80 Part 2 Fundamental Concepts in Financial Management
b. Construct the statement of stockholders' equity for the year ending December 31,
2008, and the 2008 statement of cash flows.
C. Calculate 2007 and 2008 net working capital and 2008 free cash flow.
d. If Laiho increased its dividend payout ratio, what effect would this have on corporate
taxes paid? What effect would this have on taxes paid by the company's
shareholders?
D'LEON INC., PART I
3-1 FINANCIAL STATEMENTS AND TAXES Donna Jamison, a 2003 graduate of the University of Florida with 4 years
of banking experience, was recently brought in as assistant to the chairperson of the board of D'Leon Inc., a small
food producer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in
the snack foods market. D’Leon’s president, Al Watkins, decided in 2007 to undertake a major expansion and to
“go national” in competition with Frito-Lay, Eagle, and other major snack foods companies. Watkins believed that
D’Leon’s products were of higher quality than the competition's; that this quality differential would enable it to
charge a premium price; and that the end result would be greatly increased sales, profits, and stock price.
The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an
expensive advertising campaign. D’Leon’s results were not satisfactory, to put it mildly. Its board of directors,
which consisted of its president, vice president, and major stockholders (who were all local businesspeople), was
most upset when directors learned how the expansion was going. Unhappy suppliers were being paid late; and the
bank was complaining about the deteriorating situation, threatening to cut off credit. As a result, Watkins was
informed that changes would have to be made-and quickly; otherwise, he would be fired. Abo, at the board's
insistence, Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was
D’Leon’s chairperson and largest stockholder. Campo agreed to give up a few of his golfing days and help nurse the
company back to health, with Jamison's help.
Jamison began by gathering the financial statements and other data given in Tables IC 3-1, IC 3-2, IC 3-3,
and IC 3-4. Assume that you are Jamison's assistant. You must help her answer the following questions for
Campo. (Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis
there. But answering these questions will help prepare you for Chapter 4. Provide clear explanations.)
a. What effect did the expansion have on sales, after-tax operating income, net working capital (NWC), and
net income?
b. What effect did the company's expansion have on its free cash flow?
c. D'Leon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within
30 days of receipt. Judging from its 2008 balance sheet, do you think that D'Leon pays suppliers on time?
Explain, including what problems might occur if suppliers are not paid in a timely manner.
d. D'Leon spends money for labor, materials, and fixed assets (depreciation) to make products-and spends
still more money to sell those products. Then the firm makes sales that result in receivables, which
eventually result in cash inflows. Does it appear that D’Leon’s sales price exceeds its costs per unit sold?
How does this affect the cash balance?
e. Suppose D’Leon’s sales manager told the sales staff to start offering 60-day credit terms rather than the
30-day terms now being offered. D’Leon’s competitors react by offering similar terms, so sales remain
constant. What effect would this have on the cash account? How would the cash account be affected if
sales doubled as a result of the credit policy change?
f. Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of
output, yet a dramatic increase in sales volume causes the cash balance to decline? Explain.
g. Did D'Leon finance its expansion program with internally generated funds (additions to retained earnings
plus depreciation) or with external capital? How does the choice of financing affect the company's
financial strength?
h. Refer to Tables IC 3-2 and IC 3-4. Suppose D'Leon broke even in 2008 in the sense that sales revenues
equaled total operating costs plus interest charges. Would the asset expansion have caused the company to
experience a cash shortage that required it to raise external capital? Explain.
i. If D'Leon starts depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the
physical stock of assets, (2) the balance sheet account for fixed assets, (3) the company's reported net
income, and (4) the company's cash position? Assume that the same depreciation method is used for
stockholder reporting and for tax calculations and that the accounting change has no effect on assets'
physical lives.
j. Explain how earnings per share, dividends per share, and book value per share are calculated and what
they mean. Why does the market price per share not equal the book value per share?
k. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends
received, (3) capital gains, and (4) tax loss carry-back and carry-forward. How might each of these items
affect D’Leon’s taxes?
3-2.
Chapter 3 Financial Statements, Cash Flow, and Taxes 81
Balance Sheets
2008 2007
Assets
Cash $ 7,282 $ 57,600
Accounts receivable 632,160 351,200
Inventories 1,287,360 715,200
Total current assets $1,926,802 $1,124,000
Gross fixed assets 1,202,950 491,000
Less accumulated depreciation 263,160 146,200
Net fixed assets $ 939,790 $ 344,800
Total assets $2,866,592 $1,468,800
Liabilities and Equity
Accounts payable $ 524,160 $ 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total current liabilities $1,650,568 $ 481,600
Long-term debt 723,432 323,432
Common stock (100,000 shares) 460,000 460,000
Retained earnings 32,592 203,768
Total equity $ 492,592 $ 663,768
Total liabilities and equity $2,866,592 $1,468,800
Ta hIe IC 3-Z Income Statements
2008 2007
Sales $6,034,000 $3,432,000
Cost of goods sold 5,528,000 2,864,000
Other expenses 519,988 358,672
Total operating costs excluding depreciation and amortization $6,047,988 $3,222,672
Depreciation and amortization 116,960 18,900
EBIT ($ 130,948) $ 190,428
Interest expense 136,012 43,828
EBT ($ 266,960) $ 146,600
Taxes (40%) (106,784)° 58,640
Net income ($ 160,176) $ 87,960
EPS ($ 1.602) $ 0.880
DPS $ 0.110 $ 0.220
Book value per share $ 4.926 $ 6.638
Stock price $ 2.25 $ 8.50
Shares outstanding 100,000 100,000
Tax rate 40.00% 40.00%
Lease payments 40,000 40,000
Sinking fund payments 0 0
Note:
"The firm had sufficient taxable income in 2006 and 2007 to obtain its full tax refund in 2008.
82 Part 2 Fundamental Concepts in Financial Management
Statement of Stockholders' Equity, 2008
COMMON STOCK Total
Retained Stockholders'
Shares Amount Earnings Equity
Balances, 12/31/07
100,000 $460,000 $ 203,768 $663,768
2008 Net Income
(160,176)
Cash Dividends
(11,000)
Addition (Subtraction)
to Retained Earnings (171,176) (171,176)
Balances, 12/31/08 100,000 $460,000 $ 32,592 $492,592
TabIe IC 3-4 Statement of Cash Flows, 2008
Operating Activities
Net income ($160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provided by operating activities ($164,176)
Long-Term Investing ActivitieS
Additions to property, plant, and equipment ($711,950)
Net cash used in investing activities ($711,950)
Financing Activities
Increase in notes payable $436,808
Increase in long-term debt 400,000
Payment of cash dividends 11,000)
Net cash provided by financing activities $825,808
Summary
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600
Cash at end of year $ 7,282