3-20 FINANCIAL STATEMENTS AND TAXES Donna Jamison, a 2014 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 2018 to undertake a major expansion and to "go national" competition with Frilo-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.) a. What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income? b. What effect did the company's expansion have on its free cash flow? 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 2019 balance sheet, do you think that D'Leon pays suppliers on time? Provide an explanation and include a discussion about what problems might occur if suppliers are not paid in a timely manner. 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 cash inflows. Does it appear that D'Leon's sales price exceeds its costs per unit sold? How does this affect the cash balance? 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? t. 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. 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 sales volume causes the cash balance to decline? Explain. retained earnings plus depreciation) or with external capital? How does the choice of financing affect the company's financial 9. Did D'Leon finance its expansion program with internally generated funds (additions strength? h. Refer to Tables IC 3.2 and IC 3.4. Suppose D'Leon broke even 2019 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. i. The new tax law calls for immediate expensing of certain qualified business assets rather than depreciating them over a longer time period. How will that affect (1) a company's physical stock of assets, (2) a firm's balance sheet account for fixed assets, (3) a company's reported net income, and (4) a company's cash position? In your responses, 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. 1. 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? 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 carryforwards. How might each of these items affect D'Leon's taxes? Balance Sheets 2019 2018 $ 57,600 351,200 715,200 $1,124,000 344,800 $1,468,800 939,790 Assets Cash- $ 7,282 Accounts receivable 632,160 Inventories 1,287,360 Total current assets $1,926,802 Net fixed assets Total assets $2,866,592 Liabilities and Equity Accounts payable $ 524,160 Accruals 489,600 Notes payable 636,808 Total current liabilities $1,650,568 Long-term debt 723.432 Common stock (100,000 shares) 460,000 Retained earnings 32,592 Total equity $ 492,592 Total liabilities and equity $2.866,592 "Assume that all cash is excess cash; ie, this cash is not needed for operating purposes. . $ 145,600 136,000 200,000 $ $ 481,600 323,432 460,000 203,768 $ 663,768 $ $1,468,800 $ Table IC 3.2. Income Statements 2019 2018 Sales $6,126,796 $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 $ 38,152) $ 190,428 Interest expense 122,024 43,828 EBT ($ 160,176) $ 146,600 Taxes (2596) 0$ 36,650 Net income ($ 160,176) $ $ 109,950 EPS $ 1.602) $ 1.100 DPS $ s 0.110 $ 0.275 Book value per share $ 4.926 $ 6.638 Stock price $ 2.25 $ 8.50 Shares outstanding 100,000 100,000 Tax rate 25.00% 25.00% Lease payments $ 40,000 $ 40,000 Sinking fund payments 0 0 0 D'Leon Inc's annual gross receipts have been less than $25 million for the past three years, so it's exempt from the interest expense *$ Statement of Stockholders' Equity, 2019 Common Stock Amount Shares 100,000 Total Stockholders Equity $ 663,768 $460,000 Retained Earnings $ 203,768 (160,176) (11,000 Balances, December 31, 2018 2019 Net income Cash dividends Addition (subtraction) to retained earnings Balances, December 31, 2019 100,000 (171,176) $ 492,592 $460,000 $ 32,592 Table IC 3.4. Statement of Cash Flows, 2019 ($ 160,176) 116,960 378,560 353,600 (280,960) (572,160) $ ($ 164,176) Operating Activities Net income Depreciation and amortization Increase in accounts payable Increase in accruals Increase in accounts receivable Increase in inventories Net cash provided by operating activities Investing Activities Additions to property, plant, and equipment Net cash used in investing activities Financing Activities Increase in notes payable Increase in long-term debt Payment of cash dividends Net cash provided by financing activities Summary Net decrease in cash Cash at beginning of year Cash at end of year ($ 711,950) ($ 711,950) $ 436,808 $ 400,000 (11,000) $ 825,808 ($ 50,318) 57,600 $ 7.282 EXHIBITS: INPUT DATA (for D'Leon) Table IC3.1 Balance Sheets 2019 2018 $ Assets Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets 7,282 $ 57,600 632,160 351,200 1,287,360 715,200 1,926,802 $1,124,000 939,790 $ 344,800 4,793,394 $2,592,800 $ $ $ $ $ Liabilities and equity Accounts payable Accruals Notes payable Total current liabilities Long-term debt Total liabilities Common stock (100,000 shares) Retained earnings Total common equity Total liabilities and equity 524,160 $ 145,600 489,600 136,000 636,808 200,000 1,013,760 $ 281,600 723,432 323,432 3,387,760 $1,086,632 460,000 460,000 32,592 203,768 $ a Assume that all cash is excess cash; i.e., this cash is not needed for operating purposes. Table IC3.2 Income Statements 2019 2018 $ 6,126,796 $3,432,000 5,528,000 2,864,000 519,988 358,672 Sales Cost of goods sold Other expenses Total operating exp. excl. depreciation and amortization Depreciation and amortization Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Taxes (25%) Net income 116,960 18,900 122,024 43,828 $0.110 $0.275 $ EPS DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments 2.25 $ 100,000 25.00% 40,000 $ 0 8.50 100,000 25.00% 40,000 0 $ Table IC3.3 Statement of Stockholders' Equity, 2019 Common Stock Total Retained Earnings Stockholders' Equity Amount Shares 100,000 Balances, Dec. 31, 2018 Add: Net Income, 2019 Less: Dividends to common stockholders Addition (Subtraction) to Retained Earnings Balances, Dec. 31, 2019 Table IC3.4 Statement of Cash Flows, 2019 Operating Activities Net Income Depreciation and amortization Increase in accounts payable Increase in accruals Increase in accounts receivable Increase in inventories Net cash provided by operating activities Investing Activities Additions to property, plant, and equipment Net cash used in investing activities Financing Activities Increase in notes payable Increase in long-term debt Payment of cash dividends Net cash provided by financing activities Summary Net decrease in cash Cash at beginning of the year Cash at end of the year PART A What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income? EBIT x (1 - T) AT operating income 19 = AT operating income 19 - AT operating income 19 = X EBIT (1 - T) AT operating income 18 = AT operating income 18 = AT operating income 18 = x x X (Current assets - Excess cash) (Current liabilities - Notes payable) NOWC19 = NOWC19 = NOWC19 = NOWC18 = NOWC18 = NOWC19 NOWC18 Change in NOWC Change in NOWC Change in NOWC = = = NI 19 N118 Change in NI Change in NI Change in NI E PART B What effect did the company's expansion have on its free cash flow? EBIT X (1 - T) + Depreciation [Capital Expenditures + ANOWC] X + FCF 19 = FCF 19 = FCF 19 = FCF 19 = + Calculate the firm's MVA using 2018 and 2019 data. (Po Shares O/S) Book Value of Equity 2018 MVA19 = MVA19 = MVA19 = MVA18 = MVA18 = 3-20 FINANCIAL STATEMENTS AND TAXES Donna Jamison, a 2014 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 2018 to undertake a major expansion and to "go national" competition with Frilo-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.) a. What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income? b. What effect did the company's expansion have on its free cash flow? 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 2019 balance sheet, do you think that D'Leon pays suppliers on time? Provide an explanation and include a discussion about what problems might occur if suppliers are not paid in a timely manner. 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 cash inflows. Does it appear that D'Leon's sales price exceeds its costs per unit sold? How does this affect the cash balance? 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? t. 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. 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 sales volume causes the cash balance to decline? Explain. retained earnings plus depreciation) or with external capital? How does the choice of financing affect the company's financial 9. Did D'Leon finance its expansion program with internally generated funds (additions strength? h. Refer to Tables IC 3.2 and IC 3.4. Suppose D'Leon broke even 2019 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. i. The new tax law calls for immediate expensing of certain qualified business assets rather than depreciating them over a longer time period. How will that affect (1) a company's physical stock of assets, (2) a firm's balance sheet account for fixed assets, (3) a company's reported net income, and (4) a company's cash position? In your responses, 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. 1. 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? 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 carryforwards. How might each of these items affect D'Leon's taxes? Balance Sheets 2019 2018 $ 57,600 351,200 715,200 $1,124,000 344,800 $1,468,800 939,790 Assets Cash- $ 7,282 Accounts receivable 632,160 Inventories 1,287,360 Total current assets $1,926,802 Net fixed assets Total assets $2,866,592 Liabilities and Equity Accounts payable $ 524,160 Accruals 489,600 Notes payable 636,808 Total current liabilities $1,650,568 Long-term debt 723.432 Common stock (100,000 shares) 460,000 Retained earnings 32,592 Total equity $ 492,592 Total liabilities and equity $2.866,592 "Assume that all cash is excess cash; ie, this cash is not needed for operating purposes. . $ 145,600 136,000 200,000 $ $ 481,600 323,432 460,000 203,768 $ 663,768 $ $1,468,800 $ Table IC 3.2. Income Statements 2019 2018 Sales $6,126,796 $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 $ 38,152) $ 190,428 Interest expense 122,024 43,828 EBT ($ 160,176) $ 146,600 Taxes (2596) 0$ 36,650 Net income ($ 160,176) $ $ 109,950 EPS $ 1.602) $ 1.100 DPS $ s 0.110 $ 0.275 Book value per share $ 4.926 $ 6.638 Stock price $ 2.25 $ 8.50 Shares outstanding 100,000 100,000 Tax rate 25.00% 25.00% Lease payments $ 40,000 $ 40,000 Sinking fund payments 0 0 0 D'Leon Inc's annual gross receipts have been less than $25 million for the past three years, so it's exempt from the interest expense *$ Statement of Stockholders' Equity, 2019 Common Stock Amount Shares 100,000 Total Stockholders Equity $ 663,768 $460,000 Retained Earnings $ 203,768 (160,176) (11,000 Balances, December 31, 2018 2019 Net income Cash dividends Addition (subtraction) to retained earnings Balances, December 31, 2019 100,000 (171,176) $ 492,592 $460,000 $ 32,592 Table IC 3.4. Statement of Cash Flows, 2019 ($ 160,176) 116,960 378,560 353,600 (280,960) (572,160) $ ($ 164,176) Operating Activities Net income Depreciation and amortization Increase in accounts payable Increase in accruals Increase in accounts receivable Increase in inventories Net cash provided by operating activities Investing Activities Additions to property, plant, and equipment Net cash used in investing activities Financing Activities Increase in notes payable Increase in long-term debt Payment of cash dividends Net cash provided by financing activities Summary Net decrease in cash Cash at beginning of year Cash at end of year ($ 711,950) ($ 711,950) $ 436,808 $ 400,000 (11,000) $ 825,808 ($ 50,318) 57,600 $ 7.282 EXHIBITS: INPUT DATA (for D'Leon) Table IC3.1 Balance Sheets 2019 2018 $ Assets Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets 7,282 $ 57,600 632,160 351,200 1,287,360 715,200 1,926,802 $1,124,000 939,790 $ 344,800 4,793,394 $2,592,800 $ $ $ $ $ Liabilities and equity Accounts payable Accruals Notes payable Total current liabilities Long-term debt Total liabilities Common stock (100,000 shares) Retained earnings Total common equity Total liabilities and equity 524,160 $ 145,600 489,600 136,000 636,808 200,000 1,013,760 $ 281,600 723,432 323,432 3,387,760 $1,086,632 460,000 460,000 32,592 203,768 $ a Assume that all cash is excess cash; i.e., this cash is not needed for operating purposes. Table IC3.2 Income Statements 2019 2018 $ 6,126,796 $3,432,000 5,528,000 2,864,000 519,988 358,672 Sales Cost of goods sold Other expenses Total operating exp. excl. depreciation and amortization Depreciation and amortization Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Taxes (25%) Net income 116,960 18,900 122,024 43,828 $0.110 $0.275 $ EPS DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments 2.25 $ 100,000 25.00% 40,000 $ 0 8.50 100,000 25.00% 40,000 0 $ Table IC3.3 Statement of Stockholders' Equity, 2019 Common Stock Total Retained Earnings Stockholders' Equity Amount Shares 100,000 Balances, Dec. 31, 2018 Add: Net Income, 2019 Less: Dividends to common stockholders Addition (Subtraction) to Retained Earnings Balances, Dec. 31, 2019 Table IC3.4 Statement of Cash Flows, 2019 Operating Activities Net Income Depreciation and amortization Increase in accounts payable Increase in accruals Increase in accounts receivable Increase in inventories Net cash provided by operating activities Investing Activities Additions to property, plant, and equipment Net cash used in investing activities Financing Activities Increase in notes payable Increase in long-term debt Payment of cash dividends Net cash provided by financing activities Summary Net decrease in cash Cash at beginning of the year Cash at end of the year PART A What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), and net income? EBIT x (1 - T) AT operating income 19 = AT operating income 19 - AT operating income 19 = X EBIT (1 - T) AT operating income 18 = AT operating income 18 = AT operating income 18 = x x X (Current assets - Excess cash) (Current liabilities - Notes payable) NOWC19 = NOWC19 = NOWC19 = NOWC18 = NOWC18 = NOWC19 NOWC18 Change in NOWC Change in NOWC Change in NOWC = = = NI 19 N118 Change in NI Change in NI Change in NI E PART B What effect did the company's expansion have on its free cash flow? EBIT X (1 - T) + Depreciation [Capital Expenditures + ANOWC] X + FCF 19 = FCF 19 = FCF 19 = FCF 19 = + Calculate the firm's MVA using 2018 and 2019 data. (Po Shares O/S) Book Value of Equity 2018 MVA19 = MVA19 = MVA19 = MVA18 = MVA18 =