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ENMA 600

Cost Estimation and Financial Analysis

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Example 1:

Goal of the firm (Gitman, 2006)

Loren Seguara and Dale Johnson both work for Sports Products Inc., a major producer of boating
equipment and accessories. Loren works as a clerical assistant in the Accounting Department,
and Dale works as a packager in the Shipping Department. During their lunch break one day, they
began talking about the company. Dale complained that he had always worked hard trying not to
waste packing materials and efficiently and cost-effectively performing his job. In spite of his
efforts and those of his co-workers in the department, the firms stock price had declined nearly
$2 per share over the past 9 months. Loren indicated that she shared Dales frustration,
particularly because the firms profits had been rising. Neither could understand why the firms
stock price was falling as profits rose.
Loren indicated that she had seen documents describing the firms profit-sharing plan under
which all managers were partially compensated on the basis of the firms profits. She suggested
that maybe it was profit that was important to management, because it directly affected their pay.
Dale said, Shouldnt management do whats best for the stockholders? Somethings wrong!
Loren responded, Well, maybe that explains why the company hasnt concerned itself with the
stock price. Look, the only profits the stockholders receive are in the form of cash dividends, and
this firm has never paid dividends in its 20-year history. We as stockholders therefore dont
directly benefit from the profits. The only way we benefit is for the stock price to rise. Dale
chimed in, That probably explains why the firm is being sued by state and federal environmental
officials for dumping pollutants in the adjacent stream. Why spend money for pollution control?
It increases costs, lowers profits, and therefore lowers managements earnings!
Loren and Dale realized that the lunch break had ended and they must quickly return to work.
Before leaving, they decided to meet the next day to continue the discussion.
a. What should the management of the company pursue as its overriding goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firms approach to pollution control. Does it seem ethical? Why might
incurring the expense to control pollution be in the best interests of the firms owners
despite its negative effect on profits?
d. Does the firm appear to have an effective corporate governance structure? Explain any
shortcomings.
e. On the basis of the information provided, what specific recommendations would you
offer the firm?

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Solution:
(a) Maximizationofshareholderwealth,whichmeansmaximizationofshareprice,should
betheprimarygoalofthefirm.Unlikeprofitmaximization,thisgoalconsiderstiming,
cashflows,andrisk.Italsoreflectstheworthoftheownersinvestmentinthefirmatany
time.Itisthevaluetheycanrealizeshouldtheydecidetoselltheirshares.
(b)Yes,thereappearstobeanagencyproblem.Althoughcompensationformanagementis
tiedtoprofits,itisnotdirectlylinkedtoshareprice.Inaddition,managementsactions
withregardtopollutioncontrolssuggestaprofitmaximizationfocus,whichwould
maximizetheirearnings,ratherthananattempttomaximizeshareprice.
(c) Thefirmsapproachtopollutioncontrolseemstobequestionableethically.Whileitis
unclearwhethertheiractswereintentionaloraccidental,itisclearthattheyareviolating
thelawanillegalactpotentiallyleadingtolitigationcostsandasaresultare
damagingtheenvironment,animmoralandunfairactthathaspotentialnegative
consequencesforsocietyingeneral.Clearly,SportsProductshasnotonlybrokenthelaw
butalsoestablishedpoorstandardsofconductandmoraljudgment.
(d)Fromtheinformationgiventhereappearstobeaweakcorporategovernancesystem.The
factthatmanagementisabletomeasureandrewardtheirperformanceonprofits
indicatesthatnooneiswatchingoutfortheshareholders.LorenandDalesconcerns
indicatethatemployeesapparentlyhaveaninterestinthelongrunsuccessofthefirm.
Allowingthecontinuationofpollutionviolationsisalsoapparentlyescapingtheinterest
andcontrolabilityofotherswhoshouldbemonitoringthefirm.
(e) Somespecificrecommendationsforthefirminclude:
Tiemanagement,andpossiblyemployee,compensationtosharepriceoraperformance
basedmeasureandmakesurethatallinvolvedownstockandhaveastakeinthefirm.
Thiswillmorecloselylinkthewealthofmanagersandemployeestothefirms
performance.
Complywithalllawsaswellasacceptedstandardsofconductormoraljudgment.
Establishacorporateethicspolicy,tobereadandsignedbyallemployees.
Setupacorporategovernancesystemthathasasitsbasistheoversightandwelfareof
allthestakeholdersinthefirm.

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Example 2:

Accounting (Source: Horngren et al. 2006)

Briefly answer the following questions:


a. Describe accounting.
b. Give three examples where the decision maker is likely to use financial statements.
c. Give three examples of users of financial statements.
Solution:
a)

Accounting is a process of identifying, recording, summarizing and reporting economic


information to decision makers.

b)

Examples of decisions that are likely to be influenced by financial statements include


choosing where to expand or reduce operations, lending money, investing ownership
capital, and rewarding mangers.

c)

Users of financial statements include managers, lenders, suppliers, owners, income tax
authorities, and government regulators.

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Example 3:

Income statement (Gitman, 2006)

You are a summer intern at the office of a local tax-preparer. To test your basic knowledge of
financial statements, your manager, who graduated from your alma matter 2 years ago, gives you
the following list of accounts and asks you to prepare an income statement using those accounts.
Depreciation
Generalandadministrativeexpense
Sales
Salesexpenses
COGS
Leaseexpense
Interestexpense

$(000,000)
25
22
345
18
255
4
3

(a) ArrangeintoanIncomeStatement:
NameofCompany
IncomeStatement($000,000)
FortheyearendedDecember31,2005
Salesrevenue
Less:Costofgoodssold
Grossprofits
Less:Operatingexpenses
SellingExpense
Generalandadministrativeexpenses
Leaseexpense
Depreciationexpense
Totaloperatingexpense
Operatingprofits(EBIT)
Less:Interestexpense
Netprofitbeforetaxes
Less:Taxes(rate35%)
Netprofitsaftertaxes
Lesspreferredstockdividend
Earningsavailableforcommonstockholders
Earningspershare(EPS)1
Dividendpershare(DPS)

$345.0
255.0
$90.0
$18.0
22.0
4.0
25.0
$69.0
$21.0
3.0
$18.0
6.3
$11.7
0.0
$11.7
$2.75
$1.10

Assumes4.25millionsharesoutstanding

(b) Calculatetaxespaidandnetprofitaftertaxes(seeabove)
(c) Calculateadditionstoretainedearnings$11,700,000$4,675,000$7,025,000

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Example 4:

Statement of retained earnings (Source: Gitman, 2006)

Hayes Enterprises began 2006 with retained earnings of $928,000. During 2006, the firm earned
$377,000 after taxes. From this amount, preferred stockholders were paid $47,000 in dividends.
At year-end 2006, the firms retained earnings totaled $1,048,000. The firm had 140,000 shares
of common stock outstanding during 2006.
a. Prepare a statement retained earnings for the year ended December 31, 2006.
b. Calculate the firms EPS.
c. How large a per-share cash dividend did the firm pay on common stock during 2006?
Solution:
(a) CashdividendspaidoncommonstockNetprofitsaftertaxespreferred
dividendschangeinretainedearnings
$377,000$47,000($1,048,000928,000)
$210,000
HayesEnterprises
StatementofRetainedEarnings
FortheYearEndedDecember31,2006
Retainedearningsbalance(January1,2006)
Plus:Netprofitsaftertaxes(for2006)
Less:Cashdividends(paidduring2006)
Preferredstock
Commonstock
Retainedearnings(December31,2006)
(b) Earningspershare
Earningspershare

$928,000
377,000
(47,000)
(210,000)
$1,048,000

Netprofitaftertax Preferreddividends(EACS* )
Numberofcommonsharesoutstanding

$377,000 $47,000
$2.36
140,000

Earningsavailabletocommonstockholders

Totalcashdividend
#shares
$210,000(frompart(a))
Cashdividendpershare
$1.50
140,000

(c) Cashdividendpershare

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Example 5:

Balance sheet (Source: Flynn, 2006)

You know the following things about a distribution business:

COGS for the business is the purchase cost of goods; no other items go into COGS.
The gross profit margin for the business is 25%.
As a result of careful credit checks, bad debt is insignificant.
Monthly sales are steady at $2 million per month.
The business floats on a short term credit line and has no cash or short term
investments on hand.
Accrued expenses are negligible.
There are no taxes payable.
The long-term debt is a $400,000 loan with a straight line principal repayment over a ten
year period (i.e. the repayment is $40,000 per year for ten years).
Receivables are running 42 days of sales.
Inventory is 54 days of sales.
Suppliers are faithfully paid on net 30 days terms.
The short-term lender has specified a minimum working capital ratio (i.e. current assets
divided by current liabilities) of two.

Can you complete a full balance sheet for this company? If yes, do so. If not, show what
information is missing by placing an X in those spots.
Solution:
($000)
Assets
Current Assets:
Cash
Marketable Securities
Receivables
Inventory

Liabilities
Current Liabilities:
Notes Payable
Accounts Payable
Accruals
Cur.Por. of L T Debt

$2800
$3600
$6400

$1660
$1500
$40
$3200

Fixed Assets:
Land, Bld.& Equip. @ Cost
Less Acc. Depreciation

X
X

Long Term Debt:


Repayable Grants
Long Term Debt

Long Term Investments


Goodwill

X
X

Stockholders Equity:
Capital Shares
Retained Earnings

X
X

Total Assets

Total Liab. and Equity

$360

Notes: Receivables = 42/30 * 2,000,000


Inventory = 54/30 * 2,000,000
Current liabilities = 6,400,000/2
Accounts payable = 0.75 * 2,000,000
Notes payable = 3,200,000 40,000 1,500,000

Example Problems (Modules 1-3)

ENMA 600 Cost Estimation and Financial Analysis


Long-term debt = 400,000 40,000 = 360,000
Example 6:
Statement of cash flows (Source: Gitman, 2006)
Identify each expense or revenue as a cash flow from operating activities (O), a cash flow from
investment activities (I), or a cash flow from financing activities (F).
Administrative expenses
Rent payment
Interest on a note payable
Interest on a note receivable
Sale of equipment
Dividend payment
Stock repurchase
Sale of finished goods

Labor expense
Sale of a bond issue
Repayment of a long-term debt
Selling expenses
Depreciation expense
Sale of common stock
Purchase of fixed assets

Solution:
Administrativeexpenses............................
Rentpayment.......................................
Interestonanotepayable.........................
Interestonanotereceivable......................
Saleofequipment..................................
Dividendpayment...................................
Stockrepurchase...................................
Saleoffinishedgoods.............................
Laborexpense......................................
Saleofabondissue...............................
Repaymentofalongtermdebt...............
Sellingexpenses...................................
Depreciationexpense...............................
Saleofcommonstock...............................
Purchaseoffixedassets...........................

Example Problems (Modules 1-3)

O
O
F
F
I
F
F
O
O
F
F
O
O
F
I