Question

2.  Use the following balance sheet and simplified income statement in answering parts (a) – (c) below: BALANCE SHEET Cash $75,000 Accounts receivables100,000 Inventory95,000 Fixed assets$500,000 Total assets$770,000 Account payable$135,000 Other current liabilities50,000 Long-term debt150,000 Stockholders’ equity (75,000 shares)$435,000 Total liability and equity$770,000 INCOME STATEMENT Sales$1,250,000 Less:  Cost of goods sold635,000 Less:  All expenses (incl. taxes)370,000 Net Income$245,000 a.)  Based on the financial information above, conduct a liquidity analysis for this firm by determining the current ratio, net working capital, the ratio of current assets/total assets, and the cash conversion period. b.)  What is the current market price of the firm’s stock (P0) if the firm’s P/E ratio is 11.5?   Hint:  Note that a firm’s earnings per share = NI/S, where NI = earnings.  Therefore P0 = P/E x E/S c.)  A proposal is made by this firm’s CFO to increase the current ratio to 2x.  The CFO suggests that the firm issue 5,000 new shares of common stock (ignore any flotation costs) and the estimated price per share based on secondary market conditions will be $28.50.  The proceeds from the equity issue will be added to the firm’s cash account.  Assuming everything else remains the same, determine: i)  The impact on the firm’s liquidity position by re-calculating the current ratio, net working capital, the ratio of current assets/total assets, and the cash conversion period as you did in part (a) above. ii)  The new market price (assume the P/E ratio is constant at 11.5). iii)  Based on your estimate of the new price per share of this company’s stock, should the firm adopt the changes suggested by the CFO?  Briefly explain.

Answer 1

Liabilities	Amt	Assets	Amt
Accounts Payable	135000	Cash	75000
Other Current Liabilities	50000	Accounts Receivable	100000
Long term debt	150000	Inventory	95000
Equity (75000 shares)	435000	Fixed Assets	500000
	770000		770000

Ratios

1)

Current Ratio = Current Assets /Current Liabilities

CA = Cash + Accounts Receivable +Inventory = 75000 + 100000 + 95000 => 270000

CL = Accounts Payable + Other Current Liabilities = 135000 + 50000 => 185000

Current Ratio = 270000 / 185000 => 1.46

2) Net Working Capital = Current Assets - Current Liabilities

= 270000 - 185000 => 85000

3)

Total Assets = 770000

Current Assets / Total Assets = 270000 / 770000 = > 0.35

4)

Sales = 1250000

COGS or (cost of goods sold) = 635000

Average Inventory = 95000

Accounts receivables = 100,000

Account payable = $ 135000

Cash Conversion Cycle = Days Inventory outstanding + Days sales outstanding - Days payable Outstanding

Days Inventory outstanding = Average Inventory / COGS * 365

= 95000 / 635000 * 365 = >54.6

Days sales outstanding = Average Receivables / Credit Sales or Sales * 365

= 100000 / 1250000 * 365 => 29.2

Days payable Outstanding = Average Payables / COGS * 365

= 135000 / 635000 * 365 = 77.59 or 77.6

Cash Conversion Cycle = 54.6 + 29.2 - 77.6 = > 6.2

B)

Current Market Price of the Firm

P/E = Price / EPS

P/E = 11.5

EPS = Net Income / Number of shares

= 245000 / 75000 =>$ 3.27

Now

P/E = Price / EPS

11.5 = price / 3.27

price = 11.5 * 3.27 => 37.60

Current market price of the firm’s stock (P0) if the firm’s P/E ratio is 11.5 = $ 37.60

C)

i) 5000 New shares issued at $ 28.5

New Share Capital  = 5000 * 28.5 => $ 142500

Cash increased by 142500 to 217500 (75000 + 142500)

New Balance Sheet

Liabilities	Amt	Assets	Amt
Accounts Payable	135000	Cash	217500
Other Current Liabilities	50000	Accounts Receivables	100000
Long term debt	150000	Inventory	95000
Equity (75000 shares)	435000	Fixed Assets	500000
5000 shares @ 28.5	142500
	912500		912500

New Ratios

1) Current Ratio = Current Assets /Current Liabilities

CA = Cash + Accounts Receivable +Inventory =217500+ 100000 + 95000 =>412500

CL = Accounts Payable + Other Current Liabilities = 135000 + 50000 => 185000

Current Ratio = 412500 / 185000 => 2.23

2) Net Working Capital = Current Assets - Current Liabilities

= 412500- 185000 =>227500

3)

Total Assets = 770000

Current Assets / Total Assets =412500/ 770000 = > 0.53

4) Shares issue will have no impact on Cash conversion cycle

ii)

New Market Price of the Firm

P/E = Price / EPS

P/E = 11.5

EPS = Net Income / Number of shares

Number of shares = 75000 +5000 = 80000

= 245000 / 80000 =>$3.06

Now

P/E = Price / EPS

11.5 = price / 3.27

price = 11.5 * 3.06 =>35.21

The new market price (assume the P/E ratio is constant at 11.5) = $ 35.21

iii)

The share price of the stock reduces after new issue as number of share increases and there is no change in net income. The company may not accept CFOs suggestions as new issue has more impact on liquidity ratio only which were good earlier as well. Also the estimated price per share based on secondary market conditions of $28.50 is lower than estimated price on 11.5 multiple $ 37.6.