Chapter 10, Problem 10.8APEM

Earnings Management

Renegade Clothing is struggling to meet analysts’ forecasts. It’s early December 2015, and the year-end projections are in. Listed below are the projections for the year ended 2015 and the comparable actual amounts for 2014.

	Projected 2015	Actual 2014
Sales	$14,000,000	$16,023,000
Net income	878,000	1,113,000
Total assets	$ 6,500,000	$ 6,821.000
Total liabilities	$ 2,500,000	$ 2,396,000
Stockholders' equity	4,000,000	4,425,000
Total liabilities and stockholders' equity	$ 6,500,000	$ 6,821,000
Shares outstanding at year end	950,000	950,000

 Analysts forecast earnings per share for 2015 to be $0.95 per share. It looks like earnings per share will fall short of expectations in 2015.

  Ronald Outlaw, the director of marketing, has a creative idea to improve earnings per share and the return on equity for 2015. He proposes the company borrow additional funds and use the proceeds to repurchase some of its own stock—treasury shares. Is this a good idea?

  Required:

  1.    Calculate the projected earnings per share and return on equity for 2015 before any repurchase of stock.

 Now assume Renegade Clothing borrows $1 million and uses the money to purchase 100,000 shares of its own stock at $10 per share. The projections for 2015 will change as follows:

	2015	2014
Sales	$14,000,000	$16,023,000
Net income	878,000	1,113,000
Total assets	$ 6,500,000	$ 6,821,000
Total liabilities	$ 3,500,000	$ 2,396,000
Stockholders' equity	3,000,000	4,425,000
Total liabilities and stockholders' equity	$ 6,500,000	$ 6,821,000
Shares outstanding at year end	850,000	950,000

  2.    Calculate the new projected earnings per share and return on equity for 2015, assuming the company goes through with the treasury stock repurchase. (Hint: In computing earnings per share, average shares outstanding is now 900,000 = (850,000 + 950,000) / 2.)

  3.    Explain how the repurchase of treasury stock near year end improves earnings per share and the return on equity ratio.