Chapter 15, Problem 66P

1.

To determine

Calculate earnings per share, dividend yield, dividend payout ratio, price earnings ratio, return on assets, return on stockholders’ equity.

Explanation of Solution

Profitability Ratio:

These ratios evaluate a firm’s ability to earn profits. They help the stakeholders of the company to measure the degree to which funds invested by them are efficiently used. Some of the ratios calculated return on sales, total assets and stockholder’s equity.

(a)

Use the following formula to calculate the value of earnings per share of Company MC:

$\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{\text{Average Common Shares}}$

Substitute $2,640,000 for net income, $300,000 for preference dividend and 1,000,000 for average common shares in the above formula.

$\begin{array}{c}\text{Earnings per Share}=\frac{\$2,640,000-\$300,000}{1,000,000}\\ =\$2.34\end{array}$

Therefore, the value of earnings per share is $2.34 per share.

Use the following formula to calculate the value of earnings per share of Company FA:

$\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Shares}}^{}}$

Substitute $2,640,000 for net income, $100,000 for preference dividend and 1,200,000 for average common shares in the above formula.

$\begin{array}{c}\text{Earnings per Share}=\frac{\$2,640,000-\$100,000}{1,200,000}\\ =\$2.12\end{array}$

Therefore, the value of earnings per share is $2.12 per share.

(b)

Use the following formula to calculate the value of dividend yield of Company MC:

$\text{Dividend Yield}=\frac{{\text{Dividend per Common Shares}}^1}{\text{Market Price per Common Share}}$

Substitute $0.54 for dividend per common shares, and $5.00 for market price per common share in the above formula.

$\begin{array}{c}\text{Dividend Yield}=\frac{\text{\$0}\text{.54}}{\text{\$5}\text{.00}}\\ =0.11\end{array}$

Therefore, the value of dividend yield is 0.11.

Use the following formula to calculate the value of dividend yield of Company FA:

$\text{Dividend Yield}=\frac{{\text{Dividend per Common Shares}}^{\text{2}}}{\text{Market Price per Common Share}}$

Substitute $0.78 for dividend per common shares, and $9.80 for market price per common share in the above formula.

$\begin{array}{c}\text{Dividend Yield}=\frac{\text{\$0}\text{.78}}{\text{\$9}\text{.80}}\\ =0.08\end{array}$

Therefore, the value of dividend yield is 0.08.

(c)

Use the following formula to calculate the value of dividend payout ratio of Company MC:

$\text{Dividends Payout Ratio}=\frac{\text{Common Dividend}}{\text{Net Income}-\text{Preference Dividend}}$

Substitute $540,000 for common dividend, $2,640,000 for net income and $300,000 for preference dividend in the above formula.

$\begin{array}{c}\text{Dividends Payout Ratio}=\frac{\$540,000}{\$2,640,000-\$300,000}\\ =0.23\end{array}$

Therefore, the value of dividend payout ratio is 0.23.

Use the following formula to calculate the value of dividend payout ratio of Company FA:

$\text{Dividends Payout Ratio}=\frac{\text{Common Dividend}}{\text{Net Income}-\text{Preference Dividend}}$

Substitute $940,000 for common dividend, $2,640,000 for net income and $100,000 for preference dividend in the above formula.

$\begin{array}{c}\text{Dividends Payout Ratio}=\frac{\$940,000}{\$2,640,000-\$100,000}\\ =0.37\end{array}$

Therefore, the value of dividend payout ratio is 0.37.

(d)

Use the following formula to calculate the price-earnings ratio of Company MC:

$\text{Price-Earnings Ratio}=\frac{\text{Market Price Per Share}}{\text{Earnings per Share}}$

Substitute $5.00 for market price per share and $2.34 (this amount is calculated in part a) for earnings per share in the above formula.

$\begin{array}{c}\text{Price-Earnings Ratio}=\frac{\text{\$5}\text{.00}}{\text{\$2}\text{.34}}\\ =2.14\end{array}$

Therefore, the value of price-earnings ratio is 2.14.

Use the following formula to calculate the price-earnings ratio of Company FA:

$\text{Price-Earnings Ratio}=\frac{\text{Market Price Per Share}}{{\text{Earnings per Share}}^{\text{7}}}$

Substitute $9.80 for market price per share and $2.12 (this amount is calculated in part a) for earnings per share in the above formula.

$\begin{array}{c}\text{Price-Earnings Ratio}=\frac{\text{\$9}\text{.80}}{\text{\$2}\text{.12}}\\ =4.62\end{array}$

Therefore, the value of price-earnings ratio is 4.62.

(e)

Use the following formula to calculate the value of return on assets of Company MC:

$\text{Return On Assets}=\frac{\text{Net Income}+\left[\text{Interest Expense}\times \left(\text{1}-\text{Tax Rate}\right)\right]}{\text{Average Total Assets}}$

Substitute $2,640,000 for net income, $1,000,000 for interest expense, 34% for tax rate and $20,000,000 for average total assets in the above formula.

$\begin{array}{c}\text{Return On Assets}=\frac{\$2,640,000+\left[\$1,000,000\times \left(\text{1}-\text{34\%}\right)\right]}{\$20,000,000}\\ =0.17\end{array}$

Therefore, the value of return on assets is 0.17.

Use the following formula to calculate the value of return on assets of Company FA:

$\text{Return On Assets}=\frac{\text{Net Income}+\left[\text{Interest Expense}\times \left(\text{1}-\text{Tax Rate}\right)\right]}{\text{Average Total Assets}}$

Substitute $2,640,000 for net income, $3,000,000 for interest expense, 34% for tax rate and $22,000,000 for average total assets in the above formula.

$\begin{array}{c}\text{Return On Assets}=\frac{\$2,640,000+\left[\$3,000,000\times \left(\text{1}-\text{34\%}\right)\right]}{\$22,000,000}\\ =0.21\end{array}$

Therefore, the value of return on assets is 0.21.

(f)

Use the following formula to calculate the value of return on stockholder’s equity of Company MC:

$\text{Stockholder's Equity}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Stockholder's Equity}}^4}$

Substitute $2,640,000 for net income, $300,000 for preference dividend and $10,000,000 for average common stockholder’s equity in the above formula.

$\begin{array}{c}\text{Stockholder's Equity}=\frac{\$2,640,000-\$300,000}{\$10,000,000}\\ =0.23\end{array}$

Therefore, the value of return on stockholder’s equity is 0.23.

Use the following formula to calculate the value of return on stockholder’s equity of Company FA:

$\text{Stockholder's Equity}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Stockholder's Equity}}^5}$

Substitute $2,640,000 for net income, $100,000 for preference dividend and $13,000,000 for average common stockholder’s equity in the above formula.

$\begin{array}{c}\text{Stockholder's Equity}=\frac{\$2,640,000-\$100,000}{\$13,000,000}\\ =0.2\end{array}$

Therefore, the value of return on stockholder’s equity is 0.2.

Working Note:

1. Calculation of dividend per common share of Company MC:

$\begin{array}{c}\text{Dividend per Common Share}=\frac{\text{Value of Dividends}-\text{Value of Preference Shares}}{\text{CommonShares}}\\ =\frac{\$840,000-\$300,000}{1,000,000}\\ =\$0.54\end{array}$

2. Calculation of dividend per common share of Company FA:

$\begin{array}{c}\text{Dividend per Common Share}=\frac{\text{Value of Dividends}-\text{Value of Preference Shares}}{\text{CommonShares}}\\ =\frac{\$1,040,000-\$100,000}{1,200,000}\\ =\$0.78\end{array}$

2.

To determine

Identify the best company for investors. Also, explain the reason.

Explanation of Solution

The profitability ratios show that Company FA is a better option for investors because Company FA has control on all the ratios except earnings per share, dividend yield ratio and return on equity. Therefore, investors should invest in Company FA.