Financial Statements and Taxes Donna Jamison, a 2010 graduate of the University of Florida, with 4 years of banking experience, was recently brought in as assistant to the chairperson of the board of D’Leon Inc., a small food producer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the snack foods market. D’Leon’s president, Al Watkins, decided in 2014 to undertake a major expansion and to “go national” in competition with Frito-Lay, Eagle, and other major snack foods companies. Watkins believed that D’Leon’s products were of higher quality than the competition’s; that this quality differential would enable it to charge a premium price; and that the end result would be greatly increased sales, profits, and stock price. The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. D’Leon’s results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president, vice president, and major stockholders (all of whom were local businesspeople), was most upset when directors learned how the expansion was going. Unhappy suppliers were being paid late; and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Watkins was informed that changes would have to be made—and quickly; otherwise, 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 D’Leon’s chairperson and largest stockholder. Campo agreed to give up a few of his golfing days and help nurse the company back to health, with Jamison’s help. Jamison began by gathering the financial statements and other data given in Tables IC 3.1, IC 3.2, IC 3.3, and IC 3.4. Assume that you are Jamison’s assistant. You must help her answer the following questions for Campo. ( Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis there. But answering these questions will help prepare you for Chapter 4. Provide clear explanations.) a. What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income? b. What effect did the company’s expansion have on its free cash flow? c. D’Leon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30 days of receipt. Judging from its 2015 balance sheet, do you think that D’Leon pays suppliers on time? Explain, including 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 still 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? f. 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. g. Did D’Leon finance its expansion program with internally generated funds (additions to retained earnings plus depreciation) or with external capital? How does the choice of financing affect the company’s financial 1. strength? h. Refer to Tables IC 3.2 and IC 3.4. Suppose D’Leon broke even in 2015 in the sense that sales revenues equaled 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. i. If D’Leon starts depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the physical 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. j. 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? k. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends received, (3) capital gains, and (4) tax loss carry-backs and carry-forwards. How might each of these items affect D’Leon’s taxes? 2015 2014 Assets Cash $ 7,282 $ 57,600 Accounts receivable 632,160 351,200 Inventories 1,287,360 715,200 Total current assets $1,926,802 $1,124,000 Gross fixed assets 1,202,950 491,000 Less accumulated depreciation 263,160 146,200 Net fixed assets $ 939,790 $ 344,800 Total assets $2,866,592 $1,468,800 Liabilities and Equity Accounts payable $ 524,160 $ 145,600 Accruals 489,600 136,000 Notes payable 636,808 200,000 Total current liabilities $1,650,568 $ 481,600 Long-term debt 723,432 323,432 Common stock (100,000 shares) 460,000 460,000 \ Retained earnings 32,592 203,768 | Total equity $ 492,592 $ 663,768 S. Total liabilities and equity $2,866,592 $1,468,800 8 TABLE IC 3.2 2015 2014 Sales $6,034,000 $3,432,000 Cost of goods sold 5,528,000 2,864,000 Other expenses 519.988 358,672 Total operating costs excluding depreciation and amortization $6,047,988 $3,222,672 Depreciation and amortization 116,960 18,900 EBIT ($ 130,948) $ 190,428 Interest expense 136.012 43,828 EBT ($ 266,960) $ 146,600 Taxes (40%) (106,784) a 58,640 Net income ($ 160.176) $ 87,960 EPS ($ 1.602) $ 0.880 DPS $ 0.110 $ 0.220 Book value per share $ 4.926 $ 6.638 Stock price $ 2.25 $ 8.50 Shares outstanding 100,000 100,000 f Tax rate 40.00% 40.00% I Lease payments $ 40,000 $ 40,000 I Sinking fund payments 0 TABLE IC 3.3 Statement’ stockholder’s Equity, 2015 Common Stock Retained Earnings Total Stockholders' Equity Shares Amount Balances, December 31, 2014 100,000 $460,000 $203,768 $ 663,768 2015 Net Income (160,176) Cash Dividends (11,000) Addition (Subtraction) to Retained Earnings (171.176) Balances, December 31, 2015 100.000 $460,000 $ 32.592 $ 492.592 TABLE IC 3.4 Statement of cash Flows, 2015 Operating Activities Net income ($ 160,176) Depreciation and amortization 116,960 Increase in accounts payable 378,560 Increase in accruals 353,600 Increase in accounts receivable (280,960) Increase in inventories (572,160) Net cash provided by operating activities ($164,176) Long-Term Investing Activities Additions to property, plant, and equipment ($ 711,950) Net cash used in investing activities ($ 711,950) Financing Activities Increase in notes payable $ 436,808 Increase in long-term debt 400,000 Payment of cash dividends (11,000) Net cash provided by financing activities $ 825,808 Summary Net decrease in cash ($ 50,318) Cash at beginning of year 57,600 Cash at end of year $ 7,282

BuyFind

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977
BuyFind

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977

Solutions

Chapter
Section
Chapter 3, Problem 20IC
Textbook Problem

Financial Statements and Taxes Donna Jamison, a 2010 graduate of the University of Florida, with 4 years of banking experience, was recently brought in as assistant to the chairperson of the board of D’Leon Inc., a small food producer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the snack foods market. D’Leon’s president, Al Watkins, decided in 2014 to undertake a major expansion and to “go national” in competition with Frito-Lay, Eagle, and other major snack foods companies. Watkins believed that D’Leon’s products were of higher quality than the competition’s; that this quality differential would enable it to charge a premium price; and that the end result would be greatly increased sales, profits, and stock price.

The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. D’Leon’s results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president, vice president, and major stockholders (all of whom were local businesspeople), was most upset when directors learned how the expansion was going. Unhappy suppliers were being paid late; and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Watkins was informed that changes would have to be made—and quickly; otherwise, 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 D’Leon’s chairperson and largest stockholder. Campo agreed to give up a few of his golfing days and help nurse the company back to health, with Jamison’s help.

Jamison began by gathering the financial statements and other data given in Tables IC 3.1, IC 3.2, IC 3.3, and IC 3.4. Assume that you are Jamison’s assistant. You must help her answer the following questions for Campo. (Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis there. But answering these questions will help prepare you for Chapter 4. Provide clear explanations.)

  1. a. What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income?
  2. b. What effect did the company’s expansion have on its free cash flow?
  3. c. D’Leon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30 days of receipt. Judging from its 2015 balance sheet, do you think that D’Leon pays suppliers on time? Explain, including what problems might occur if suppliers are not paid in a timely manner.
  4. d. D’Leon spends money for labor, materials, and fixed assets (depreciation) to make products—and spends still 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?
  5. 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?
  6. f. 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.
  7. g. Did D’Leon finance its expansion program with internally generated funds (additions to retained earnings plus depreciation) or with external capital? How does the choice of financing affect the company’s financial
  8. 1. strength?
  9. h. Refer to Tables IC 3.2 and IC 3.4. Suppose D’Leon broke even in 2015 in the sense that sales revenues equaled 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.
  10. i. If D’Leon starts depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the physical 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.
  11. j. 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?
  12. k. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends received, (3) capital gains, and (4) tax loss carry-backs and carry-forwards. How might each of these items affect D’Leon’s taxes?
  2015 2014
Assets    
Cash $ 7,282 $ 57,600
Accounts receivable 632,160 351,200
Inventories 1,287,360 715,200
Total current assets $1,926,802 $1,124,000
Gross fixed assets 1,202,950 491,000
Less accumulated depreciation 263,160 146,200
Net fixed assets $ 939,790 $ 344,800
Total assets $2,866,592 $1,468,800
Liabilities and Equity    
Accounts payable $ 524,160 $ 145,600
Accruals 489,600 136,000
Notes payable 636,808 200,000
Total current liabilities $1,650,568 $ 481,600
Long-term debt 723,432 323,432
Common stock (100,000 shares) 460,000 460,000 \
Retained earnings 32,592 203,768 |
Total equity $ 492,592 $ 663,768 S.
Total liabilities and equity $2,866,592

$1,468,800 8

TABLE IC 3.2

  2015   2014
Sales $6,034,000 $3,432,000
Cost of goods sold 5,528,000 2,864,000
Other expenses 519.988   358,672
Total operating costs excluding depreciation and amortization $6,047,988 $3,222,672
Depreciation and amortization 116,960   18,900
EBIT ($ 130,948) $ 190,428
Interest expense 136.012   43,828
EBT ($ 266,960) $ 146,600
Taxes (40%) (106,784)a   58,640
Net income ($ 160.176) $ 87,960
EPS ($ 1.602) $ 0.880
DPS $ 0.110 $ 0.220
Book value per share $ 4.926 $ 6.638
Stock price $ 2.25 $ 8.50
Shares outstanding 100,000   100,000 f
Tax rate 40.00%   40.00% I
Lease payments $ 40,000 $ 40,000 I
Sinking fund payments 0    

TABLE IC 3.3 Statement’ stockholder’s Equity, 2015

  Common Stock    
   

Retained

Earnings

Total Stockholders'

Equity

  Shares Amount
Balances, December 31, 2014 100,000 $460,000 $203,768 $ 663,768
2015 Net Income     (160,176)  
Cash Dividends     (11,000)  
Addition (Subtraction) to Retained Earnings       (171.176)
Balances, December 31, 2015 100.000 $460,000 $ 32.592 $ 492.592

TABLE IC 3.4 Statement of cash Flows, 2015

Operating Activities  
Net income ($ 160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provided by operating activities ($164,176)
Long-Term Investing Activities  
Additions to property, plant, and equipment ($ 711,950)
Net cash used in investing activities ($ 711,950)
Financing Activities  
Increase in notes payable $ 436,808
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $ 825,808
Summary  
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600

Cash at end of year

$ 7,282

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