Chapter 15, Problem 64P

Albion Inc. provided the following information for its most recent year of operations. The tax rate is 40%.

Required:

1. 1. Compute the following: (a) return on sales, (b) return on assets, (c) return on stockholders’ equity, (d) earnings per share, (e) price-earnings ratio, (f) dividend yield, and (g) dividend payout ratio.
2. 2. CONCEPTUAL CONNECTION If you were considering purchasing stock in Albion, which of the above ratios would be of most interest to you? Explain.

To determine

Calculate the return on sales, return on assets, return on stockholders’ equity, and earnings per share, price earnings ratio, and 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 sales:

$\text{Return On Sales}=\frac{\text{Net Income}}{\text{Sales}}$

Substitute $10,500 for net income and $100,000 for sales in the above formula.

$\begin{array}{c}\text{Return On Sales}=\frac{\$10,500}{\$100,000}\\ =0.105\end{array}$

Therefore, the value of return on sales is 0.105 or 10.5%.

(b)

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

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

Substitute $10,550 for net income, $350 for interest expense, 40% for tax rate and $123,000 for average total assets in the above formula.

$\begin{array}{c}\text{Return On Assets}=\frac{\$10,500+\left[\$350\times \left(\text{1}-4\text{0\%}\right)\right]}{\$123,000}\\ =\frac{\$10,710}{\$123,000}\\ =0.087\end{array}$

Therefore, the value of return on assets is 0.087 or 8.7%.

(c)

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

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

Substitute $10,500 for net income, $300 for preference dividend and $55,000 for average common stockholder’s equity in the above formula.

$\begin{array}{c}\text{Stockholder's Equity}=\frac{\$10,500-\$300}{\$55,000}\\ =\frac{\$10,200}{\$55,000}\\ =\text{0}\text{.185}\end{array}$

Therefore, the value of return on stockholder’s equity is 0.185 or 18.5%.

(d)

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

$\text{Earnings per Share}=\frac{\text{Net Income}-\text{Preference Dividend}}{{\text{Average Common Shares}}^{\text{2}}}$

Substitute $10,500 for net income, $300 for preference dividend and 35,000 for average common shares in the above formula.

$\begin{array}{c}\text{Earnings per Share}=\frac{\$10,500-\$300}{100,000}\\ =\frac{\$10,200}{35,000}\\ =\$0.2\text{9 per share}\end{array}$

Therefore, the value of earnings per share is $0.29 per share.

(e)

Use the following formula to calculate the price-earnings ratio:

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

Substitute $12.00 for market price per share and $0.29 (this value is calculated in part d) for earnings per share in the above formula.

$\begin{array}{c}\text{Price-Earnings Ratio}=\frac{\text{\$12}\text{.00}}{\text{\$0}\text{.29}}\\ =41.38\end{array}$

Therefore, the value of price-earnings ratio is 41.38.

(f)

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

$\text{Dividend Yield}=\frac{{\text{Dividend per Common Shares}}^{\text{3}}}{\text{Market Price per Common Share}}$

Substitute $0.20 for dividend per common shares, and $12.00 for market price per common share in the above formula.

$\begin{array}{c}\text{Dividend Yield}=\frac{\text{\$0}\text{.20}}{\text{\$12}\text{.00}}\\ =0.017\end{array}$

Therefore, the value of dividend yield is 0.017 or 1.7%.

(g)

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

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

Substitute $8,000 for common dividend, $10,500 for net income and $300 for preference dividend in the above formula.

$\begin{array}{c}\text{Dividends Payout Ratio}=\frac{\$8,000}{\$10,500-\$300}\\ =\frac{\$8,000}{\$10,200}\\ =0.7843\end{array}$

Therefore, the value of dividend payout ratio is 0.7843.

Working Note:

1. Calculation of average total assets:

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

2. Calculation of average common stockholder’s equity:

$\begin{array}{c}\text{Average Common Stockholder's Equity}=\left[\frac{\left(\begin{array}{l}\text{Opening Stockholder's Equity }\\ \text{+Closing Stockholder's Equity}\end{array}\right)}{\text{2}}\right]\\ =\frac{\$30,000+\$40,000}{2}\\ =\$35,000\end{array}$

3. Calculation of dividends common shares:

$\begin{array}{c}\text{Dividend per Share}=\frac{\text{Value of Dividend}}{\text{Number of Common Shares}}\\ =\frac{8,000}{40,00\text{0 shares}}\\ =\$0.20\end{array}$

To determine

Identify the ratio which would interest an investor while considering to purchase stock.

Explanation of Solution

The ratios computed are profitability ratios, and they are equally important for the investors. Therefore, it totally depends on the objectives of the investors which ratio is would be of more interest. For example: if an investor is thinking of having income after retirement by investing in stock of a company, then the investor would be interested in analyzing dividend payout ratio of the company.