Business 2019, Spring 2003

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1 Business 2019, Spring 2003 Assignment 1 Suggested Answers 1. Financial Statements and Cash Flow Answer the following questions using Table 1. Bed Rock s tax rate in 2002 was 34%. (a) (6 points) Complete Bed Rock s balance sheets and income statement. (b) (2 points) Compute Bed Rock s 2002 operating cash flow. Answer: OCF = EBIT + Depreciation Taxes = , = $1, 364. (c) (3 points) Compute Bed Rock s 2002 cash flow from asset. Answer: Net capital spending in 2002 was NFA 2002 NFA Depreciation = 13, , , 000 = $1, 000, and additions to net working capital were 5, 000 4, 000 (4, 000 3, 500) = $500. Cash flow from assets in 2002 was then CF(A) = 1, 364 1, = $136. 1

2 (d) (2 points) Compute Bed Rock s 2002 cash flow to creditors. Answer: There was no net new borrowing in 2002 and thus cash flow to creditors in 2002 was simply the interest payment of $100. (e) (2 points) Compute Bed Rock s 2002 cash flow to stockholders. Answer: CF(S) = Dividend Net new stock issue = 104 (2, 840 2, 500) = $236. (f) (5 points) From your cash flow calculations, would you say that Bed Rock is a healthy firm? Answer: Operating cash flow is positive, which is a good starting point. Cash flow from assets, on the other hand, is negative. This is not a problem when a firm is growing, but this firm s net fixed assets have remained constant in 2002, which is not a sign of growth. The funds raised from shareholders have thus been used to finance interest payments, depreciation and current assets. An increase in current assets cannot really be seen as an investment since this may be the result of an increase in inventory and/or accounts receivable, meaning that either output is not being sold or that the firm s customers are not paying their bills. 2. Individual Tax Rates Using Canada s tax rates for 2002, answer to following questions. (a) (2 points) How much taxes would an individual with an income of $40,000 pay on a $2,500 interest payment? Answer: The marginal tax rates seen in class for this income are 22% at the federal level and 9.15% at the provincial level. There being no credit for interest, taxes paid are ( ) 2, 500 = $

3 Bed Rock, Inc and 2001 Balance Sheets Assets Current assets 5,000 4,000 Net fixed assets 13,000 13,000 Total assets 18,000 17,000 Liabilities and Owners Equity Current liabilities 4,000 3,500 Long-term debt 8,000 8,000 Common stock 2,840 2,500 Accum. retained earnings 3,160 3,000 Total liabilities and equity 18,000 17,000 Bed Rock, Inc Income Statement Sales 5,000 Cost of goods sold (3,000) Depreciation (1,000) Other expenses (500) EBIT 500 Interest (100) Taxable income 400 Taxes (136) Net income 264 Dividend 104 Retained earnings 160 Table 1: Balance sheets and income statement for Question 1. (b) (2 points) How much taxes would an individual with an income of $70,000 pay on a $2,500 dividend payment? Answer: Tax rates for this income are 26% at the federal level and 11.16% at the provincial level. Tax credits, applied on 125% of the dividend, are 13.33% at the federal level and 5.13% at the provincial level. Taxes paid are then 1.25 [ ] 2, 500 = $ (c) (2 points) How much taxes would an individual with an income of $110,000 pay on a $2,500 capital gain? Answer: Marginal tax rates are t f = 29% and t p = 11.16%. This type of revenue is taxed at half the income tax rate, so taxes paid are , 500 = $502. (d) (2 points) At which level of income would an individual be indifferent between a $2,500 dividend payment and a $2,500 interest payment? Answer: None. 3

4 (e) (2 points) At which level of income would an individual be indifferent between a $2,500 dividend payment and a $2,500 capital gain? Answer: None, although taxes paid are very close for incomes in the second tax bracket. 3. Capital Cost Allowance Interblue Corporation bought new photocopiers (class 8, 20% CCA rate) for $200,000 in (a) (4 points) Suppose these new photocopiers are the only assets in class 8 for Interblue. Calculate, for years 2000 to 2005, the UCC at the beginning of the year, the CCA depreciation for the year and the UCC at the end of the year. Answer: Please see Table 2. Year UCC beg CCA UCC end , , , , , , , , , , , , , , , , , , Table 2: CCA for Problem 3, part (a). (b) (2 points) Suppose these new photocopiers are the only assets in class 8 for Interblue. What would be the tax consequences for Interblue if the photocopiers were sold for $65,000 at the end of 2005? Answer: The asset pool is terminated and thus the difference between UCC and market value, 65, , = $6, , will be taxed at the firm s income tax rate. (c) (2 points) Suppose these new photocopiers are the only assets in class 8 for Interblue. What would be the tax consequences for Interblue if the photocopiers 4

5 were sold for $35,000 at the end of 2005? Answer: This is a terminal loss of 58, , 000 = $23, which will be deducted from the firm s income before tax, thus generating some tax savings. (d) (8 points) Redo (a), (b) and (c), assuming that Interblue already had class 8 assets worth $1,000,000 in 2000 prior to the new photocopiers purchase. Assume also that no class 8 assets are either sold or purchased between 2000 and Answer: Please see Table 3. Note that the half-year rule in 2000 only applies to the material purchased that year, i.e. the new photocopiers. CCA depreciation in 2000 is then 1, 000, % + 200, % = $220, 000. The asset pool is not terminated when the photocopiers are sold and thus there are no immediate tax consequences. In this case, UCC in asset class 8 is reduced by the amount of the sale proceeds. Year UCC beg CCA UCC end ,200, , , , , , , , , , , , , , , , , , Table 3: CCA for Problem 3, part (d). 4. Statement of Changes in Financial Position (10 points) Using the information in Table 4, produce a statement of changes in financial position for Instruments du Rhône, Inc.. Answer: Please see Table 5. 5

6 Instrument du Rhône, Inc and 2001 Balance Sheets Assets Cash Accounts receivable Inventory Other Total current assets Net fixed assets 1,118 1,035 Total assets 1,879 1,742 Liabilities and Owners Equity Accounts payable Notes payable Accrued expenses Total current liabilities Deferred taxes Long-term debt Total long-term liabilities Common stock Accum. retained earnings Total equity Total liabilities and equity 1,879 1,742 Instrument du Rhône, Inc Income Statement Sales 2,291 Cost of goods sold (1,655) Selling, gen. and admin. (327) Depreciation (90) EBIT 219 Interest expense (49) Taxable income 170 Taxes (84) Current: 71 Deferred 13 Net income 86 Dividend 43 Retained earnings 43 Table 4: Balance sheets and income statement for Question Ratio Analysis Using the 2002 audited financial statements for Sleeman Breweries Ltd, answer the following questions. (a) (5 points) Analyze Sleeman s performance with respect to the three profitability ratios seen in class. How does Sleeman compare with Unibroue? Answer: All ratios are in Table 6. Sleeman s profitability ratios are significantly higher than those of Unibroue. These ratios have increased for the two firms in 2002, but the increase in those of Unibroue was much greater than those of Sleeman. Hence, Unibroue seems to be on the rise and thus may look like an 6

7 attractive investment even though it has lower profitability ratios than its competitor Sleeman. (b) (5 points) Analyze Sleeman s capital structure using some short-term and longterm solvency ratios. How does Sleeman compare with Unibroue? Answer: We can see from these ratios that Sleeman uses debt more intensively than Unibroue, and thus one might think that Unibroue s management is too conservative. Assuming that Sleeman s capital structure is optimal for this type of firm, Unibroue s low usage of debt may explain its low return on equity. Note also that the two firms have reduced their use of debt in (c) (4 points) Analyze Sleeman s stock price using the two market value ratios seen in class. How does Sleeman compare with Unibroue? Answer: Unibroue s market-to-book ratios are a little low compared with those of Sleeman. Given the turnover ratios discussed below, we cannot say that Unibroue s management uses its assets inefficiently, and thus we could conclude that the stock price is low because this company has not yet been discovered, creating some liquidity problems in trading the stock. (d) (4 points) Use some asset turnover ratios to analyze the efficiency of Sleeman s management and compare your numbers with those of Unibroue. Answer: No significant difference between the two firms, except for Unibroue s 17.9% increase in days sales in inventory in (e) (2 points) Which company is better? Sleeman or Unibroue? Answer: Any well-justified answered was accepted here. 6. Financial Planning The most recent financial statements for Brick Enterprises are shown in Table 7. Sales for 2003 are projected to grow at a 15 percent rate. The tax rate and the dividend payout rate will remain constant. Costs, current assets and accounts payable increase in proportions with sales. (a) (2 points) If the firm operates at full capacity and no new debt or equity is issued, 7

8 what is the external financing needed to support the projected growth rate? Answer: In this case, net fixed assets have to increase in proportions with sales, and thus all assets increase by 15%, as can be seen in Table 9. Since all items in the income statement increase in the same proportions as sales, projected retained earnings are = $101.20, as can be seen in Table 8. Accounts payable being a constant fraction of sales, they also increase by 15%, which means an increase of $45, as can be seen in Table 9. External financing needed (EFN) is then EFN = 0.15 Total assets Retained earnings 0.15 Accounts payable = , = $ (b) (4 points) Suppose now that the firm operates at 75 percent of capacity in What is EFN now? Answer: Brick operating at 75% of capacity means that the level of sales that is attainable with the actual fixed assets is 1, = $1, , and thus net fixed asset don t have to increase in this case. The increase in total assets is then , 200 = $180, and thus EFN = = $ The partial pro forma balance sheet for this case is depicted in Table 10. (c) (4 points) Assume the firm operates at full capacity in If it wishes to keep a current ratio of at least 3 and a total debt ratio of at most 0.4, what is a possible financing plan? 8

9 Answer: Let the projected current ratio be 3. Then projected current liabilities are Proj. current assets 3 = 1, = 460, which means that notes payable can go up to = 115. That is, Brick Enterprises can raise $15 through notes payable. Suppose now that the projected debt ratio is exactly 0.4. Then projected longterm debt is 0.4 Proj. total assets Proj. current liabilities = 0.4 3, = 920. That is, Brick can raise an extra $120 through long-term borrowing. EFN is $303.80, and thus the remaining = $ has to be raised by issuing equity (that is, common stock will increase by $168.80). The pro forma balance sheet is depicted in table 11. Note: Table 12 shows Brick s pro forma balance sheet under the above constraints when the firm initially operates at 75% of its capacity. Try this one out. (d) (2 points) Find Brick s internal growth rate. Answer: Brick s internal growth rate is g i = rps A rps A/P = 88 3, = 3.37%, where rps is Brick s level of retained earnings, A is total assets and A/P is Brick s value for accounts payable. (e) (2 points) Find Brick s sustainable growth rate. Answer: Brick s sustainable growth rate is g s = 2 r ROE 1 r ROE = , ,800 = 5.14%, where r is Brick s retention ratio and ROE is its return on equity. 9

10 Instrument du Rhône, Inc Statement of Changes in Financial Position Operating activities Net income 86 Add Depreciation 90 Deferred taxes 13 Increase in accounts payable 16 Increase in accrued expenses 18 Decrease in inventory 11 Deduct Decrease in accounts receivable (24) Decrease in other (8) Net cash from operations 202 Investing activities Net capital spending (173) Net cash from investing activities (173) Financing activities Decrease in notes payable (3) Increase in long-term debt 13 Dividends paid (43) Increase in common stock 37 Net cash from financing activities 4 Net change in cash 33 Table 5: Answer to Question 4. 10

11 Ratio Sleeman Unibroue Profitability ratios Profit margin 7.85% 6.90% 4.07% 2.82% Return on assets 5.60% 4.94% 2.83% 1.84% Return on equity 13.66% 13.36% 4.34% 2.81% Long-term solvency ratios Total debt ratio Debt/equity ratio Long-term ratio Times interest earned Cash coverage Liquidity ratios Current ratio Acid-test ratio Cash ratio Market value ratios P/E ratio Market-to-book ratio Asset management ratios Days sales in inventory Days sales in receivables Fixed assets turnover Total asset turnover Table 6: Ratios for Sleeman and Unibroue. 11

12 Assets Brick Enterprises Balance Sheet as of December 31, 2002 Liabilities and Owners Equity Cash 160 Accounts payable 300 Accounts receivable 440 Notes payable 100 Inventory 600 Total current liabilities 400 Total current assets 1,200 Long-term debt 800 Net fixed assets 1,800 Common stock 800 Accum. retained earnings 1,000 Total assets 3,000 Total liabilities and equity 3,000 Brick Enterprises 2002 Income Statement Sales 1,000 Costs (800) Taxable income 200 Taxes (34%) (68) Net income 132 Dividends 44 Earnings retained 88 Table 7: Financial statements for Question 6. Brick Enterprises Pro Forma Income Statement Sales 1,150.0 Costs (920.0) Taxable income Taxes (34%) (78.2) Net income Dividends 50.6 Earnings retained Table 8: Pro forma income statement for Brick. 12

13 Assets Brick Enterprises Partial Pro Forma Balance Sheet (Full Capacity) Liabilities and Owners Equity 2002 Proj Proj. Cash Accounts payable Accounts receivable Notes payable 100? Inventory Total current liabilities 400 Total current assets 1,200 1,380 Long-term debt 800? Net fixed assets 1,800 2,070 Common stock 800? Accum. retained earnings 1,000 1,101.2 Total assets 3,000 3,450 Total liabilities and equity 3,000 3,450.0 Table 9: Partial Pro forma balance sheet for Question 6(a). Assets Brick Enterprises Partial Pro Forma Balance Sheet (75% Capacity) Liabilities and Owners Equity 2002 Proj Proj. Cash Accounts payable Accounts receivable Notes payable 100? Inventory Total current liabilities 400 Total current assets 1,200 1,380 Long-term debt 800? Net fixed assets 1,800 1,800 Common stock 800? Accum. retained earnings 1,000 1,101.2 Total assets 3,000 3,180 Total liabilities and equity 3,000 3,180.0 Table 10: Partial Pro forma balance sheet for Question 6(b). 13

14 Assets Brick Enterprises Partial Pro Forma Balance Sheet (Full Capacity) Liabilities and Owners Equity 2002 Proj Proj. Cash Accounts payable Accounts receivable Notes payable Inventory Total current liabilities Total current assets 1,200 1,380 Long-term debt Net fixed assets 1,800 2,070 Common stock Accum. retained earnings 1,000 1,101.2 Total assets 3,000 3,450 Total liabilities and equity 3,000 3,450.0 Table 11: Pro forma balance sheet for Question 6(c). Assets Brick Enterprises Pro Forma Balance Sheet (75% Capacity) Liabilities and Owners Equity 2002 Proj Proj. Cash Accounts payable Accounts receivable Notes payable Inventory Total current liabilities Total current assets 1,200 1,380 Long-term debt Net fixed assets 1,800 1,800 Common stock Accum. retained earnings 1,000 1,101.2 Total assets 3,000 3,180 Total liabilities and equity 3,000 3,180.0 Table 12: Pro forma balance sheet for Brick at 75% capacity. 14

Business 2019, Spring 2003

Business 2019, Spring 2003 Assignment 1 Due Monday, May 12, 2003, 5:00pm (beginning of class) Can be done in groups of at most FOUR 1. Financial Statements and Cash Flow Answer the following questions