4-10. (Financial ratios—investment analysis) The annual sales for Salco Inc. wer
ID: 2666905 • Letter: 4
Question
4-10. (Financial ratios—investment analysis) The annual sales for Salco Inc. were $4.5 million last year. The firm’s end-of-year balance sheet was as follows:Current assets
$ 500,000
Liabilities
$1,000,000
Net fixed assets
1,500,000
Owners’ equity
1,000,000
$2,000,000
$2,000,000
The firm’s income statement for the year was as follows:
Sales
$ 4,500,000
Less cost of goods sold
(3,500,000)
Gross profit
$ 1,000,000
Less operating expenses
(500,000)
Operating income
$ 500,000
Less interest expense
(100,000)
Earnings before taxes
$ 400,000
Less taxes (50%)
(200,000)
Net income
$ 200,000
a. Calculate Salco’s total asset turnover, operating profit margin, and operating return on assets.
b. Salco plans to renovate one of its plants, which will require an added investment in plant and equipment of $1 million. The firm will maintain its present debt ratio of .5 when financing the new investment and expects sales to remain constant. The operating profit margin will rise to 13 percent. What will be the new operating return on assets for Salco after the plant’s renovation?
c. Given that the plant renovation in part b occurs and Salco’s interest expense rises by $50,000 per year, what will be the return earned on the common stockholders’ investment? Compare this rate of return with that earned before the renovation.
(Keown. Foundations of Finance: The Logic and Practice of Financial Management, 6th Edition. Pearson Learning Solutions p. 124).
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Explanation / Answer
Current assets = $500,000
Liabilities = $1,000,000
Net Fixed Assets = $1,500,000
Owner’s Equity = $1,000,000
Total Assets = Total Liabilities + Total Stockholder’s Equity
[($500,000 + $1,500,000)] = [$1,000,000 + $1,000,000]
$2,000,000 = $2,000,000
(1) Total Assets Turnover = [Sales / Total Assets]
Sales = $4,500,000
Total Assets = $2,000,000
Total Asset Turnover = [$4,500,000 / $2,000,000]
Total Asset Turnover = 2.25 times
Operating Profit Margin = [Operating Income / Sales]
Operating Income = $500,000
Sales = $4,500,000
Operating Profit Margin = [$500,000 / $4,500,000]
Operating Profit Margin = 0.1111 (or) 11.11%
Operating Profit Margin = 11.11%
Operating Return on Assets = [Operating Income / Total Assets]
Total Assets = $2,000,000
Operating Income = $500,000
Operating Return on Assets = [$500,000 / $2,000,000]
Operating Return on Assets = 0.25 (or) 25%
Operating Return on Assets = 25%
Firm’s Debt Ratio = 0.5
Operating Profit Margin will rise to 13%
Debt Ratio = [Total Debt / Total Assets] = 0.5
Investment in plant and equipment of = $1,000,000
New Operating Return on Assets = [Operating Income / Total Assets]
Total Assets = [Current Assets + Fixed Assets]
Fixed Assets = $1,500,000
Current Assets = $500,000
Investment in Plant and Equipment = $1,000,000
Operating Profit Margin = [Net Operating Income / Sales]
Sales = $4,500,000
0.13 = [Net Operating Income / $4,500,000]
Net Operating Income = [$4,500,000 * 0.13]
Net Operating Income = $585,000
Total Assets = [$500,000 + $1,500,000 + $1,000,000]
Total Assets = $3,000,000
Operating Return on Assets = [Net Operating Income / Total Assets]
Net Operating Income = $585,000
Operating Return on Assets = [$585,000 / $3,000,000]
Operating Return on Assets = 0.195 (or) 19.50%
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