Case Problem 6.1 Sara Decides to Take the Plunge
1. LG 1
2. LG 6
Sara Thomas is a child psychologist who has built a thriving practice in her hometown of Boise, Idaho. Over the past several years she has been able to accumulate a substantial sum of money. She has worked long and hard to be successful, but she never imagined anything like this. Even so, success has not spoiled Sara. Still single, she keeps to her old circle of friends. One of her closest friends is Terry Jenkins, who happens to be a stockbroker and who acts as Sara’s financial advisor.
Not long ago Sara attended a seminar on investing in the stock market, and since then she’s been doing some reading about the market. She has concluded that keeping all of her money in low-yielding savings accounts doesn’t make sense. As a result, Sara has decided to move part of her money to stocks. One evening, Sara told Terry about her decision and explained that she had found several stocks that she thought looked “sort of interesting.” She described them as follows:
· North Atlantic Swim Suit Company. This highly speculative stock pays no dividends. Although the earnings of NASS have been a bit erratic, Sara feels that its growth prospects have never been brighter—“what with more people than ever going to the beaches the way they are these days,” she says.
· Town and Country Computer. This is a long-established computer firm that pays a modest dividend yield (of about 1.50%). It is considered a quality growth stock. From one of the stock reports she read, Sara understands that T&C offers excellent long-term growth and capital gains potential.
· Southeastern Public Utility Company. This income stock pays a dividend yield of around 5%. Although it’s a solid company, it has limited growth prospects because of its location.
· International Gold Mines, Inc. This stock has performed quite well in the past, especially when inflation has become a problem. Sara feels that if it can do so well in inflationary times, it will do even better in a strong economy. Unfortunately, the stock has experienced wide price swings in the past. It pays almost no dividends.
a. What do you think of the idea of Sara keeping “substantial sums” of money in savings accounts? Would common stocks make better investments for her than savings accounts? Explain.
Answer: It is not a smart idea for Sara to retain substantial sums of money in her savings account for the reason that she could potentially make more money by investing in stocks. For example, the average rate for a savings account is 0.06%, and if you invest in stock, you can make anywhere from 0-15% depending on the amount of risk you is willing to take.
b. What is your opinion of the four stocks Sara has described? Do you think they are suitable for her investment needs? Explain.
Answer: Three out of the four stocks are ok investments to make since there is so little information provided. I do not think the NASS is a good investment because the stock pays no dividends and their earnings have been erratic. If Sara wants to make more money for her investments, she needs to find a company that has better growth potential and dividend payouts.
c. What kind of common stock investment program would you recommend for Sara? What investment objectives do you think she should set for herself, and how can common stocks help her achieve her goals?
Answer: The IPA program would be the program I would recommend to Sara because it allows Sara to take classes and speak with educated individuals who know about investing. I think Sara should sit down with a financial advisor and figure out exactly what she wants to do with her money and how much she wants to make from her investments. Common stocks can help her reach her goal faster because they offer a higher return than a savings account.
Case Problem 6.2 Wally Wonders Whether There’s a Place for Dividends
1. LG 5
|Year||Expected EPS ($)||Expected Dividend Payout Ratio (%)|
2. LG 6
Wally Wilson is a commercial artist who makes a good living by doing freelance work—mostly layouts and illustrations—for local ad agencies and major institutional clients (such as large department stores). Wally has been investing in the stock market for some time, buying mostly high-quality growth stocks as a way to achieve long-term growth and capital appreciation. He feels that with the limited time he has to devote to his security holdings, high-quality issues are his best bet. He has become a bit perplexed lately with the market, disturbed that some of his growth stocks aren’t doing even as well as many good-grade income shares. He therefore decides to have a chat with his broker, Al Fried.
During their conversation, it becomes clear that both Al and Wally are thinking along the same lines. Al points out that dividend yields on income shares are indeed way up and that, because of the state of the economy, the outlook for growth stocks is not particularly bright. He suggests that Wally seriously consider putting some of his money into income shares to capture the high dividend yields that are available. After all, as Al says, “the bottom line is not so much where the payoff comes from as how much it amounts to!” They then talk about a high-yield public utility stock, Hydro-Electric Light and Power. Al digs up some forecast information about Hydro-Electric and presents it to Wally for his consideration:
The stock currently trades at $60 per share. Al thinks that within five years it should be trading at $75 to $80 a share. Wally realizes that to buy the Hydro-Electric stock, he will have to sell his holdings of CapCo Industries—a highly regarded growth stock that Wally is disenchanted with because of recent substandard performance.
a. How would you describe Wally’s present investment program? How do you think it fits him and his investment objectives?
Answer: Wally has a good investment program right because high-quality growth stocks are a good way to make money, but he needs to change the type of stock he is invested in because it is not meeting up to his expectations. His investments are for long-term, which is what he is looking for.
b. Consider the Hydro-Electric stock.
1. Determine the amount of annual dividends Hydro-Electric can be expected to pay over the years 2016 to 2020.
|Year||Expected EPS||Payout Ratio||Divided|
2. Compute the total dollar return that Wally will make from Hydro-Electric if he invests $6,000 in the stock and all the dividend and price expectations are realized.
|Year||Dividends Share||Share||Shares Value|
3. If Wally participates in the company’s dividend reinvestment plan, how many shares of stock will he have by the end of 2020? What will they be worth if the stock trades at $80 on December 31, 2020? Assume that the stock can be purchased through the dividend reinvestment plan at a net price of $50 a share in 2016, $55 in 2017, $60 in 2018, $65 in 2019, and $70 in 2020. Use fractional shares, to 2 decimals, in your computations. Also, assume that, as in part b, Wally starts with 100 shares of stock and all dividend expectations are realized.
|Year||Beginning shares||Price||Shares Value||Dividends||Dividends Per Share|
|SHARES END 2020||115.10||SHARE VALUE END 2020||$9,208.17||
c. Would Wally be going to a different investment strategy if he decided to buy shares in Hydro-Electric? If the switch is made, how would you describe his new investment program? What do you think of this new approach? Is it likely to lead to more trading on Wally’s behalf? If so, can you reconcile that with the limited amount of time he has to devote to his portfolio?
Answer: Wally will not be changing him the investment strategy if he wants to purchase stock in Hydro-Electric. He would be altering the way he is investing. It is a common practice amongst aggressive investors in a long term goal. If Wally changed back to investing in his long-term shares and invests the way he usually does it. I think this new approach is a good idea and if things work out, I believe it would lead to more trading for him.
Case Problem 7.1 Some Financial Ratios Are Real Eye-Openers
1. LG 5
2. LG 6
|Accounts receivable||$ 8,000||Current liabilities||$10,000|
|Inventory||$12,000||Long-term debt||$ 8,000|
|Current assets||$21,250||Stockholders’ equity||$12,000|
|Fixed and other assets||$ 8,750||Total liabilities and|
|Total assets||$30,000||stockholders’ equity||$30,000|
|South Plains Chemical Company Balance Sheet ($ thousands)|
|Cost of goods sold||$25,000|
|Interest expense||$ 2,500|
|Net profit||$ 5,000|
|Dividends paid to common stockholders ($ in thousands)||$ 1,250|
|Number of common shares outstanding||5 million|
|Recent market price of the common stock||$ 25|
|South Plains Chemical Company Income Statement ($ thousands)|
Jack Arnold is a resident of Lubbock, Texas, where he is a prosperous rancher and businessman. He has also built up a sizable portfolio of common stock, which, he believes, is due to the fact that he thoroughly evaluates each stock he invests in. As Jack says, “You can’t be too careful about these things! Anytime I plan to invest in a stock, you can bet I’m going to learn as much as I can about the company.” Jack prefers to compute his own ratios even though he could easily obtain analytical reports from his broker at no cost. (In fact, Bob Smith, his broker, has been volunteering such services for years.)
Recently Jack has been keeping an eye on a small chemical stock. The firm, South Plains Chemical Company, is big in the fertilizer business—which is something Jack knows a lot about. Not long ago, he received a copy of the firm’s latest financial statements (summarized here) and decided to take a closer look at the company.
a. Using the South Plains Chemical Company figures, compute the following ratios.
|Latest Industry Averages||Latest Industry Averages|
|a. Net working capital||N/A||h. Net profit margin||8.5%|
|b. Current ratio||1.95||i. Return on assets||22.5%|
|c. Receivables turnover||5.95||Common-Stock Ratios|
|d. Inventory turnover||4.50||k. Earnings per share||$2.00|
|e. Total asset turnover||2.65||l. Price-to-earnings ratio||20.0|
|Leverage||m. Dividends per share||$1.00|
|f. Debt-equity ratio||0.45||n. Dividend yield||2.5%|
|g. Times interest earned||6.75||o. Payout ratio||50.0%|
|p. Book value per share||$6.25|
|q. Price-to-book-value ratio||6.4|
b. Compare the company ratios you prepared to the industry figures given in part a. What are the company’s strengths? What are its weaknesses?
Answer: We can see that the SPC Company has a net working capital of $ 11,250,000. It indicates that the SPC Company has $ 11.25 million of working capital available to pay its bill and grow the business. This value is a good sign for SPC Company because it is a higher amount than the industry average. We also can see the current ratio for SPC Company is 2.125 that are more than 0.175 when compare to the industry average, 1.95. It indicates that SPC Company can pay its accounts creditor on time and get the discounts for prompt payment and credibility from future supplies. SPC Company may able to do essential maintenance and replacement of fixed assets, it will result in reducing operating expenses, such that selling expenses and depreciation expenses. Also, the company has a liquid cash for a new investment project, which may increase the future growth rate of the company. This ratio is a good sign for the company. The receivables turnover for SPC Company is 6.25, which is more than 0.3 when you compare it to the industry average of 5.95. It means that the SPC Company is collecting its accounts receivable more quickly than the industry average. The SPC Company can have a valuable discipline on credit control that will possibly result in a bad debt decrease, which is good for SPC Company. The inventory turnover for the SPC Company is 4.167, which is less than 0.333 when you are comparing it to the industry average of 4.5. It might be because the SPC Company may have too many inventories in hand than the industry average. It is expensive because inventories take up costly warehouse space, some inventories may become spoiled or obsolete and also a high risk of stock pilferage. The total asset turnover for SPC Company is 1.67 that is less than 0.98 when you compare it to the industry average of 2.65. It indicates that the company is not able to get any more sales out of its assets than the industry average. The company should reduce the selling price to achieve higher sales volume since they are in a very price competitive industry. When sales volume increase, given no new investment in fixed assets, then the total asset turnover will increase.
As for the compare profitability ratio, we can see that the net profit margin, ROA, and ROE for SPC Company is 10%, 16.67%, 41.67% compared to the industry average of 8.5%, 22.5%, and 32.2% respectively. The results are mixed. When compared to common stock ratios the dividends per share for SPC Company is $ 0.25 that is less than $ 0.75 when compared to the industry average of $ 1.00. Some dividends paid out to the common stockholder is less than the average. Also, the dividend yield for SPC Company is 1 % that is less than 1.5 % when you compare it to the industry average of 2.5 %. It indicates that the rate of current income earned on the investments dollar is less than the average. Moreover, the price-to-book-value for SPC Company is 10.40 that are higher 4.0 when compare to the industry average, 6.4. It indicates that the stock for SPC Company is overpriced than average.
c. What is your overall assessment of South Plains Chemical? Do you think Jack should continue with his evaluation of the stock? Explain
Answer: No, the stock for SPC Company is overpriced. We can see the fact from the price-to-book-value for SPC Company is 10.42 that are higher 4.0 when compare to the industry average, 6.4.
Case Problem 7.2 Doris Looks at an Auto Issue
Doris Wise is a young career woman. She lives in Phoenix, Arizona, where she owns and operates a highly successful modeling agency. Doris manages her modest but rapidly growing investment portfolio, made up mostly of high-grade common stocks. Because she’s young and single and has no pressing family requirements, Doris has invested primarily in stocks that offer the potential for attractive capital gains. Her broker recently recommended an auto company stock and sent her some literature and analytical reports to study. One report, prepared by the brokerage house she deals with, provided an up-to-date look at the economy, an extensive study of the auto industry, and an equally extensive review of several auto companies (including the one her broker recommended). She feels strongly about the merits of security analysis and believes it is important to spend time studying a stock before making an investment decision.
a. Doris tries to stay informed about the economy on a regular basis. At the present time, most economists agree that the economy is getting stronger. What information about the economy do you think Doris would find helpful in evaluating an auto stock? Prepare a list—and be specific. Which three items of economic information (from your list) do you feel are most important? Explain.
Answer: The majority of economists would agree that a strong economy would affect a company positively. Other factors that Doris should take into consideration before she invests are the following:
1- Jobs and Unemployment – You have to look at the current unemployment rate. People have to be working to qualify for loans to finance or purchase a car.
2- Interest Rates – The interest rate has to be low to entice the consumer to borrow money to purchase a car. When rates are high consumers are less likely to purchase or finance a car.
3- Inflation Rate – Once the price of items starts to go up, many consumers may start to grow concerned about inflation. Once people are concerned about inflation, it starts to affect your investments negatively.
4- Taxes: A tax break can offer savings and incentives through tax credits, deductions and exemptions to order to boost spending.
5- Labor Relations: Labor relations are important because many automakers in the US have to deal with unions and union influence. How they negotiate pay, medical benefits, and retirement benefits has a big impact on how they do business and how they keep their costs in line. But any change in cost from paying higher wages and benefits usually gets passed on to the consumer. Higher prices will mean lower sales.
The most important economic factors I feel is inflation and unemployment. The reason they are the most important is without a job nobody can buy a car and inflation lowers a person buying power which makes them less likely to purchase a car because they may feel the price is too high. It will all impact the car sales.
b. In relation to a study of the auto industry, briefly note the importance of each of the following.
1. Auto imports
Answer: Imported automobiles and those built by foreign manufacturers in the U.S have had a tremendous impact on the domestic industry. Imported automobile have a significant part of the market, and this goes to domestic company end up losing revenue.
2. The United Auto Workers union
Answer: Their unions are known to be aggressive when negotiating for labor benefits.
3. Interest rates
Answer: The average price of a new car now is close to the uppers $30,000, so it’s no surprise that consumers increasingly finance their purchases with loans that last from 5 to 7 years. When interest rates are lower people are willing to borrow more money to purchase big items. When people are paying less interest, it gives them more money to spend and when a consumer has more money to spend that means good news for companies that sell big ticket items like cars and homes.
4. The price of a gallon of gas
Answer: The price of a gallon of gas will reduce the number of cars sales depending on what types of cars the company is selling. Also if the gallon of gas is high, consumers are spending more money to purchase gas than purchasing cars.
c. A variety of financial ratios and measures are provided about one of the auto companies and its stock. These are incomplete, however, so some additional information will have to be computed. Specifically, we know the following:
|Net profit margin||15%|
|Total assets||$25 billion|
|Earnings per share||$3.00|
|Total asset turnover||1.5|
|Net working capital||$3.4 billion|
|Current liabilities||$5 billion|
Given this information, calculate the following:
Total Assets Turnover * Total Assets =
1.5 * $25 Billion= $37.5 Billion
2. Net profits after taxes
Net Profit Margin * Sales
15% X $ 37.5 = $5.625 billion
3. Current ratio
Current assets = Net working cap + Current liabilities
$3.4 +$5 billion = $ 8.4 Billion
Current assets / Current liabilities = Current ratio
$ 8.4 billion÷ $5 billion= 1.68
4. Market price of the stock
Price-to-earnings ratio*Earnings per share
12.5 X $3.00= $37.5 per share
5. Dividend yield
(Earnings per share * Payout ratio) ÷ Market price of the stock
($3 X 40%) ÷$37.5= 0.032
0.032 X 100 =3.2%
Case Problem 8.1 Chris Looks for a Way to Invest His Wealth
1. LG 1
2. LG 2
3. LG 4
Chris Norton is a young Hollywood writer who is well on his way to television superstardom. After writing several successful television specials, he was recently named the head writer for one of TV’s top-rated sitcoms. Chris fully realizes that his business is a fickle one, and on the advice of his dad and manager, he has decided to set up an investment program. Chris will earn about a half-million dollars this year. Because of his age, income level, and desire to get as big a bang as possible from his investment dollars, he has decided to invest in speculative, high-growth stocks.
Chris is currently working with a respected Beverly Hills broker and is in the process of building up a diversified portfolio of speculative stocks. The broker recently sent him information on a hot new issue. She advised Chris to study the numbers and, if he likes them, to buy as many as 1,000 shares of the stock. Among other things, corporate sales for the next three years have been forecasted as follows:
|Year||Sales ($ millions)|
The firm has 2.5 million shares of common stock outstanding. They are currently being traded at $70 a share and pay no dividends. The company has a net profit rate of 20%, and its stock has been trading at a P/E of around 40 times earnings. All these operating characteristics are expected to hold in the future.
a. Looking first at the stock:
1. Compute the company’s net profits and EPS for each of the next 3 years.
120/100) * 22.5 = $27 million
Therefore 27-22.5= $4.5 million
20% * 35.0 = $7
20% of 50 = $ 10 million
Profit = $142857.14285
2. Compute the price of the stock three years from now.
Price of stocks= total profits for 3 years + total sales
= (4.5+7+10) + 107.5
= $129 million
3. Assuming that all expectations hold up and that Chris buys the stock at $70, determine his expected return on this investment.
$ Stock= $ 70.00
Total sales = $107.5 million
Return = $107,500,000/70
Profit= 20% of $535,714.29
Total return= $535,714.29+$10,712.85
4. What risks is he facing by buying this stock? Be specific.
Answer: The earning per share is not stable, and therefore Chris might run into high percentage loss. The 40% times earning will, therefore, be tempered which will make the investment drop.
5. Should he consider the stock a worthwhile investment candidate? Explain.
Answer: Yes, The EPS from the previous years have constantly been increasing, and therefore this shows a significant increase and the net profit.
b. Looking at Chris’s investment program in general:
1. What do you think of his investment program? What do you see as its strengths and weaknesses?
Answer: Constant change to EPS is the only weakness if not so, therefore, this program is good.
2. Are there any suggestions you would make?
Answer: The suggestion I would make is to determine the appropriate asset allocation. Chris needs to have a strategy whereby the input should remain a hundred percent.
3. Do you think Chris should consider adding foreign stocks to his portfolio? Explain.
Answer: I would say yes because I think it will amplify the expansion of Chris’ investments and therefore increasing the input per EPS.
Case Problem 8.2 An Analysis of a High-Flying Stock
1. LG 2
2. LG 6
Marc Dodier is a recent university graduate and a security analyst with the Kansas City brokerage firm of Lippman, Brickbats, and Shaft. Marc has been following one of the hottest issues on Wall Street, C&I Medical Supplies, a company that has turned in an outstanding performance lately and, even more important, has exhibited excellent growth potential. It has five million shares outstanding and pays a nominal annual dividend of $0.05 per share. Marc has decided to take a closer look at C&I to assess its investment potential. Assume the company’s sales for the past five years have been as follows:
|Year||Sales ($ millions)|
Marc is concerned with the future prospects of the company, not its past. As a result, he pores over the numbers and generates the following estimates of future performance:
|Expected net profit margin||12%|
|Estimated annual dividends per share||5¢|
|Number of common shares outstanding||No change|
|P/E ratio at the end of 2017||35|
|P/E ratio at the end of 2018||50|
a. Determine the average annual rate of growth in sales over the past five years. (Assume sales in 2011 amounted to $7.5 million.)
1. Use this average growth rate to forecast revenues for next year (2017) and the year after that (2018).
|2012 to 2013||( 12.5 – 10.0 )/10.0 = 0.250|
|2013 to 2014||( 16.2 – 12.5 )/12.5 = 0.296|
|2014 to 2015||( 22.0 – 16.2 )/16.2 = 0.358|
|2015 to 2016||( 28.5 – 22.0 )/22.0 = 0.296|
250 + .296 + .358 + .296 / 4 = .30
Average Annual Growth Rate = 30%
2. Now determine the company’s net earnings and EPS for each of the next two years (2017 and 2018).
Earnings in 2017
Sales x Profit margin
$37,000,000 x 0.12
Earnings in 2018
Sales x Profit margin
$48,100,000 x 0.12
$4,440,000 / 5,000,000 = $0.89
$5,772,000 / 5,000,000 = $1.15
3. Finally, determine the expected future price of the stock at the end of this two-year period.
P/E ratio for 2006 = 50
Share Price, 2006
P/E ratio for 2006 x 2006 EPS
50 x $1.15 = $57.50
$57.50 Share Price
b. Because of several intrinsic and market factors, Marc feels that 25% is a viable figure to use for a desired rate of return.
1. Using the 25% rate of return and the forecasted figures you came up with in question a, compute the stock’s justified price.
Price of the share
We can calculate the price of the share by using PE ratio
PE ratio is MPS/EPS i.e market price of share to earnings per share
for 2017= PE ratio is given as 35
2. If C&I is currently trading at $32.50 per share, should Marc consider the stock a worthwhile investment candidate? Explain.
The stock is currently trading for $32.5 per share which is less than the value we have calculated. so Marc should consider it as a worthwhile investment because the MPS is going to pick up more in future.
Case Problem 9.2 Deb Takes Measure of the Market
1. LG 5
Several months ago, Deb Forrester received a substantial sum of money from the estate of her late aunt. Deb initially placed the money in a savings account because she was not sure what to do with it. Since then, however, she has taken a course in investments at the local university. The textbook for the course was, in fact, this one, and the class just completed this chapter. Excited about what she has learned in class, Deb has decided that she definitely wants to invest in stocks. But before she does, she wants to use her newfound knowledge in technical analysis to determine whether now would be a good time to enter the market.
Deb has decided to use all of the following measures to help her determine if now is, indeed, a good time to start putting money into the stock market:
· Advance-decline line
· New highs-new lows indicator (Assume the current 10-day moving average is 0 and the last 10 periods were each 0.)
· Arms index
· Mutual fund cash ratio
Deb goes to the Internet and, after considerable effort, is able to put together the accompanying table of data.
a. Based on the data presented in the table, calculate a value (where appropriate) for periods 1 through 5, for each of the four measures listed above. Chart your results, where applicable.
The Arms index = (The number of advancing stocks/The number of declining stocks)/(The composite volume of advancing stocks/The composite volume of declining stocks)
Arms Index[(Advancing issues(NYSE)/Declining issues (NYSE))/(Volume up/Volume down) 0.525821596 0.20439551 1.91830855 0.696730457 0.39463639
b. Discuss each measure individually and note what it indicates for the market, as it now stands. Taken collectively, what do these four measures indicate about the current state of the market? According to these measures, is this a good time for Deb to consider getting into the market, or should she wait a while? Explain.
It is fairly bullish for investment purpose in period 1 period2period 4 and period 5 since Arms index is below 1. Anything above 1as in the case of period 3 is considered bearish. An Arms index of1 is said to be balanced market.
Period 1 Period 2 Period 3 Period 4 Period 5
Mutual Fund Cash
cash/Total Assets) 4% 5% 7% 9% 10%
c. Comment on the time periods used in the table, which are not defined here. What if they were relatively long intervals of time? What if they were relatively short? Explain how the length of the time periods can affect the measures.
Mutual fund cash ratio is below 5% for period 1 which seems fairly bullish. The perspective remains balanced for period 2.However since Mutual fund cash ratio is above 5% for period 3period 4 Period 5, the sentiment is fairly bearish and not advisable for making investments under these periods.
A/D Line = (No of Advancing Stocks – No of Declining Stocks) + Previous Period\’s A/D Line Value
Period 1 Period 2 Period 3 Period 4 Period 5
(NYSE) -1,010 -1,704 -2,414 -1,832 -1,224
As per AD Line, The Sentiment is fairly bearish with regard to all periods and hence investment should be avoided.
|Period 1||Period 2||Period 3||Period 4||Period 5|
|Dow Jones Industrial Average||8,300||7,250||8,000||9,000||9,400|
|Dow Transportation Average||2,375||2,000||2,000||2,850||3,250|
|New highs||$ 68||$ 85||$ 85||$ 120||$ 200|
|New lows||$ 75||$ 60||$ 80||$ 75||$ 20|
|Mutual fund cash (trillions of dollars)||$0.31||$0.32||$0.47||$0.61||$0.74|
|Total assets managed (trillions of dollars)||$6.94||$6.40||$6.78||$6.73||$7.42|
|Advancing issues (NYSE)||1,120||1,278||1,270||1,916||1,929|
|Declining issues (NYSE)||2,130||1,972||1,980||1,334||1,321|