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Managerial Finance

Hussain A. Al Awami, B.Sc. Pharm., M.Sc., MBA

Chapter III
Mini case

Mini case
Donna Jamison brought as assistant to chairman of
the board.
The company doubled its plant capacity, opened
new sales offices outside its home territory, and
launched an expensive advertising campaign.
Computrons results were not satisfactory, to put it
mildly.
As a result, Al Watkins, Computrons president, was
informed that changes would have to be made, and
quickly, or he would be fired.

Balance sheet
Assets
Assets
Cash
Cash
Short-term
Short-terminvestments.
investments.
Accounts
Accountsreceivable
receivable
Inventories
Inventories
total
totalcurrent
currentassets
assets
Gross
Grossfixed
fixed assets
assets
Less:
Less:accumulated
accumulated
depreciation
depreciation
net
netfixed
fixed assets
assets
Total
Totalassets
assets

2003
2003
$9,000
$9,000
48,600
48,600
351,200
351,200
715,200
715,200
$1,124,000
$1,124,000
491,000
491,000
146,200
146,200

2004
2004
$7,282
$7,282
20,000
20,000
632,160
632,160
1,287,360
1,287,360
$1,946,802
$1,946,802
1,202,950
1,202,950
263,160
263,160

$344,800
$344,800
$1,468,800
$1,468,800

$939,790
$939,790
$2,886,592
$2,886,592

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

Income statements
Sales
Sales
Cost
Costof
ofgoods
goodssold
sold
Other
Otherexpenses
expenses
Depreciation
Depreciation
total
totaloperating
operatingcosts
costs
EBIT
EBIT
Interest
Interestexpense
expense
EBT
EBT
Taxes
Taxes(40%)
(40%)
Net
Netincome
income

2003
2003
$3,432,000
$3,432,000
2,864,000
2,864,000
340,000
340,000
18,900
18,900
$3,222,900
$3,222,900
$209,100
$209,100
62,500
62,500
$146,600
$146,600
58,640
58,640
$87,960
$87,960

2004
2004
$5,834,400
$5,834,400
4,980,000
4,980,000
720,000
720,000
116,960
116,960
$5,816,960
$5,816,960
$17,440
$17,440
176,000
176,000
($158,560)
($158,560)
-63,424
-63,424
($95,136)
($95,136)

Other
Otherdata
data

2002
2002

Stock
Stock price
price
Shares
Shares outstanding
outstanding
EPS
EPS
DPS
DPS

$8.50
$8.50
100,000
100,000
$0.88
$0.88
$0.22
$0.22

2003
2003
$6.00
$6.00
100,000
100,000
($0.95)
($0.95)
$0.11
$0.11

Statement
Statementof
ofretained
retainedearnings,
earnings,2004
2004

Balance
Balanceof
ofretained
retainedearnings,
earnings,
12/31/2003
12/31/2003
add:
add: net
netincome,
income,2004
2004
less:
less:dividend
dividendpaid,
paid,2004
2004
Balance
Balanceof
ofretained
retainedearnings,
earnings,
12/31/2004
12/31/2004

$203,768
$203,768
($95,136)
($95,136)
($11,000)
($11,000)
$97,632
$97,632

Operating
Operatingactivities
activities
Net
Netincome
income
Adjustments:
Adjustments:
noncash
noncashadjustments:
adjustments:
depreciation
depreciation
changes
changesininworking
workingcapital:
capital:
change
changeininaccounts
accountsreceivable
receivable
change
changeinininventories
inventories
change
changeininaccounts
accountspayable
payable

($95,136)
($95,136)

116,960
116,960
-280,960
-280,960
-572,160
-572,160
178,400
178,400

change
changeininaccruals
accruals
Net
Netcash
cashprovided
providedby
byoperating
operatingactivities
activities

148,960
148,960
($503,936)
($503,936)

Long-term
Long-terminvesting
investingactivities
activities
Cash
Cashused
usedtotoacquire
acquirefixed
fixedassets
assets

($711,950)
($711,950)

Financing
Financingactivities
activities
change
changeininshort
shortterm
terminvestments
investments
change
changeininnotes
notespayable
payable
change
changeininlong-term
long-termdebt
debt
change
in
common
stock
change in common stock
payment
paymentofofcash
cashdividends
dividends
Net
Netcash
cashprovided
providedby
byfinancing
financingactivities
activities

$28,600
$28,600
$520,000
$520,000
$676,568
$676,568
$$
-($11,000)
($11,000)
$1,214,168
$1,214,168

Summary
Summary
Net
Netchange
change inincash
cash
Cash
Cashat
atbeginning
beginningof
ofyear
year
Cash
Cashat
atend
end of
ofyear
year

($1,718)
($1,718)
9,000
9,000
$7,282
$7,282

Assume you are her assistant


and answer the following
questions:

What effect did the expansion have


on sales and net income? What
effect did the expansion have on the
asset side of the balance sheet?
What effect did it have on liabilities
and equity?

Answer
Sales
Sales
Cost
Costofofgoods
goodssold
sold
Other
Otherexpenses
expenses
Depreciation
Depreciation
total
totaloperating
operatingcosts
costs
EBIT
EBIT
Interest
Interestexpense
expense
EBT
EBT
Taxes
Taxes(40%)
(40%)
Net
Netincome
income

2003
2003
$3,432,000
$3,432,000
2,864,000
2,864,000
340,000
340,000
18,900
18,900
$3,222,900
$3,222,900
$209,100
$209,100
62,500
62,500
$146,600
$146,600
58,640
58,640
$87,960
$87,960

2004
2004
$5,834,400
$5,834,400 =2,402,400
4,980,000
4,980,000
720,000
720,000
116,960
116,960
$5,816,960
$5,816,960
$17,440
$17,440
176,000
176,000
($158,560)
($158,560)
-63,424
-63,424
($95,136)
($95,136) =(-)183,093

Sales
Sales
Cost
Costofofgoods
goodssold
sold
Other
Otherexpenses
expenses
Depreciation
Depreciation
total
totaloperating
operatingcosts
costs
EBIT
EBIT
Interest
Interestexpense
expense
EBT
EBT
Taxes
Taxes(40%)
(40%)
Net
Netincome
income

2003
2003
$3,432,000
$3,432,000
2,864,000
2,864,000
340,000
340,000
18,900
18,900
$3,222,900
$3,222,900
$209,100
$209,100
62,500
62,500
$146,600
$146,600
58,640
58,640
$87,960
$87,960

2004
2004
$5,834,400
$5,834,400 =2,402,400
4,980,000
4,980,000
720,000
720,000
116,960
116,960
$5,816,960
$5,816,960
$17,440
$17,440
176,000
176,000
($158,560)
($158,560)
-63,424
-63,424
($95,136)
($95,136) =183,093

Assets
Assets
Cash
Cash
Short-term
Short-terminvestments.
investments.
Accounts
Accountsreceivable
receivable
Inventories
Inventories
total
totalcurrent
currentassets
assets
Gross
Grossfixed
fixedassets
assets
Less:
Less:accumulated
accumulated
depreciation
depreciation
net
netfixed
fixedassets
assets
Total
Totalassets
assets

2003
2003
$9,000
$9,000
48,600
48,600
351,200
351,200
715,200
715,200
$1,124,000
$1,124,000
491,000
491,000
146,200
146,200

2004
2004
$7,282
$7,282
20,000
20,000
632,160
632,160
1,287,360
1,287,360
$1,946,802
$1,946,802
1,202,950
1,202,950
263,160
263,160

$344,800
$344,800
$1,468,800
$1,468,800

$939,790
$939,790
$2,886,592
$2,886,592 =1,417,792

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000 =178,400
=520,000
720,000
720,000
284,960
284,960 =148,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

=178,400
=520,000
=148,960
=847,360

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960 =847,360
=676,568
1,000,000
1,000,000
460,000
460,000
=1,523,928

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632 =106,136
$557,632
$557,632
$2,886,592
$2,886,592

What do you conclude from the


statement of cash flows?

Operating
Operatingactivities
activities
Net
Netincome
income
Adjustments:
Adjustments:
noncash
noncashadjustments:
adjustments:
depreciation
depreciation
changes
changesininworking
workingcapital:
capital:
change
changeininaccounts
accountsreceivable
receivable
change
changeinininventories
inventories
change
changeininaccounts
accountspayable
payable

($95,136)
($95,136)

116,960
116,960
-280,960
-280,960
-572,160
-572,160
178,400
178,400

change
changeininaccruals
accruals
Net
Netcash
cashprovided
providedby
byoperating
operatingactivities
activities

148,960
148,960
($503,936)
($503,936)

Long-term
Long-terminvesting
investingactivities
activities
Cash
Cashused
usedtotoacquire
acquirefixed
fixedassets
assets

($711,950)
($711,950)

Financing
Financingactivities
activities
change
changeininshort
shortterm
terminvestments
investments
change
changeininnotes
notespayable
payable
change
changeininlong-term
long-termdebt
debt
change
in
common
stock
change in common stock
payment
paymentofofcash
cashdividends
dividends
Net
Netcash
cashprovided
providedby
byfinancing
financingactivities
activities

$28,600
$28,600
$520,000
$520,000
$676,568
$676,568
$$
-($11,000)
($11,000)
$1,214,168
$1,214,168

Operating
Operatingactivities
activities
Net
Netincome
income
Adjustments:
Adjustments:
noncash
noncashadjustments:
adjustments:
depreciation
depreciation
changes
changesininworking
workingcapital:
capital:
change
changeininaccounts
accountsreceivable
receivable
change
changeinininventories
inventories
change
changeininaccounts
accountspayable
payable

($95,136)
($95,136)

116,960
116,960
-280,960
-280,960
-572,160
-572,160
178,400
178,400

change
changeininaccruals
accruals
Net
Netcash
cashprovided
providedby
byoperating
operatingactivities
activities

148,960
148,960
($503,936)
($503,936)

Long-term
Long-terminvesting
investingactivities
activities
Cash
Cashused
usedtotoacquire
acquirefixed
fixedassets
assets

($711,950)
($711,950)

Financing
Financingactivities
activities
change
changeininshort
shortterm
terminvestments
investments
change
changeininnotes
notespayable
payable
change
changeininlong-term
long-termdebt
debt
change
in
common
stock
change in common stock
payment
paymentofofcash
cashdividends
dividends
Net
Netcash
cashprovided
providedby
byfinancing
financingactivities
activities

$28,600
$28,600
$520,000
$520,000
$676,568
$676,568
$$
-($11,000)
($11,000)
$1,214,168
$1,214,168

Operating
Operatingactivities
activities
Net
Netincome
income
Adjustments:
Adjustments:
noncash
noncashadjustments:
adjustments:
depreciation
depreciation
changes
changesininworking
workingcapital:
capital:
change
changeininaccounts
accountsreceivable
receivable
change
changeinininventories
inventories
change
changeininaccounts
accountspayable
payable

($95,136)
($95,136)

116,960
116,960
-280,960
-280,960
-572,160
-572,160
178,400
178,400

change
changeininaccruals
accruals
Net
Netcash
cashprovided
providedby
byoperating
operatingactivities
activities

148,960
148,960
($503,936)
($503,936)

Long-term
Long-terminvesting
investingactivities
activities
Cash
Cashused
usedtotoacquire
acquirefixed
fixedassets
assets

($711,950)
($711,950)

Financing
Financingactivities
activities
change
changeininshort
shortterm
terminvestments
investments
change
changeininnotes
notespayable
payable
change
changeininlong-term
long-termdebt
debt
change
in
common
stock
change in common stock
payment
paymentofofcash
cashdividends
dividends
Net
Netcash
cashprovided
providedby
byfinancing
financingactivities
activities

$28,600
$28,600
$520,000
$520,000
$676,568
$676,568
$$
-($11,000)
($11,000)
$1,214,168
$1,214,168

What is free cash flow? Why is it important? What are


the five uses of FCF?

Answer
FCF is the amount of cash available from
operations for distribution to all investors.
A companys value depends upon the amount of
FCF it can generate.
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets

What are operating current assets? What are operating


current liabilities? How much net operating working capital
and total net operating capital does Computron have?

Answer
Assets
Assets
Cash
Cash
Short-term
Short-terminvestments.
investments.
Accounts
Accountsreceivable
receivable
Inventories
Inventories
total
totalcurrent
currentassets
assets
Gross
Grossfixed
fixedassets
assets
Less:
Less:accumulated
accumulated
depreciation
depreciation
net
netfixed
fixedassets
assets
Total
Totalassets
assets

2003
2003
$9,000
$9,000
48,600
48,600
351,200
351,200
715,200
715,200
$1,124,000
$1,124,000
491,000
491,000
146,200
146,200

2004
2004
$7,282
$7,282
20,000
20,000
632,160
632,160
1,287,360
1,287,360
$1,946,802
$1,946,802
1,202,950
1,202,950
263,160
263,160

$344,800
$344,800
$1,468,800
$1,468,800

$939,790
$939,790
$2,886,592
$2,886,592

Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

NOWC= Operating CA Operating CL


Assets
Assets
Cash
Cash
Short-term
Short-terminvestments.
investments.
Accounts
Accountsreceivable
receivable
Inventories
Inventories
total
totalcurrent
currentassets
assets
Gross
Grossfixed
fixedassets
assets
Less:
Less:accumulated
accumulated
depreciation
depreciation
net
netfixed
fixedassets
assets
Total
Totalassets
assets

2003
2003
$9,000
$9,000
48,600
48,600
351,200
351,200
715,200
715,200
$1,124,000
$1,124,000
491,000
491,000
146,200
146,200

2004
2004
$7,282
$7,282
20,000
20,000
632,160
632,160
1,287,360
1,287,360
$1,946,802
$1,946,802
1,202,950
1,202,950
263,160
263,160

$344,800
$344,800
$1,468,800
$1,468,800

$939,790
$939,790
$2,886,592
$2,886,592

NOWC= Operating CA Operating CL


Liabilities
Liabilitiesand
andequity
equity
Accounts
Accountspayable
payable
Notes
Notespayable
payable
Accruals
Accruals
total
totalcurrent
currentliabilities
liabilities
Long-term
Long-termdebt
debt
Common
Commonstock
stock(100,000
(100,000
shares)
shares)
Retained
Retainedearnings
earnings
total
totalequity
equity
Total
Totalliabilities
liabilitiesand
andequity
equity

2003
2003
$145,600
$145,600
200,000
200,000
136,000
136,000
$481,600
$481,600
323,432
323,432
460,000
460,000

2004
2004
$324,000
$324,000
720,000
720,000
284,960
284,960
$1,328,960
$1,328,960
1,000,000
1,000,000
460,000
460,000

203,768
203,768
$663,768
$663,768
$1,468,800
$1,468,800

97,632
97,632
$557,632
$557,632
$2,886,592
$2,886,592

NOWC= Operating CA Operating CL


NOWC= 1,926,802 608,960
NOWC= 1,317,842

NOWC= 793,800

2004

2003

Total operating working capital = NOWC + net fixed assets


Assets
Assets
Cash
Cash
Short-term
Short-terminvestments.
investments.
Accounts
Accountsreceivable
receivable
Inventories
Inventories
total
totalcurrent
currentassets
assets
Gross
Grossfixed
fixedassets
assets
Less:
Less:accumulated
accumulated
depreciation
depreciation
net
netfixed
fixedassets
assets
Total
Totalassets
assets

2003
2003
$9,000
$9,000
48,600
48,600
351,200
351,200
715,200
715,200
$1,124,000
$1,124,000
491,000
491,000
146,200
146,200

2004
2004
$7,282
$7,282
20,000
20,000
632,160
632,160
1,287,360
1,287,360
$1,946,802
$1,946,802
1,202,950
1,202,950
263,160
263,160

$344,800
$344,800
$1,468,800
$1,468,800

$939,790
$939,790
$2,886,592
$2,886,592

NOWC= 1,317,842

Operating working capital in 2004 = 2,257,632

Operating working capital in 2003 = 1,138,600

What are Computrons net operating


profit after taxes (NOPAT) and free cash
flow (FCF)?

NOPAT = EBIT (1 - tax rate)


Sales
Sales
Cost
Costofofgoods
goodssold
sold
Other
Otherexpenses
expenses
Depreciation
Depreciation
total
totaloperating
operatingcosts
costs
EBIT
EBIT
Interest
Interestexpense
expense
EBT
EBT
Taxes
Taxes(40%)
(40%)
Net
Netincome
income

2003
2003
$3,432,000
$3,432,000
2,864,000
2,864,000
340,000
340,000
18,900
18,900
$3,222,900
$3,222,900
$209,100
$209,100
62,500
62,500
$146,600
$146,600
58,640
58,640
$87,960
$87,960

2004
2004
$5,834,400
$5,834,400
4,980,000
4,980,000
720,000
720,000
116,960
116,960
$5,816,960
$5,816,960
$17,440
$17,440 (1-0.4)
176,000
176,000 NOPAT= 10,464
($158,560)
($158,560)
-63,424
-63,424
($95,136)
($95,136)

FCF = NOPAT- net investment in capital


NOPAT=10,464

operating working capital in 2004

- operating working capital in 2003

2,257,632 1,138,600
=1,119,032
FCF = 10,464 1,119,032
= - 1,108,568

Calculate Computrons return on invested capital.


Computron has a 10% cost of capital (WACC). Do
you think Computrons growth added value?

NOPAT
_________________________
ROIC =
Total net operating capital
10,464
__________
ROIC =
= 0.5%
2,257,632
ROIC = 11%

2004

2003

The ROIC of 0.5% is less than the WACC


of 10%.
Investors did not get the return they
require.
Note: high growth usually causes negative
FCF (due to investment in capital), but
thats ok if ROIC > WACC.

Jamison also has asked you to estimate


Computron's EVA. She estimates that the aftertax cost of capital was 10 percent in both years.

EVA = NOPAT- (WACC)(CAPITAL)


=$10,464 - (0.1)($2,257,632)
= -$215,299

2004

= 11,600

2003