Donna Jamison, a 2011 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 2017 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 (all of whom were 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 and 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. Also, 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 the tables below. Assume that you are Jamison's assistant. You must help her answer the following questions for Campo.
a. What effect did the expansion have on sales, after-tax operating income, net operating working capital (NOWC), 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 2018 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 2 and 4. Suppose D'Leon broke even in 2018 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 salesthe 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 carrybacks and carryforwards. How might each of these items affect D'Leon's taxes?
Table 1 Balance Sheet
|
2018 |
2017 |
| Assets |
|
|
| Cash a |
7,282 dollars |
57,600 dollars |
| Accounts receivable |
632,160 |
351,200 |
| Inventories |
1,287,360 |
715,200 |
| Total current assets |
1,926,802 dollars |
1,124,000 dollars |
| Gross fixed assets |
1,202,950 |
491,000 |
| Less accumulated depreciation |
263,160 |
146,200 |
| Net fixed assets |
939,790 dollars |
344,800 dollars |
| Total assets |
2,866,592 dollars |
1,468,800 dollars |
| Liabilities and Equity |
|
|
| Accounts payable |
524,160 dollars |
145,600 dollars |
| Accruals |
489,600 |
136,000 |
| Notes payable |
636,808 |
200,000 |
| Total current liabilities |
1,650,568 dollars |
481,600 dollars |
| Long-term debt |
723,432 |
323,432 |
| Common stock (100,000 shares) |
460,000 |
460,000 |
| Retained earnings |
32,592 |
203,786 |
| Total equity |
492,592 dollars |
663,786 dollars |
| Total liabilities and equity |
2,866,592 dollars |
1,468,800 dollars |
a Assume that all cash is excess cash; i.e., this cash is not needed for operating purposes.
Table 2 Income Statements
|
2018 |
2017 |
| Sales |
6,034,000 dollars |
3,432,000 dollars |
| 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 dollars |
3,222,672 dollars |
| Depreciation and amortization |
116,960 |
18,900 |
| EBIT |
(130,948 dollars ) |
(190,428 dollars) |
| Interest expense |
136,012 |
43,828 |
| EBT |
(266,960 dollars) |
146,600 dollars |
| Taxes (40 percent) |
(106,784 a) |
58,640 |
| Net income |
(160,176 dollars) |
87,960 dollars |
| EPS |
(1.602 dollars) |
0.880 dollars |
| DPS |
0.110 dollars |
0.220 dollars |
| Book value per share |
4,926 dollars |
6,638 dollars |
| Stock price |
2.25 dollars |
8.50 dollars |
| Shares outstanding |
100,000 |
100,000 |
| Tax rate |
40.00 percent |
40.00 percent |
| Lease payments |
40,000 dollars |
40,000 dollars |
| Sinking fund payments |
0 |
0 |
a The firm had sufficient taxable income in 2016 and 2017 to obtain its full tax refund in 2018.
Table 3 Statement of Stockholders’ Equity, 2018
|
Common Stock |
|
|
|
|
Shares |
Amount |
Retained Earnings |
Total Stockholders Equity |
| Balances, December 31, 2017 |
100,000 |
460,000 dollars |
203,768 dollars |
663,768 dollars |
| 2018 Net income |
|
|
(160,176) |
|
| Cash dividends |
|
|
(11,000) |
|
| Addition (subtraction) to retained earnings |
|
|
|
(171,176) |
| Balances, December 31, 2018 |
100,000 |
460,000 dollars |
32,592 dollars |
492,592 dollars |
Table 4 Statement of Cash Flows, 2018
| Operating Activities |
|
| Net income |
(160,176 dollars) |
| 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 dollars) |
| Investing Activities |
|
| Additions to property, plant, and equipment |
(711,950 dollars) |
| Net cash used in investing activities |
(711,950 dollars) |
| Financing Activities |
|
| Increase in notes payable |
436,808 dollars |
| Increase in long-term debt |
400,000 |
| Payment of cash dividends |
(11,000) |
| Net cash provided by financing activities |
825,808 dollars |
| Summary |
|
| Net decrease in cash |
(50,318 dollars) |
| Cash at beginning of year |
57,600 |
| Cash at end of year |
7,282 dollars |
