FM Class 1 Qns - practice questions Financial Statement PDF

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MSc Finance / MSc CFS Financial Markets Class 1: Financial Statement Q1. Price-weighted Index vs Market capitalisation-weighted Index (For this question, read the Appendix.) Assume there are only two stocks traded in the stock market, and you are trying to construct an index for stock prices. In the base year the prices were $20 per share for stock 1 with 100 million share outstanding, and $10 for stock 2 with 50 million shares outstanding. A year later the prices are $30 and $2 respectively. Using two different methods compute stock indices showing what has happened to the overall stock market. Which of the two methods do you prefer and why? Q2. Financial Statements Given the financial statements on next page (use the spreadsheet on the website): a. Determine which items varied in constant proportion to sales between 20x6 and 20x7. b. Determine the rate of growth in sales that was achieved from 20x6 to 20x7. c. What was the firm’s return on equity (ROE) for 20x7? (Hint: use the average of the beginning and the end 20x7 shareholders’ equity as the denominator.) Assuming that the total value of common stock was also $1.1 million in 20x5, can you calculate the ROE for 20x6? d. What was the firm’s external (additional) funding requirement for 20x7? How was the funding obtained? e. Prepare pro forma Income Statement for 20x8 with the following assumptions:    

Rate of growth in sales = 15%. The tax rate remains at 35%. For 20x8 the interest rates are 10% and 7% for short-term and long-term debts respectively, and are applied to the 1 Jan 20x8 balances of the debts. The firm’s dividend payout in 20x8 will be reduced to 30%.

f. Now prepare pro forma Balance Sheet for 20x8, taking into account the following: 1) How much additional funding will the firm need for 20x8? 2) The firm will close 40% of any additional funding gap by issuing new stock. It will then use up to $100,000 of long-term debt, with the remainder coming from new short-term borrowing. Complete the 20x8 pro forma Balance Sheet. g. What is the firm’s forecast for the 20x8 ROE?

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Income Statement Sales Cost of goods sold Gross margin Operating expenses Advertising expense Rent expense Salesperson commission expense Utilities expense EBIT Interest expense Taxable income Taxes (35%) Net income Dividends (40% payout for 20x6&7) Change in retained earnings Balance Sheet Assets Cash Receivables Inventory Property, plant and equipment Total assets Liabilities and shareholders’ equity Liabilities Payables Short-term debt Long-term debt Shareholders’ equity Common stock Retained earnings Total liabilities and equity

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20x6 $1,200,000 750,000 450,000

20x7 $1,500,000 937,500 562,500

50,000 72,000 48,000 15,000 265,000 106,000 159,000 55,650 103,350 41,340 $62,010

62,500 90,000 60,000 18,750 331,250 113,000 218,250 76,388 141,863 56,745 $85,118

20x6

20x7

$300,000 200,000 700,000 1,800,000 $3,000,000

$375,000 250,000 875,000 2,250,000 $3,750,000

300,000 500,000 800,000

375,000 989,882 900,000

1,100,000 300,000 $3,000,000

1,100,000 385,118 $3,750,000

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20x8 est

20x8 est

Appendix: Alternative Stock Market Indexes (Bodie, Merton & Cleeton, Ch2 Appendix) In the United States, perhaps the stock index most often cited in the news is the Dow Jones Industrial Index (DJI). It is an index of the prices of 30 stocks of major industrial U.S. corporations. The DJI has two major defects that limit its usefulness as a benchmark for measuring stock performance. One is that it is not broadly diversified enough to accurately reflect the wide spectrum of stocks in the United States. The other is that it corresponds to a portfolio strategy that is unsuitable as a performance benchmark. Most investment professionals, therefore, prefer to use other indexes such as the Standard and Poor's 500 (S&P 500) as a performance benchmark. The S&P 500 index corresponds to a portfolio of 500 stocks selected from among the largest public corporations in the United States, with dollar amounts invested in each in proportion to their shares of the total market value. To illustrate the construction of these two types of indexes and to compare them, let us simplify matters by analyzing a hypothetical two-stock index. The two stocks in the index are IBM (International Business Machines) and HPQ (Hewlett-Packard Company). The relevant data on the two stocks are presented in Table 2A.l:

TABLE 2A.1 Data for Constructing Stock Price Indexes Stock Price

Market Value

Company Base Year

Now

Number of Shares

Base Year

Now

IBM HPQ

$50 $110

200 million 100 million

$20 billion $5 billion $25 billion

$10 billion $11 billion $21 billion

$100 $50

Total

The DJI-type index is computed by taking the average current price of a share, dividing by the average price in the base year, and multiplying the result by 100.

DJI - Type Index 

Average of Current Stock Prices 100 Average of Stock Prices in Base Year

Let us say that in the base year the prices were $100 per share for IBM and $50 for HPQ. The average price per share, computed by adding the two prices and dividing by 2, is, therefore, $75. A year later, the prices are $50 per share for IBM and $110 per share for HPQ, and the average is $80.The DJI-type index would, therefore, show a value of 106.67, indicating an increase of 6.67%.

DJI - Type Index 

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50  110/ 2 100 100  50/ 2

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

80 100  106.67 75

The DJI-type index assumes that the benchmark portfolio consists of one share of each stock. Had investors bought one share of IBM stock and one share of HPQ in the base year, then their portfolio would have increased in value by 6.67%. Such a portfolio is not a natural benchmark for measuring performance, because the total value of all stocks declined from $25 billion to $21 billion in our example, which is a 16% decline. Investment professionals typically use a market-weighted index as a benchmark for measuring the performance of common stock mutual funds. Market-weighted stock indexes represent the price performance of a portfolio that holds each stock in proportion to its total market value. In the preceding example, IBM accounted for 80% of the total value of the stock market and HPQ for 20%. A market-weighted index gives each stock these weights: 

Current Price of IBM  S & P - Type Index   Weight of IBM  IBM's Price in Base Year  Current Price of HPQ   100  Weight of HPQ  HPQ' s Price in Base Year    0.8 0.5  0.2  2.2  100  84 Thus, this index shows a 16% decline, which accurately reflects what has happened to the total market value of all stocks.

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