Chapter 15, Problem 63P

Mike Sanders is considering the purchase of Kepler Company, a firm specializing in the manufacture of office supplies. To be able to assess the financial capabilities of the company, Mike has been given the company’s financial statements for the 2 most recent years.

Required:

Note: Round all answers to two decimal places.

1. 1. Compute the following for each year: (a) return on assets, (b) return on stockholders’ equity, (c) earnings per share, (d) price-earnings ratio, (e) dividend yield, and (f ) dividend payout ratio.
2. 2. CONCEPTUAL CONNECTION Based on the analysis in Requirement 1, would you invest in the common stock of Kepler?

To determine

Calculate the return on assets, return on stockholders’ equity, earnings per share, price earnings ratio, dividend yield and dividend payout ratio.

Explanation of Solution

Profitability Ratio:

These ratios evaluate a firm’s ability to earn profits. They help the stakeholders of the company to measure the degree to which funds invested by them are efficiently used. Some of the ratios calculated return on sales, total assets and stockholder’s equity.

(a)

Use the following formula to calculate the value of return on assets of this year:

$\text{Return On Assets}=\frac{\text{Net Income}+\left[{\text{Interest Expense}}^1\times \left(\text{1}-\text{Tax Rate}\right)\right]}{{\text{Average Total Assets}}^{\text{2}}}$

Substitute $97,800 for net income, $12,000 for interest expense, 40% for tax rate and $965,000 for average total assets in the above formula.

$\begin{array}{c}\text{Return On Assets}=\frac{\$97,800+\left[\$12,000\times \left(\text{1}-\text{40\%}\right)\right]}{\$965,000}\\ =\frac{\$105,000}{\$965,000}\\ =0.11\end{array}$

Therefore, the value of return on assets is 0.11.

Use the following formula to calculate the value of return on assets of last year:

$\text{Return On Assets}=\frac{\text{Net Income}+\left[{\text{Interest Expense}}^1\times \left(\text{1}-\text{Tax Rate}\right)\right]}{{\text{Average Total Assets}}^{\text{3}}}$

Substitute $97,880 for net income, $12,000 for interest expense, 40% for tax rate and $965,000 for average total assets in the above formula.

$\begin{array}{c}\text{Return On Assets}=\frac{\$97,880+\left[\$12,000\times \left(\text{1}-\text{40\%}\right)\right]}{\$965,000}\\ =\frac{\$105,000}{\$965,000}\\ =0.11\end{array}$

Therefore, the value of return on assets is 0.11.

(b)

Use the following formula to calculate the value of return on stockholder’s equity of this year:

$\text{Stockholder's Equity}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Stockholder's Equity}}^4}$

Substitute $97,880 for net income, $0 for preference dividend and $365,000 for average common stockholder’s equity in the above formula.

$\begin{array}{c}\text{Stockholder's Equity}=\frac{\$97,800-\$0}{\$365,000}\\ =\frac{\$97,800}{\$365,000}\\ =0.27\end{array}$

Therefore, the value of return on stockholder’s equity is 0.27.

Use the following formula to calculate the value of return on stockholder’s equity of last year:

$\text{Stockholder's Equity}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Stockholder's Equity}}^5}$

Substitute $79,220 for net income, $0 for preference dividend and $330,000 for average common stockholder’s equity in the above formula.

$\begin{array}{c}\text{Stockholder's Equity}=\frac{\$79,220-\$0}{\$330,000}\\ =\frac{\$79,220}{\$330,000}\\ =0.24\end{array}$

Therefore, the value of return on stockholder’s equity is 0.24.

(c)

Use the following formula to calculate the value of return on earnings per share of this year:

$\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{\text{Average Common Shares}}$

Substitute $97,800 for net income, $0 for preference dividend and 100,000 for average common shares in the above formula.

$\begin{array}{c}\text{Earnings per Share}=\frac{\$97,800-\$0}{100,000}\\ =\frac{\$97,800}{100,000}\\ =\$0.98\end{array}$

Therefore, the value of earnings per share is $0.98 per share.

Use the following formula to calculate the value of earnings per share of last year:

$\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Shares}}^{}}$

Substitute $79,200 for net income, $0 for preference dividend and 100,000 for average common shares in the above formula.

$\begin{array}{c}\text{Earnings per Share}=\frac{\$79,200-\$0}{100,000}\\ =\frac{\$79,200}{100,000}\\ =\$0.79\end{array}$

Therefore, the value of earnings per share is $0.79 per share.

(d)

Use the following formula to calculate the price-earnings ratio of this year:

$\text{Price-Earnings Ratio}=\frac{\text{Market Price Per Share}}{{\text{Earnings per Share}}^{\text{6}}}$

Substitute $2.98 for market price per share and $0.98 for earnings per share in the above formula.

$\begin{array}{c}\text{Price-Earnings Ratio}=\frac{\text{\$2}\text{.98}}{\text{\$0}\text{.98}}\\ =3.04\end{array}$

Therefore, the value of price-earnings ratio is 3.04.

Use the following formula to calculate the price-earnings ratio of last year:

$\text{Price-Earnings Ratio}=\frac{\text{Market Price Per Share}}{{\text{Earnings per Share}}^{\text{7}}}$

Substitute $2.98 for market price per share and $0.79 for earnings per share in the above formula.

$\begin{array}{c}\text{Price-Earnings Ratio}=\frac{\text{\$2}\text{.98}}{\text{\$0}\text{.79}}\\ =3.77\end{array}$

Therefore, the value of price-earnings ratio is 3.77.

(e)

Use the following formula to calculate the value of dividend yield of this year:

$\text{Dividend Yield}=\frac{{\text{Dividend per Common Shares}}^{\text{8}}}{\text{Market Price per Common Share}}$

Substitute $0.278 for dividend per common shares, and $2.98 for market price per common share in the above formula.

$\begin{array}{c}\text{Dividend Yield}=\frac{\text{\$0}\text{.278}}{\text{\$2}\text{.98}}\\ =0.0933\end{array}$

Therefore, the value of dividend yield is 0.0933 or 9.33%.

Use the following formula to calculate the value of dividend yield of last year:

$\text{Dividend Yield}=\frac{{\text{Dividend per Common Shares}}^{\text{9}}}{\text{Market Price per Common Share}}$

Substitute $0.192 for dividend per common shares, and $2.98 for market price per common share in the above formula.

$\begin{array}{c}\text{Dividend Yield}=\frac{\text{\$0}\text{.192}}{\text{\$2}\text{.98}}\\ =0.0644\end{array}$

Therefore, the value of dividend yield is 0.0644 or 6.44%.

(f)

Use the following formula to calculate the value of dividend payout ratio of this year:

$\text{Dividends Payout Ratio}=\frac{\text{Common Dividend}}{\text{Net Income}-\text{Preference Dividend}}$

Substitute $27,800 for common dividend, $97,800 for net income and $0 for preference dividend in the above formula.

$\begin{array}{c}\text{Dividends Payout Ratio}=\frac{\$27,800}{\$97,800-\$0}\\ =\frac{\$27,800}{\$97,800}\\ =0.28\end{array}$

Therefore, the value of dividend payout ratio is 0.28.

Use the following formula to calculate the value of dividend payout ratio of last year:

$\text{Dividends Payout Ratio}=\frac{\text{Common Dividend}}{\text{Net Income}-\text{Preference Dividend}}$

Substitute $19,200 for common dividend, $79,200 for net income and $0 for preference dividend in the above formula.

$\begin{array}{c}\text{Dividends Payout Ratio}=\frac{\$19,200}{\$79,200-\$0}\\ =\frac{\$19,200}{\$79,200}\\ =0.24\end{array}$

Therefore, the value of dividend payout ratio is 0.24.

Working Note:

1. Calculation of interest expense:

$\begin{array}{c}\text{Interest Expense}=\text{Value of Bond}\times \text{Interest Rate}\\ =\$100,000\times 12\%\\ =\$12,000\end{array}$

2. Calculation of average total assets of this year:

$\begin{array}{c}\text{Average Assets}=\frac{\text{Total Assets of this Year}+\text{Total assets of last year}}{\text{2}}\\ =\frac{\text{\$1,100,000}+\text{\$830,000}}{\text{2}}\\ =\text{\$965,000}\end{array}$

3. Calculation of average total assets of last year:

$\begin{array}{c}\text{Average Assets}=\frac{\text{Total Assets of this Year}+\text{Total assets of last year}}{\text{2}}\\ =\frac{\text{\$830,000}+\text{\$830,000}}{\text{2}}\\ =\text{\$830,000}\end{array}$

4. Calculation of average common stockholder’s equity of this year:

$\begin{array}{c}\text{Average Common Stockholder's Equity}=\left[\frac{\left(\begin{array}{l}\text{Stockholder's Equity for this year}\\ \text{+Stockholder's Equity for last year}\end{array}\right)}{\text{2}}\right]\\ =\frac{\$400,000+\$330,000}{2}\\ =\$365,000\end{array}$

5. Calculation of average common stockholder’s equity of last year:

$\begin{array}{c}\text{Average Common Stockholder's Equity}=\left[\frac{\left(\begin{array}{l}\text{Stockholder's Equity for this year}\\ \text{+Stockholder's Equity for last year}\end{array}\right)}{\text{2}}\right]\\ =\frac{\$330,000+\$330,000}{2}\\ =\$330,000\end{array}$

6. Calculation of earnings per share for this year:

$\begin{array}{c}\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{\text{Average Common Shares}}\\ =\frac{\$97,800-\$0}{100,000}\\ =\$0.98\end{array}$

7. Calculation of earnings per share for last year:

$\begin{array}{c}\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{\text{Average Common Shares}}\\ =\frac{\$79,200-\$0}{100,000}\\ =\$0.79\end{array}$

8. Calculation of dividends common shares of this year:

$\begin{array}{c}\text{Dividend per Share}=\frac{\text{Value of Dividend}}{\text{Number of Common Shares}}\\ =\frac{27,800}{100,00\text{0 shares}}\\ =0.278\end{array}$

9. Calculation of dividends common shares of last year:

$\begin{array}{c}\text{Dividend per Share}=\frac{\text{Value of Dividend}}{\text{Number of Common Shares}}\\ =\frac{19,200}{100,00\text{0 shares}}\\ =0.192\end{array}$

To determine

Identify whether an individual should invest in Company KE on the basis of above calculations.

Explanation of Solution

The value of return on assets has remained more or less same but other ratios such as return on equity, earning per share, dividend yield and dividend payout ratio have increased. On the other hand, the price earnings ratio decreased considerably. Computation of profitability ratios have provided mixed results. An individual needs other information as well for making an investment decisions. Other information includes the comparison report of rate of return with the other companies and past data of dividend payout ratio to analyze the growth trend of the company.