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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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