Question

11. What’s wrong with this picture? In the following discussion see how many errors you can spot and explain briefly why each is an error. You do not need to correct the error. “Natalie, I think we’ve got a winner here.

Take a look at these numbers! Year Initial cost Units sold Price/unit 15 ($ thousand 0 1 2 3 ... 10 ??1,000 100 100 100 ... 100 15 15 ... 15 Total revenue Cost of goods sold Gross profit Operating expenses Depreciation Interest expense Income before tax Tax @ 40% Income after tax 1,500 1,500 1,500 ... 1,500 800 800 800 ... 800 700 700 700 ... 700 100 100 100 ... 100 100 100 100 ... 100 500 500 500 ... 500 200 200 200 ... 200 300 300 300 ... 300 “Now, Natalie, here’s how I figure it: The boss says our corporate goal should be to increase earnings by at least 15 percent every year, and this project certainly increases earnings. It adds $300,000 to net income after tax every year. My trusty calculator tells me that the rate of return on this project is 30 percent ($300/$1,000), well above our minimum target return of 10 percent. And if you want to use net pres- ent value, its NPV discounted at 10 percent is $843.50. So, what do you think, Natalie?” “Well, David, it looks pretty good, but I do have a few questions.” “Shoot, Natalie.” “OK. What about increases in accounts receivab“But, David, what about extra selling and administrative costs? Haven’t you left those out?” “That’s the beauty of this, Natalie. Given the recent recession, I fig- ure we can handle the added business with existing personnel. In fact, one of the virtues of the proposal is that we should be able to retain some people we would otherwise have to terminate.” “Well, you’ve convinced me, David. Now, I think it will be only fair if the boss puts you in charge of this exciting new project.”

Answer 1

Based on the information provided in the question, it can be observed that interest expense has been taken as an operating expense. Interest paid is a non-operating expense and therefore, its categorization in the picture is not correct. The financial statement can be further segregated by calculating EBIT (after deducting depreciation from gross profit), EBT (after deducting interest expense from EBIT) and Income after Taxes (after deducting taxed from EBT).

Another important factor that has been excluded while determine net income is any increase/decrease in selling and administrative costs which could have caused an increase/decrease in net income and after-tax operating cash flows.

Finally, it can be seen that the methodology used to calculate the value of NPV and rate of return is incorrect. NPV is determined by taking into after-tax operating cash flows and not net income (which has been done in this case). Also, the rate of return (also known as internal rate of return) should be calculated by taking into after-tax operating cash flows for all the years and initial project cost. Simply dividing net income by project's initial cost is not the correct approach. Actual NPV and rate of return may turn out to be higher or lower if correct values are used. While determing after-tax operating cash flows, non-cash charges such as depreciation and amortization are added back to EBIT.