Question

Which of the following statements is incorrect?

a) DuPont analysis refers to a method of decomposing the return on equity into its components to better understand the ROE and why it may have changed or why it is different than that of some other firm.
b) One overriding rule of ratio analysis is that a single ratio provides very little information and may be misleading, and therefore you should never draw conclusions from a single ratio.
c) Inventories can easily be converted into cash with only small discounts and therefore it is considered as liquid asset.
d) All the answers are correct except one.
e) Return on Common Equity = Net Income / Common Equity.

Answer 1

The incorrect statement is about inventories being considered liquid assets, which they are not, as they often require significant discounts to be converted into cash rapidly. To answer the early-stage corporate finance questions, small companies use private investors due to the high cost and complexity of IPOs, while venture capitalists usually have better information about a firm's profitability than bondholders. Fred's equity in his home is $20,000.

Step-by-step explanation:

The statement that is incorrect is: c) Inventories can easily be converted into cash with only small discounts and therefore it is considered as liquid asset. Inventories are less liquid assets compared to cash or cash equivalents, and selling them quickly often requires significant discounts, potentially impacting the financial stability of a firm.

Now to address the early-stage corporate finance questions:

1. Very small companies tend to raise money from private investors instead of through an IPO because an IPO is costly, complex, and requires a company to disclose financial details publicly, which very small companies may not be prepared for or may benefit from avoiding.
2. Small, young companies might prefer an IPO to borrowing from a bank or issuing bonds as it allows them to raise equity without incurring debt, and gain access to public markets, which can improve liquidity and provide subsequent opportunities for capital.
3. A venture capitalist is likely to have better information about whether a small firm is likely to earn profits compared to a potential bondholder because venture capitalists typically engage in due diligence and may take an active role in firm management.

From a firm's perspective, a bond is similar to a bank loan in that both are ways of raising capital through debt. They differ in that bonds are traded on open markets, which can offer more flexibility in terms, while a bank loan is typically a private agreement with the lending institution and may come with more restrictive covenants.

Fred's equity in his home is calculated by taking the market value of the property and subtracting the amount owed on the mortgage. Fred provided a 10% down payment on a $200,000 house, thus his initial equity is $20,000 (10% of $200,000).