National Software, Inc.

Six years ago, after 14 years in public accounting, Sylvia Banks, CPA, resigned her position as managers of cost systems for Coastal Bend CPA and started National Software, Inc. In the 2 years preceding her departure from Coastal Bend CPA, Sylvia had spent nights and weekends developing a sophisticated cost-accounting software program that became National Softwares initial product offering. As the firm grew, Sylvia planned to develop and expand the software product offeringsall of which would be related to streamlining the accounting processes of medium and large-sized manufacturers.

Although National experienced loses during its first two years of operation--2010 and 2011its profit has increased steading from 2012 to the present (2016). The firms history, including dividend payments and contributions to retained earnings, is summarized in Exhibit 1.

Sylvia started the firm with a $1000,000 investmenther savings of $50,000 as equity and a $50,000 long-term loan from the bank. She had hoped to maintain her initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2010), she sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although she owns 40% of the firm, Sylvia actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The stocks value was estimated to be $4.50 per share in 2014 and at $5.28 in 2015.

Sylvia has just prepared the firms 2016 income statement, balance sheet, and statement of retained earnings, shown in Tables 2,3, and 4, along with the 2015 balance sheet. In addition, he has compiled the 2015 ratio values and industry for 2016, which are summarized in table 5. She is quite pleased to have achieved record earnings of $48,000 in 2016, but she is concerned about the firms cash flows. Specifically, she is finding it more difficult to pay the firms bills in a timely manner and generate cash flows to investorsboth creditors and owners. To gain insight into these cash flow problems, Sylvia is planning to determine the firms 2016 operating cash flows and free cash flows.

Sylvia is further frustrated by the firms inability to afford to hire a software developer to complete development of a cost estimation package that is believed have blockbuster sales potential. Sylvia began development of this package two years ago, but the firms growing complexity has forced her to devote more of her time to administrative duties, thereby halting the development of this product. Sylvias reluctance to fill this position stems from her concern that the added $90,000 per year in salary and benefits for the position would certainly lower the firms earnings per share (EPS) over the next couple of years. Although the projects success is in no way guaranteed, Sylvia believes that if the money were spent to hire the software developer, the firms sales and earnings would significantly rise once the 2- to3-year development, production, and marketing process were completed.

Jimmy Perez has recently approached Sylvia with an offer to buy National Software for $200,000. Through discussion with Mr. Perez, Sylvia found out that he uses a ten percent discount rate on projects with this level of risk. By comparison, Sylvia uses a nine percent required rate of return on new projects.

TABLE 1
National Software Profit, Dividends, and Retained Earnings, 2010-2016
Year	Net Profit after taxes [1]	Dividends Paid [2]	Contributions to Retained Earnings [{1] [2]}
2010	-50,000	$0	-50,000
2011	-20,000	0	-20,000
2012	15,000	0	15,000
2013	35,000	0	35,000
2014	40,000	1,000	39,000
2015	43,000	3,000	40,000
2016	48,000	5,000	43,000

TABLE 2
National Software, Inc. Income Statement for the Fiscal-Year Ended March 31, 2016 ($000)
Sale Revenue	$ 1,550
Less: Cost of goods sold	1,030
Gross profit	$ 520
Less: Operating expenses
Selling expense	$150
General and administrative expenses	270
Depreciation expense	11
Total operating expenses	$ 431
Operating Profit (EBIT)	$89
Less: Interest expenses	29
Net profit after taxes	$ 60
Less: Taxes	12
Net profit after taxes	$ 48

TABLE 3
National Software, Inc. Balance Sheet ($000)
Assets	3/31/2016	3/31/2015
Cash	$12	$31
Marketable securities	66	82
Accounts payable	152	104
Inventories	191	145
Total current assets	$421	$362
Gross fixed assets	$195	$180
Less: Accumulated depreciation	63	52
Net fixed assets	$132	$128
Total Assets	$553	$490
Liabilities and Stockholders Equity
Accounts payable	$136	$126
Notes payable	200	190
Accruals	27	25
Total current liabilities	$363	$341
Long-term debt	$38	$40
Total liabilities	$401	$381
Common stock (50,000 shares outstanding at $0.10)	$5	$5
Paid-in capital in excess of par	45	45
Retained earnings	102	59
Total stockholders equity	$152	$109
Total liabilities and stockholders equity	$553	$490

TABLE 4
National Software, Inc. Statement of Retained Earnings ($000) For the Year Ended Mach 31, 2016
Retained earnings balance (3/31/2015)	$59
Plus: Net profit after taxes (2016)	48
Less: Cash dividends paid on common stock	5
Retained earnings balance (3/31/2016)	$102

TABLE 5
Ratio	Actual 2015	Industry Average 2016
Current ratio	1.06	1.82
Quick ratio	0.63	1.1
Inventory turnover	10.40	12.45
Average collection period	29.6 days	20.2 days
Total asset turnover	2.66	3.92
Debt ratio	0.78	0.55
Times interest earned	3.0	5.6
Gross profit margin	32.1%	42.3%
Operating profit margin	5.5%	12.4%
Net profit margin	3.0%	4.0%
Return on total assets (ROA)	8.0%	15.6%
Return on common equity (ROE)	36.4%	34.7%
Price/earnings (P/E) ratio	5.5	7.1
Market/book (M/B) ratio	2.1	2.2

With all of these concerns in mind, Sylvia set out to review the various data and develop strategies that would help to ensure a bright future for National Software. Sylvia believed that as part of this process, a thorough analysis of 2016s financial statements would provide important additional insights. You have been hired to assist in this evaluation. The syllabus provides information related how your report should be presented. In the critical analysis portion, be sure to cover the following items:

F. Firm Valuation: Discount rate focused

1. In light of the cash flows and dividend payments, critique Jimmy Perez offer.

2. Justify the10% required return of return assigned by the investor.

********************* I will need this question answered **************************

G. Firm Valuation: Cash Flow Focused

1. Assume a free cash flow growth rate going forward that equates to zero, at what price would Sylvia place the value of National Software? Attribute the difference in Part F and Part G to differences in the definition of return.

2. Construct a diagram showing how the amount you are willing to pay varies with the firms anticipated free-cash flow.

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