac{\text{Cash dividend declared on common stock}}{\text{Average}\text{number}\text{of}\text{common}\text{shares}\text{outstanding}}\\ \text{=}\frac{\text{\$26}\text{.8}}{\text{109}\text{.7}\text{shares}}\\ \text{=\$0}\text{.24}\text{per}\text{share}\end{array}$

For year ended after purchase of treasury stock

  $\begin{array}{c}\begin{array}{l}\text{Average}\text{cash}\text{dividend}\\ \text{paid}\text{per}\text{share}\end{array}]\text{ = }\frac{\text{Cash dividend declared on common stock}}{\text{Average}\text{number}\text{of}\text{common}\text{shares}\text{outstanding}}\\ \text{=}\frac{\text{\$31}\text{.0}}{\text{119}\text{.9}\text{shares}}\\ \text{=\$0}\text{.26}\text{per}\text{share}\end{array}$

Explanation of Solution

Average cash dividend paid per share: It refers to a measure that evaluates the amount of cash dividend paid on each share owned by the common shareholders out of the total cash dividends paid by a corporation. The formula to calculate the average cash dividend paid per share as follows:

  $\begin{array}{l}\text{Average}\text{cash}\text{dividend}\\ \text{paid}\text{per}\text{share}\end{array}]\text{ = }\frac{\text{Cash dividend declared on common stock}}{\text{Average}\text{number}\text{of}\text{common}\text{shares}\text{outstanding}}$

Conclusion

Therefore, the average cash dividend paid per share for year ended after purchase of treasury stock is $0.24 per share and, for year ended before purchase of treasury stock is $0.26 per share.

To determine

To discuss: the change in these ratios during this period and the implications for the company’s dividend policy.

Explanation of Solution

After the purchase of treasury stock, the company has paid lesser dividends to its common stockholders as compared to before the purchase of treasury stock. Thus, it implies that the company is intentionally retained its earnings for investing in operations.

To determine

To Compute: the debt to assets ratio for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Compute the debt to assets ratio for W International:

For year ended after purchase of treasury stock.

  $\begin{array}{c}\text{Debt to total assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100\\ \text{=}\frac{\text{\$1,046}\text{.3}}{\text{\$2,076}\text{.0}}\times 100\\ \text{= 50}\text{.4\%}\end{array}$

For year ended before purchase of treasury stock.

  $\begin{array}{c}\text{Debt to total assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100\\ \text{=}\frac{\text{\$769}\text{.9}}{\text{\$1,837}\text{.9}}\times 100\\ \text{= 41}\text{.9\%}\end{array}$

Explanation of Solution

Debt to assets ratio: It is the ratio that measures the ability of a company to meet its long-term obligations out of its total assets available. It shows the relationship of total liabilities and total assets.

The formula to calculate the debt to assets ratio is as follows:

  $\text{Debt to assets ratio}]\text{ = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100$

Conclusion

Therefore, the Debt to assets ratio for year ended after purchase of treasury stock is 50.4% and, for year ended before purchase of treasury stock is 41.9%.

To determine

To Compute: the times interest earned ratio for year ended after and before purchase of treasury stock.

Answer to Problem 11.6EYCT

Calculate the times interest earned ratio for W International:

For year ended after purchase of treasury stock.

  $\begin{array}{c}\begin{array}{l}\text{Times interest }\\ \text{earned ratio }\end{array}\}\text{= }\frac{\text{Net income + Income tax expense + Interest expense}}{\text{Interest expense}}\\ =\frac{\$193.6+\$30.2+\$113.7}{\$30.2}\\ \text{=11}\text{.2 times}\end{array}$

For year ended after purchase of treasury stock.

  $\begin{array}{c}\begin{array}{l}\text{Times interest }\\ \text{earned ratio }\end{array}\}\text{= }\frac{\text{Net income + Income tax expense + Interest expense}}{\text{Interest expense}}\\ =\frac{\$123.4+\$19.8+\$84.3}{\$19.8}\\ \text{=11}\text{.5 times}\end{array}$

Explanation of Solution

Times interest earned ratio: This ratio that measures a company’s ability to meet its interest payments with its available earnings.

The formula to calculate the times interest earned ratio is as follows:

  $\begin{array}{l}\text{Times interest }\\ \text{earned ratio }\end{array}\}\text{= }\frac{\text{Net income + Income tax expense + Interest expense}}{\text{Interest expense}}$

Conclusion

Therefore, the Times interest earned ratio for year ended after purchase of treasury stock is 11.2 times and, for year ended before purchase of treasury stock is 11.5times.

To determine

To discuss: the change in company’s solvency.

Explanation of Solution

The change in company’s solvency is discussed below:

• Although the purchase of treasury stock has increased the profitability of the company but reduced its solvency.
• The company has increased the debts to assets ratio from 41.9% to 50.4% that decreased the solvency rate.
• The times interest earned ratio also slightly decreased from 11.5 times to 11.2 times due to the increase in interest expenses.
• Thus, this decrease in solvency might not much worry the investors.

To determine

To discuss: to what extent the increased reliance on debts changes in the return on common stockholders’ equity.

Explanation of Solution

As from the above calculated ratios, it is seen that there is an increase in both return on assets and return on common stockholders’ equity. Thus, it can be implied that the increased reliance and debt financing as well as the increased return on assets lead to the increase in the return on common stockholders’ equity.

To determine

To explain: whether the purchase of treasury stock and the reliance on debt financing was a wise strategic move.

Explanation of Solution

From the above calculated ratios, it is found that all the calculated ratios showed an improvement after the purchase of treasury stock. Thus, it indicates that the company has effectively used its available resources to increase its profitability significantly. However, there is seen a slight decrease in solvency rate and hence, it should not be a matter of concern for the company. It can smoothly handle its debt payments.

Therefore, it can be concluded that the purchase of treasury stock and the reliance on debt financing was a wise strategic move for W International.