Gleim CMA Review Updates to Part Edition, 1st Printing March 2015

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1 Page 1 of 5 Gleim CMA Review Updates to Part Edition, 1st Printing March 2015 NOTE: Text that should be deleted is displayed with a line through it. New text is shown with a blue background. Study Unit 3 Profitability Analysis and Analytical Issues Page 67, Subunit 3.1, 1.a.: This update clarifies the definition of gross profit margin. 3.1 PROFITABILITY RATIOS 1. Income Statement Percentages a. Gross profit margin is what the percentage of gross revenues that remains with the firm after paying for merchandise. The key analysis with respect to the gross profit margin is whether it is keeping up remains stable with the any increase or decrease in sales. 1) For example, a 10% increase in sales should be accompanied by at least a 10% increase in the gross profit margin. Thus, the gross profit margin should remain relatively constant at different sales levels. Page 71, Subunit 3.2, 4.c.: This update adds information on sustainable equity growth to the outline material. 4. Other Measures a. The net profit margin on sales equals net income divided by sales. 1) The numerator may also be stated in terms of the net income available to common shareholders. 2) Another form of the ratio excludes nonrecurring items from the numerator, e.g., unusual or infrequent items, discontinued operations, extraordinary items, and effects of accounting changes. The result is sometimes called the net profit margin. This adjustment may be made for any ratio that includes net income. a) Still other numerator refinements are to exclude equity-based earnings and items in the other income and other expense categories. b. The ratio of net operating income to sales may also be defined as earnings before interest and taxes (EBIT) divided by net sales. 1) Use of EBIT emphasizes operating results and more nearly approximates cash flows than other income measures. c. The sustainable growth rate equals the return on equity times the difference of 1 and the dividend payout ratio. 1) This ratio measures the potential growth of a firm without borrowing additional funds. 2) The retention ratio, or the difference of 1 and the dividend payout ratio, is the portion of the income kept to grow the firm.

2 Page 2 of 5 Page 73, Subunit 3.4, 1.b.: This update makes the wording in the outline consistent. 3.4 EARNINGS PER SHARE AND DIVIDEND PAYOUT 1. Earnings per Share (EPS) a. EPS is probably the most heavily relied-upon performance measure used by investors. EPS states the amount of current-period earnings that can be associated with a single share of a corporation s common stock. 1) EPS is only calculated for common stock because common shareholders are the residual owners of a corporation. Since preferred shareholders have superior claim to the firm s earnings, amounts associated with preferred stock must be removed during the calculation of EPS. b. A corporation is said to have a simple capital structure if one of the following two conditions applies apply: 1) The firm has only common stock; i.e., there are no preferred shareholders with a superior claim to earnings in the form of dividends; or and 2) The firm has no dilutive potential common stock. a) Potential common stock (PCS) is a security or other contract that may entitle the holder to obtain common stock. Examples include convertible securities, stock options and warrants, and contingently issuable common stock. b) Potential common stock is said to be dilutive if its inclusion in the calculation of EPS results in a reduction of EPS. Page 93, Subunit 3.2, Question 6: This update corrects a transposition error. 6. Zoron Corporation experienced the following yearover-year changes. Net profit margin Increased 25% Total asset turnover Increased 40% Total assets Decreased 10% Total equity Increased 40% Using DuPont analysis, what is the year-over-year change in Zoron s return on equity (ROE)? A. Increased 95.0%. B. Increased 63.0%. C. Increased 12.5%. D. Increased 10.0%. Answer (C) is correct. REQUIRED: The calculation of return on equity using the DuPont method. DISCUSSION: The ROE using the DuPont analysis is calculated as follows: Net profit margin Total asset turnover Equity Multiplier (Total assets Total equity) The best way to solve this problem is to use actual numbers for the return on equity comparison of this year to last year. Assuming that last year Zoron had a net profit margin of.025, total asset turnover of 1.05, total assets of $500,000, and total equity of $200,000, last year s ROE is equal to 6.56% [ ($500,000 $200,000)]. By using the information given in the problem, Zoron s current-year amounts can be calculated, resulting in a net profit margin of (increased by 25%), total asset turnover of 1.47 (increased by 40%), total assets of $450,000 (decreased by 10%), and total equity of $280,000 (increased by 40%). Therefore, this year s ROE is equal to 7.38% [ (450, ,000)]. The increase in ROE from last year to this year can now be calculated as 12.5% [( ) 6.56]. Answer (A) is incorrect. The DuPont Model for ROE is as follows: Net profit margin Total asset turnover Equity multiplier (Total assets Total equity). The year-over-year change is not calculated by simply adding and subtracting the increases and decreases from last year to this year. The incorrect amount of 95% results from adding and subtracting the year-over-year changes (25% + 40% 10% + 40%). Answer (B) is incorrect. The year-over-year change is not calculated by simply dividing the increase in the net profit margin by the increase in the total asset turnover. Answer (D) is incorrect. This answer choice incorrectly multiples the year-over-year change for the net profit margin by the year-over-year change for the total asset turnover to get an increase in ROE of 10.0%.

3 Page 3 of 5 Page 96, Subunit 3.3, Question 14: This update corrects answer choices and explanations. 14. Information concerning Hamilton s common stock is presented below for the fiscal year ended May 31, Year 2. Common stock outstanding 750,000 Stated value per share $15.00 Market price per share Year 1 dividends paid per share 4.50 Year 2 dividends paid per share 7.50 Basic earning per share Diluted earnings per share 9.00 The price-earnings ratio for Hamilton s common stock is Answer (C) is correct. REQUIRED: The price-earnings ratio for the common stock. DISCUSSION: The price-earnings ratio is calculated by dividing the current market price of the stock by the earnings per share. Diluted earnings per share is used if disclosed. Thus, Hamilton s price-earnings ratio is ($45 market price $9 $11.25 DBEPS). Answer (A) is incorrect. The figure of 3.0 is based on use of the stated value per share as the denominator. Answer (B) is incorrect. The figure of is based on erroneously using the basic diluted earnings per share as the denominator. Answer (D) is incorrect. The figure of 6.0 is derived by using Year 2 dividends per share as the denominator. A. 3.0 times. B times. C times. D. 6.0 times. Page 99, Subunit 3.6, Question 22: This update moves a question from Subunit 6 to Subunit In assessing the financial prospects for a firm, financial analysts use various techniques. An example of vertical, common-size analysis is A. An assessment of the relative stability of a firm s level of vertical integration. B. A comparison in financial ratio form between two or more firms in the same industry. C. Advertising expense is 2% greater compared with the previous year. D. Advertising expense for the current year is 2% of sales. Answer (D) is correct. REQUIRED: The example of vertical, common-size analysis. DISCUSSION: Vertical, common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical, common-size analysis. Answer (A) is incorrect. Vertical integration occurs when a corporation owns one or more of its suppliers or customers. Answer (B) is incorrect. Vertical, common-size analysis restates financial statements amounts as percentages. Answer (C) is incorrect. A statement that advertising expense is 2% greater than in the previous year results from horizontal analysis.

4 Page 4 of 5 Study Unit 8 CVP Analysis and Marginal Analysis Page 242, Subunit 8.3, 1.a.1) and 2.a.: This update clarifies the equations for target operating income and target net income. 8.3 CVP ANALYSIS -- TARGET INCOME CALCULATIONS 1. Target Operating Income a. An amount of operating income, either in dollars or as a percentage of sales, is frequently required. 1) By treating target income as an additional fixed cost, CVP analysis can be applied. Target income in units volume = Fixed costs + Target operating income UCM 2) EXAMPLE: The manufacturer from the previous example with the $0.40 contribution margin per unit wants to find out how many units must be sold to generate $25,000 of operating income. Target unit volume = (Fixed costs + Target operating income) UCM = ($10,000 + $25,000) $0.40 = $35,000 $0.40 = 87,500 units b. Other target income situations call for the application of the standard formula for operating income. Operating income = Sales Variable costs Fixed costs 1) EXAMPLE: If units are sold at $6.00 and variable costs are $2.00, how many units must be sold to realize operating income of 15% ($ = $.90 per unit) before taxes, given fixed costs of $37,500? 2. Target Net Income Operating income = Sales Variable costs Fixed costs $0.90 Q = ($6.00 Q) ($2.00 Q) $37,500 $3.10 Q = $37,500 Q = 12,097 units a) Selling 12,097 units results in $72,582 of revenues. Variable costs are $24,194, and operating income is $10,888 ($72,582 15%). The proof is that variable costs of $24,194, plus fixed costs of $37,500, plus operating income of $10,888, equals $72,582 of sales. a. A variation of this problem asks for net income (an after-tax amount) instead of operating income (a pretax amount). Target income in units volume = Fixed costs + [Target net income (1.0 tax rate)] UCM 1) EXAMPLE: The manufacturer wants to generate $30,000 of net income. The effective tax rate is 40%. Target unit volume = {Fixed costs + [Target net income (1.0.40)]} UCM = [$10,000 + ($30,000.60)] $.40 = 150,000 units

5 Page 5 of 5 Study Unit 10 Investment Decisions Page 309, Subunit 10.1, 6.a.Example: This update provides more information on the tax value and residual value of the old equipment in the example. EXAMPLE A company is determining the relevant cash flows for a potential capital project. The company has a 40% tax rate. 1) Net initial investment: a) The project will require an initial outlay of $500,000 for new equipment. b) The company expects to commit $12,000 of working capital for the duration of the project in the form of increased accounts receivable and inventories. c) Calculating the after-tax proceeds from disposal of the existing equipment is a two-step process. i) First, the tax gain or loss is determined. Disposal value $ 5,000 Less: Tax value (20,000) Tax-basis loss on disposal $(15,000) ii) The after-tax effect on cash can then be calculated. Disposal value $ 5,000 Add: Tax savings on loss ($15,000.40) 6,000 After-tax cash inflow from disposal $11,000 d) The cash outflow required for this project s net initial investment is therefore $(501,000) [$(500,000) + $(12,000) + $11,000]. 2) Annual net cash flows: a) The project is expected to generate $100,000 annually from ongoing operations. i) However, 40% of this will have to be paid out in the form of income taxes. Annual cash collections $100,000 Less: Income tax expense ($100,000 x.40) (40,000) After-tax cash inflow from operations $ 60,000 b) The project is slated to last 8 years. i) The new equipment is projected to have a salvage value of $50,000 and will generate $62,500 per year in depreciation charges ($500,000 8). NOTE: On the CMA exam, salvage value is never subtracted when calculating the depreciable base for tax purposes. ii) The old equipment has 4 years of service life remaining. iii) Unlike the income from operations, the higher depreciation charges will generate a tax savings. This is referred to as the depreciation tax shield. iv) Since the carrying value of the old equipment is $20,000 with no residual value, tthe tax savings generated by the higher depreciation for the first 4 years is $23,000 [($62,500 $5,000).40] and for the last 4 years is $25,000 [($62,500 $0).40]. c) The annual net cash inflow from the project is thus $83,000 ($60,000 + $23,000) for the first 4 years and $85,000 ($60,000 + $25,000) for the last 4 years. 3) Project termination cash flows: a) Proceeds of $50,000 are expected from disposal of the new equipment at the end of the project. i) First, the tax gain or loss is determined. Disposal value $50,000 Less: Tax basis 0 Tax-basis gain on disposal $50,000 ii) The after-tax effect on cash can then be calculated. Tax basis gain on disposal $50,000 Less: Tax liability on gain ($50,000.40) (20,000) After-tax cash inflow from disposal $30,000 b) Once the project is over, the company will recover the $12,000 of working capital it committed to the project. c) The net cash inflow upon project termination is therefore $42,000 ($30,000 + $12,000).

CMA 2010 Support Package

CMA 2010 Support Package Ratio Definitions CMA EXAM RATIO DEFINITIONS Abbreviations EBIT = Earnings before interest and taxes EBITDA = Earnings before interest, taxes, depreciation and amortization EBT