DLEON INC PART Statements and Taxes Donna Jamison a 2009 gra

D\'LEON INC., PART Statements and Taxes Donna Jamison, a 2009 graduate of the University of Florida with 4 years of assistant to the chairperson of the board of D\'Leon Inc., a small food 3-18 Financial banking experience, was recently brought in as snack foods national\" in competition with Frito-Lay, Eagle, and other major roducer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the snack foods companies. Watkins believed that market. D\'Leon\'s president, Al Watkins, decided in 2013 to undertake a major expansion and to \"go s products were of higher quality than the competition\'s: that this quality differential would enable it to arge a premium price; and that the end result would be greatly increased sales, profits, and stock price. vertising campaign. D\'Leon\'s results were not satisfactory, to put it mildly. Its board of directors, which the expansion was going. Unhappy suppliers were being paid late; and the bank offices outside its home territory, and launched an plant capacity, opened new sales businesspeople), was most ive consisted of its t, vice president, and major stockholders (all of whom were local eteriorating situation, threatening to cut off credit. As a result, Watkins was informed borna lamison was brought in and given the job of assistant to Fred Campo, a retired banker who was D\'Leon\'s aJamison began by gathering the financial statements and other data given in Tables IC 3.1, IC 3.2, IC 3.3, and was complaining about the situati uicklv: otherwise, he would be fired. Also, at the board\'s insistence that changes would have to be made-and q back to health, with Jamison\'s help. Note: We will continue with er. Campo agreed to give up a few of his golfing days and help nurse the company s assistant. You must help her answer the following questions for Campo. for Chapter 4. Provide clear explanations.) this case in Chapter 4, and you will feel mo re comfortable with the analysis there. But answering these questions will help prepare you king capital (NOwc), What effect did the expansion have on sales, after-tax operating income, net operating wor and net income? b. What effect did the company\'s expansion have on its free cash flow? c. D\'eon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30 days of receipt. Judging from its 2014 balance sheet, do you think that D\'Leon pays suppliers on time? Explain, inclu what problems might occur if suppliers are not paid in a timely manner d. D\'Leon spends money for labor, materials, and fixed assets (depreciation) to make products - and spends stil more money to sell those products. Then the firm makes sales that result in receivables, which eventually result in cash inflows. Does it appear that D\'Leon\'s sales price exceeds its costs per unit sold? How does this affect the cash balance? e. Suppose D\'Leon\'s sales manager told the sales staff to start offering 60-day credit terms rather than the 30-day terms now being offered. D\'Leon\'s competitors react by offering similar terms, so sales remain constant. What effect would this have on the cash account? How would the cash account be affected if sales doubled as a result of the credit policy change? Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of output yet a dramatic increase in sales volume causes the cash balance to decline? Explain. f. g. Did D\'Leon finance its expansion program with internally generated funds (additions to retained earnings plus h. Refer to Tables IC 3.2 and IC 3.4. Suppose D\'Leon broke even in 2014 in the sense that sales revenues equaled i. If D\'Leon starts depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the physical depreciation) or with external capital? How does the choice of financing affect the company\'s financial strength? total operating costs plus interest charges. Would the asset expansion have caused the company to experience a cash shortage that required it to raise external capital? Explain. stock of assets, (2) the balance sheet account for fixed assets, (3) the company\'s reported net income, and (4) the company\'s cash position? Assume that the same depreciation method is used for stockholder reporting and for tax calculations and that the accounting change has no effect on assets\' physical lives. Explain how earnings per share, dividends per share, and book value per share are calculated and what they mean. Why does the market price per share not equal the book value per share? Explain briefly the (3) capital gains, and (4) tax loss carry-backs and carry-forwards. How might each of these items affect D\'Leon k. tax treatment of (1) interest and dividends paid, (2) interest earned and dividends received taxes

Solution

MINI CASE

Donna Jamison, a recent graduate of the University of Tennessee with four years of banking experience, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of electronic calculators.

      The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Computron’s results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice-president plus its major stockholders (who were all local business people), was most upset when directors learned how the expansion was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Al Watkins, Computron’s president, was informed that changes would have to be made, and quickly, or he would be fired. Also, at the board’s insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was Computron’s chairman and largest stockholder. Campo agreed to give up a few of his golfing days and to help nurse the company back to health, with Jamison’s help.

      Jamison began by gathering financial statements and other data. Assume that you are Jamison’s assistant, and you must help her answer the following questions for Campo.

                                                                  Balance Sheets

Assets

2003

2004

Cash

$         9,000

$        7,282

Short-term investments.

48,600

20,000

Accounts receivable

351,200

632,160

Inventories

715,200

1,287,360

   total current assets

$ 1,124,000

$ 1,946,802

Gross fixed assets

491,000

1,202,950

Less: accumulated depreciation

146,200

263,160

   net fixed assets

$     344,800

$    939,790

Total assets

$ 1,468,800

$ 2,886,592

Liabilities and equity

2003

2004

Accounts payable

$     145,600

$    324,000

Notes payable

200,000

720,000

Accruals

136,000

284,960

   total current liabilities

$     481,600

$ 1,328,960

Long-term debt

323,432

1,000,000

Common stock (100,000 shares)

460,000

460,000

Retained earnings

203,768

97,632

   total equity

$     663,768

$    557,632

Total liabilities and equity

$ 1,468,800

$ 2,886,592

                                                              Income Statements

2003

2004

Sales

$ 3,432,000

$ 5,834,400

Cost of goods sold

2,864,000

4,980,000

Other expenses

340,000

720,000

Depreciation

18,900

116,960

   total operating costs

$ 3,222,900

$ 5,816,960

   EBIT

$     209,100

$      17,440

Interest expense

62,500

176,000

   EBT

$     146,600

$ (158,560)

Taxes (40%)

58,640

(63,424)

Net income

$       87,960

$    (95,136)

Other data

2002

2003

Stock price

$           8.50

$          6.00

Shares outstanding

100,000

100,000

EPS

$         0.880

$      (0.951)

DPS

$         0.220

$        0.110

Statement of retained earnings, 2004

Balance of retained earnings, 12/31/2003

$    203,768

   add: net income, 2004

$    (95,136)

   less: dividend paid, 2004

$    (11,000)

Balance of retained earnings, 12/31/2004

$      97,632

                                                         Statement of Cash Flows

Operating activities

Net income

$    (95,136)

Adjustments:

     noncash adjustments:

           depreciation

116,960

     changes in working capital:

           change in accounts receivable

(280,960)

           change in inventories

(572,160)

           change in accounts payable

178,400

           change in accruals

148,960

Net cash provided by operating activities

$ (503,936)

Long-term investing activities

Cash used to acquire fixed assets

$ (711,950)

Financing activities

     change in short term investments

$      28,600

     change in notes payable

$    520,000

     change in long-term debt

$    676,568

     change in common stock

$               -

     payment of cash dividends

$    (11,000)

Net cash provided by financing activities

$ 1,214,168

Summary

Net change in cash

$      (1,718)

Cash at beginning of year

9,000

Cash at end of year

$        7,282

a.               What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity?

Answer:    Sales increased by over by over $2.4 million, but net income fell by over $190,000. Assets almost doubled. Debt and funds provided by suppliers increased, but retained earnings fell due to the year’s loss.

b.               What do you conclude from the statement of cash flows?

Answer:    Net CF from operations = -$503,936, because of negative net income and increases in working capital. The firm spent $711,950 on FA.   The firm borrowed heavily and sold some short-term investments to meet its cash requirements. Even after borrowing, the cash account fell by $1,718.

c.               What is free cash flow? Why is it important? What are the five uses of FCF?

Answer:    FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A company’s value depends upon the amount of FCF it can generate.

1. Pay interest on debt.

2. Pay back principal on debt.

3. Pay dividends.

4. Buy back stock.

5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

d.               What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?

Answer:    Operating current assets are the CA needed to support operations. OP CA include: cash, inventory, receivables. OP CA exclude: short-term investments, because these are not a part of operations.   Operating current liabilities are the CL resulting as a normal part of operations. OP CL include: accounts payable and accruals. OP CA exclude: notes payable, because this is a source of financing, not a part of operations.

NOWC      = operating CA – operating CL

NOWC₀₄ = ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960)

              = $1,317,842.

NOWC₀₃ = $793,800.

Total operating working capital    = NOWC + net fixed assets.

Operating capital in 2004 = $1,317,842 + $939,790

                                                      = $2,257,632.

Operating capital in 2003 = $1,138,600.

e.               What are Computron’s net operating profit after taxes (NOPAT) and free cash flow (FCF)?

ANSWER:     NOPAT = EBIT(1 - Tax rate)

NOPAT₀₄   = $17,440(1 - 0.4)

                   = $10,464.

NOPAT₀₃   = $125,460.

FCF      = NOPAT - Net investment in capital

              = $10,464 - ($2,257,632 - $1,138,600)

              = $10,464 - $1,119,032

              = -$1,108,568.

f.                Calculate Computron’s return on invested capital. Computron has a 10% cost of capital (WACC). Do you think Computron’s growth added value?

ANSWER:     ROIC = NOPAT / Total NET operating capital.

ROIC₀₄ = $10,464 / $2,257,632

              = 0.5%.

ROIC₀₃ = 11.0%.

The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require. Note: high growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, home depot has high growth, negative FCF, but a high ROIC.

g.               Jamison also has asked you to estimate Computron\'s EVA. She estimates that the after-tax cost of capital was 10 percent in both years.

ANSWER:     EVA = NOPAT- (WACC)(Capital).

EVA₀₄ = $10,464 - (0.1)($2,257,632)

            = $10,464 - $225,763

            = -$215,299.

EVA₀₃ = $125,460 - (0.10)($1,138,600)

            = $125,460 - $113,860

            = $11,600.

h.               What happened to Computron\'s market value added (MVA)?

Answer:    MVA = market value of the firm - book value of the firm.

Market value = (# shares of stock)(price per share) + value of debt.

Book value = total common equity + value of debt.

If the market value of debt is close to the book value of debt, then MVA is market value of equity minus book value of equity.   Assume market value of debt equals book value of debt.

Market value of equity 2003 = (100,000)($6.00) = $600,000.

Book value of equity 2003 = $557,632.

MVA₀₃ = $600,000 - $557,632 = $42,368.

MVA₀₂ = $850,000 - $663,768 = $186,232.

i.                Assume that a corporation has $100,000 of taxable income from operations plus $5,000 of interest income and $10,000 of dividend income. What is the company’s tax liability?

Answer:    Calculation of the company’s tax liability:

Taxable operating income                                                 $100,000

Taxable interest income                                                          5,000

Taxable dividend income (0.3 ´ $10,000)                              3,000

Total taxable income                                                         $108,000

Tax = $22,250 + ($108,000 - $100,000)0.39 = $25,370.

                       taxable dividend income = dividends - exclusion

                                               = $10,000 - 0.7($10,000)

                                               = $3,000.

j.                Assume that you are in the 27 percent marginal tax bracket and that you have $5,000 to invest. You have narrowed your investment choices down to California bonds with a yield of 7 percent or equally risky Exxon bonds with a yield of 10 percent. Which one should you choose and why? At what marginal tax rate would you be indifferent to the choice between California and Exxon bonds?

Answer:    After-tax return income at t = 27%:

Exxon = 0.10($5,000) - (0.10)($5,000)(0.27) = $365.

California = 0.07($5,000) - $0 = $350.

Alternatively, calculate after-tax yields:

A-T yield_Exxon = 10.0%(1 - t) = 10%(1 - 0.27) = 7.3%.

A-T yield_Calif. = 7.0%.

At what marginal tax rate would you be indifferent?

    7.0% = 10.0%(1 - t). Solve for t.

    7.0% = 10.0% - 10.0%(t)

10.0%(t) = 3%

       t = 30%.

Assets	2003		2004
Cash	$         9,000		$        7,282
Short-term investments.	48,600		20,000
Accounts receivable	351,200		632,160
Inventories	715,200		1,287,360
total current assets	$ 1,124,000		$ 1,946,802
Gross fixed assets	491,000		1,202,950
Less: accumulated depreciation	146,200		263,160
net fixed assets	$     344,800		$    939,790
Total assets	$ 1,468,800		$ 2,886,592
Liabilities and equity	2003		2004
Accounts payable	$     145,600		$    324,000
Notes payable	200,000		720,000
Accruals	136,000		284,960
total current liabilities	$     481,600		$ 1,328,960
Long-term debt	323,432		1,000,000
Common stock (100,000 shares)	460,000		460,000
Retained earnings	203,768		97,632
total equity	$     663,768		$    557,632
Total liabilities and equity	$ 1,468,800		$ 2,886,592