Discussion Questions
1. Discuss some financial variables that affect the price-earnings ratio.
2. What is the difference between book value per share of common stock and market value per share? Why does this disparity occur?
3. Explain how depreciation generates actual cash flows for the company.
4. What is the difference between accumulated depreciation and depreciation expense? How are they related?
5. How is the income statement related to the balance sheet?
6. Comment on why inflation may restrict the usefulness of the balance sheet as normally presented.
7. Explain why the statement of cash flows provides useful information that goes beyond income statement and balance sheet data.
8. What are the three primary sections of the statement of cash flows? In what section would the payment of a cash dividend be shown?
9. What is free cash flow? Why is it important to leveraged buyouts?
10. Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay?
Problems
1. Rockwell Paper Company had earnings after taxes of $580,000 in the year 2007 with 400,000 shares of stock outstanding. On January 1, 2008, the firm issued 35,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 25 percent.
a. Compute earnings per share for the year 2007.
b. Compute earnings per share for the year 2008.
2. Sosa Diet Supplements had earnings after taxes of $800,000 in the year 2008 with 200,000 shares of stock outstanding. On January 1, 2009, the firm issued 50,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent.
a. Compute earnings per share for the year 2008.
b. Compute earnings per share for the year 2009.
3.
a. Kevin Bacon and Pork Company had sales of $240,000 and cost of goods sold of $108,000. What is the gross profit margin (ratio of gross profit to sales)?
b. If the average firm in the pork industry had a gross profit of 60 percent, how is the firm doing?
4. Arrange the following income statement items so they are in the proper order of an income statement:
Taxes Earnings per share
Shares outstanding Earnings before taxes
Gross profit shares outstanding Cost of goods sold
Interest expense Earnings after taxes
Depreciation expense Earnings available to common Preferred stock dividends stockholders
Operating profit Selling and administrative expense Sales
Gross profit
5. Given the following information, prepare, in good form, an income statement for Goodman Software, Inc.
Selling and administrative expense........................................ $ 50,000
Depreciation expense ............................................................. 80,000
Sales ....................................................................................... 400,000
Interest expense...................................................................... 30,000
Cost of goods sold.................................................................. 150,000
Taxes ...................................................................................... 18,550
6. Given the following information prepare in good form an income statement for the Kid Rock and Gravel Company.
Selling and administrative expense........................................ $ 60,000
Depreciation expense ............................................................. 70,000
Sales ....................................................................................... 470,000
Interest expense...................................................................... 40,000
Cost of goods sold.................................................................. 140,000
Taxes ...................................................................................... 45,000
7. Prepare in good form an income statement for Virginia Slim Wear. Take your calculations all the way to computing earnings per share.
Sales ....................................................................................... $600,000
Shares outstanding ................................................................. 100,000
Cost of goods sold.................................................................. 200,000
Interest expense...................................................................... 30,000
Selling and administrative expense........................................ 40,000
Depreciation expense ............................................................. 20,000
Preferred stock dividends....................................................... 80,000
Taxes ...................................................................................... 100,000
8. Prepare in good form an income statement for Franklin Kite Co., Inc. Take your calculations all the way to computing earnings per share.
Sales ....................................................................................... $900,000
Shares outstanding ................................................................. 50,000
Cost of goods sold.................................................................. 400,000
Interest expense...................................................................... 40,000
Selling and administrative expense........................................ 60,000
Depreciation expense ............................................................. 20,000
Preferred stock dividends....................................................... 80,000
Taxes ...................................................................................... 50,000
9. Lasar Technology, Inc., had sales of $500,000, cost of goods sold of $180,000, selling and administrative expense of $70,000, and operating profit of $90,000. What was the value of depreciation expense? Set this problem up as a partial income statement, and determine depreciation expenses as the plug figure.
10. The Ace Book Company sold 1,500 finance textbooks for $185 each to High Tuition University in 2008. These books cost Ace $145 to produce. Ace spent $10,000 (selling expense) to convince the university to buy its books. In addition, Ace borrowed $80,000 on January 1, 2008, on which the company paid 10 percent interest. Both interest and principal of the loan were paid on December 31, 2008. Ace's tax rate is 25 percent. Depreciation expense for the year was $15,000.
Did Ace Book Company make a profit in 2008? Please verify with an income statement presented in good form.
11. Carr Auto Wholesalers had sales of $900,000 in 2004 and their cost of goods sold represented 65 percent of sales. Selling and administrative expenses were 9 percent of sales. Depreciation expense was $10,000 and interest expense for the year was $8,000. The firm's tax rate is 30 percent.
a. Compute earnings after taxes.
b. Assume the firm hires Ms. Hood, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 12 percent of sales, sales can be increased to $1,000,000. The extra sales effort will also reduce cost of goods sold to 60 percent of sales (there will be a larger markup in prices as a result of more aggressive selling). Depreciation expense will remain at $10,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to $15,000. The firm's tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Hood's suggestions for Carr Auto Wholesalers. Will her ideas increase or decrease profitability?
12. Classify the following balance sheet items as current or noncurrent:
Retained earnings Bonds payable
Accounts payable Accrued wages payable
Prepaid expenses Accounts receivable
Plant and equipment Capital in excess of par
Inventory Preferred stock
Common stock Marketable securities
13. Fill in the blank spaces with categories 1 through 7:
1. Balance sheet (BS) 5. Current liabilities (CL)
2. Income statement (IS) 6. Long-term liabilities (LL)
3. Current assets (CA) 7. Stockholders' equity (SE)
4. Fixed assets (FA)
14. Arrange the following items in proper balance sheet presentation:
Accumulated depreciation............................. ........................ $200,000
Retained earnings................................................................... 110,000
Cash........................................................................................ 5,000
Bonds payable........................................................................ 142,000
Accounts receivable............................................................... 38,000
Plant payable..........................................................................720,000
Accounts payable................................................................... 35,000
Allowance for bad debts.............................. .......................... 6,000
Common stock, $1 par, 150,000 shares outstanding..... ........ 150,000
Inventory................................................................................ 66,000
Preferred stock, $50 par, 1,000 shares outstanding... ............ 50,000
Marketable securities................................ ............................. 15,000
Investments.......................................... .................................. 20,000
Notes payable......................................................................... 83,000
Capital paid in excess of par (common stock)......... .............. 88,000
15. Elite Trailer Parks has an operating profit or $200,000. Interest expense for the year was $10,000; preferred dividends paid were $18,750; and common dividends paid were $30,000. The tax was $61,250. The firm has 20,000 shares of common stock outstanding.
a. Calculate the earnings per share and the common dividends per share for Elite Trailer Parks.
b. What was the increase in retained earnings for the year?
16. Johnson Alarm Systems had $800,000 of retained earnings on December 31, 2008. The company paid common dividends of $60,000 in 2008 and had retained earnings of $640,000 on December 31, 2007. How much did Johnson earn during 2008, and what would earnings per share be if 50,000 shares of common stock were outstanding?
17. Mozart Music Co. had earnings after taxes of $560,000 in 2008 with 200,000 shares of stock outstanding. The stock price was $58.80. In 2009, earnings after taxes increased to $650,000 with the same 200,000 shares outstanding. The stock price was $78.00
a. Compute earnings per share and the P/E ratio for 2008. The P/E ratio equals the stock price divided by earnings per share.
b. Compute earnings per share and the P/E ratio for 2009.
c. Give a general explanation of why the P/E changed.
18. Assume for Mozart Music Co. discussed in Problem 17, that in 2010, earnings after taxes declined to $300,000 with the same 200,000 shares outstanding. The stock price declined to $54.00.
a. Compute earnings per share and the P/E ratio for 2010.
b. Give a general explanation of why the P/E changed. You might want to consult the textbook to explain this surprising result.
19. Identify whether each of the following items increases or decreases cash flow: Increase in accounts receivable Decrease in prepaid expenses Increase in notes payable Increase in inventory
Increase in accounts receivable Decrease in prepaid expenses
Increase in notes payable Increase in inventory
Depreciation expense Dividend payment
Increase in investments Increase in accrued expenses Decrease in accounts payable
20. Nova Electrics anticipated cash flow from operating activities of $6 million in 2008. It will need to spend $1.2 million on capital investments in order to remain competitive within the industry. Common stock dividends are projected at $.4 million and preferred stock dividends at $.55 million.
a. What is the firm's projected free cash flow for the year 2008?
b. What does the concept of free cash flow represent?
21. The Rogers Corporation has a gross profit of $880,000 and $360,000 in depreciation expense. The Evans Corporation also has $880,000 in gross profit, with $60,000 in depreciation expense. Selling and administrative expense is $120,000 for each company.
Given that the tax rate is 40 percent, compute the cash flow for both companies.
Explain the difference in cash flow between the two firms.
22. Horton Electronics has current assets of $320,000 and fixed assets of $640,000. Current liabilities are $90,000 and long-term liabilities are $160,000. There is $90,000 in preferred stock outstanding and the firm has issued 40,000 shares of common stock. Compute book value (net worth) per share.
23. The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and long- term liabilities of $100,000. There is $40,000 in preferred stock outstanding; 20,000 shares of common stock have been issued.
a. Compute book value (net worth) per share.
b. If there is $22,000 in earnings available to common stockholders and Holtzman's stock has a P/E of 18 times earnings per share, what is the current price of the stock?
c. What is the ratio of market value per share to book value per share?
24. Bradley Gypsum Company has assets of $1,900,000, current liabilities of $700,000, and long-term liabilities of $580,000. There is $170,000 in preferred stock outstanding; 30,000 shares of common stock have been issued.
a. Compute book value (net worth) per share.
b. If there is $42,000 in earnings available to common stockholders and Bradley's stock has a P/E of 15 times earnings per share, what is the current price of the stock?
c. What is the ratio of market value per share to book value per share?
25. In problem 24, if the firm sells at two times book value per share, what will the P/E ratio be?
26. For December 31, 2007, the balance sheet of the Gardner Corporation is as follows:
|
Current Assets
|
|
Liabilities
|
|
|
Cash.............................................
|
$ 15,000
|
Accounts payable ................
|
$ 20,000
|
|
Accounts receivable ....................
|
22,500
|
Notes payable......................
|
30,000
|
|
Inventory.....................................
|
37,500
|
Bonds payable .....................
|
75,000
|
|
Prepaid expenses.........................
|
18,000
|
|
|
|
Fixed Assets
|
|
Stockholders' Equity
|
|
|
Plant and equipment (gross) ?....
|
$375,000
|
Common stock ....................
|
$112,500
|
|
Less: Accumulated......................
|
|
Paid-in capital .....................
|
37,500
|
|
depreciation..............................
|
75,000
|
Retained earnings................
|
118,000
|
|
Net plant and assets.....................
|
300,000
|
Total liabilities and
|
|
|
Total assets..................................
|
$393,000
|
stockholders' equity .........
|
$393,000
|
Sales for the year 2008 were $330,000, with cost of goods sold being 60 percent of sales. Selling and administrative expense was $33,000. Depreciation expense was 10 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while interest on the bonds payable was 12 percent. These were based on December 31, 2007, balances. The tax rate averaged 20 percent.
Two thousand dollars in preferred stock dividends were paid and $4,100 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.
During the year 2008, the cash balance and prepaid expenses balance were unchanged. Accounts receivable and inventory increased by 20 percent. A new machine was purchased on December 31, 2008, at a cost of $60,000.
Accounts payable increased by 30 percent. At year-end, December 31, 2008, notes payable increased by $10,000 and bonds payable decreased by $15,000. The common stock and paid-in capital in excess of par accounts did not change.
a. Prepare an income statement for the year 2008.
b. Prepare a statement of retained earnings for the year 2008.
c. Prepare a balance sheet as of December 31, 2008.
27. Prepare a statement of cash flows for the Crosby Corporation. Follow the general procedures indicated in Table 2
CROSBY CORPORATION
Income Statement
For the Year Ended December 31, 2008
|
Sales ..........................................................................................
|
$2,200,000
|
|
Cost of goods sold.....................................................................
|
1,300,000
|
|
Gross profits........................................................................
|
900,000
|
|
Selling and administrative expense...........................................
|
420,000
|
|
Depreciation expense ................................................................
|
150,000
|
|
Operating income ................................................................
|
330,000
|
|
Interest expense.........................................................................
|
90,000
|
|
Earnings before taxes..........................................................
|
240,000
|
|
Taxes .........................................................................................
|
80,000
|
|
Earnings after taxes.............................................................
|
160,000
|
|
Preferred stock dividends............................................................ 10,000
|
|
Earnings available to common stockholders.............................
|
$ 150,000
|
|
Shares outstanding ....................................................................
|
120,000
|
|
Earnings per share .....................................................................
|
$ 1.25
|
Statement of Retained Earnings
For the Year Ended December 31, 2008
|
Retained earnings, balance, January 1, 2008 ............................
|
$500,000
|
|
Add: Earnings available to common stockholders, 2008.......
|
150,000
|
|
Deduct: Cash dividends declared and paid in 2008 ...............
|
50,000
|
|
Retained earnings, balance, December 31, 2008 ......................
|
$600,000
|
Comparative Balance Sheets
For 2007 and 2008
| |
Year-End
|
Year-End |
Assets
|
2007
|
2008 |
| Current assets: |
|
|
|
Cash.....................................................................................
|
$ 70,000
|
$100,000
|
|
Accounts receivable (net) ...................................................
|
300,000
|
350,000
|
|
Inventory...................................................................................
|
410,000
|
430,000
|
|
Prepaid expenses.......................................................................
|
50,000
|
30,000
|
|
Total current assets .............................................................
|
830,000
|
910,000
|
|
Investments (long-term securities)............................................
|
80,000
|
70,000
|
|
Plant and equipment..................................................................
|
2,000,000
|
2,400,000
|
|
Less: Accumulated depreciation.........................................
|
1,000,000
|
1,150,000
|
|
Net plant and equipment ...........................................................
|
1,000,000
|
1,250,000
|
|
Total assets................................................................................
|
$1,910,000
|
$2,230,000
|
Liabilities and Stockholders' Equity
|
Current liabilities:
|
|
|
|
Accounts payable ................................................................
|
$ 250,000
|
$ 440,000
|
|
Notes payable......................................................................
|
400,000
|
400,000
|
|
Accrued expenses................................................................
|
70,000
|
50,000
|
|
Total current liabilities .....................................................
|
720,000
|
890,000
|
|
Bonds payable, 2008...........................................................
|
70,000
|
120,000
|
|
Total liabilities .................................................................
|
790,000
|
1,010,000
|
|
Stockholders' equity:
|
|
|
|
Preferred stock, $100 par value ..........................................
|
90,000
|
90,000
|
|
Common stock, $1 par value ..............................................
|
120,000
|
120,000
|
|
Capital paid in excess of par ...............................................
|
410,000
|
410,000
|
|
Retained earnings................................................................
|
500,000
|
600,000
|
|
Total stockholders' equity................................................
|
1,120,000
|
1,220,000
|
|
Total liabilities and stockholders' equity ..................................
|
$1,910,000
|
$2,230,000
|
28. Describe the general relationship between net income and net cash flows from operating activities for the firm.
29. Has the buildup in plant and equipment been financed in a satisfactory manner? Briefly discuss.
30. Compute the book value per common share for both 2007 and 2008 for the Crosby Corporation.
31. If the market value of a share of common stock is 3.3 times book value for 2007, what is the firm's P/E ratio for 2008?
Comprehensive Problem
CP 2-1. Additional problem not included in the text:
The chief financial officer of Morton Industries was reviewing the income statement of her firm in preparation for a meeting with the president of the company.
The information is shown in Exhibit 1.
Morton Industries Income Statement
For the Years Ended December 31, 2007 & 2008
|
|
2007
|
2008
|
|
Sales
|
$877,200
|
$923,147
|
|
Cost of goods sold
|
343,720
|
344,160
|
|
Gross profits
|
533,480
|
578,987
|
|
Selling and administrative expense
|
81,000
|
93,237
|
|
Depreciation Expense
|
112,000
|
120,000
|
|
Operating income
|
340,480
|
365,750
|
|
Interest expense
|
22,330
|
10,000
|
|
Earnings before taxes
|
318,150
|
355,750
|
|
Taxes (35%)
|
111,353
|
124,512
|
|
Earnings after taxes
|
206,797
|
231,238
|
|
Preferred stock dividends
|
20,000
|
20,000
|
|
Earnings available to common stockholders
|
186,797
|
211,238
|
|
Shares outstanding
|
100,000
|
100,000
|
|
Earnings per share
|
$1.87
|
$2.11
|
a. What is the percentage increase in sales between 2007 and 2008?
b. What is the percentage increase in earnings after-tax between 2007 and 2008?
c. Assume you are asked why earnings after taxes increased percentagewise more rapidly than sales. Take each expense account (from cost of goods sold through taxes) as a percentage of sales for each year and indicate whether it was a contributor or detractor from the superior growth in earning after taxes. Remember declining percentage "costs" contribute to profit. Also large amounts such as cost of goods sold have a greater impact than smaller amounts such as depreciation or interest.
d. If cost of goods sold could be reduced to 33 percent of sales in 2007 while all else remained constant (with the exception of taxes which remain at 35 percent of earnings before taxes), what would earnings per share be in 2008?
e. Now return to the original income statements (i.e. disregard question d). What is the cash flow for each year (earnings after taxes plus depreciation)? What is the percentage change from 2007 to 2008.
f. In 2008, add depreciation to operating income to get cash flow from operating activities. Then subtract out $20,000 for preferred stock dividends and assume there are $40,000 in capital expenditures, what is free cash flow?
g. Assume Morton Industries is considering buying all its stock back with borrowed funds (a leveraged buyback). One of the lender's requirements is that 10 times free cash flow (from question f) must be at least equal to the total value of the company. The total value of the company in 2008 is equal to earnings per share times the firm's P/E ratio (which is 19) times shares outstanding.
Figure out the value of 10 times free cash flow. Then figure out the total value of the firm. Would the firm meet the lender's requirement?