1. A is correct. The capitalized value of Silk Road’s leases, the amount by which assets would increase, is estimated as the present value of the operating lease expense (payments). The present value of eight payments of 213 at 6.5 percent is 1,297.

2. B is correct. Adjusted EBIT = EBIT + Lease expense − Adjustment to depreciation = 318 + 213 − (1,297/8) = 369. Adjusted interest expense = Interest expense + Assumed interest expense on leases = 21 + (0.065 × 1, 297) = 105.3. Adjusted interest coverage ratio = 369/105.3 = 3.50.

3. C is correct. The capitalized value of the leases is added to assets and liabilities but does not impact equity. On an adjusted basis, Silk Road’s financial leverage ratio = (2,075 + 1,297)/1,156 = 2.92.

4. A is correct. Without the accounting change, Colorful Concepts has a financial leverage ratio = 3,844/2,562 = 1.50 and an interest coverage ratio = 865/35 = 24.71. These are both passing ratios. With the accounting change, the capitalized value of Colorful Concept’s leases is 2,472. The financial leverage ratio = (3,844 + 2,472)/2,562 = 2.46 and the interest coverage ratio = [865 + 406 − (2,472/8)]/[35 + (2,472 × 0.065)] = 4.91. These are both failing ratios. The change in interest rate coverage is particularly dramatic.

5. A is correct. Silk Road has higher unadjusted and adjusted financial leverage ratios and lower unadjusted and adjusted interest coverage ratios than Colorful Concepts. Silk Road is riskier based on the financial leverage and interest coverage ratios, so it should have a lower bond rating.

6. B is correct. The investment in Exotic Imports is accounted for using the equity method and 20 percent of Exotic Import’s net income is included in the net income of Colorful Concepts. The net profit margin excluding the investment in Exotic Imports is (528 − 21)/7,049 = 7.2%. (If the investment in Exotic Imports is included, net profit margin is 7.5%.)

7. B is correct. The asset turnover ratio (Sales/Average total assets) without adjustment is 7,049/3,844 = 1.83. To compute the asset turnover ratio excluding investments in associates, the average investment in associates [(204 + 188)/2 = 196] is deducted from average total assets. The adjusted asset turnover ratio is 7,049/(3,844 − 196) = 1.93. The asset turnover ratio increased by 0.10.

8. C is correct. The calculation for interest coverage is EBIT/Interest expense, neither of which is affected by the investment in associates.

9. C is correct. The ROE has been trending higher. ROE can be calculated by multiplying (net profit margin) × (asset turnover) × (financial leverage). Net profit margin is net income/sales. In 2007 the net profit margin was 2,576/55,781 = 4.6% and the ROE = 4.6% × 0.68 × 3.43 = 10.8%. Using the same method, ROE was 12.9% in 2008 and 13.6% in 2009.

10. A is correct. The DuPont analysis shows that profit margins and asset turnover have both increased over the past three years, but leverage has declined. The reduction in leverage offsets a portion of the improvement in profitability and turnover. Thus, ROE would have been higher if leverage had not decreased.

11. B is correct. The power and industrial segment has the lowest EBIT margins but uses about 31 percent of the capital employed. Further, power and industrial’s proportion of the capital expenditures has increased from 32 percent to 36 percent over the three years. Its capital intensity only looked to get worse, as the segment’s percentage of total capital expenditures was higher than its percentage of total capital in each of the three years. If Abay is considering divesting segments that do not earn sufficient returns on capital employed, this segment is most suitable.

12. A is correct. The cash-flow-based accruals ratio = [NI − (CFO + CFI)]/(Average NOA) = [4,038 − (9,822 − 10,068)]/43,192 = 9.9%.

13. A is correct. The cash-flow-based accruals ratio falls from 11.0 percent in 2007 to 5.9 percent in 2008, and then rises to 9.9 percent in 2009. However, the change over the three-year period is a net modest decline, indicating a slight improvement in earnings quality.

14. B is correct. Net cash flow provided by (used in) operating activity has to be adjusted for interest and taxes, as necessary, in order to be comparable to operating income (EBIT). Bickchip, reporting under IFRS, chose to classify interest expense as a financing cash flow so the only necessary adjustment is for taxes. The operating cash flow before interest and taxes = 9,822 + 1,930 = 11,752. Dividing this by EBIT of 6,270 yields 1.9.

15. A is correct. Operating cash flow before interest and taxes to operating income rises steadily (not erratically) from 1.2 to 1.3 to 1.9. The ratios over 1.0 and the trend indicate that earnings are supported by cash flow.

16. A is correct. The leverage ratio is measured as total assets/total equity. As reported, this was $3,610,600/$976,500 = 3.70. Had the securitized receivables been held on the balance sheet, assets would have been $267,500 higher, or $3,878,100, and equity would have been unchanged. The ratio would then have been 3.97. The ratio of 3.70 as reported is 6.8 percent less than 3.97: 1 − 3.7/3.97 = 0.068.

17. B is correct. If the receivables had been held on the balance sheet, both assets and liabilities would have been $267,500 higher: $2,901,600/$3,878,100 = 74.8%.

18. A is correct. PDQ owns 20 percent of Astana. 0.2 × 298,350 = $59,670. Translated at the current exchange rate of $1.62 per euro, that is €36,833. 36,833/563,355 = 0.0654, or 6.5%.

19. A is correct. PDQ’s solo market capitalization is 563,355 − 36,833 = 526,522. To calculate its solo net income, because Astana is accounted for using the equity method, 20 percent of Astana’s net income of $9,945 is translated at the average exchange rate of $1.55/€ and deducted from PDQ’s net income to produce €26,884 in adjusted net income for PDQ. P/E = 526,522/26,884 = 19.6.

20. B is correct. Adjusted financial statements are created during the data processing phase of the financial analysis process.

21. A is correct. Estimates of Astana’s impact on PDQ’s financial statements are crude due to the potential differences in accounting standards used by the two firms. Based on the currencies each reports in, Astana is likely using U.S. GAAP and PDQ is likely using IFRS. Pricing (market capitalization) should reflect the other potential differences.