Chapter 3, Problem 20IC

a.

Summary Introduction

To identify: The effect of expansion on sales, after tax operating income, NOWC and net income.

Financial Statements:

Income statement, balance sheet, cash flow statement, statement of changes in equity, and relating notes and disclosures generally comprises financial statements of an entity; financial statements are statements that provide reports depicting the affairs of the entity.

Explanation of Solution

Effect of expansion on sales, after tax operating income, NOWC and net income:

Particulars	Year 2014 ($)	Year 2015 ($)	Effect
Sales	3,432,000	6,034,000	Increased
After tax operating income	114,257	(78,569)	Reduced
Net operating working capital	842,400	913,042	Increased
Net Income	87,960	(160,176)	Reduced

Table (1)

Effects:

• Sales have been increased to around 75%.
• After tax operating working capital and net income has been reduced to a large extent and turned out into losses.
• Working capital has been reduced to more than half.
• The effects of expansion have not been good as per the income statement and operating capital.

Working Notes:

Computation of after tax operating income:

$\text{After tax operating income}=\text{EBIT}\left(1-\text{Tax rate}\right)$

• EBIT of Year 2014 is $190,428 and Year 2015 is ($130,948)
• Tax rate is 40%

Therefore, the effect of expansion on sales have been good, however on after tax operating income, NOWC and net income effect of expansion has not been good.

b.

Summary Introduction

To identify: The effect of expansion on free cash flows.

Explanation of Solution

Free cash flows:

Free cash flow is the net income as increased by the depreciation expense, since depreciation expense is a non cash expense.

Effect of expansion on free cash flows:

• Free cash flows of the company have been reduced due to expansion.
• Current year free cash flows became negative.
• Thus, effect of expansion on free cash flows is not positive.

Working Notes:

Computation of free cash flows:

$\begin{array}{c}FreeCashFlo{w}_{2015}=\left[\begin{array}{l}\left(\left(EBIT\times \left(1-Tax\right)\right)+Depreciation\right)-\\ \left(\begin{array}{l}IncreaseinNetOperatingWorkingCapital+\\ CapitalExpenditure\end{array}\right)\end{array}\right]\\ =\left[\left(\left(-\$130,948\times \left(1-40\%\right)\right)+\$116,960\right)-\left(\begin{array}{l}\left(\$913,042-\$842,400\right)+\\ \left(-\$711,950\right)\end{array}\right)\right]\\ =\left[-\$78,568.80+\$116,960-\$\text{782,592}\right]\\ =-\$\text{744,200}\text{.80}\end{array}$

Therefore the free cash flow for 2015 is -$744,200.80

Computation of market value added:

$\begin{array}{c}MarketValueAdde{d}_{2015}=\left[MarketValueofStock-TotalCommonStock\right]\\ =\left[\left(100,000\times \$2.50\right)-\$492,592\right]\\ =\left[\text{\$225,000}-\$492,592\right]\\ =-\$267,592\end{array}$

$\begin{array}{c}MarketValueAdde{d}_{2014}=\left[MarketValueofStock-TotalCommonStock\right]\\ =\left[\left(100,000\times \$8.50\right)-\$492,592\right]\\ =\left[\text{\$850,000}-\$492,592\right]\\ =\$\text{357,408}\end{array}$

Therefore the market value added for 2015 is $357,408 and 2014 is -$267,592. Thus, the effect of expansion on free cash flows has not been good.

c.

Summary Introduction

To identify: The time taken by company to repay its suppliers and problems generally faced by a company in case the suppliers are not paid within time.

Explanation of Solution

Effect of expansion ontime taken by company to repay its suppliers:

• Days payable outstanding is the time taken by company to repay its suppliers.
• Due to expansion days payable outstanding have been increased.
• Days payable outstanding have been increased from 19 to 35 days.
• Therefore, the effect of expansion on the time taken by the company to repay its suppliers is that average time to repay has been increased by 16 days.
• Thus, effect of expansion has not been good on time taken by a company to repay its suppliers.

Problems faced by a company if it doesn’t pay its creditors on time:

• In case of extended delays creditors may sue the company for nonpayment.
• Creditors may start preferring selling to other companies.
• Public image of the company may get deteriorated.
• Creditors may start interfering and pressurizing the company.

Working Notes:

Computation of Days payable outstanding:

$\begin{array}{c}\text{DPO for Year 2013}=\frac{\text{Average accounts payable}}{\text{COGS}}\times \text{365}\\ =\frac{\$145,600}{\$2,864,000}\times 365\\ =18.55\text{ days}\end{array}$

$\begin{array}{c}\text{DPO for Year 2014}=\frac{\text{Average accounts payable}}{\text{COGS}}\times \text{365}\\ =\frac{\$524,160}{\$5,528,000}\times 365\\ =34.6\text{ days}\end{array}$

Therefore, effect of expansion has not been good on time taken by a company to repay its suppliers.

d.

Summary Introduction

To identify: The rise in cost of goods sold and its comparison with sales.

Explanation of Solution

Analysis of COGS after expansion program:

• Cost of goods sold before expansion was $2,864,000 which was around 83% of sales.
• Cost of goods sold, after expansion was $5,528,000 which was around 92% of sales which got further reduced by adding other expenses resulting in operating loss of $13,988.
• Thus, proportion of cost of goods sold increased after expansion and as a result cash balance declined by $2,664,000$\left(\$5,528,000-\$2,864,000\right)$.

Working notes:

Computation of operating loss:

$\begin{array}{c}\text{Operating loss}=\text{Sales}-\text{COGS}-\text{Other expenses}\\ =\$6,034,000-\$5,528,000-\$519,988\\ =\$13,988\end{array}$

Therefore, cost of goods sold increased after expansion and as a result cash balance declined by $2,664,000.

e.

Summary Introduction

To identify: The effect of increase in credit terms with or without affecting sales.

Explanation of Solution

Effect of increase in the credit terms with or without affecting sales:

• Current account receivables are $632,160 and average accounts receivable are $247,973 which implies that at any point of time $247,973 is blocked and the interest cost of $247,973 is borne by the company.
• Similarly in case credit period is doubled without increase in volume it implies that $495,945 is blocked and relative interest cost is borne by the company.
• In case credit period is doubled resulting in twice sales, $991,890is blocked and relative interest cost is borne by the company, however increase in sales volume implies increase in corresponding volume of accounts payables that may result in balance of increase and decrease of finance cost of capital blocked up to the collection period allowed.

Working Notes:

Average receivables outstanding:

$\begin{array}{c}\text{Average}\text{receivables}\text{outstanding}=\frac{\$6,034,000}{365}\times 30\times \frac{1}{2}\\ =\$247,973\end{array}$

Average receivables outstanding in case of increase in the credit period:

$\begin{array}{c}\text{Average}\text{receivables}\text{outstanding}=\frac{\$6,034,000}{365}\times 60\times \frac{1}{2}\\ =\$495,945\end{array}$

Average receivables outstanding in case of increase in credit period along with increase in sales:

$\begin{array}{c}\text{Average}\text{receivables}\text{outstanding}=\frac{\$6,034,000\times 2}{365}\times 60\times \frac{1}{2}\\ =\$991,890\end{array}$

Therefore, the effect of increase in credit terms without affecting sales doubles the average receivable outstanding.

f.

Summary Introduction

To identify: The possibility of declining cash balance due to large volume of units with positive contribution per unit.

Explanation of Solution

The possibility of declining cash balance due to large volume of units with positive contribution per unit:

• Contribution per unit is the per unit value arrived after reducing the selling prize by cost of goods sold.
• Positive contribution is not a guarantee to positive cash flows since, there are various expenses incurred after the units are being produced.
• As discussed in the question advertisement campaign have been used that would have resulted in cash outflows.
• The declining cash balance due to large volume of units with positive contribution per unit is possible since with increase in volume requirement of working capital and fixed capital also increases.

Therefore, the declining cash balance due to large volume of units with positive contribution per unit is possible since with increase in volume requirement of working capital and fixed capital also increases.

g.

Summary Introduction

To identify: The source of funds used in expansion program and its effects on company’s financial health.

Explanation of Solution

Funds used in expansion program and its effects:

• The company used long term debt of $400,000 and Notes payable of $436,808.
• Long term debt is a non current liability while notes payable is a short term liability.
• Besides that company extended the repayment period of suppliers resulting in increase in current liabilities.
• Capital structure before expansion consists of around equal debt and equity components with 55% debt.
• After expansion capital structure shifted towards use of debt and as a result debt consisted of 83% of total sources of funds resulting in increase of burden of interest costs and repayment obligations.
• Increase in debt resulted in increase in interest costs from $43,828 to $136,012 resulting reduction of net income.

Working Notes:

Computation of Debt equity ratio:

$\begin{array}{c}\text{External}\text{finance}\text{Year}\text{2013}=\frac{\text{Total Debt}}{\text{Debt}+\text{Equity}}\times 100\\ =\frac{\$805,032}{\$1,468,800}\times 100\\ =55\%\end{array}$

$\begin{array}{c}\text{External}\text{finance}\text{Year}\text{2014}=\frac{\text{Total Debt}}{\text{Debt}+\text{Equity}}\times 100\\ =\frac{\$2,374,000}{\$2,866,592}\times 100\\ =83\%\end{array}$

Therefore, mostly the external funds are used in expansion program and it affected the debt component to increase to 83% of total sources of funds resulting in increase of burden of interest costs and repayment obligations.

h.

Summary Introduction

To identify: The asset expansion being the reason of cash shortage and consequent use of external capital.

Explanation of Solution

Effect of asset expansion:

• Assets additionally procured are for $711,950.
• Since, increase in sales did not resulted in surplus of income; internally, funds are not generated to fund the procurement.
• Also, cash flow from operating activities is almost similar to the net income suggesting that procurement of assets wasn’t funded by the increase in operating credit facilities.
• Implies that, external funds are raised due to the requirement to procure assets used in expansion.
• Therefore, asset expansion is the reason of cash shortage and consequent use of external capital.

Therefore, asset expansion is the reason of cash shortage and consequent use of external capital.

i1.

Summary Introduction

To identify: Whether change in the useful life of assets would affect physical stock of assets.

Explanation of Solution

The effect of variation in useful life of the assets on physical stock of assets:

• Physical life of a fixed asset doesn’t change due to change in accounting operations.
• Physical stock of assets refers to the tangible assets available with the company.
• Change in accounting method doesn’t change the physical existence of an asset.
• Therefore, change in useful life from ten to seven years for the depreciation purpose would not affect the physical stock of asset.

Therefore, change in useful life from ten to seven years for the depreciation purpose would not affect the physical stock of asset.

i2.

Summary Introduction

To identify: Whether change in the useful life of assets would affect balance sheet account of fixed assets.

Explanation of Solution

The effect of variation in useful life of the assets on balance sheet account of fixed assets:

• Because of the change in useful life from ten to seven years, depreciation per annum gets increased.
• Such depreciation is to be computed on prospective basis since the change in useful life of the asset is change in accounting estimate.
• The burden of increase in depreciation is recorded in the year of change that is current year.
• In balance sheet, current year depreciation will increase and net amount of assets will decrease consequently.
• Therefore, asset account in balance sheet will reduce because of the revision of change in the useful life of asset.

Therefore, asset account in balance sheet will reduce because of the revision of change in the useful life of asset.

i3.

Summary Introduction

To identify: Whether change in the useful life of assets would affect the net income.

Explanation of Solution

The effect of variation in useful life of the assets on net income of the year:

• Due to change in useful life from ten to seven years depreciation per annum gets increased.
• Such depreciation is to be calculated on the basis of prospective basis since the change in useful life of the asset is change in accounting estimate.
• The burden of increase in depreciation is recorded in the year of change that is current year.
• Therefore, increase in depreciation would reduce the net income of the current year.

Therefore, increase in depreciation would reduce the net income of the current year.

i4.

Summary Introduction

To identify: Whether change in the useful life of assets would affect the change in cash position.

Explanation of Solution

The effect of variation in useful life of the assets on cash position:

• Depreciation is a non cash item and is charged on the basis of estimate made by the management.
• Since, depreciation is a non cash expense it does not change the cash position og the entity.
• However increase in depreciation due to reduction of useful life will reduce the cash burden of the entity.
• Therefore cash balance will get increased to the extent of proportion of tax reduced due to increase in depreciation.

Therefore cash balance will get increased to the extent of proportion of tax reduced due to increase in depreciation.

j.

Summary Introduction

To identify: The valuation and meaning of EPS, DPS and book value per share.

Explanation of Solution

Earnings per Share:

EPS means the net income earned by each share of the entity; EPS is calculated by dividing the net income of the current year by the number of shareholders of the company.

Dividend per Share:

DPS means the net income available for distribution to each share of the entity; DPS is calculated by dividing the net income, as reduced by retained earnings of the current year by the number of shareholders of the company.

Book Value per Share:

Book value per share represents the share by each shareholder in the net assets of the company; book value per share is computed by dividing net assets of the company with number of shareholder of the company and net assets can be computed by reducing external liabilities from total assets.

Difference in book value and market value of share:

• Book value of share depicts the current position of the entity; however market value of share depicts current position as well as future prospects of the entity.
• Book value of share is measured by using the financial statements of the entity; however market value consists of economic factors such as demand and supply of the shares.

Therefore, book value and market value of shares can be different

k1.

Summary Introduction

To identify: The tax treatment of interest and dividends paid.

Explanation of Solution

The tax treatment of interest and dividends paid:

• Interest paid by a company can reduce the income and therefore the taxes get reduced due to payment of interest.
• Dividend paid is not allowed to be reduced from the profits and consequently taxes are paid from pre dividend income.
• Therefore, interest reduces the tax whereas dividends payment has no impact on taxes of the company.

Therefore, interest reduces the tax whereas dividends payment has no impact on taxes of the company.

k2.

Summary Introduction

To identify: The tax treatment of interest and dividends received.

Explanation of Solution

The tax treatment of interest and dividends received.

• Interest received by a corporate is taxed like the ordinary income of the company.
• Dividend received is exempted to the extent of 70% and remaining 30% of dividend is taxed at ordinary rates.
• The company’s taxes get increased due to receipt of interest and dividends.

Therefore, company’s taxes get increased due to receipt of interest and dividends.

k3.

Summary Introduction

To identify: The tax treatment of capital gains.

Explanation of Solution

The tax treatment of capital gains:

• Capital gains are taxed at rates which is similar to the ordinary income.
• Capital gains therefore increase the tax burden of the entity.

Therefore, capital gains increases the tax burden of the entity.

k4.

Summary Introduction

To identify: The tax treatment of tax loss carry backs and carries forwards.

Explanation of Solution

The tax treatment of, tax loss carry backs and carry forwards:

• Corporate losses can be carried back to two preceding years and consequently refund can be claimed by the entity.
• Corporate losses can also be carried forward to next twenty years and consequently tax can be forgone to the extent losses are set off.

Therefore, corporate losses can be carried back to two years and carried forward for twenty years.