Do The Assigned Problems Using Summer Peebles Inc's Condense
Do The Assigned Problems Using Summer Peebles Incs Condensed 2014 F
Do the assigned problems using Summer Peebles, Inc.’s condensed 2014 financial data below: Assets Current Assets $250,000.00 Noncurrent Assets $1,750,000.00 Total Assets $2,000,000.00 Liabilities and Equity Current Liabilities $200,000.00 Noncurrent Liabilities (8% Bonds) $675,000.00 Common Stockholders' Equity $1,125,000.00 Total Liabilities and Equity $2,000,000.00 Additional Information: Net income for 2014 is $157,500. Income tax rate is 50%. Amounts for total assets and shareholders' equity are the same for 2013 and 2014. All assets and current liabilities are considered to be operating. Required: Determine whether leverage (from long-term debt) benefits Rose's shareholders. (Hint: Examine ROCE with and without leverage.) Compute the NOPAT and RNOA (use ending NOA). Demonstrate the favorable effect of leverage given the disaggregation of ROCE and your answer to part (B). Your submission should: Be 1-2 pages for the written portion. Include the Excel spreadsheet with computations. Clearly separate your responses so your instructor knows the problems you are answering.
Paper For Above instruction
Introduction
This analysis evaluates whether leverage from long-term debt enhances shareholder value for Summer Peebles, Inc., by examining the impact of financial leverage on return metrics such as Return on Capital Employed (ROCE) and Return on Net Operating Assets (RNOA). The assessment involves calculating key financial ratios—specifically NOPAT (Net Operating Profit After Tax), RNOA, and ROCE—both with and without leverage, to determine the benefits or drawbacks of using debt financing in the company's capital structure.
Financial Data and Assumptions
The company's condensed 2014 financial data are as follows:
- Current Assets: $250,000
- Noncurrent Assets: $1,750,000
- Total Assets: $2,000,000
- Current Liabilities: $200,000
- Noncurrent Liabilities (8% Bonds): $675,000
- Shareholders’ Equity: $1,125,000
- Net Income: $157,500
- Income Tax Rate: 50%
The total assets and equity figures remain unchanged from 2013 to 2014, and all assets and current liabilities are operating items.
Analysis of Leverage and ROCE
To determine whether leverage benefits shareholders, we first analyze the company's ROCE, which measures the efficiency of capital utilization. ROCE is calculated as:
\[
\text{ROCE} = \frac{\text{EBIT}}{\text{Net Operating Assets}}
\]
where EBIT (Earnings Before Interest and Taxes) equals Net Income plus interest expenses, adjusted for taxes.
Interest expense on bonds is:
\[
\text{Interest} = 8\% \times 675,000 = 54,000
\]
Net Operating Profit After Tax (NOPAT) is derived from EBIT adjusted for taxes:
\[
\text{EBIT} = \text{Net Income} + \text{Interest} \times (1 - \text{Tax Rate}) = 157,500 + 54,000 \times 0.5 = 157,500 + 27,000 = 184,500
\]
\[
\text{NOPAT} = \text{EBIT} \times (1 - \text{Tax Rate}) = 184,500 \times 0.5 = 92,250
\]
RNOA is calculated as:
\[
\text{RNOA} = \frac{\text{NOPAT}}{\text{Operating Net Assets}} = \frac{92,250}{(250,000 + 1,750,000) - (200,000 + 675,000)} = \frac{92,250}{2,000,000 - 875,000} = \frac{92,250}{1,125,000} \approx 8.2\%
\]
The ROCE, incorporating leverage, is influenced by the after-tax cost of debt and the equity returns.
Impact of Leverage on Shareholder Returns
Using the disaggregated approach, leverage magnifies returns to equity when ROCE exceeds the after-tax cost of debt. The after-tax cost of debt is:
\[
\text{Cost of Debt after Tax} = 8\% \times (1 - 0.5) = 4\%
\]
Given that ROCE is approximately 8.2%, which exceeds 4%, leverage provides a favorable benefit to shareholders.
The leverage effect is demonstrated by calculating the Return on Equity (ROE), considering interest expense:
\[
\text{ROE} = \frac{\text{Net Income}}{\text{Equity}} = \frac{157,500}{1,125,000} \approx 14\%
\]
This is significantly higher than the net return on assets (RNOA), indicating that leverage is positively amplifying shareholder returns.
Conclusion
The analysis confirms that leverage benefits shareholders for Summer Peebles, Inc., by increasing ROE compared to RNOA, due to the favorable spread between the company's ROCE and the after-tax cost of debt. The disaggregation of returns highlights how leverage acts as a financial lever that enhances shareholder value when the company's ROCE exceeds the after-tax cost of debt. Therefore, using long-term debt appears to be a beneficial strategy for maximizing shareholder wealth in this scenario.