Mini Case 2018 Chapter 2 Mini Case: Situation Jenny Cochran

Mini Case112018chapter 2 Mini Casesituationjenny Cochran A Graduate

Mini Case 11/20/18 Chapter 2 Mini Case Situation Jenny Cochran, a graduate of The University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components. During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data. Computron's Balance Sheets (Millions of Dollars) Assets Cash and equivalents $ 60 $ 50 Short-term investments Accounts receivable Inventories Total current assets $ 1,180 $ 1,400 Gross fixed assets $ 3,900 $ 4,820 Less: Accumulated depreciation 1,320 Net fixed assets $ 2,900 $ 3,500 Total assets $ 4,080 $ 4,900 Liabilities and equity Accounts payable $ 300 $ 400 Notes payable Accruals Total current liabilities $ 550 $ 890 Long-term bonds ,100 Total liabilities $ 1,350 $ 1,990 Common stock 1,000 Retained earnings 1,910 Total equity $ 2,730 $ 2,910 Total liabilities and equity $ 4,080 $ 4,900 Computron's Income Statement (Millions of Dollars) Net sales $ 5,500 $ 6,000 Cost of goods sold (Excluding depr. & amort.) 4,800 Depreciation and amortizationa Other operating expenses Total operating costs $ 4,940 $ 5,540 Earnings before interest and taxes (EBIT) $ 560 $ 460 Less interest Pre-tax earnings $ 492 $ 352 Taxes (25%) Net Income $ 369 $ 264 Notes: a Computron has no amortization charges. Other Data Stock price $50.00 $30.00 Shares outstanding (millions) Common dividends (millions) $90 $84 Tax rate 25% 25% Weighted average cost of capital (WACC) 10.00% 10.00% Computron's Statement of Cash Flows (Millions of Dollars) Bart Kreps: The statement of cash flows provides information about cash inflows and outflows during an accounting period. 2019 Operating Activities Net Income before preferred dividends $ 264 Noncash adjustments Depreciation and amortization 320 Due to changes in working capital Change in accounts receivable (120) Change in inventories (200) Change in accounts payable 100 Change in accruals 40 Net cash provided by operating activities $ 404 Investing activities Cash used to acquire fixed assets $ (920) Bart Kreps: Make sure to add back annual Depreciation to Net PP&E. Bart Kreps: The statement of cash flows provides information about cash inflows and outflows during an accounting period. Change in short-term investments 90 Net cash provided by investing activities $ (830) Financing Activities Change in notes payable $ 200 Change in long-term debt 300 Payment of cash dividends (84) Net cash provided by financing activities $ 416 Net change in cash and equivalents $ (10) Cash and securities at beginning of the year 60 Cash and securities at end of the year $ 50 a. (1.) What effect did the expansion have on sales and net income? (2 pts) a. (2.) What effect did the expansion have on the asset side of the balance sheet? (2 pts) b. What do you conclude from the statement of cash flows? (2 pts) c. What is free cash flow? Why is it important? What are the five uses of FCF? (2 pts) d. What is Computron’s net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have? (7 pts) Net Operating Profit After Taxes NOPAT is the amount of profit Computron would generate if it had no debt and held no financial assets. 2019 NOPAT = EBIT x (1 - T) = x = 2018 NOPAT = EBIT x (1 - T) = x = Net Operating Working Capital Those current assets used in operations are called operating current assets, and the current liabilities that result from operations are called operating current liabilities. Net operating working capital is equal to operating current assets minus operating current liabilities. 2019 NOWC = Operating current assets − Operating current liabilities = − = 2018 NOWC = Operating current assets − Operating current liabilities = − = Total Net Operating Capital (TNOC) TNOC = NOWC + net operating long-term assets 2019 TNOC = NOWC + Fixed assets = + = 2018 TNOC = NOWC + Fixed assets = + = e. What is Computron’s free cash flow (FCF)? What are Computron’s “net uses” of its FCF? (4 pts) Free Cash Flow Computron's Free Cash Flow calculation is the cash flow actually available for distribution to investors after the company has made all necessary investments in fixed assets and working capital to sustain ongoing operations. 2019 FCF = NOPAT − Net Investment in Operating Capital = − = Uses of FCF 2019 After-tax interest payment = Reduction (increase) in debt = Payment of dividends = Repurchase (Issue) stock = Purchase (Sale) of short-term investments = Total uses of FCF = f. Calculate Computron’s return on invested capital (ROIC). Computron has a 10% cost of capital (WACC). What caused the decline in the ROIC? Was it due to operating profitability or capital utilization? Do you think Computron’s growth added value? (6 pts) Return on Invested Capital The Return on Invested Capital tells us the amount of NOPAT per dollar of operating capital. 2019 ROIC = NOPAT ÷ Operating Capital = = 2018 ROIC = NOPAT ÷ Operating Capital = = Operating Profitability The operating profitability (OP) ratio shows how many dollars of operating profit are generated by each dollar of sales. 2019 OP = NOPAT ÷ Sales = = 2018 OP = NOPAT ÷ Sales = = Capital Utilization The capital utilization (CR) ratio shows how many dollars of operating assets are needed to generated a dollar of sales. 2019 CR = Total Op. Cap. ÷ Sales = = 2018 CR = Total Op. Cap. ÷ Sales = = Operating profitability declined and the capital utilization worsened, each contributing to the big decrease in ROIC. Do you think Computron’s growth added value? (6 pts) Return on Invested Capital The Return on Invested Capital tells us the amount of NOPAT per dollar of operating capital. 2019 ROIC = NOPAT ÷ Operating Capital = = 2018 ROIC = NOPAT ÷ Operating Capital = = Operating Profitability The operating profitability (OP) ratio shows how many dollars of operating profit are generated by each dollar of sales. 2019 OP = NOPAT ÷ Sales = = 2018 OP = NOPAT ÷ Sales = = Capital Utilization The capital utilization (CR) ratio shows how many dollars of operating assets are needed to generated a dollar of sales. 2019 CR = Total Op. Cap. ÷ Sales = = 2018 CR = Total Op. Cap. ÷ Sales = = Operating profitability declined and the capital utilization worsened, each contributing to the big decrease in ROIC. g. What is Computron's EVA? The cost of capital was 10% in both years. (4 pts) Economic Value Added Economic Value Added represents Computron's residual income that remains after the cost of all capital, including equity capital, has been deducted. 2019 EVA = NOPAT − Operating Capital × WACC = − x = 2018 EVA = NOPAT − Operating Capital × WACC = − x = h. What happened to Computron's market value added (MVA)? (2 pts) Year-end common stock price $50.00 $30.00 Year-end shares outstanding (in millions) Market Value Added Assume that the market value of debt is equal to the book value of debt. In this case, Market Value Added (MVA) is the difference between the market value of Computron's stock and the amount of equity capital supplied by shareholders. 2019 MVA = Stock price × # of shares − Total common equity = x − = 2018 MVA = Stock price × # of shares − Total common equity = x − = i. Assume that a corporation has $87 million of taxable income from operations. It also received interest income of $8 million and dividend income of $10 million. The federal tax rate is 21% and the dividend exclusion rate is 50%. What is the company's federal tax liability? (2 pts) Operating income = $87 million Interest income received = $8 million Dividend income received = $10 million Federal tax rate = 21% Dividend exclusion rate = 50% Taxable dividends= million Taxable income = million Federal corporate tax liability = million j. Assume that you are in the 25% marginal tax bracket and that you have $20,000 to invest. You have narrowed your investment choices down to municipal bonds yielding 7% or equally risky corporate bonds with a yield of 10%. Which one should you choose and why? At what marginal tax rate would you be indifferent? (4 pts)

Paper For Above instruction

The recent expansion undertaken by Computron Industries has had notable impacts on its financial performance, balance sheet composition, cash flows, and overall valuation measures. Analyzing these effects provides insights into the company's strategic decisions and financial health. This comprehensive assessment will examine the changes in sales and net income, balance sheet structure, cash flow implications, free cash flow, return on invested capital (ROIC), economic value added (EVA), market value added (MVA), tax liabilities, and investment considerations associated with municipal and corporate bonds.

Impact on Sales and Net Income

The expansion at Computron significantly influenced both sales and profitability. The increase in sales from $5,500 million to $6,000 million reflects the company's enhanced capacity and expanded market outreach. This 9.1% rise in sales, driven by new plants, market expansion, and advertising, naturally led to an incremental increase in net income, from $369 million to $264 million, representing roughly a 28.3% decrease in net income relative to sales growth. The disparity between sales growth and net income decline suggests pressure on margins, possibly due to increased operational costs, higher depreciation, or investment-related expenses associated with the expansion.

Balance Sheet Effects of Expansion

On the asset side, the increase in total assets from $4,080 million to $4,900 million underscores substantial capital investment. Fixed assets grew from $2,900 million to $3,500 million, reflecting the cost of new plants and equipment. Current assets also increased, notably cash and equivalents, short-term investments, receivables, and inventories, to support greater sales activities. The liabilities side also expanded, with total liabilities rising from $1,350 million to $1,990 million, largely due to higher accounts payable, accrued expenses, and long-term debt. This suggests strategic financing of the expansion via both debt and reinvested earnings, aligning with corporate growth strategies.

Cash Flow Analysis and Implications

The statement of cash flows reveals crucial insights. While net income rose modestly, operating cash flow increased significantly to $404 million, indicating operating efficiency improvements or adjustments in working capital. Nonetheless, cash used for investing activities soared to $920 million, primarily due to significant capital expenditures to support expansion. The net effect was a negative cash flow from investing activities, indicating substantial reinvestment into fixed assets.

Financing activities contributed to cash inflows, with a total of $416 million, stemming from new debt issuance and change in notes payable, offset partially by dividend payouts. The slight net decrease in cash and equivalents ($10 million) highlights ongoing reinvestment commitments and the importance of debt financing in sustaining growth.

Understanding Free Cash Flow (FCF)

Free cash flow, defined as the cash available after covering operating expenses and capital investments, is vital for assessing a company's capacity to generate value beyond operational needs. It is calculated as NOPAT minus net investment in operating capital. FCF is crucial because it reflects the company's ability to return value to shareholders, fund growth, reduce debt, or pursue acquisitions. Typical uses include paying dividends, repurchasing shares, reducing debt, investing in new projects, and maintaining working capital.

Calculating NOPAT, Operating Assets, and Operating Liabilities

Computron’s NOPAT for 2019 can be derived from EBIT multiplied by (1-tax rate), which amounts to $560 million × (1-0.25) = $420 million, indicating its profit performance ignoring financial structure. Operating current assets, derived from cash, receivables, and inventories, totaled approximately $1,180 million. Operating current liabilities, including accounts payable and accruals, totaled around $550 million.

Net Operating Working Capital (NOWC) = Operating current assets − Operating current liabilities = approximately $630 million, which is essential for understanding operational liquidity. Total net operating capital adds long-term assets financed by operating liabilities, summing up to significant capital tied directly to operational activities—about $2,900 million in fixed assets plus working capital components.

Free Cash Flow and Its Uses

Given the net investments in fixed assets and working capital, Computron's free cash flow for 2019 is a key indicator of operational sustainability. It remains negative primarily due to high capital expenditures necessary for expansion, with ongoing reinvestments exceeding operational cash inflow. The "net uses" of FCF primarily involve investment in fixed assets and working capital, which support future sales growth but temporarily constrain cash holdings.

Return on Invested Capital (ROIC) and Its Decline

ROIC measures how effectively a company generates profits relative to its total invested capital. For 2019, Computron’s ROIC declined due to diminished operating profitability and less efficient capital utilization. Calculations show that while NOPAT increased in absolute terms, the substantial rise in invested capital from expanded operations caused the ROIC to fall, indicating less efficient use of resources. The decline suggests that growth initiatives, though necessary, may not yet be delivering proportional returns, thus emphasizing the importance of operational efficiency improvements.

Economic Value Added (EVA)

EVA calculates the residual income after deducting the cost of capital from NOPAT. For 2019, utilizing the total operating capital and a WACC of 10%, the EVA was likely negative, reflecting that the company’s returns did not fully cover its cost of capital amidst expanded operations. EVA's decline aligns with the ROIC decrease, confirming that current investments are not yet adding sufficient value, emphasizing the importance of improving operational efficiency.

Market Value Added (MVA) Dynamics

The MVA, reflecting market perceptions of the company's value above its shareholders’ equity, declined from its previous year due to the drop in stock price from $50 to $30, and the increase in the number of shares outstanding. This decline indicates investors' cautious outlook on the company’s growth prospects and profitability, aligning with financial metrics signaling decreased operational efficiency and value creation.

Tax Liability Calculation

With a taxable income of $87 million from operations, interest income of $8 million, and dividend income of $10 million, the company's taxable income is adjusted for the tax-advantaged dividend income. The taxable dividend income, after applying the 50% exclusion, reduces the taxable dividend income to $5 million ($10 million × 50%). The total taxable income includes operational income, interest, and adjusted dividends: $87 million + $8 million + $5 million = $100 million. The tax liability at 21% results in approximately $21 million in federal taxes, reflecting the combined effects of income sources and tax provisions.

Investment Choice: Municipal vs. Corporate Bonds

For an investor in the 25% tax bracket, choosing between municipal bonds yielding 7% and corporate bonds yielding 10% involves comparing after-tax yields. Municipal bonds are tax-exempt, offering a clean 7%. The corporate bonds, taxed at 25%, have an effective yield of 7.5% (10% × (1 − 0.25)). Since 7.5% exceeds 7%, corporate bonds are preferable for this investor. The indifference point occurs when the after-tax yield on the corporate bond equals the municipal yield: 7% = 10% × (1 − T). Solving yields that the investor would be indifferent at a marginal tax rate of 30%, where both yields provide equivalent after-tax returns.

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