Question

​(Financial statement​ analysis)  The annual sales for​ Salco, Inc. were $ 4.39 million last year. The​ firm's end-of-year balance sheet was as​ follows: Salco's income statement for the year was as​ follows:
b.  Salco plans to renovate one of its plants and the renovation will require an added investment in plant and equipment of $ 1.03 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 13.4 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 $ 52000 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?

End of Year balance sheet:

Current assets   $494,000   Liabilities   $996,000
Net fixed assets   1498000   Owners' equity   996000
Total Assets   $1,992,000   Total   $1,992,000

Income statement:

Sales $4,390,000
Less: Cost of goods sold    (3,496,000)
Gross profit $894,000
Less: Operating expenses    (491,000)
Net operating income $403,000
Less: Interest expense (99,000)
Earnings before taxes $304,000
Less: Taxes (35%) (106,400)
Net income $197,600

Answer 1

b) Net operating income = Operating profit margin * total sales = 0.134 * 4,390,000 = 588,260

Net operating income = 588,260

Total assets = 1,992,000 + 1,030,000 (addition this year) = 3,022,000

Operating return on assets = operating income/ total assets

Operating return on assets = 588,260/3,022,000 =0.1947 =19.47%

Operating return on assets ratio = 19.47%

c) Operating Income = 588,260

Interest = 99,000 +52,000 = 151,000

Earnings before taxes = 437,260

Net Income = Earnings before taxes *(1- tax rate ) = 437,260*(1-0.35)

Net Income = 284,219

Total equity = 50% * Assets

Total equity = 0.5*3,022,000 = 1,511,000

Return on equity = Net income/total equity = 284,219/1,511,000 = 0.1881 = 18.81%

Return on equity =  18.81%

Now, we check if the renovation a favorable effect on the profitability of the​ firm

Before the renovation, return on equity = Net income/Total equity = 197,600/(0.5*1992,000) = 0.183 = 19.83%

Before the renovation, return on equity = = 19.83%

Now, we can see that renovation caused the return on equity to reduce from 19.83% to 18.81% which is a decrease of 1% and hence we can conclude that renovation did not have a favorable effect on the profitability of the​ firm.