Chapter 2 Mini Case
Situation
Jenny Cochran, a graduate of The University of OBO with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components. During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data.
Computron’s Income Statement
2015 2016
INCOME STATEMENT
Net sales $ 3,432,000 $ 5,834,400
Cost of Goods Sold Except Depr. 2,864,000 4,980,000
Depreciation and amortization 18,900 116,960
Other Operating Expenses 340,000 720,000
Total Operating Costs $ 3,222,900 $ 5,816,960
Earnings before interest and taxes (EBIT) $ 209,100 $ 17,440
Less interest 62,500 176,000
Pre-tax earnings $ 146,600 $ (158,560)
Taxes (40%) 58,640 (63,424)
Net Income $ 87,960 $ (95,136)
Dividends $22,000 $11,000
Tax rate 40% 40%
a. (1.) What effect did the expansion have on sales and net income?
Computron’s Balance Sheets
2015 2016
Assets
Cash and equivalents $ 9,000 $ 7,282
Short-term investments 48,600 20,000
Accounts receivable 351,200 632,160
Inventories 715,200 1,287,360
Total current assets $ 1,124,000 $ 1,946,802
Gross fixed assets $ 491,000 $ 1,202,950
Less: Accumulated depreciation 146,200 263,160
Net plant and equipment $ 344,800 $ 939,790
Bart Kreps: Property, Plant and Equipment minus Depreciation
Total assets $ 1,468,800 $ 2,886,592
Liabilities and equity
Accounts payable $ 145,600 $ 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total current liabilities $ 481,600 $ 1,328,960
Long-term bonds $ 323,432 $ 1,000,000
Common Stock 460,000 460,000
Retained Earnings 203,768 97,632
Total Equity $ 663,768 $ 557,632
Total Liabilites and Equity $ 1,468,800 $ 2,886,592
a. (2.) What effect did the expansion have on the asset side of the balance sheet?
Computron’s Statement of Cash Flows
Bart Kreps: The statement of cash flows provides information about cash inflows and outflows during an accounting period.
2016
Operating Activities
Net Income before preferred dividends $ (95,136)
Noncash adjustments
Depreciation and amortization 116,960
Due to changes in working capital
Change in accounts receivable (280,960)
Bart Kreps: Change is negative because accounts receivable went up in 2001. This means that more sales revenue has been reflected in net income than has been collected in cash.
Change in inventories (572,160)
Bart Kreps: Inventories went up meaning that Computron used cash to purchase inventories.
Change in accounts payable 178,400
Bart Kreps: This is positive because accounts payable went up. Computron bought on credit from suppliers and did not dispense cash.
Change in accruals 148,960
Bart Kreps: Accruals increased in 2001. Cash flow is positive because it recognizes an increased expense prior to the payment of cash.
Net cash provided by operating activities $ (503,936)
Investing activities
Cash used to acquire fixed assets $ (711,950)
Bart Kreps: Make sure to add back annual Depreciation to Net PP&E.
Change in short-term investments 28,600
Bart Kreps: Short term investments went down in 2001. Computron received cash through the sale or maturity of these assets.
Net cash provided by investing activities $ (683,350)
Financing Activities
Change in notes payable $ 520,000
Bart Kreps: Notes payable went up in 2001. Computron received cash from creditors.
Change in long-term debt 676,568
Bart Kreps: Long term debt went up in 2001. Computron received cash from creditors.
Payment of cash dividends (11,000)
Bart Kreps: Computron used cash to pay dividends to shareholders.
Net cash provided by financing activities $ 1,185,568
Net change in cash and equivilents $ (1,718)
Cash and securities at beginning of the year 9,000
Cash and securities at end of the year $ 7,282
b. What do you conclude from the statement of cash flows?
c. What is free cash flow? Why is it important? What are the five uses of FCF?
d. What is Computron’s net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?
Net Operating Profit After Taxes
NOPAT is the amount of profit Computron would generate if it had no debt and held no financial assets.
2016 NOPAT = EBIT x ( 1 – T )

= x

2015 NOPAT = EBIT x ( 1 – T )

= x

Net Operating Working Capital
Those current assets used in operations are called operating current assets, and the current liabilities that result from operations are called operating current liabilities. Net operating working capital is equal to operating current assets minus operating current liabilities.
2016 NOWC = Operating current assets – Operating current liabilities

= –

2015 NOWC = Operating current assets – Operating current liabilities

= –

Total Net Operating Capital
The Total OperatingCapital is Net Operating Working Capital plus any fixed assets.
2016 TOC = NOWC + Fixed assets

= +

2015 TOC = NOWC + Fixed assets

= +

e. What is Computron’s free cash flow (FCF)? What are Computron’s “net uses” of its FCF?
Free Cash Flow
Computron’s Free Cash Flow caluclation is the cash flow actually availabe for distribution to investors after the company has made all necessary investments in fixed assets and working capital to sustain ongoing operations.
2016 FCF = NOPAT – Net Investment in Operating Capital

= –

Uses of FCF: 2016
After-tax interest payment =
Reduction (increase) in debt =
Payment of dividends =
Repurchase (Issue) stock =
Purchase (Sale) of short-term investments =
Total uses of FCF =
f. Calculate Computron’s return on invested capital. Computron has a 10% cost of capital (WACC). Do you think Computron’s growth added value?
2015 2016
Cost of Capital (WACC) 10% 10%
Return on Invested Capital
The Return on Invested Capital tells us the amount of NOPAT per dollar of operating capital.

2016 ROIC = NOPAT ÷ Operating Capital

=

2015 ROIC = NOPAT ÷ Operating Capital

=
Operating Profitability
The operating profitability (OP) ratio shows how many dollars of operating profit are generated by each dollar of sales.

2016 OP = NOPAT ÷ Sales

=

2015 OP = NOPAT ÷ Sales

=
Capital Utilization
The capital utilization (CR) ratio shows how many dollars of operating assets are needed to generated a dollar of sales.

2016 CR = Total Op. Cap. ÷ Sales

=

2015 CR = Total Op. Cap. ÷ Sales

=
Operating profitability declined and the capital utlization worsened, each contributing to the big decrease in ROIC.
g. What is Computron’s EVA? The after-tax cost of capital was 10 percent in both years.
Economic Value Added
Economic Value Added represents Computron’s residual income that remains after the cost of all capital, including equity capital, has been deducted.
2016 EVA = NOPAT – Operating Capital x WACC
= – x 10%

= – $0.0

2015 EVA = NOPAT – Operating Capital x WACC
= $0 – $0 x 10%
= $0 – $0.0
= $0
h. What happened to Computron’s market value added (MVA)?
Year-end common stock price $8.50 $6.00
Year-end shares outstanding (in millions) 100,000 100,000
Earnings per share (EPS)

Bart Kreps: An increase in Earnings Per Share either means the company is generating more net income or they are reducing the amount of common shares outstanding. Shares that are repurchased by the company are called Treasury stocks. Dividends per share (DPS)
Bart Kreps: The same rational holds for interpreting Dividends Per Share data. If the company increases their dividend payout policies or reduces shares outstanding, DPS will increase. $0.11 $0.22
Market Value Added
Assume that the market value of debt is equal to the book value of debt. In this case, Market Value Added (MVA) is the difference between the market value of Computron’s stock and the amount of equity capital supplied by shareholders.
2016 MVA = Stock price x # of shares – Total common equity
= x –

= $0 –

2015
MVA = Stock price x # of shares – Total common equity
= x –

= $0 –

i. Assume that a corporation has $100,000 of taxable income from operations plus $5,000 of interest income and $10,000 of dividend income. What is the company’s tax liability?
Operating income = $100,000
Interest income = $5,000
Dividends = $10,000
Taxable dividends=
Taxable Income:
Corporate Tax Rates
If a corporation’s taxable income is between: It pays this amount on the base of the bracket: Plus this percentage on the excess over the base
(1) (2) (3) (4)
$0 $50,000 $0 15.0%
$50,000 $75,000 $7,500 25.0%
$75,000 $100,000 $13,750 34.0%
$100,000 $335,000 $22,250 39.0%
$335,000 $10,000,000 $113,900 34.0%
$10,000,000 $15,000,000 $3,400,000 35.0%
$15,000,000 $18,333,333 $5,150,000 38.0%
$18,333,333 and up $6,416,667 35.0%
Base amount of tax <– Might need a VLOOKUP formula.
Marginal tax rate in bracket <– Might need a VLOOKUP formula.
Income above base of bracket <– Might need a VLOOKUP formula.
Tax on income above base
Total tax liability:
j. Assume that you are in the 25 percent marginal tax bracket and that you have $5,000 to invest. You have narrowed your investment choices down to California bonds with a yield of 7 percent or equally risky ExxonMobil bonds with a yield of 10 percent. Which one should you choose and why? At what marginal tax rate would you be indifferent to the choice between California and ExxonMobil bonds?
Taxable vs. Tax Exempt bonds
ExxonMobil bonds at 10% vs. California muni bonds at 7%
Amount to invest $5,000
ExxonMobil Yield 10%
California Yield 7%
Tax Rate 25.0%
ExxonMobil = Yield * (Investment) – Yield * (Investment) * (Tax Rate)
ExxonMobil =
California = Yield * (Investment) – 0
California =
Tax rate which you would be indifferent
Solve for T
Muni Yield = Corp Yield *(1-Tax rate)
Tax Rate =