Question

Paul Sabin organized Sabin Electronics 10 years ago to produce and sell several electronic devices on which he had secured patents. Although the company has been fairly profitable, it is now experiencing a severe cash shortage. For this reason, it is requesting a $620,000 long-term loan from Gulfport State Bank, $160,000 of which will be used to bolster the Cash account and $460,000 of which will be used to modernize equipment. The company’s financial statements for the two most recent years follow:

Sabin Electronics
Comparative Balance Sheet
	This Year		Last Year
Assets
Current assets:
Cash	$	118,000	$	270,000
Marketable securities		0		30,000
Accounts receivable, net		633,000		420,000
Inventory		1,065,000		715,000
Prepaid expenses		30,000		34,000
Total current assets		1,846,000		1,469,000
Plant and equipment, net		1,969,200		1,490,000
Total assets	$	3,815,200	$	2,959,000
Liabilities and Stockholders Equity
Liabilities:
Current liabilities	$	820,000	$	420,000
Bonds payable, 12%		850,000		850,000
Total liabilities		1,670,000		1,270,000
Stockholders' equity:
Common stock, $15 par		810,000		810,000
Retained earnings		1,335,200		879,000
Total stockholders’ equity		2,145,200		1,689,000
Total liabilities and equity	$	3,815,200	$	2,959,000

Sabin Electronics
Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales	$	5,600,000	$	4,710,000
Cost of goods sold		3,995,000		3,570,000
Gross margin		1,605,000		1,140,000
Selling and administrative expenses		677,000		572,000
Net operating income		928,000		568,000
Interest expense		102,000		102,000
Net income before taxes		826,000		466,000
Income taxes (30%)		247,800		139,800
Net income		578,200		326,200
Common dividends		122,000		101,000
Net income retained		456,200		225,200
Beginning retained earnings		879,000		653,800
Ending retained earnings	$	1,335,200	$	879,000

During the past year, the company introduced several new product lines and raised the selling prices on a number of old product lines in order to improve its profit margin. The company also hired a new sales manager, who has expanded sales into several new territories. Sales terms are 2/10, n/30. All sales are on account.

Assume that Paul Sabin has asked you to assess his company’s profitability and stock market performance.

Required:
1.	You decide first to assess the company’s stock market performance. For both this year and last year, compute:

a.	The earnings per share. There has been no change in common stock over the last two years.(Round your answers to 2 decimal places.)

           

b.	The dividend yield ratio. The company’s stock is currently selling for $50 per share; last year it sold for $45 per share. (Do not round intermediate calculations. Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

             

c.	The dividend payout ratio. (Round intermediate calculations to 2 decimal places. Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

             

d.	The price-earnings ratio. (Round intermediate calculations to 2 decimal places. Round your answers to 2 decimal places.)

             

e.	The book value per share of common stock. (Round your answers to 2 decimal places.)

             

2.	You decide next to assess the company’s profitability. Compute the following for both this year and last year:

a.	The gross margin percentage. (Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

           

b.	The net profit margin percentage. (Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

           

c.	The return on total assets. (Total assets at the beginning of last year were $2,919,000.) (Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

           

d.	The return on equity. (Stockholders’ equity at the beginning of last year was $1,679,000.) (Round your percentage answers to 1 decimal place (i.e., 0.1234 should be entered as 12.3).)

             

e.	Is the company’s financial leverage positive or negative?
	Positive Negative

Answer 1

1a) Earnings per share :

Earnings per share = Net income/No. of common stock shares outstanding

We know Net Income but to calculate No. of common stock shares outstanding we need to use the formula: Common stock shares outstanding = Common stock/Par value per share

Common Stock shares outstanding this year : 810,000/15 = 54,000 shares

Common Stock shares outstanding last year : 810,000/15 = 54,000 shares

Earnings per share this year : 578,200/54,000 = $10.71

Earnings per share last year : 326,200/54,000 = $6.04

Note: As there is no preferred stock, preferred dividend will be zero.

1b) Dividend yield ratio:

Dividend per Share = Common dividends / Outstanding common shares

This year = $ 122,000/ 54,000 common shares = $ 2.26 per share

Last year = $ 101,000/ 54,000 common shares = $ 1.87 per share

For calculation of outstanding common shares refer solution of part (a).

Dividend yield ratio = Dividend per Share / Current Share Price x100

Dividend yield ratio this year = 2.26 / 50 * 100 = 4.5%

Dividend yield ratio last year = 1.87 / 45 * 100 = 4.2%

1c) Dividend Payout Ratio :

Dividend payout ratio : Common dividends/Net income

This year : 122,000/578,200 = 0.211 = 21.1%

Last year : 101,000/326,200 = 0.3096 = 31.0%

1d) Price earnings ratio :

Price earning ratio: Market value per share / Earnings per share

Price earnings ratio this year = 50 / 10.71 = 4.67

Price earnings ratio last year = 45 / 6.04 = 7.45

1e) Book value per share of common stock :

Book value per share of common stock: Total stockholder’s equity / Common stock shares outstanding

Book value per share of common stock this year: 2,145,200 / 54,000 = $39.73

Book value per share of common stock last year: 1,689,000 / 54,000 = $31.28

2a) Gross Margin Percentage:

Gross margin percentage: Gross margin / Sales

Gross margin percentage this year : 1,605,000 / 5,600,000 = 0.287 = 28.7%

Gross margin percentage last year : 1,140,000 / 4,710,000 = 0.242 = 24.2%

2b) Net profit margin percentage :

Net profit margin percentage: Net income / sales

Net profit margin percentage this year: 578,200 / 5,600,000 = 10.3%

Net profit margin percentage last year: 326,200 / 4,710,000 = 6.9%

2c) Return on total assets :

Return on total assets = Net income / Average total assets X 100

This year	Last year
= $ 578,200 / $ 3,387,100 X 100	= $ 326,200 / $ 2,939,000 X 100
= 17.1 % (Answer)	= 11.1 % (Answer)
*Average total assets	*Average total assets
= (Total assets at the end of this year + Total assets last year) / 2	= (Total assets of last year + Total assets at beginning of last year ) / 2
= ( $3,815,200 + $2,959,000 ) / 2	= ( $2,959,000  + $2,919,000) / 2
= $ 6,774,200 / 2	= $ 5,878,000 / 2
= $ 3,387,100	= $ 2,939,000

2d) Return on equity:

Return on equity = Net income / Average stockholder's equity X 100

This year	Last year
= $ 578,200 / $ $1,917,100 X 100	= $ 326,200 / $1,684,000X 100
= 30.2% (Answer)	= 19.4 % (Answer)
*Average stockholder's equity	*Average stockholder's equity
= (Total stockholder's equity at the end of this year + Total stockholder's equity last year) / 2	= (Total stockholder's equity of last year + Total stockholder's equity at beginning of last year ) / 2
= ( $2,145,200 + $1,689,000 ) / 2	= ( $1,689,000 + $1,679,000) / 2
= $ 3,834,200 / 2	= $ 3,368,000 / 2
= $1,917,100	= $1,684,000

2e) Company's financial leverage is positive because return on assets and return on equity is higher than the rate of interest payable to the providers of funds. In this sum interest is payable only on bonds which equals to $102,000. This expense is fully covered by return on assets. Further in this sum there is no preferred stock. Companies which source funds through debts than preferred stock will have positive leverage because interest on debt is tax deductible whereas dividend on preferred stock is not. Therefore Company's Financial Leverage is Positive.