MGAB03H3 Lecture Notes - Lecture 16: Icq, Earnings Before Interest And Taxes, Weighted Arithmetic Mean
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Measures of liquidity, solvency, and profitability
The comparative financial statements of Marshall Inc. are as follows. The market price of Marshall common stock was $82.60 on December 31, 20Y2.
| Marshall Inc. | ||
| Comparative Retained Earnings Statement | ||
| For the Years Ended December 31, 20Y2 and 20Y1 | ||
| 20Y2 | 20Y1 | |
| Retained earnings, January 1 | $3,704,000 | $3,264,000 |
| Net income | $ 600,000 | $ 550,000 |
| Dividends: | ||
| On preferred stock | (10,000) | (10,000) |
| On common stock | (100,000) | (100,000) |
| Increase in retained earnings | $ 490,000 | $ 440,000 |
| Retained earnings, December 31 | $4,194,000 | $3,704,000 |
| Marshall Inc. | ||
| Comparative Income Statement | ||
| For the Years Ended December 31, 20Y2 and 20Y1 | ||
| 20Y2 | 20Y1 | |
| Sales | $ 10,850,000 | $10,000,000 |
| Cost of goods sold | (6,000,000) | (5,450,000) |
| Gross profit | $ 4,850,000 | $ 4,550,000 |
| Selling expenses | $ (2,170,000) | $ (2,000,000) |
| Administrative expenses | (1,627,500) | (1,500,000) |
| Total operating expenses | $(3,797,500) | $ (3,500,000) |
| Operating income | $ 1,052,500 | $ 1,050,000 |
| Other revenue and expense: | ||
| Other revenue | 99,500 | 20,000 |
| Other expense (interest) | (132,000) | (120,000) |
| Income before income tax expense | $ 1,020,000 | $ 950,000 |
| Income tax expense | (420,000) | (400,000) |
| Net income | $ 600,000 | $ 550,000 |
| Marshall Inc. | ||
| Comparative Balance Sheet | ||
| December 31, 20Y2 and 20Y1 | ||
| 20Y2 | 20Y1 | |
| Assets | ||
| Current assets: | ||
| Cash | $1,050,000 | $ 950,000 |
| Marketable securities | 301,000 | 420,000 |
| Accounts receivable (net) | 585,000 | 500,000 |
| Inventories | 420,000 | 380,000 |
| Prepaid expenses | 108,000 | 20,000 |
| Total current assets | $ 2,464,000 | $2,270,000 |
| Long-term investments | 800,000 | 800,000 |
| Property, plant, and equipment (net) | 5,760,000 | 5,184,000 |
| Total assets | $ 9,024,000 | $8,254,000 |
| Liabilities | ||
| Current liabilities | $ 880,000 | $ 800,000 |
| Long-term liabilities: | ||
| Mortgage note payable, 6% | $ 200,000 | $ 0 |
| Bonds payable, 4% | 3,000,000 | 3,000,000 |
| Total long-term liabilities | $ 3,200,000 | $3,000,000 |
| Total liabilities | $ 4,080,000 | $3,800,000 |
| Stockholders’ Equity | ||
| Preferred 4% stock, $5 par | $ 250,000 | $ 250,000 |
| Common stock, $5 par | 500,000 | 500,000 |
| Retained earnings | 4,194,000 | 3,704,000 |
| Total stockholders’ equity | $ 4,944,000 | $4,454,000 |
| Total liabilities and stockholders’ equity | $ 9,024,000 | $8,254,000 |
Determine the following measures for 20Y2. Round to one decimal place, including percentages, except for per-share amounts, which should be rounded to the nearest cent.
| 1. Working Capital | $ | |
| 2. Current ratio | ||
| 3. Quick ratio | ||
| 4. Accounts receivable turnover | ||
| 5. Number of days’ sales in receivables | ||
| 6. Inventory turnover | ||
| 7. Number of days’ sales in inventory | ||
| 8. Ratio of fixed assets to long-term liabilities | ||
| 9. Ratio of liabilities to stockholders’ equity | ||
| 10. Times interest earned | ||
| 11. Asset turnover | ||
| 12. Return on total assets | % | |
| 13. Return on stockholders’ equity | % | |
| 14. Return on common stockholders’ equity | % | |
| 15. Earnings per share on common stock | $ | |
| 16. Price-earnings ratio | ||
| 17. Dividends per share of common stock | $ | |
| 18. Dividend yield |
AQ-8
Blue Transport Company
Blue Transport Company operates a Truck Rental Division (that rents trucks to individuals) and a Transportation Division (that transports goods from one city to another). Some division financial measures for the year are as follows:
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Required:
1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment.
2. Calculate residual income (RI) for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment.
3. Tony Red, the Truck Rental Division manager, argues that the Transportation Division has âloaded up on a lot of short-term debtâ to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the Transportation Division. Comment on the result.
4. Blue, whose tax rate is 40%, has two sources of funds: long term debt with a market value of $9,000,000 at an interest rate of 10%, and equity capital with a market value of $6,000,000 and a cost of equity of 15%. Applying the same weighted average cost of capital to each division, calculate EVA for each division.
5. Use your preceding calculations to comment on the relative performance of each division.
MINI CASE: CASTILLO PRODUCTS COMPANY
The Castillo Products Company was started in 2011. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2012, was followed by a profitable 2013. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital since they are expecting to secure additional external financing to support planned growth.
Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent and a long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A default-risk premium on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks.
Following are income statements and balance sheets for the Castillo Products Company for 2012 and 2013.
Castillo Products Company
| 2012 | 2013 | |
| Net sales | $900,000 | $1,500,000 |
| Cost of goods sold | 540,000 | 900,000 |
| Gross profit | 360,000 | 600,000 |
| Marketing | 90,000 | 150,000 |
| General and administrative | 250,000 | 250,000 |
| Depreciation | 40,000 | 40,000 |
| EBIT | -20,000 | 160,000 |
| Interest | 45,000 | 60,000 |
| Earnings before taxes | -65,000 | 100,000 |
| Income taxes | 0 | 25,000 |
| Net income (loss) | -$ 65,000 | $ 75,000 |
| 2012 | 2013 | |
| Cash | $ 50,000 | $ 20,000 |
| Accounts receivable | 200,000 | 280,000 |
| Inventories | 400,000 | 500,000 |
| Total current assets | 650,000 | 800,000 |
| Gross fixed assets | 450,000 | 540,000 |
| Accumulated depreciation | -100,000 | -140,000 |
| Net fixed assets | 350,000 | 400,000 |
| Total assets | $1,000,000 | $1,200,000 |
| Accounts payable | $ 130,000 | $ 160,000 |
| Accruals | 50,000 | 70,000 |
| Bank loan | 90,000 | 100,000 |
| Total current liabilities | 270,000 | 330,000 |
| Long-term debt | 300,000 | 400,000 |
| Common stock (.05 par) | 150,000 | 150,000 |
| Additional paid-in-capital | 200,000 | 200,000 |
| Retained earnings | 80,000 | 120,000 |
| Total liabilities and equity | $1,000,000 | $1,200,000 |
E.Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2013. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2013. Estimate the market value-based weighted average cost of capital for Castillo Products.
F.Would you recommend to Cindy and Rob that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why?
