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Exercise 13-2 (30 minutes) 1. No, production and sale of the racing bikes should not be discontinued. If the racing bikes were discontinued, then the net operating income for the company as a whole would decrease by $11,000 each quarter: Lost contribution margin.......................... Fixed costs that can be avoided: Advertising, traceable........................... Salary of the product line manager....... Decrease in net operating income for the company as a whole..................... .........

$(27,000) $ 6,000 10,00 0

16,000 $(11,000)

The depreciation of the special equipment is a sunk cost and is not relevant to the decision. The common costs are allocated and will continue regardless of whether or not the racing bikes are discontinued; thus, they are not relevant to the decision. Alternative Solution:

Sales Less variable expenses Contribution margin Less fixed expenses: Advertising, traceable Depreciation on special equipment* Salaries of product

Difference : Net Operating Total If Income Racing Increase Bikes or Current Are (Decrease Total Dropped ) $300,00 0 $240,000 $(60,000) 120,00 0 87,000 33,000 180,00 0 153,000 (27,000) 30,000

24,000

6,000

23,000 35,000

23,000 25,000

0 10,000

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managers Common allocated costs Total fixed expenses Net operating income

60,00 0 60,000 0 148,00 0 132,000 16,000 $ 32,00 0 $ 21,000 $ (11,000)

*Includes pro-rated loss on the special equipment if it is disposed of.

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Exercise 13-2 (continued) 2. The segmented report can be improved by eliminating the allocation of the common fixed expenses. Following the format introduced in Chapter 12 for a segmented income statement, a better report would be:

Sales Less variable manufacturing and selling expenses Contribution margin Less traceable fixed expenses: Advertising Depreciation of special equipment Salaries of the product line managers Total traceable fixed expenses Product line segment margin Less common fixed expenses Net operating income

Dirt Mountai Racing Total Bikes n Bikes Bikes $300,00 $90,00 $150,00 0 0 0 $60,000 120,00 0 27,000 180,00 0 63,000

60,000

33,000

90,000

27,000

30,000 10,000

14,000

6,000

23,000 6,000 35,00 0 12,000 88,00 0 28,000 $35,00 92,000 0 60,00 0 $  32,000

9,000

8,000

13,000

10,000

36,000 24,000 $ 54,000 $ 3,000

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Exercise 13-3 (30 minutes) 1.

Per Unit Differenti al Costs M ake Buy Cost of purchasing.................

$35

15,000 units Make

Direct materials..................... Direct labor........................... Variable manufacturing overhead......................... .... Fixed manufacturing overhead, traceable1........... Fixed manufacturing overhead, common.............

$14 10

$210,00 0 150,000

3

45,000

2

30,000

Total costs.............................

$29 $35

Difference in favor of continuing to make the carburetors.........................

$6

Buy $525,00 0

$435,00 $525,00 0 0

$90,000

Only the supervisory salaries can be avoided if the carburetors are purchased. The remaining book value of the special equipment is a sunk cost; hence, the $4 per unit depreciation expense is not relevant to this decision. Based on these data, the company should reject the offer and should continue to produce the carburetors internally. Make

2. Cost of purchasing (part 1)..................... Cost of making (part 1).......................... Opportunity cost—segment margin foregone on a potential new product line.................................................. ..... Total cost............................. ...................

$435,00 0

Buy $525,00 0

150,000 $585,00 $525,00

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0 Difference in favor of purchasing from the outside supplier.............................

0

$60,00 0

Thus, the company should accept the offer and purchase the carburetors from the outside supplier.

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Exercise 13-4 (15 minutes) Only the incremental costs and benefits are relevant. In particular, only the variable manufacturing overhead and the cost of the special tool are relevant overhead costs in this situation. The other manufacturing overhead costs are fixed and are not affected by the decision. Total Per for 20 Unit Bracelets $169.9 $3,399.0 5 0

Incremental revenue..................... .. Incremental costs: Variable costs: Direct materials......................... $ 84.00 Direct labor................................ 45.00 Variable manufacturing overhead................................. 4.00 Special filigree........................... 2.00 $135.0 Total variable cost........................ 0 Fixed costs: Purchase of special tool............. Total incremental cost..................... Incremental net operating income..

1,680.00 900.00 80.00 40.00 2,700.00 250.00 2,950.00 $ 449.00

Even though the price for the special order is below the company's regular price for such an item, the special order would add to the company's net operating income and should be accepted. This conclusion would not necessarily follow if the special order affected the regular selling price of bracelets or if it required the use of a constrained resource.

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Exercise 13-5 (30 minutes) 1.

(1) Contribution margin per unit.................... (2) Direct material cost per unit..................... (3) Direct material cost per pound................. Pounds of material required per unit (2) (4) ÷ (3)......................... ............................. (5) Contribution margin per pound (1) ÷ (4). .

A B C $54 $108 $60 $24 $72 $32 $8 $8 $8 3 9 4 $18 $12 $15

2. The company should concentrate its available material on product A: Contribution margin per pound (above).........................................

A $

B 18 $

C 12 $

15 × Pounds of material available............ × 5,000 × 5,000 5,000 $75,00 Total contribution margin................. $90,000 $60,000 0 Although product A has the lowest contribution margin per unit and the second lowest contribution margin ratio, it is preferred over the other two products since it has the greatest amount of contribution margin per pound of material, and material is the company’s constrained resource. 3. The price Barlow Company would be willing to pay per pound for additional raw materials depends on how the materials would be used. If there are unfilled orders for all of the products, Barlow would presumably use the additional raw materials to make more of product A. Each pound of raw materials used in product A generates $18 of contribution margin over and above the usual cost of raw materials. Therefore, Barlow should be willing to pay up to $26 per pound ($8 usual price plus $18 contribution margin per pound) for the additional raw material, but would of course prefer to pay far less. The upper limit of $26 per pound to manufacture more product A signals to managers how valuable additional raw materials are to the company. If all of the orders for product A have been filled, Barlow © The McGraw-Hill Companies, Inc., 2008. All rights reserved. Solutions Manual, Chapter 15

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Company would then use additional raw materials to manufacture product C. The company should be willing to pay up to $23 per pound ($8 usual price plus $15 contribution margin per pound) for the additional raw materials to manufacture more product C, and up to $20 per pound ($8 usual price plus $12 contribution margin per pound) to manufacture more product B if all of the orders for product C have been filled as well.

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Problem 13-19 (60 minutes) 1. The $90,000 in fixed overhead costs charged to the new product is a common cost that will be the same whether the tubes are produced internally or purchased from the outside. Hence, they are not relevant. The variable manufacturing overhead per box of Chap-Off would be $0.50, as shown below: Total manufacturing overhead cost per box of Chap-Off........................ ..................................... $1.40 Less fixed portion ($90,000 ÷ 100,000 boxes)...... 0.90 Variable overhead cost per box............................. $0.50 The total variable costs of producing one box of Chap-Off would be: Direct materials............................................. ........ $3.60 Direct labor........................................................... 2.00 Variable manufacturing overhead......................... 0.50 Total variable cost per box.................................. ... $6.10 If the tubes for the Chap-Off are purchased from the outside supplier, then the variable cost per box of Chap-Off would be: Direct materials ($3.60 × 75%)............................ Direct labor ($2.00 × 90%)................................... Variable manufacturing overhead ($0.50 × 90%). Cost of tube from outside..................................... Total variable cost per box....................................

$2.70 1.80 0.45 1.35 $6.30

Therefore, the company should reject the outside supplier’s offer. A savings of $0.20 per box of Chap-Off will be realized by producing the tubes internally.

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Problem 13-19 (continued) Another approach to the solution would be: Cost avoided by purchasing the tubes: Direct materials ($3.60 × 25%)................... $0.90 Direct labor ($2.00 × 10%).......................... 0.20 Variable manufacturing overhead ($0.50 × 10%)................................................... ....... 0.05 Total costs avoided....................... .................. $1.15 * Cost of purchasing the tubes from the outside............................................... .......... $1.35 Cost savings per box by making internally..... $0.20 * This $1.15 is the cost of making one box of tubes internally, since it represents the overall cost savings that will be realized per box of Chap-Off by purchasing the tubes from the outside. 2. The maximum purchase price would be $1.15 per box. The company would not be willing to pay more than this amount, since the $1.15 represents the cost of producing one box of tubes internally, as shown in Part 1. To make purchasing the tubes attractive, however, the purchase price should be less than $1.15 per box.

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Problem 13-19 (continued) 3. At a volume of 120,000 boxes, the company should buy the tubes. The computations are: Cost of making 120,000 boxes: 120,000 boxes × $1.15 per box............. Rental cost of equipment...................... . Total cost................................................. Cost of buying 120,000 boxes: 120,000 boxes × $1.35 per box.............

$138,00 0 40,000 $178,00 0 $162,00 0

Or, on a total cost basis, the computations are: Cost of making 120,000 boxes: 120,000 boxes × $6.10 per box............. Rental cost of equipment...................... . Total cost................................................. Cost of buying 120,000 boxes: 120,000 boxes × $6.30 per box.............

$732,00 0 40,000 $772,00 0 $756,00 0

Thus, buying the boxes will save the company $16,000 per year.

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Problem 13-19 (continued) 4. Under these circumstances, the company should make the 100,000 boxes of tubes and purchase the remaining 20,000 boxes from the outside supplier. The costs would: Cost of making: 100,000 boxes × $1.15 per box............................................................ ... Cost of buying: 20,000 boxes × $1.35 per box............................................................ ... Total cost....................................... .................

$115,00 0 27,000 $142,00 0

Or, on a total cost basis, the computation would be: Cost of making: 100,000 boxes × $6.10 per box............................................................ ... $610,000 Cost of buying: 20,000 boxes × $6.30 per box............................................................ ... 126,000 Total cost....................................... ................. $736,000 Since the amount of cost under this alternative is $20,000 less than the best alternative in Part 3, the company should make as many tubes as possible with the current equipment and buy the remaining tubes from the outside supplier. 5. Management should take into account at least the following additional factors: a) The ability of the supplier to meet required delivery schedules. b) The quality of the tubes purchased from the supplier. c) Alternative uses of the capacity that would be used to make the tubes. d) The ability of the supplier to supply tubes if volume increases in future years. e) The problem of alternative sources of supply if the supplier proves undependable.

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Problem 13-20 (30 minutes) 1. Since the fixed costs will not change as a result of the order, they are not relevant to the decision. The cost of the new machine is relevant, and this cost will have to be recovered by the current order since there is no assurance of future business from the retail chain. U nit Revenue from the order ($50 × 84%).......... $42 Less costs associated with the order: Direct materials................................ ......... 15 Direct labor............................................... 8 Variable manufacturing overhead.............. 3 Variable selling expense ($4 × 25%)......... 1 Special machine ($10,000 ÷ 5,000 units).. 2 Total costs........................................... ......... 29 Net increase in profits....................... ........... $13 2. Revenue from the order: Reimbursement for costs of production (variable production costs of $26, plus fixed manufacturing overhead cost of $9 = $35 per unit; $35 per unit × 5,000 units).............. Fixed fee ($1.80 per unit × 5,000 units)............ Total revenue................................................... .... Less incremental costs—variable production costs ($26 per unit × 5,000 units)............................. . Net increase in profits......................................... 3. Sales revenue: From the U.S. Army (above).............................. From regular channels ($50 per unit × 5,000 units)........................................... ................... Net decrease in revenue..................................... Less variable selling expenses avoided if the Army’s order is accepted ($4 per unit × 5,000 units)........................... .....................................

Total— 5,000 units $210,000 75,000 40,000 15,000 5,000 10,000 145,000 $ 65,000

$175,000 9,000 184,000 130,000 $ 54,000 $184,000 250,000 (66,000) 20,000

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Net decrease in profits if the Army’s order is accepted........................................... ................

$(46,000)

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Problem 13-25 (45 minutes) 1. A product should be processed further so long as the incremental revenue from the further processing exceeds the incremental costs. The incremental revenue from further processing of the Grit 337 is: Selling price of the silver polish, per jar......... Selling price of 1/4 pound of Grit 337 ($2.00 ÷ 4)............................................................ Incremental revenue per jar..........................

$4.00 0.50 $3.50

The incremental variable costs are: Other ingredients.......................................... Direct labor................................................... Variable manufacturing overhead (25% × $1.48)............................... .......................... Variable selling costs (7.5% × $4)................. Incremental variable cost per jar...................

$0.65 1.48 0.37 0.30 $2.80

Therefore, the incremental contribution margin is $0.70 per jar ($3.50 – $2.80). The $1.60 cost per pound ($0.40 per 1/4 pound) required to produce the Grit 337 would not be relevant in this computation, since it is incurred regardless of whether the Grit 337 is further processed into silver polish or sold outright.

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Problem 13-25 (continued) 2. Only the cost of advertising and the cost of the production supervisor are avoidable if production of the silver polish is discontinued. Therefore, the number of jars of silver polish that must be sold each month to justify continued processing of the Grit 337 into silver polish is: Production supervisor.................................. $3,000 Advertising—direct................................ ....... 4,000 Avoidable fixed costs................................... $7,000 Avoidable fixed costs $7,000 = = 10,000 jars per Incremental CM per jar $0.70 per jar month Therefore, if 10,000 jars of silver polish can be sold each month, the company would be indifferent between selling it or selling all of the Grit 337 as a cleaning powder. If the sales of the silver polish are greater than 10,000 jars per month, then continued processing of the Grit 337 into silver polish would be advisable since the company’s total profits will be increased. If the company can’t sell at least 10,000 jars of silver polish each month, then production of the silver polish should be discontinued. To verify this, we show on the next page the total contribution to profits of sales of 9,000, 10,000 and 11,000 jars of silver polish, contrasted to sales of equivalent amounts of Grit 337 sold outright (i.e., 10,000 jars of silver polish would require the use of 2,500 pounds of Grit 337 that otherwise could be sold outright as cleaning powder, etc.):

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Problem 13-25 (continued) 9,000 Jars of Polish; or 2,250 pounds of Grit 337

10,000 Jars of Polish; or 2,500 pounds of Grit 337

11,000 Jars of Polish; or 2,750 pounds of Grit 337

Sales of Silver Polish: Sales @ $4.00 per jar................... $36,000 $40,000 $44,000 Less variable expenses: Production cost of Grit 337 @ $1.60 per pound........................ 3,600 * 4,000 * 4,400 * Further processing and selling costs of the polish @ $2.80 per jar.............................................. 25,200 28,000 30,800 Total variable expenses.................. 28,800 32,000 35,200 Contribution margin........................ 7,200 8,000 8,800 Less avoidable fixed costs: Production supervisor................... 3,000 3,000 3,000 Advertising................................... 4,000 4,000 4,000 Total avoidable fixed costs.............. 7,000 7,000 7,000 Total contribution to common fixed costs and to profits....................... $ 200 $ 1,000 $ 1,800 Sales of Grit 337: Sales @ $2.00 per pound $ 4,500 $ 5,000 $ 5,500 Less variable expenses: Production cost of Grit 337 @ $1.60 per pound........................ 3,600 * 4,000 * 4,400 * Contribution to common fixed costs and to profits....................... $ 900 $ 1,000 $ 1,100 * This cost will be incurred regardless of whether the Grit 337 is further processed into silver polish or sold outright as cleaning powder; therefore, it is not relevant to the decision, as stated earlier. It is included in the computation above for the specific purpose of showing that it will be incurred under either alternative. The same thing could have been done with the © The McGraw-Hill Companies, Inc., 2008. All rights reserved. Solutions Manual, Chapter 15

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depreciation on the mixing equipment.

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Exercise 14-18 (15 minutes)

Item Project A: Cost of equipment........ Annual cash inflows.............. Salvage value of the equipment. . Net present value Project B: Working capital investment....... Annual cash inflows.............. Working capital released............ Net present value

Year(s)

Amount of Cash Inflows

14% Present Facto Value of r Cash Flows

Now

$(100,000)

1.000 $(100,000)

1-6 6

Now 1-6 6

$21,000

3.889

$8,000

0.456

$(100,000)

81,669 3,648 $ (14,683)

1.000 $(100,000)

$16,000

3.889

62,224

$100,000

0.456

45,600 $ 7,824

The $100,000 should be invested in Project B rather than in Project A. Project B has a positive net present value whereas Project A has a negative net present value.

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Exercise 14-19 (15 minutes) 1. Computation of the annual cash inflow associated with the new pinball machines: Net operating income......................... ........... Add noncash deduction for depreciation....... Net annual cash inflow..................................

$40,000 35,000 $75,000

The payback computation would be: Payback period = =

Investment required Net annual cash inflow $300,000 = 4.0 years $75,000 per year

Yes, the pinball machines would be purchased. The payback period is less than the maximum 5 years required by the company. 2. The simple rate of return would be: Annual incremental - Annual incremental expenses, revenues including depreciation Simple rate = of return Initial investment =

Annual incremental net income Initial investment

=

$40,000 = 13.3% $300,000

Yes, the pinball machines would be purchased. The 13.3% return exceeds 12%. Problem 14-22 (20 minutes) Present Amount 20% Value of Year(s of Cash Facto Cash Item ) Flows r Flows R(275,000 R(275,000 Cost of new equipment...... Now ) 1.000 ) © The McGraw-Hill Companies, Inc., 2008. All rights reserved. Solutions Manual, Chapter 15

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Working capital required.... Net annual cash receipts. . . Cost to construct new roads............................... Salvage value of equipment....................... Working capital released. . . Net present value..............

Now 1-4

R(100,000 ) 1.000 (100,000) R120,000 2.589 310,680

3

R(40,000) 0.579

(23,160)

4 4

R65,000 0.482 R100,000 0.482

31,330 48,200 R (7,950)

No, the project should not be accepted; it has a negative net present value at a 20% discount rate. This means that the rate of return on the investment is less than the company’s required rate of return of 20%.

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Problem 14-26 (30 minutes) 1. The formula for the project profitability index is: Project profitability index =

Net present value of the project Investment required by the project

The indexes for the projects under consideration would be: Project Project Project Project Project

1: 2: 3: 4: 5:

$66,140 ÷ $270,000 = 0.24 $72,970 ÷ $450,000 = 0.16 -$20,240 ÷ $400,000 = -0.05 $73,400 ÷ $360,000 = 0.20 $87,270 ÷ $480,000 = 0.18

2. a., b., and c.

First preference..... Second preference Third preference.... Fourth preference.. Fifth preference.....

Net Present Value 5 4 2 1 3

Project Profitabilit y Index 1 4 5 2 3

Internal Rate of Return 2 1 5 4 3

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Problem 14-26 (continued) 3. Which ranking is best will depend on Revco Products’ opportunities for reinvesting funds as they are released from the project. The internal rate of return method assumes that any released funds are reinvested at the internal rate of return. This means that funds released from project #2 would have to be reinvested in another project yielding a rate of return of 19%. Another project yielding such a high rate of return might be difficult to find. The project profitability index approach assumes that funds released from a project are reinvested in other projects at a rate of return equal to the discount rate, which in this case is only 10%. On balance, the project profitability index is the most dependable method of ranking competing projects. The net present value is inferior to the project profitability index as a ranking device, since it looks only at the total amount of net present value from a project and does not consider the amount of investment required. For example, it ranks project #1 as fourth in terms of preference because of its low net present value; yet this project is the best available in terms of the amount of cash inflow generated for each dollar of investment (as shown by the profitability index).

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Problem 15-14 (45 minutes) 1. and 2.

Rusco Products Statement of Cash Flows For the Year Ended July 31, 2009

Operating activities: Net income............................................. ... Adjustments to convert net income to cash

$ 30,000

basis: Depreciation charges.............................. $20,000 Increase in accounts receivable.............. (40,000) Increase in inventory.............................. (50,000) Decrease in prepaid expenses................ 4,000 Increase in accounts payable.................. 63,000 Decrease in accrued liabilities................ (9,000) Gain on sale of investments.................... (10,000) Loss on sale of equipment...................... 2,000 Increase in deferred income taxes.......... 8,000 (12,000) Net cash provided by operating activities. 18,000 Investing activities: Proceeds from sale investments................ Proceeds from sale of equipment..............

 30,000 8,000 (150,000 Additions to plant and equipment............. ) Net cash used for investing activities........ Financing activities: Increase in bonds payable......................... Increase in common stock......................... Cash dividends.............................. ............ Net cash provided by financing activities. . Net decrease in cash................................. Cash balance, August 1, 2008................... Cash balance, July 31, 2009...................... Schedule of noncash investing and financing activities: Preferred stock converted into common

70,000 20,000 (9,000)

(112,000 )

81,000 (13,000) 21,000 $   8,000 $

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stock....................................................

16,000

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Problem 15-14 (continued) 3. Although the company reported a large net income for the year, a relatively small amount of cash was provided by operations due to increases in both accounts receivable and inventory. The cash provided by operations, when added to the cash provided by the sale of investments, the issue of bonds, and the sale of common stock, was not sufficient to cover the purchase of plant and equipment during the year. Note that the company increased its investment in plant and equipment by almost 50%. More care should have been taken in planning for this major investment in plant assets. Also, the company should get better control over its accounts receivable and inventory.

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Problem 15-14 (continued) Note to the instructor: Although it is not a requirement, a worksheet may be helpful. Source Change or use? Assets (except cash and cash equivalents) Current assets: Accounts receivable..... +40 Use Inventory...................... +50 Use Prepaid expenses......... –4 Source Noncurrent assets: Long-term investments –20 Source Plant and equipment.... +130 Use Liabilities, Contra-assets, and Stockholders’ Equity Contra-assets: Accumulated depreciation............... +10 Source Current liabilities: Accounts payable......... +63 Source Accrued liabilities......... –9 Use

Cash Flow Effect

Adjustments

–40 –50 +4

Adjusted Effect

Classification

–40 –50 +4

Operating Operating Operating

+20 –130

–20 –20

0 –150

Investing Investing

+10

+10

+20

Operating

+63 –9

Operating Operating

+63 –9

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Problem 15-14 (continued)

Noncurrent liabilities: Bonds payable............. Deferred income taxes. Stockholders’ equity: Preferred stock............. Common stock............. Retained earnings: Net income................ Dividends...................

Change

Source or use?

Cash Flow Effect

+70 +8

Source Source

+70 +8

–16 +36

Use Source

+36

+30 –9

Source Use

+30 –9

Additional entries Proceeds from sale of investments................. Gain on sale of investments................. Proceeds from sale of equipment.................... Loss on sale of equipment.................... Total............................. ...

–13

Adjustments

Adjusted Effect

Classification

+70 +8

Financing Operating

0 +20

Financing

+30 –9

Operating Financing

+30

+30

Investing

–10

–10

Operating

+8

+8

Investing

+2

  +2

Operating

+16 –16

–13

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Problem 16-11 (60 minutes) This Year Last Year 1. a. Current assets.................................. $1,520,000 $1,090,000 Current liabilities.............................. 800,000 430,000 Working capital................................. $ 720,000 $ 660,000 b. Current assets (a)............................. $1,520,000 $1,090,000 Current liabilities (b)......................... $800,000 $430,000 Current ratio (a) ÷ (b)...................... 1.90 2.53 c. Quick assets (a).......................... ...... Current liabilities (b)......................... Acid-test ratio (a) ÷ (b)....................

$550,000 $800,000 0.69

$468,000 $430,000 1.09

d. Sales on account (a)......................... $5,000,000 $4,350,000 Average receivables (b).................... $390,000 $275,000 Accounts receivables turnover (a) ÷ (b)................................... ............... 12.8 15.8 Average collection period: 365 days ÷ turnover......................

28.5 days

23.1 days

e. Cost of goods sold (a)....................... $3,875,000 $3,450,000 Average inventory (b)....................... $775,000 $550,000 Inventory turnover (a) ÷ (b)............. 5.0 6.3 Average sales period: 365 days ÷ turnover......................

73 days

58 days

f. Total liabilities (a)............................. $1,400,000 $1,030,000 Stockholders’ equity (b)................... $1,600,000 $1,430,000 Debt-to-equity ratio (a) ÷ (b)........... 0.875 0.720 Net income before interest and g. taxes (a)......................................... Interest expense (b)......................... Times interest earned (a) ÷ (b)........

$472,000 $72,000 6.6

$352,000 $72,000 4.9

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Problem 16-11 (continued) 2. a.

Sabin Electronics Common-Size Balance Sheets This Year Current assets: Cash........................................... ..... 2.3% Marketable securities...................... 0.0 Accounts receivable, net................. 16.0 Inventory........................................ 31.7 Prepaid expenses............................ 0.7 Total current assets........................... 50.7 Plant and equipment, net.................. 49.3 Total assets....................................... . 100.0% Current liabilities............................... 26.7% Bonds payable, 12%.......................... 20.0 Total liabilities................................. 46.7 Stockholders’ equity: Preferred stock, $25 par, 8%........... 8.3 Common stock, $10 par.................. 16.7 Retained earnings........................... 28.3 Total stockholders’ equity.................. 53.3 Total liabilities and equity.................. 100.0%

Last Year 6.1% 0.7 12.2 24.4 0.9 44.3 55.7 100.0% 17.5% 24.4 41.9 10.2 20.3 27.6 58.1 100.0%

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Problem 16-11 (continued) b.

Sabin Electronics Common-Size Income Statements

Sales.............................. ................. Less cost of goods sold................... Gross margin.................................. Less operating expenses................. Net operating income..................... Less interest expense..................... Net income before taxes................. Less income taxes.......................... . Net income.....................................

This Last Year Year 100.0% 100.0 % 77.5 79.3 22.5 20.7 13.1 12.6 9.4 8.1 1.4 1.7 8.0 6.4 2.4 1.9 5.6% 4.5 %

3. The following points can be made from the analytical work in parts (1) and (2) above: a. The company has improved its profit margin from last year. This is attributable primarily to an increase in gross margin, which is offset somewhat by a small increase in operating expenses. Overall, the company’s income statement looks very good. b. The company’s current position has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average and are trending downward. At the present rate, it will soon be impossible for the company to pay its bills as they come due. c. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. Notice that the average age of the receivables has increased by five days since last year, and now is 10 days over the industry average. Many of the company’s customers are not taking their discounts, since the average collection period is 28 days and collections terms are 2/10, n/30. This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks.

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Problem 16-11 (continued) d. The inventory turned only five times this year as compared to over six times last year. It takes nearly two weeks longer for the company to turn its inventory than the average for the industry (73 days as compared to 60 days for the industry). This suggests that inventory stocks are higher than they need to be. e. In the authors’ opinion, the loan should be approved only if the company gets its accounts receivable and inventory back under control. If the accounts receivable collection period is reduced to about 20 days, and if the inventory is pared down enough to reduce the turnover time to about 60 days, enough funds could be released to substantially improve the company’s cash position. Then a loan might not even be needed.

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Problem 16-19 (60 minutes or longer) Pepper Industries Income Statement For the Year Ended March 31

Sales.......................................... Less cost of goods sold.............. Gross margin.......................... .... Less operating expenses............ Net operating income................ Less interest expense................ Net income before taxes............ Less income taxes (30%)........... Net income................................

$4,200,000 2,730,000 1,470,000 930,000 540,000 80,000 460,000 138,000 $  322,000

Key to Computatio n (h) (i) (j) (a) (b) (c) (d)

Peppers Industries Balance Sheet March 31 Current assets: Cash........................................ Accounts receivable, net.......... Inventory................................. Total current assets.................... Plant and equipment.................. Total assets................................ Current liabilities........................ Bonds payable, 10%.................. Total liabilities............................ Stockholders’ equity: Common stock, $5 par value.. . Retained earnings.................... Total stockholders’ equity........... Total liabilities and equity...........

$   70,000 330,000 480,000 880,000 1,520,000 $2,400,000

(f) (e) (g) (g) (q) (p)

$  320,000 800,000 1,120,000

(k) (l)

700,000 580,000 1,280,000 $2,400,000

(m) (o) (n) (p)

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Problem 16-19 (continued) Computation of missing amounts: a.

Times interest earned =

Earnings before interest and taxes Interest expense

=

Earnings before interest and taxes $80,000

= 6.75 Therefore, the earnings before interest and taxes for the year must be $540,000. b. $540,000 – $80,000 = $460,000. c. Income tax expense = $460,000 × 30% tax rate = $138,000. d. $460,000 – $138,000 = $322,000. e.

Sales on account Accounts receivable = turnover Average accounts receivable balance =

$4,200,000 Average accounts receivable balance

= 14.0 Therefore, the average accounts receivable balance for the year must have been $300,000. Since the beginning balance was $270,000, the ending balance must have been $330,000. f.

Acid-test ratio=

Cash + Marketable securities + Current receivables Current liabilities

=

Cash + Marketable securities + Current receivables $320,000

= 1.25 © The McGraw-Hill Companies, Inc., 2008. All rights reserved. Solutions Manual, Chapter 16

34

Problem 16-19 (continued) Therefore, the total quick assets must be $400,000. Since there are no marketable securities and since the accounts receivable are $330,000, the cash must be $70,000. g.

Current ratio = =

Current assets Current liabilities Current assets $320,000

= 2.75 Therefore, the current assets must total $880,000. Since the quick assets (cash and accounts receivable) total $400,000 of this amount, the inventory must be $480,000. h.

Inventory turnover =

Cost of goods sold Average inventory

=

Cost of goods sold 1/2($360,000+$480,000)

=

Cost of goods sold $420,000

= 6.5 Therefore, the cost of goods sold for the year must be $2,730,000. i. Gross margin = $4,200,000 – $2,730,000 = $1,470,000. j.

Net operating income = Gross margin - Operating expenses Operating expenses = Gross margin - Net operating income = $1,470,000 - $540,000 = $930,000

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Problem 16-19 (continued) k. Since the interest expense for the year was $80,000 and the interest rate was 10%, the bonds payable must total $800,000. l. $320,000 + $800,000 = $1,120,000. Net income - Preferred dividends Earnings per share = m Average number of common shares outstanding . $322,000 = Average number of common shares outstanding = $2.30 Therefore, there must be 140,000 common shares outstanding. Since the stock is $5 par value per share, the total common stock must be $700,000. n.

Debt-to-equity ratio =

Total liabilities Stockholders' equity

=

$1,120,000 Stockholders' equity

= 0.875 Therefore, the total stockholders’ equity must be $1,280,000. o.

Total stockholders' equity = Common stock + Retained earnings Retained earnings = Total stockholders' equity - Common Stock = $1,280,000 - $700,000 = $580,000

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Problem 16-19 (continued) p.

Total assets = Liabilities + Stockholders' equity = $1,120,000 + $1,280,000 = $2,400,000 This answer can also be obtained using the return on total assets: Return on = Net income + [Interest expense × (1 - Tax rate)] total assets Average total assets =

$322,000 + [$80,000 × (1 - 0.30)] Average total assets

=

$378,000 Average total assets

= 18.0% Therefore the average total assets must be $2,100,000. Since the total assets at the beginning of the year were $1,800,000, the total assets at the end of the year must have been $2,400,000 (which would also equal the total of the liabilities and the stockholders’ equity). q.

Total assets = Current assets + Plant and equipment $2,400,000 = $880,000 + Plant and equipment Plant and equipment = $2,400,000 - $880,000 = $1,520,000

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© The McGraw-Hill Companies, Inc., 2008. All rights reserved. Solutions Manual, Chapter 16

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