land, buildings, machinery (last more than 1 year) bill due at feed store or with farm supplier (due within 1 year)

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Julianna Mitchell
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1 AAE 320 Spring 2009 Exam #2 Name: KEY 1) (15 pts. total) Below is a simplified farm Balance Sheet. a) (5 pts.) Use the information given and your knowledge of the relationships among Balance Sheet entries to fill in the five missing cells and then answer the questions below. BALANCE SHEET 12/31/ /31/ /31/ /31/2007 Current Assets 250, ,000 Current Liabilities 170, ,000 Non-Current Assets 455, ,000Non-Current Liabilities 305, ,000 Total Liabilities 475, ,000 Equity 230, ,000 Total Assets 705, ,000Total Liabilities & Equity 705, ,000 b) (4 pts.) This Balance Sheet only lists values for generic categories of assets and liabilities. Give one specific farm/agricultural example for each type below: Current Asset: corn in the grain bin, hogs in pen (quickly sellable in active market Non-Current Asset: Current Liability: Non-Current Liability: land, buildings, machinery (last more than 1 year) bill due at feed store or with farm supplier (due within 1 year) payment on land mortgage (money owed more than 1 year) c) (3 pts.) Based on this Balance Sheet, what is the Current Ratio on 12/31/2008? CR = Current assets/current liabilities = 250,000 / 170,000 = 1.47 d) (3 pts.) Based on this Balance Sheet, what is the Debt to Asset Ratio on 12/31/2008? D:A = total liabilities / total assets = 475,000 / 705,000 = ) (10 pts. total) Briefly and concisely answer each question below. a) (3 pts.) What would be the problem (if any) if a farm had a current ratio of 8.7? What would be the problem (if any) if a farm had a current ratio of 0.87? 8.7 too high, holding too much cash/liquidity; such assets usually have lower rates of return too low, means will have cash flow problems, especially if hit with an emergency cost b) (3 pts.) You are an egg farmer who sells eggs daily to a large stable company and regularly buy feed for the laying hens (you have little on farm storage). You generally have a current ratio around Explain why this is or is not a problem. May be okay, since have daily cash flow from a stable source, so if hit with cash emergency, can come up with the cash to cover costs. Still, may be a little low.

2 c) (4 pts.) Suppose a farm s debt to asset ratio increased in each of the last 3 years, but the farm s income statement showed that the farm business had high net farm incomes. Give an explanation of how this could happen and why it is or is not a problem. The most likely I thought of was that they could be expanding the farm by buying more land or building more buildings, buying machinery, as the farm seems to be doing well. However, there are other explanations. They may be removing equity for some reason (e.g., sending child to school, paying large health bills due to emergency, large legal bill/lawsuit to pay, etc.). Also, they farm assets (land) could be going down in value. Also, (though it has not been seen for a while), the interest rate on the farm loans could be very high in the 1980s, rates hit well above 15% for some farms. Finally, maybe the income statement does not include the cost of unpaid labor and management by the farmer, and so misrepresents the farm income. Once it was subtracted, the farm income may be negative and so the farms increasing debt to asset ratio makes sense. There are likely other possibilities as well. 3) (18 pts. total) Below is a simplified farm Income Statement. a) (3 pts.) Use the given information and your knowledge of the relationships among Income Statement entries to fill in the three missing cells. INCOME STATEMENT 12/31/2007 to 12/31/2008 Crop Sales 150,000 Livestock/Dairy Sales 160,000 Total Revenue 310,000 Operating Costs 165,000 Interest Expenses 40,000 Total Costs 205,000 Net Farm Income from Operations 105,000 Unpaid Labor and Management 60,000 Net Farm Income 45,000 Use the Income Statement above and the Balance Sheet in Question 1 to answer the questions below. Show how you calculate your answers for potential partial credit. b) (6 pts.) What is this farm s Return on Assets? What is this farm s Rate of Return on Assets? ROA = Revenue Operating Costs Unpaid Labor/Management ROA = 310, ,000 60,000 = 85,000 ROA = NFI + Interest = 45, ,000 = 85,000 ROROA = ROA/Avg Assets = 85,000/[½(705, ,000)] = 85,000/665,000 = 12.8%

3 c) (6 pts.) What is this farm s Return on Equity? What is this farm s Rate of Return on Equity? ROE = Revenue Operating Costs Unpaid Labor/Management Interest ROE = 310, ,000 60,000 40,000 = 45,000 ROE = ROA Interest = 85,000 40,000 45,000; ROE = NFI = 45,000 ROROE = ROE/Avg Equity = 85,000/[½(230, ,000)] = 45,000/217,500 = 20.7% d) (3 pts.) What is this farm s Operating Profit Margin Ratio (i.e. Profit Margin)? PM = ROA/Revenue = 85,000/310,000 = 27.4% 4) (10 pts. total) You buy a truck for $20,000 with a useful life of 4 years and no salvage value. a) (3 pts.) Fill in this table using Straight Line Depreciation. Show your work. Year Depreciation During Year Value at Year End 1 $5,000 $15,000 2 $5,000 $10,000 3 $5,000 $5,000 4 $5,000 $0 SL Depreciation per year = purchase price/useful life = $20,000/4 = $5,000 b) (4 pts.) Fill in this table using Double Declining Balance Depreciation. Show your work. Year Depreciation During Year Value at Year End 1 20,000 x 50% = 10,000 20,000 10,000 = 10, ,000 x 50% = 5,000 10,000 5,000 = 5, ,000 x 50% = 2,500 5,000 2,500 = 2,500 2,500 x 50% = 1,250 2,500 1,250 = 1,250 Must equal salvage value, Must equal salvage value 4 so take all = 2,500: 2,500 2,500 = 0 Depreciation Rate = 200% x 1/useful life = 200% x ¼ = 50% Must adjust depreciation in last year so that asset value equals salvage value in last year, so take all remaining value in last year. c) (3 pts.) Calculate depreciation for this truck to claim for income tax purposes for year 2 and year 8, using a 7-year recovery period and the half-year convention based on the following table: Depreciation Each year, multiply initial purchase price by the percentage from table Year Rate % % 20,000 x 19.13% = $3, % % % % % % 20,000 x 6.13% = $1,226

4 5) (20 pts. total) Provide short answers to each of the following questions. Mom and Dad own a farm, with all assets owned as marital property under Wisconsin s marital property law. Among their assets is stored corn currently worth $250,000 with a zero income tax basis because they raised the corn and deducted all the costs of raising it. Use this information to answer each question below. Give a brief explanation for each answer. a) (3 pts.) If Mom and Dad gave the corn to Son and he sold it the next day, how much income would Son have to report as a result of the sale? Son must report $250,000 of income. He has a carryover basis of zero in the corn so the entire sales price is income to him. (Although not required for the answer, it is is ordinary income subject to self-employment tax.) b) (3 pts.) If Mom died and Dad gave the corn to Son, how much income would Son have to report if he sold it the next day for the same value? Son would have no income to report. Upon Mom s death, Dad s basis is adjusted to the $250,000 date of death value. That basis is carried over to Son so that there is no gain when son sells for $250,000. c) (3 pts.) If Mom and Dad contributed the corn to an LLC taxed as a partnership in exchange for an ownership interest in the LLC and the LLC sold the corn the next day, how much income would the LLC realize? The LLC would realize $250,000 of income. It has a zero transferred basis from Mom and Dad so the entire sales price is income to it. i) (2 pts.) If the LLC has income from the sale, does it pay income tax on that income? No, the LLC does not pay tax on its income. The income is taxed on the member s individual returns in proportion to their ownership interests in the LLC. ii) (2 pts.) If instead the LLC returned the corn back to Mom and Dad before the corn was sold, would the LLC and/or Mom and Dad have to pay income tax as a result of this transfer? No. If the corn is distributed to the members who contributed it, no gain or loss is recognized. The zero basis would transfer back to Mom and Dad so that they must recognize the $250,000 of income if and when they sell the corn. d) (3 pts.) If Mom and Dad contributed the corn to an S-Corporation in exchange for shares in the S-Corporation and the S-Corporation sold the corn the next day, how much income would the S-Corporation realize? The S-Corporation would realize $250,000 of income. It has a zero transferred basis from Mom and Dad so the entire sales price is income to it.

5 i) (2 pts.) If the S-Corporation has income from the sale does it pay income tax on that income? No, the S-Corporation does not pay tax on its income. The income is taxed on the shreholder s individual returns in proportion to their ownership of the S-Corporation stock. ii) (2 pts.) If instead the S-Corporation returned the corn back to Mom and Dad before the corn was sold, would the S-Corporation and/or Mom and Dad have to pay income tax as a result of this transfer? Yes, the transfer would cause the S-Corporation to recognize $250,000 of gain. The S- Corporation does not pay tax on that gain. The gain passes through to the shareholders and they report their share of the gain on their individual returns in proportion to their ownership of the S-Corporation stock. 6) (3 pts.) This problem continues the ongoing saga of Mom, Dad, and Son. Mom and Dad own all assets as marital property under Wisconsin s marital property law. Mom and Dad bought land years ago for $100,000. Mom dies and the next day Dad sells the land to Son at its fair market value of $600,000. How much taxable gain does Dad realize from this land sale? Dad does not recognize any taxable gain. Upon Mom s death, the income tax basis in the land is adjusted to the $600,000 date of death value so there is no gain when Dad sells for $600,000. 7) (3 pts.) Which of the business entities discussed in class provide some limited liability to the owners of the entity? C Corporations, S Corporations and LLCs provide some limited liability for all owners. Limited partnerships provide some limited liability for limited partners. 8 a) (3 pts.) Your sister wants to invest $9,000 in your farm, with you paying 4% interest compounded annually. How much will you owe in 4 years if you return her $9,000 plus interest? FV = PV(1 + r) t = 9000(1.04) 4 = 10, b) (3 pts.) How much money must be invested today earning a 10% interest rate compounded annually to have $50,000 in 5 years? PV = FV x [(1/1 + r) t ] = 50,000/(1.1 5 ) = 31, c) (3 pts.) Shares in a wind farm sell for $1,000 today and will be worth $2,000 in 5 years. What is the rate of return expressed as an annually compounded interest rate? r = (FV/PV) (1/t) 1 = (2000/1000) (1/5) 1 = = 14.87%

6 9 a) (9 pts.) What is the net present value (NPV) for a berry patch that costs $3,000 to plant in year 1, then generates a net return of $2,500 in years 2 and 3 and $2,000 in year 4, assuming a 10% discount rate? As part of your calculations, fill in the Present Value column in the table below. Show your work for potential partial credit. Year Net Return Present Value 1 3,000 2, ,500 2, ,500 1, ,000 1, NPV 2, NPV = 2, , , , = 2, For each year, the PV = FV x [(1/1 + r) t ], so Year 1: 3,000/(1.1 1 )= 2, Year 2: 2,500/(1.1 2 )= 2, Year 3: 2,500/(1.1 3 )= 1, Year 4: 2,000/(1.1 4 )= 1, NPV = sum of all the PV s. 9 b) (3 pts.) What is the annuity equivalent to the time varying returns from the berry patch? 1 1 The annuity factor formula is K = 1 t r (1+ r), so that the annuity is C = NPV/K K = 1-1- r = t 4 (1 + r ) 0.1 ( ) = C = NPV/K = 2,583.16/ = $814.91

c) (3 pts.) Based on this Balance Sheet, what is the Current Ratio on 1/1/2010?

c) (3 pts.) Based on this Balance Sheet, what is the Current Ratio on 1/1/2010? AAE 320 Spring 2010 Exam #2 Name: 1) (16 pts. total) a) (5 pts.) Use the information given and your knowledge of the relationships among Balance Sheet entries to fill in the five missing cells and then