MGAB01H3 Study Guide - Midterm Guide: Retained Earnings, Income Tax, Income Statement
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Making Long Term FM Decisions - Integrative Case
Introduction: As a special analytical group set up by ACME Iron by the firmâs Controller, you have been tasked to respond to the following issues raised in a meeting with the CFO.
You must look over several prospective financial strategies to aid in the successful growth of ACME Iron: Capital investment analysis; CAPM â Capital Asset Pricing Model determination for the company; WACC â Weighted Average Cost of Capital computations; EVA â Economic Value Analysis; MVA â Market Value Added; Capital structure of the company; Dividend policy; Stock repurchase and option pricing strategy; Bankruptcy risk analysis; Decision Tree Creation; Real option analysis of projects
The CFO wants to test you out on a simple project in the first task before you get into preparing items for his board presentation in subsequent tasks and projects. He wants to see how well you perform tasks as well as how accurate and thoughtful you are in your work. Details are important to him as well as good organization/presentation and communication.
Financial Statements for use on Tasks
| ACME Iron | Balance Sheet | ||
| Assets | |||
| Current assets: | 2014 | 2015 | change |
| Cash | 500,000 | 600,000 | 100,000 |
| Investments | 1,000,000 | 1,025,000 | 25,000 |
| Inventories | 110,000,000 | 117,000,000 | 7,000,000 |
| Accounts receivable | 11,750,000 | 12,500,000 | 750,000 |
| Pre-paid expenses | 2,500,000 | 2,600,000 | 100,000 |
| Other | 0 | 0 | - |
| Total current assets | 125,750,000 | 133,725,000 | 7,975,000 |
| Fixed assets: | 2014 | 2015 | change |
| Property and equipment | 165,000,000 | 175,000,000 | 10,000,000 |
| Leasehold improvements | 0 | 0 | - |
| Equity and other investments | 55,000,000 | 65,000,000 | 10,000,000 |
| Less accumulated depreciation | 15,000,000 | 15,500,000 | 500,000 |
| Total fixed assets | 235,000,000 | 255,500,000 | 20,500,000 |
| Other assets: | 2014 | 2015 | change |
| Goodwill | 75,000,000 | 70,000,000 | (5,000,000) |
| Total other assets | 75,000,000 | 70,000,000 | (5,000,000) |
| Total assets | 435,750,000 | 459,225,000 | 23,475,000 |
| Liabilities and owner's equity | |||
| Current liabilities: | 2014 | 2015 | change |
| Accounts payable | 40,500,000 | 42,400,000 | 1,900,000 |
| Accrued wages | 85,000,000 | 90,500,000 | 5,500,000 |
| Accrued compensation | 10,000,000 | 10,855,000 | 855,000 |
| Income taxes payable | 4,024,000 | 4,697,000 | 673,000 |
| current portion of LT debt | 5,500,000 | 10,350,000 | 4,850,000 |
| Other | 0 | 0 | - |
| Total current liabilities | 145,024,000 | 158,802,000 | 13,778,000 |
| Long-term liabilities: | 2014 | 2015 | change |
| Long term debt | 125,000,000 | 130,000,000 | 5,000,000 |
| Total long-term liabilities | 125,000,000 | 130,000,000 | 5,000,000 |
| Owner's equity: | 2014 | 2015 | change |
| Common stock | 122,000,000 | 122,000,000 | - |
| Preferred stock | 16,725,000 | 16,725,000 | - |
| Accumulated retained earnings | 27,001,000 | 31,698,000 | 4,697,000 |
| Total owner's equity | 165,726,000 | 170,423,000 | 4,697,000 |
| Total liabilities and owner's equity | 435,750,000 | 459,225,000 | 23,475,000 |
Income Statement
ACME Iron
December 2015
Financial Statements in '000s of U.S. Dollars
| REVENUE | ||
| Gross Sales | 250,000 | |
| Less: Sales Returns & Allowances | 2,500 | |
| Net Sales | 247,500 | |
| COST OF GOODS SOLD | ||
| Beginning Inventory | 7,500 | |
| Add: Purchases | 4,500 | |
| Freight-in | 0 | |
| Direct Labor | 75,000 | |
| Indirect Expenses | 15,000 | |
| Inventory Available | 102,000 | |
| Less: Ending Inventory | ||
| Cost of Goods Sold | 102,000 | |
| Gross Profit (Loss) | 145,500 | |
| EXPENSES | ||
| Advertising | 7,500 | |
| Amortization | 0 | |
| Bad Debts | 5,000 | |
| Depreciation | 500 | |
| Dues and Subscriptions | 0 | |
| Employee Benefit Programs | 18,750 | |
| Insurance | 2,500 | |
| Interest | 10,350 | |
| Legal & Professional Fees | 100 | |
| Licenses & Fees | 0 | |
| Miscellaneous | 10 | |
| Office Expenses | 100 | |
| Payroll Taxes | 5,625 | |
| Postage | 3 | |
| Rent | 0 | |
| Repairs & Maintenance | 5,000 | |
| Supplies | 2,000 | |
| Telephone | 120 | |
| Travel | 1,750 | |
| Utilities | 50,000 | |
| Vehicle Expenses | 450 | |
| Wages | 25,000 | |
| Total Expenses | 134,758 | |
| Net Operating Income | 10,742 | |
| OTHER INCOME | ||
| Gain (Loss) on Sale of Assets | 0 | |
| Interest Income | 1,000 | |
| Total Other Income | 1,000 | |
| TAXES | 4,697 | |
| Net Income (Loss) | 7,045 |
TASK 2
In this task we are examining the current capital structure of ACME Iron and determining the WACC of the company. Assume that ACMEâs tax rate is 40%.
To compute the WACC you must first find the after-tax cost of debt, the cost of equity and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 8% for the firm. Please clearly show how you derive each of these values:
After-tax cost of debt =
Cost of equity =
Proportions of debt and equity in the firm =
How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?
Any insights into the capital structure of ACME Iron?
The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is computing the effect of the capital structure on expected returns by investors.
WACC= S/B+S x Rs + B/B+S x RB x (1 â tc )
Where
S = value of equity
B = value of debt
Rs = cost of equity
After tax cost of debt: RB x (1 â tc )
Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:
1. Risk is deviation from expectations.
2. We need to set expectations for our investments in relation to risk and return. Higher risk = higher return.
3. Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.
4. We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).
5. If cost of capital rises then our risk rises and the projects we undertake to increase sales and return to our investors is reduced.
6. If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.
7. If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows.
TASK 3
Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years.
When will this project break-even on a simple cash basis and a discounted cash basis.
What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)?
Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.
