Solutions Guide: Please do not present as your own. I sometimes post solutions that are totally mine, from the book’s solutions manual, or a mix of my work and the books solutions manual. But this is only meant as a solutions guide for you to answer the problem on your own. I recommend doing this with any content you buy online whether from me or from someone else.
The annual sales for Salco Inc. were $4.5 million last year. The firm’s end-of-year balance sheet was as follows: Current assets $500,000 Liabilities $1,000,000 Net fixed assets 1,500,000 Owners’ equity 1,000,000 $2,000,000 $2,000,000 The firm’s income statement for the year was as follows: Sales $ 4,500,000 Less cost of goods sold (3,500,000) Gross profit $ 1,000,000 Less operating expenses (500,000) Operating income $500,000 Less interest expense (100,000) Earnings before taxes $400,000 Less taxes (50%) (200,000) Net income $200,000 a. Calculate Salco’s total asset turnover, operating profit margin, and operating return on assets. b. Salco plans to renovate one of its plants, which will require an added investment in plant and equipment of $1 million. The firm will maintain its present debt ratio of .5 when financing the new investment and expects sales to remain constant. The operating profit margin will rise to 13 percent. What will be the new operating return on assets for Salco after the plant’s renovation? c. Given that the plant renovation in part b occurs and Salco’s interest expense rises by $50,000 per year, what will be the return earned on the common stockholders’ investment? Compare this rate of return with that earned before the renovation.
a. Salco’s total asset turnover, operating profit margin, and operating return on assets.
Total Asset Turnover =
=
= 2.25 times
Operating Profit Margin =
=
= 11.11%
=
=
= 25%
or = x
= .1111 X 2.25 = 25%
b. The new operating return on assets for Salco after the plant renovation:
= x
=
= .13 x 1.5 = 19.5%
c. Return earned on the common stockholders’ investment:
Post-Renovation Analysis:
=
=
= 14.5%
Net Income Available to Common following the renovation was calculated as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 + $50,000) (150,000)
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500)
Net Income Available to Common $ 217,500
Pre-renovation Analysis:
The pre-renovation rate of return on common equity (ROCE) is calculated as follows:
ROCE = = 20%
Comparative Analysis:
A comparison of the two rates of return would argue that the renovation not be undertaken. However, since investments in fixed assets generally produce cash flows over many years, it is not appropriate to base decisions about their acquisition on a single year’s ratios. There are additional problems with this approach to fixed asset decision making which we will discover when we discuss capital budgeting in a later chapter.