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Fundamentals of Financial Manageme...

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

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

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

a.

Summary Introduction

To identify: The effect of expansion on sales, after tax operating income, NOWC and net income.

Financial Statements:

Income statement, balance sheet, cash flow statement, statement of changes in equity, and relating notes and disclosures generally comprises financial statements of an entity; financial statements are statements that provide reports depicting the affairs of the entity.

Explanation

Effect of expansion on sales, after tax operating income, NOWC and net income:

Particulars

Year 2014

($)

Year 2015

($)

Effect
Sales3,432,0006,034,000Increased
After tax operating income114,257(78,569)Reduced
Net operating working capital842,400913,042Increased
Net Income87,960(160,176)Reduced

Table (1)

Effects:

  • Sales have been increased to around 75%.
  • After tax operating working capital and net income has been reduced to a large extent and turned out into losses...

b.

Summary Introduction

To identify: The effect of expansion on free cash flows.

c.

Summary Introduction

To identify: The time taken by company to repay its suppliers and problems generally faced by a company in case the suppliers are not paid within time.

d.

Summary Introduction

To identify: The rise in cost of goods sold and its comparison with sales.

e.

Summary Introduction

To identify: The effect of increase in credit terms with or without affecting sales.

f.

Summary Introduction

To identify: The possibility of declining cash balance due to large volume of units with positive contribution per unit.

g.

Summary Introduction

To identify: The source of funds used in expansion program and its effects on company’s financial health.

h.

Summary Introduction

To identify: The asset expansion being the reason of cash shortage and consequent use of external capital.

i1.

Summary Introduction

To identify: Whether change in the useful life of assets would affect physical stock of assets.

i2.

Summary Introduction

To identify: Whether change in the useful life of assets would affect balance sheet account of fixed assets.

i3.

Summary Introduction

To identify: Whether change in the useful life of assets would affect the net income.

i4.

Summary Introduction

To identify: Whether change in the useful life of assets would affect the change in cash position.

j.

Summary Introduction

To identify: The valuation and meaning of EPS, DPS and book value per share.

k1.

Summary Introduction

To identify: The tax treatment of interest and dividends paid.

k2.

Summary Introduction

To identify: The tax treatment of interest and dividends received.

k3.

Summary Introduction

To identify: The tax treatment of capital gains.

k4.

Summary Introduction

To identify: The tax treatment of tax loss carry backs and carries forwards.

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