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An analyst finds return-on-equity (ROE) a good measure of management performance and wants to compare two firms: Firm A and Firm B. Firm A reports net income of \$3.2 million and has a ROE of 18. Firm B reports income of \$16 million and has an ROE of 16.

A review of the notes to the financial statements for Firm A, shows that the earnings include a loss from smelting operations of \$400,000 and that the firm has exited this business. In addition, the firm sold the smelting equipment and had a gain on the sale of \$300,000.

A similar review of the notes for Firm B discloses that the \$16 million in net income includes \$2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for both firms is 36%, and that the notes describe pre-tax amounts. Which of the following is closest to the “normalized” ROE for Firm A and for Firm B, respectively?
 A) 17.1 and 16.9.
 B) 16.0 and 18.0.
 C) 18.4 and 14.3.

The ROE for Firm A is adjusted for the \$400,000 loss on discontinued operations and the \$300,000 non-recurring gain. The ROE for Firm B is adjusted to remove the effects of the \$2.6 million one-time gain.

The first step in this problem is to solve for equity using ROE. Then, “normalize” net income by adjusting for discontinued operations and non-recurring items. Then, solve for “normalized” ROE.

Firm A:
18% = 3,200,000 / EquityA
EquityA = 17,777,778 (rounding)
Normalized Net IncomeA = 3,200,000 + (1 – 0.36)(400,000 – 300,000)
Normalized ROEA = 3,264,000 / 17,777,778 = 18.360%

Firm B:
16% = 16,000,000 / EquityB
EquityB = 100,000,000
Normalized Net IncomeB = 16,000,000 + (1 – 0.36)(–2,600,000)
Normalized ROEB = 14,336,000 / 100,000,000 = 14.336%

18.360 and 14.336 are closest to 18.4 and 14.3
Which of the following statements is CORRECT when inventory prices are falling?
 A) LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows.
 B) LIFO results in higher COGS, lower earnings, higher taxes, and higher cash flows.
 C) LIFO results in lower COGS, lower earnings, lower taxes, and higher cash flows.

Remember, prices are falling. Under LIFO, the most recent purchases flow to COGS. So, LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows.
MKF Consolidated reports \$500 million in goodwill on its balance sheet. The market consensus indicates that the value of MKF’s intangible assets is \$300 million. How should an analyst adjust MKF’s balance sheet? Reduce goodwill and:
 A) increase liabilities by \$200 million.
 B) equity by \$500 million.
 C) equity by \$200 million.

If goodwill has no economic value apart from the firm, it should be eliminated from the balance sheet. If the value of the intangibles can be reliably estimated they can be substituted for accounting goodwill.
A firm has reported net income of \$136 million, but the notes to financial statements includes a statement that the results “include a \$27 million charge for non-insured earthquake damage” and a “gain on the sale of certain assets during restructuring of \$16 million.” If we assume that both of these items are given on a pre-tax basis and the effective tax rate is 36%, what would be the “normal operating income?”
 A) \$94.08 million.
 B) \$147.00 million.
 C) \$143.04 million.

To normalize earnings you would increase it by the non-recurring charge of \$27 million and decrease it by the non-recurring gain, both tax adjusted.
\$136 + (27 - 16)(1 - 0.36) = \$143.04.
ABC Tie Company reports income for the year 2009 as \$450,000. The notes to its financial statements state that the firm uses the last in, first out (LIFO) convention to value its inventories, and that had it used first in, first out (FIFO) instead, inventories would have been \$62,000 greater for the year 2008 and \$78,000 greater for the year 2009. If earnings were restated using FIFO to determine the cost of goods sold (COGS), what would the net income be for the year 2009? Assume a tax rate of 36%. Net income would have been:
 A) \$460,240.
 B) \$455,760.
 C) \$439,760.

The reduction in COGS would result in an increase in net income (62,000 − 78,000) × (1 − 0.36).
Coastal Drilling Corp (CDC) reported the following year-end data:
 EBIT \$23 million EBT \$20 million Effective tax rate 40 percent

CDC reported in the footnotes to its financial statements that it had increased the expected return on pension plan assets assumption which resulted in an increase of EBIT of \$2 million. Analyst Wanda Brunner, CFA, thinks this change in assumptions is unfounded and removes the \$2 million increase in EBIT. Which of the following is closest to the tax burden ratio after adjustment?
 A) 61.9%.
 B) 60.0%.
 C) 55.6%.

Tax burden = NI/EBT or 1 - the effective tax rate. The increase in the return on pension plan assets assumption increased EBIT, EBT, Income Taxes, and Net Income from what it would have been. Removing \$2 million from the reported numbers will reduce EBIT, EBT, Income Taxes, and Net Income. However, the tax burden ratio will still be 1 - the effective tax rate.
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