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Module 8

Proforma ProformaWith Stock With Loan

AssetsCash $5,000 $20,000 $20,000Inventory 10,000 20,000 20,000 Cart 35,000 70,000 70,000

Total 50,000 110,000 110,000 Liabilities Note Payable - - 60,000

Owners' EquityCommon Stock $1 50,000 110,000 50,000 Total Liabilities and Owners' Equity 50,000 110,000 110,000

Sales 60,000$ 120,000$ 120,000$ Cost of Sales 12,000 24,000 24,000 Gross Margin 48,000 96,000 96,000 Operating Expenses Wages 23,000 46,000 46,000 Other 10,000 12,000 12,000 Total Operating Expenses 33,000 58,000 58,000

Operating Income 15,000 38,000 38,000 Other Expenses Interest 4,800 Income Before Tax 15,000 38,000 33,200 Tax expense (30%) 4,500 11,400 9,960 Net Income 10,500$ 26,600$ 23,240$

EPS 0.210 0.242 0.465

ROA 21.00% 24.18% 21.13%

ROE 21.00% 24.18% 46.48%

Borrowed 60,000. After tax cost = (.08 X 60,000) X (1-t)4,800 X .7 = 3,360

Increase in Net Income = 26,600 – 10,500 =16,100So Shareholders got 13,240 by using the loan strategy. (About .22 per share.)

20. Return on assets

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Net Income ÷ Average total assets (2017 Assets, 197,295)

2018 2019

30,736 34,343

197,295 + 232,792 232,792 + 275,909

2 2

30,736 34,343

215,044 254,351

14.29% 13.50%

Preliminary measure of management effectiveness

21. Return on equity

Net Income ÷ Average shareholders’ equity (Shareholders’ Equity, 2017= 152,502)Need to subtract any preferred dividends from Net Income

2018 2019

30,736 34,343 152,502 + 177,628 177,628 + 201,442

2 2 30,736 34,343 165,065 189,535

18.62% 18.125%

Tells me- How effectively the company is using other peoples’ money to make money!!!!

ALSO SEE RATIO 23

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22. Return on total capital Earnings before interest and taxes ÷ (Interest bearing debt + Shareholders’ Equity)

2018 2019

27,524 34,231 4,012 + 177,628 4,554 + 201,442

27,524 34,231

181,640 205,993

15.15% 16.62%

23. Return on common equity(Net income – preferred dividends) ÷ Average shareholders’ equity

2018 2019

30,736 34,343 152,502 + 177,628 177,628 + 201,442

2 2 30,736 34,343 165,065 189,535

18.62% 18.125%

Tax burden

Net Income ÷ Earnings before tax

2018 2019

30,736 34,343 34,913 39,625

88.04 86.67

The difference between the Tax Burden and 1 is the effective tax rate for that year.

That is different from the “marginal tax rate”. The marginal tax rate is the tax rate on the next dollar you earn.

Federal corporate tax rate Currently, the federal corporate tax rate is set at 21%. Prior to the Tax Cuts and Jobs Act of 2017, the tax rate was 35%.

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24. Interest burdenEarnings before tax ÷ Earnings before interest and taxes

2018 2019

34,913 39,625 27,524 34,231

1.27 1.16

Times Interest Earned

EBIT / Interest Expense

2018 2019

27,524 34,231 7,389 5,394

3.72 6.35

25. EBIT margin Earnings before interest and taxes ÷ Total Revenue

2018 2019

Be careful of “Earnings Before All the Bad Stuff” (Charlie Munger)

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26.Financial leverage ratio (equity multiplier) (2017 Assets, 197,295; 2017 Share Equity 152,502)

Average total assets ÷ Average shareholders’ equity

2018 2019

(197,295 + 232,792)/2 (232,792 + 275,909) / 2(152,502 + 177,628)/2 (177,628 + 201,442) / 2

215,044 254,351165,065 189,535

1.303 1.342

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27. Total debtThe total of interest-bearing short-term and long-term debt excluding liabilities such as accrued expenses and accounts payable

2018 2019

4,012 4,554

For Home Depot

2019 2020

1,056 + 26,807 1,839 + 26,807

27,863 28,646

28. Debt to assets ratioTotal Debt ÷ Total assets

2018 2019

4,012 4,554 232,792 275,909

1.73% 1.65%

Not a real example

For Home Depot

2019 2020

28,646 27,863 44,003 51,236

65.10% 54.38%

Means that in 2019, 65.10% of the total assets are financed by long-term debt. 54.38% in 2020.

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29. Debt to equity ratioTotal Debt ÷ Total shareholders’ Equity

2018 2019

4,012 4,554 177,628 201,442

2.25% 2.26%

For Home Depot

Negative Shareholder equity so this one makes no sense

2019 2020

31. Debt to capital ratio

Total debt / (total debt + total shareholders’ equity)

2018 2019

For Home Depot

2019 2020

No sense for either

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32. Interest coverage ratioEarnings before interest and taxes / interest payments

2018 2019

27,524 34,231 7,389 5,394

3.72 6.35

For Home Depot

2019 2020

15,530 15,843 1,051 1,201

` 14.78 times 13.91 times

33. Fixed charge coverage ratio Earnings before interest and taxes + lease payments

/ interest payments + Lease payments2018 2019

34. Dividends payout ratioCommon share dividends / earnings attributable to common shares

Home Depot

2019 2020

4,704 5,958 11,121 11,242

42.30% 53.00%

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35. Retention rateEarnings attributable to common shares – common shares dividends / Net income attributable to common shares = 1 – payout ratio

2018 2019

36. Sustainable growth rateRetention rate X Return on equity

2018 2019

37. Earnings per shareNet Income – Preferred Dividends / weighted average shares outstanding

2018 2019

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Diluted Earnings Per Share- Treasury Stock Method

Treasury stock method means that any money the company receives from the exercise of options or the conversion of bonds, preferred stock, etc. is assumed used to repurchase shares at the average share price for the period. This lowers the weighted average shares outstanding. Weighted average shares outstanding is increased by the share represented by the option or conversions of convertible securities.

38. Book Value per share

Common stock equity / total shares of common stock outstanding

(Total Owners’ Equity – Preferred share amounts) / total shares outstanding

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Now we in order to go forward toward

“But I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate.”

Warren Buffett

We go back to Fixed Income Instruments

The coupon rate of a bond is:

On January 1, 2020, Isabella Company of Las Vegas, Nevada, issues $100,000 of 8% bonds. The bonds pay interest annually and mature in three years. Interest is to be paid on December 31 of each year. (First interest is to be paid 12/31/20)

The purpose of education isn’t knowledge, it is action.

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What if by the time it got to the market, interest rates had risen to 10%?

Kirch’s 3rd law of the Universe…. You _____________ ______________ the _____________!!!

How much does Isabella receive?

Bonds issued for less than the face are said to be issued at d__________.

Amortize the bond

Show how the Bond Accounts appear on the Balance Sheet for each year.What about current portion?

What if the current interest rate was 6%? (3rd law applies!!!)

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calculate issuance amount, and amortize

Bonds sold for an amount higher than the face are said to sell at a p________________.

Are you listening, or just reloading?

A zero coupon bond is

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Also called a D________ D_____________ B________

Why issue/buy?

Malcom Co. issues a $100,000 zero on December 31, 2018, interest rate 10% per annum, bond is due in three years. How much do they get? Amortize it

Module 8, Homework

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Hermi’s Bumbles, Inc.

Hermi’s Bumbles is a company that has been in business for three years. The company is a wholesaler of Bumbles. Bumbles are bulbs which grow into beautiful, sweet smelling plant-trees. They are a cross between a hyacinth and a buckeye. They are refrigerated and must be planted within one year of when they are harvested. Hermi buys the bumbles from a grower when they are one month old. Hermi has one location in Columbus, Ohio. It has three refrigerated trucks which deliver the Bumbles throughout Ohio. The financial statements on the previous page summarize Hermi’s operations for its first three years.

Hermi began operations with individuals investing $120,000 for 12,000 shares of common stock and a small business loan of $200,000 from the bank. The loan carries interest at 12%. Hermi must pay the interest plus $10,000 on the principal on January 1 of each year. Hermi sells using terms of 2/10 n/30. The latest sale of stock between individuals was yesterday at $85.00 per share. There are more shares available from the other investors for this amount. The tax rate is 30%.

The financial statements for Hermi’s are on the following page.

Calculate and comment on each of the following ratios for 2018 and 2019.

1. Current Ratio

2. The Quick or “Acid Test” ratio

3. Accounts Receivable Turn and Average Collection Period

4. Inventory Turn and Average Days Sales in Inventroy

5. Book Value Per Share

6. Return on Assets (ROA)

7. Return on Equity (ROE)

8. Debt Ratio

9. Debt to Equity

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Balance Sheet Assets 2019 2018 2017

Current Assets Cash 64,770$ 44,140$ 87,000$ Accounts Receivable - Net 110,000 60,000 40,000 Inventories 200,000 160,000 80,000 Other current assets 8,000 8,000 5,000 Total Current Assets 382,770 272,140 212,000

Net Fixed Assets 240,000 220,000 180,000

Other Assets 10,000 10,000 10,000

Total Assets 632,770$ 502,140$ 402,000$

Current Liabilities Accounts Payable 210,000$ 150,000$ 100,000$ Other Payables 28,000 32,000 38,000 Current Portion- Long Term Debt 10,000 10,000 10,000 Total Current Liabilities 248,000 192,000 148,000

Long-Term Debt- Net of Current Maturities 170,000 180,000 190,000

Total Liabilities 418,000 372,000 338,000

Owners' Equity Common Stock $10 Par 120,000 120,000 120,000 Retained Earnings 94,770 10,140 (56,000) Total Owners' Equity 214,770 130,140 64,000

Total Liabilities and Owners' Equity 632,770$ 502,140$ 402,000$ - - -

Income StatementSales 1,100,000$ 700,000$ 400,000$ Cost of sales 687,500 360,000 240,000 Gross Margin 412,500 340,000 160,000

Operating Expenses Salaries and wages 110,000 100,000 80,000 Rent 48,000 48,000 48,000 Utilities 20,000 19,000 18,000 Advertising 25,000 20,000 15,000 Vehicle expenses (Gas, oil etc) 29,000 26,000 13,000 Depreciation 15,000 10,000 10,000 Other Operating Expenses 23,000 18,000 12,000 Total Operating Expenses 270,000 241,000 196,000

Income From Operations 142,500 99,000 (36,000) Other Expenses Interest (21,600) (22,800) (24,000) Income Before Taxes 120,900 76,200 (60,000) Income Tax Expense 36,270 6,060 - Net Income 84,630$ 70,140$ (56,000)$

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Problem 2 Brynnie Company issues a $100,000 on 12/31/19, 15%, bond that matures in 3 years. Interest is paid on December 31st of each year. Prepare all journal entries for all years related to this bond issue if it was priced to yield: 10% 15% 20%Amortize these

Problem 3 Charleight Company issued 8% zero on 12/31/19, due in 3 years, face amount of $100,000. How much would you pay? Amortize it.

Problem 4 Ryan Company issues a $100,000 on 8/31/19, 10%, bond that matures in 5 years. Interest is paid on August 31st of each year. How much would you pay to yield:

8% 10% 14% Amortize each of these

Problem 5 Still Ryan Company - How about a zero issued on 5/31/19, due in 4 years, face amount of $100,000. Current market rates are 11%. How much would you pay?Amortize it.

Problem 6 Extra Hard!! Go back to the Isabella Company bonds, 8% coupon, issued to yield 10%, – What if the date of issuance is April 1st and not December 31st? What would be the interest expense for the second year?

Now do same bonds, 8% coupon, issued to yield 6%. What would be the interest expense for the second year?