Question

The annual sales for​ Salco, Inc. were $ 4.46 million last year. The​ firm's end-of-year balance sheet was as​ follows:  Salco's income statement for the year was as​ follows:

a. Calculate​ Salco's total asset​ turnover, operating profit​ margin, and operating return on assets. b. Salco plans to renovate one of its plants and the renovation will require an added investment in plant and equipment of $ 1.09 million. The firm will maintain its present debt ratio of 50 percent when financing the new investment and expects sales to remain constant. The operating profit margin will rise to 13.9 percent. What will be the new operating return on assets ratio​ (i.e., net operating income divided by total ​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 $ 53,000 per​ year, what will be the return earned on the common​ stockholders' investment? Compare this rate of return with that earned before the renovation. Based on this​ comparison, did the renovation have a favorable effect on the profitability of the​ firm?

Balance sheet

Current assets	$500,000	Liabilities	$994,000
Net fixed assets	1488000	Owners' equity	994000
Total Assets	$1,988,000	Total	$1,988,000

Income statement

Sales	$4,460,000
Less: Cost of goods sold	(3,490,000)
Gross profit	$970,000
Less: Operating expenses	(505,000)
Net operating income	$465,000
Less: Interest expense	(102,000)
Earnings before taxes	$363,000
Less: Taxes (35%)	(127,050)
Net income	$235,950

Answer 1

Part a.

The required values alongwith the respective formulas used:

Total Assets turnover	2.2	=Sales/Total Assets
Operating Profit margin	10.43%	=Net Operating income/Sales
Operating return on assets	23.39%	=Net operating income/Total Assets

Part b.

After the renovation, the total assets will increase by $1.09 million to $3,078,000.

Also given that operating profit margin will increase to 13.9 so we can deduce the new operating income figure from this as

Net Operating income=sales*Operating profit margin

=$4.46 million x 13.9%

=619,940

Using these values we calculate Operating return on assets as given below

Operating return on Assets

20.14%

=Net operating income/Total Assets

Part c.

The net income will get changed due to increased interest expense as follows

Net operating income (as calculated in part b)	619940.00
Less: Interest expense (Additional expense of $53,000)	-155000.00
Earnings before taxes	464940.00
Less: Taxes (35%)	-162729.00
Net income	302211.00

Also the owner's equity will be increased by $545,000 which is 50% of the additional funds of $1.09 million as it is given that debt ratio of 50% will be maintained. So new value of owner's equity will be $1,539,000.

Using these values , we can calculate the new rate of return on owner's equity as

Return on equity (after renovation)

19.64%

=Net income/Owner's Equity (after renovation)

Comparing this with return on equity before renovation (using original given values of income & equity)

Return on equity (before renovation)

23.74%

=Net income/Owner's Equity

Since the return on equity has decreased after renovation, the renovation did not have a favourable effect on the firm's profitability.