FIN_520_Critical_Thinking_Module_5

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Module 5 Erin Mazzola Colorado State University Global FIN520: Financial Reporting and Analysis Dr. John Halstead January 21, 2023

Profitability Analysis Exercises and Problems Do the assigned problems using Summer Peebles, Inc.'s condensed 2014 financial data below: Assets Current Assets $ 250,000.00 Noncurrent Assets 1,750,000.00 Total Assets $ 2,000,000.00 Liabilities and Equity Current Liabilities $ 200,000.00 Noncurrent Liabilities (8% Bonds) 675,000.00 Common Stockholders' Equity 1,125,000.00 Total Liabilities and Equity $ 2,000,000.00 Additional Information: * Net income for 2014 is $ 157,500.00 * Income tax rate is 50% * Amounts for total assets and shareholders' equity are the same for 2013 and 2014. * All assets and current liabilities are considered to be operating. Determine Whether Keverage (from long-term debt) Benefits Rose's Shareholders Since there are no preferred dividends to take into account, the return on common equity (ROCE) with leverage is 14.00%. This is calculated by dividing the net income of $157,500.00 reported for 2014 by the average equity held by common shareholders (Subramanyam, 2014). The average common shareholders' equity is identical to the $1,125,000.00 stated for 2014 common stockholders' equity because the 2013 and 2014 shareholders' equity were equivalent. Conversely, ROCE in the absence of leverage is 10.25 percent. The initial pretax profit was multiplied by the interest expenditure of $54,000.00 to arrive at a new pretax gain (without leverage) of $369,000.00 [315,000.00 + $54,000.00]. Net income (before deducting the 50% income tax) without leverage is $184,500. Additionally, since it is assumed that equity will be

used in place of the noncurrent liabilities (8% Bonds) in order to fund the net operating assets (NOA), the $675,000 is added to the $1,125,000.00 reported for 2014 common stockholder equity, making the total equity (without leverage) equal to $1,800,000. Based on the computed percentages, Summer Peebles, Inc. stockholders do profit from the long-term debt's leverage since its ROCE with leverage (14.00%) is higher than its ROCE without leverage (10.25%). ROCE with Leverage = $ 157,500.00 = 14.00% $ 1,125,000.00 Net income $ 157,500.00 Income tax rate 50% Pretax profit (with leverage) $ 315,000.00 Interest Expense 54,000.00 Pretax profit (without leverage) $ 369,000.00 Tax expense (without leverage) 184,500.00 Net income (without leverage) $ 184,500.00 ROCE without Leverage = 184,500.00 = 10.25% 1,800,000.00 Compute the NOPAT and RNOA Effective tax rate 50%

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NOPAT = Operating Profit * (1 - Effective tax rate) = $ 184,500.00 The NOA utilized for the denominator below is equal to $1,800,000, which is the total assets of $2,000,000.00 minus the current liabilities of $200,000.00, since the numbers for total assets are identical for 2013 and 2014 and because all assets and current liabilities are regarded as operational. RNOA = NOPAT = 10.25% Average net operating assets (NOA) Demonstrate the Favorable Effect of Leverage Given the Disaggregation of ROCE When broken down, the return of net operating assets (RNOA) in addition to the impact of economic leverage (LEV x Spread) equals ROCE, according to Subramanyam (2014). The following is a breakdown of the ROCE of 14.00% using this formula: The net operating income post tax (NOPAT) split by the average NOA yields the RNOA of 10.25%, which is equivalent to the ROCE sans leverage. The average net financial obligation (NFO) of $675,000.00, which is the noncurrent liabilities (8% Bonds) split by the average equity of $1,125,000.00, yields an LEV of 0.60. Spread of 6.25% is computed by dividing the net financial expenditure (NFE) of $27,000 [$54,000 * 1 – 50%] by the average NFO of $675,000. This results in RNOA of 10.25% minus the net financial rate (NFR) of 4.00%. The beneficial

impact of leverage is equivalent to 3.75%, that is the ROCE of 14% less the RNOA of 10.75%, since ROCE is bigger than RNOA. This indicates that by offering the 8% bonds to fund NOA, the firm was able to increase its ROCE. ROCE = RNOA + (LEV x Spread ) = 10.25% + 0.60 x 6.25% = 14.00% Favorable effect of leverage 3.75%