This is question Chapter 5, Problem 1IC in Principles of Managerial Finance 14th
ID: 2742413 • Letter: T
Question
This is question Chapter 5, Problem 1IC in Principles of Managerial Finance 14th Edition
Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and O’Brien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings, all of which would be related to streamlining the accounting processes of medium- to large-sized manufacturers. Although Track experienced losses during its first 2 years of operation—2009 and 2010—its profit has increased steadily from 2011 to the present (2015). The firm’s profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1. Stanley started the firm with a $100,000 investment: his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2009), he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The firm’s stock was valued at $4.50 per share in 2014 and at $5.28 per share in 2015.
Track Software, Inc.,
Profit, Dividends, and Retained Earnings, 2009–2015
Year Net profits after taxes(1) Dividends paid (2) Contribution to retained earnings [(1) (2)] (3)
2009 ($50,000) $ 0 ($50,000)
2010 (20,000) 0 (20,000)
2011 15,000 0 15,000
2012 35,000 0 35,000
2013 40,000 1,000 39,000
2014 43,000 3,000 40,000
2015 48,000 5,000 43,000
Stanley has just prepared the firm’s 2015 income statement, balance sheet, and
statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014
balance sheet. In addition, he has compiled the 2014 ratio values and industry
average ratio values for 2015, which are applicable to both 2014 and 2015 and
are summarized in Table 5. He is quite pleased to have achieved record earnings of
$48,000 in 2015, but he is concerned about the firm’s cash flows. Specifically, he
is finding it more and more difficult to pay the firm’s bills in a timely manner and
generate cash flows to investors, both creditors and owners. To gain insight into
these cash flow problems, Stanley is planning to determine the firm’s 2015 operating
cash flow (OCF) and free cash flow (FCF).
Stanley is further frustrated by the firm’s inability to afford to hire a software
developer to complete development of a cost estimation package that is believed
to have “blockbuster” sales potential. Stanley began development of this package
2 years ago, but the firm’s growing complexity has forced him to devote more of
his time to administrative duties, thereby halting the development of this product.
Stanley’s reluctance to fill this position stems from his concern that the added
$80,000 per year in salary and benefits for the position would certainly lower the
firm’s earnings per share (EPS) over the next couple of years. Although the project’s
success is in no way guaranteed, Stanley believes that if the money were spent to hire
the software developer, the firm’s sales and earnings would significantly rise once
the 2- to 3-year development, production, and marketing process was completed.
With all these concerns in mind, Stanley set out to review the various data to
develop strategies that would help ensure a bright future for Track Software. Stanley
believed that as part of this process, a thorough ratio analysis of the firm’s 2015
results would provide important additional insights.
Sales revenue $ 1,550
Less: Cost of goods sold $ 1,030
Gross profits $ 520
Less: Operating expenses
Selling expense $ 150
General and administrative expenses 270
Depreciation expense 11
Total operating expense 431
Operating profits (EBIT) $ 89
Less: Interest expense 29
Net profits before taxes $ 60
Less: Taxes (20%) 12
Net profits after taxes $ 48
Sales revenue $ 1,550
Less: Cost of goods sold $ 1,030
Gross profits $ 520
Less: Operating expenses
Selling expense $ 150
General and administrative expenses 270
Depreciation expense 11
Total operating expense 431
Operating profits (EBIT) $ 89
Less: Interest expense 29
Net profits before taxes $ 60
Less: Taxes (20%) 12
Net profits after taxes $ 48
Sales revenue $ 1,550
Less: Cost of goods sold $ 1,030
Gross profits $ 520
Less: Operating expenses
Selling expense $ 150
General and administrative expenses 270
Depreciation expense 11
Total operating expense 431
Operating profits (EBIT) $ 89
Less: Interest expense 29
Net profits before taxes $ 60
Less: Taxes (20%) 12
Net profits after taxes $ 48
Ratio
Actual
2014
Industry average
2015
Current ratio 1.06 1.82
Quick ratio 0.63 1.10
Inventory turnover 10.40 12.45
Average collection period 29.6 days 20.2 days
Total asset turnover 2.66 3.92
Debt ratio 0.78 0.55
Times interest earned ratio 3.0 5.6
Gross profit margin 32.1% 42.3%
Operating profit margin 5.5% 12.4%
Net profit margin 3.0% 4.0%
Return on total assets (ROA) 8.0% 15.6%
Return on common equity (ROE) 36.4% 34.7%
Price/earnings (P/E) ratio 5.2 7.1
Market/book (M/B) ratio 2.1 2.2
TO DO
a. (1) On what financial goal does Stanley seem to be focusing? Is it the correct
goal? Why or why not?
(2) Could a potential agency problem exist in this firm? Explain.
Explanation / Answer
1) Stanley seems to be focusing on achieving maximum profits as financial goal for the company.He is correct in this approach because the ultimate goal of any company is to earn maximum profits and increase the shareholders' wealth.
2) There could be potential agency problem exist in the firm, if Stanley decides to invest in software development by hiring software developer.This would certainly lower the firm’s earnings per share (EPS) over the next couple of years.If some shareholders wants to gain money from the stocks sooner than it will be a problem and if shareholders believe in maximizing the wealth then there may not be the agency problem as Stanley's goal is to maximize wealth.
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