A mature company on Beverage and Food Industry, with stable earnings expects to have earnings per share (EPS) of 30 AED in the coming year and its current stock price is 280 AED. The management must decide between the following alternatives: Pay all of its earnings as dividends and abandon the new investment in Dubai or Cut its dividend payout rate to 75% and implement the Dubai Project. If the second policy is followed there is a divergence in the estimation of the Return on New Investment.

(i). Pay all of its earnings as dividends. Because of the status of the company and its strength in the market, the CEO believes that cash flow from operations is sufficient to continue to reinvest in growth, though has to abandon Dubai Project for next year, and decided to pay out all of its earnings to investors. Besides that, current economic conditions are weak due to the crisis, and the CEO is more willing to pay dividends than to enter a program of share buybacks.

(ii). Cut its dividend payout rate to 75%. On the other hand, the company’s manager has negative expectations regarding the recent financial crisis and advise to cut dividends even if this is not consistent with its long-run growth in earnings. He believes that it is better to reinvest some of the earnings to open new stores in Dubai, a project that will last 2 years and hence, it is advisable to safeguard its financial reserves for future expenses. If the firm follows this program the return on investment is expected to be 17%. Suppose that the required rate of return is the same as calculated in Question (2) above.

(iii). Expected return on New investment is 9% rather than 17%. Financial crisis is severe and persist. The manager of the company estimates that in this case the return on the new investment will be 9% rather than 17%.

Questions:

(9) What do you advise the firm given the above scenarios, firm’s conditions, and economic situation?

(iv). Taking into consideration the market’s systematic risk. Our firm has a beta factor (systematic risk) quite low, equal to 0.67. This is expected as our firm belongs to Beverage and Food industry. The economy’s risk-free rate is 6% and the market’s return is 10%.

Questions:

(10) Estimate the risk premium.

(11) Estimate the required rate of return using CAPM.

(12) Estimate the price of the stock under alternative (ii) using your answer to Q (7). How do you explain the difference in price found in Question (4)?

(13). What should be your final estimation of the firm’s stock price?

Profit center responsibility reporting for a service company

Red Line Railroad Inc. has three regional divisions organized as profit centers. The chief executive officer (CEO) evaluates divisional performance, using operating income as a percent of revenues. The following quarterly income and expense accounts were provided from the trial balance as of December 31:

The company operates three support departments: Shareholder Relations, Customer Support, and Legal. The Shareholder Relations Department conducts a variety of services for shareholders of the company. The Customer Support Department is the company’s point of contact for new service, complaints, and requests for repair. The department believes that the number of customer contacts is a cost driver for this work. The Legal Department provides legal services for division management. The department believes that the number of hours billed is a cost driver for this work. The following additional information has been gathered:

Required:

1. Prepare quarterly income statements showing operating income for the three divisions. Use three column headings: East, West, and Central.

2. What is the profit margin of each region? Round percentages to the nearest whole number.

Identify the most successful region according to the profit margin.

3. What would you include in a recommendation to the CEO for a better method for evaluating the performance of the regions?

1. A better divisional performance measure would be return on investment, residual income as these methods consider the assets used by the division.
2. The current performance measures are based on the operating income per dollar of earned revenue. This method meets the requirement.
3. A better divisional performance measure would be return on investment, and residual income as these methods consider the dollar revenue earned by the division.

Consider the following situation as if you were Ian.

Ian was a senior analyst at a major hotel company. Although Ian worked mostly in corporate headquarters, he would occasionally travel to the field where he met with front-line employees and learned what was on their minds.

On a trip to Portland, Ian had the chance to speak with two people working at the front desk about what it was like to work at the hotel. Daniel, the younger of the two had joined the staff recently; Ellen, the other employee (and Daniel’s supervisor), had been with the company for almost 15 years. Both employees seemed particularly interested in talking with Ian because they rarely got a chance to talk directly to anyone from headquarters.

As the three discussed changes in the hospitality industry, Ellen and Daniel complained about their company’s aggressive cost control initiatives, spearheaded by the charismatic but frugal CEO, whose policies were occasionally unpopular. After a few more minutes of conversation, Ellen casually said, “The CEO is so tight with a buck, I wonder if he is Jewish.”

As a Jewish person, Ian did not know how to react. He had never actually experienced anything like this before, especially in a professional setting. Ian’s instinct was not to be combative or hostile, but he felt a bit like a deer caught in the headlights. Daniel looked a little surprised at his supervisor’s remark, but, laughing, he quickly changed the subject. Smiling, Ian made an excuse to end or discussion and walk away.

The next day Ian woke up still bothered by Ellen’s remark. While checking out, he saw Daniel at the front desk. Ian mentioned to him that he may want to tell his supervisor to watch her remarks about other peoples’ ethnicity, to which Daniel replied, “I know what you mean because I am Puerto Rican, but I think that she meant it as a joke.” Ian could see that Daniel just wanted to smooth the issue over.

On the ride to the airport, Ian kept thinking about what he might do. Should he report Ellen to Human Resources? The company had a process in place for such matters, but he was worried. Ian did not know who he was dealing with; maybe Ellen would retaliate if he said something, especially since she would know who filed the complaint. Plus, Ian was not sure what the consequences would be – he didn’t want to get her fired. Ian only wanted Ellen to know how offensive the comments were.

As a team, consider what steps Ian should take.

What are the concerns facing Ian?

Karane Enterprises, a calendar year manufacturer based in College Station, Texas, began business in 2017. In the process of setting up the business, Karane has acquired various types of assets. Below is a list of assets acquired during 2017:

Assets    Cost Date   Placed in Service

Office furniture 150,000 2/3/17

Machinery 1,560,000 7/22/17

Used delivery truck 40,000 8/17/17

During 2017, Karane was very successful (and had no 179 limitation) and decided to acquire more assets this next year to increase its production capacity. These are the assets acquired during 2018:

Assets                    Cost Date    Placed in Service

Computers & info syst 400,000 3/31/18

Luxury auto 80,000 5/26/18

Assembly equip 1,200,000 8/15/18

Storage bldg. 700,000 11/13/18

Karane generated taxable income in 2018 of $1,732,500 for purposes of computing the 179 expense.

Required:

Compute the maximum 2018 depreciation deductions including 179 expense (ignoring bonus depreciation) AND Compute Part 1 of Form 4562.

6-40 Replacement of Old Equipment

Three years ago, the Oak Street TCBY brought a frozen yogurt machine for $11,200. A salesman has just suggested to the TCBY manager that she replace the machine with a new $13,500 machine. The manager has gathered the following data:

1. Compute the difference in total costs over the next 5 years under both alternatives, that is, keeping the original machine or replacing in with the new machine. Ignore taxes.

2. Suppose the Oak Street TCBY manager replaces the original machine. Compute the “loss on disposal” of the original machine. How does this amount offset your computation in number 1? Explain

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Discussion Case 6-1

Should We Implement an Earnings-Based Bonus Plan? Benjamin Vincent is the CFO of Annie Company. The company’s CEO has asked Benjamin to design an incentive scheme that will motivate employees to focus more on the company’s bottom-line results. Benjamin is considering a plan that will give each employee a bonus based on the company’s reported net income for the year. Each employee will receive an amount equal to the company’s earnings per share multiplied by either 10,000 times, 50,000 times, or 200,000 times, depending on the employee’s level in the company. Last year, Annie Company’s earnings per share was $1.32. Benjamin has asked you for your advice. In particular, he wants you to explain the disadvantages of having an earnings-based bonus system.

We Only Need Another $100,000!

Chris Titera is the CFO for Dallas Company. It is January 10, and Chris has just finished compiling the preliminary financial results for the most recent fiscal year, which ended on December 31. The preliminary results indicate that Dallas lost $100,000 during the year. Dallas is a large company (with assets in excess of $1 billion), so the $100,000 loss is essentially the same as zero. However, the board of directors thinks that it conveys a very negative image for Dallas Company to report a loss for the year, even if the loss amount is very small. As a result, it has instructed Chris to look at the numbers again and see if he can turn this loss into a profit. What things can Chris do, as the CFO, to turn this loss into a profit? What concerns should Chris have?

The following selected transactions relate to investment activities of Ornamental Insulation Corporation. The company buys securities, not intending to profit from short-term differences in price and not necessarily to hold debt securities to maturity, but to have them available for sale when circumstances warrant. Ornamental’s fiscal year ends on December 31. No investments were held by Ornamental on December 31, 2015. 2016 Feb. 21 Acquired Distribution Transformers Corporation common shares costing $530,000. Mar. 18 Received cash dividends of $10,000 on the investment in Distribution Transformers common shares. Sep. 1 Acquired $1,290,000 of American Instruments' 10% bonds at face value. Oct. 20 Sold the Distribution Transformers shares for $565,000. Nov. 1 Purchased M&D Corporation common shares costing $2,050,000. Dec. 31 Recorded any necessary adjusting entry(s) relating to the investments. The market prices of the investments are: American Instruments bonds $ 1,243,000 M&D Corporation shares $ 2,123,000 (Hint: Interest must be accrued for the American Instruments’ bonds.) 2017 Jan. 20 Sold the M&D Corporation shares for $2,148,000. Mar. 1 Received semiannual interest of $64,500 on the investment in American Instruments bonds. Aug. 12 Acquired Vast Communication common shares costing $780,000. Sept. 1 Received semiannual interest of $64,500 on the investment in American Instruments bonds. Dec. 31 Recorded any necessary adjusting entry(s) relating to the investments. The market prices of the investments are: Vast Communication shares $ 800,000 American Instruments bonds $ 1,223,000 Required: 1. Prepare the appropriate journal entry for each transaction or event during 2016. 2. Indicate any amounts that Ornamental Insulation would report in its 2016 balance sheet and income statement as a result of these investments. 3. Prepare the appropriate journal entry for each transaction or event during 2017. 4. Indicate any amounts that Ornamental Insulation would report in its 2017 balance sheet and income statement as a result of these investments.

On January 1, 2017, Allan Company bought a 15 percent interest in Sysinger Company. The acquisition price of $235,500 reflected an assessment that all of Sysinger’s accounts were fairly valued within the company’s accounting records. During 2017, Sysinger reported net income of $127,300 and declared cash dividends of $37,800. Allan possessed the ability to influence significantly Sysinger’s operations and, therefore, accounted for this investment using the equity method.

On January 1, 2018, Allan acquired an additional 80 percent interest in Sysinger and provided the following fair-value assessments of Sysinger’s ownership components:

Also, as of January 1, 2018, Allan assessed a $443,000 value to an unrecorded customer contract recently negotiated by Sysinger. The customer contract is anticipated to have a remaining life of four years. Sysinger’s other assets and liabilities were judged to have fair values equal to their book values. Allan elects to continue applying the equity method to this investment for internal reporting purposes.

At December 31, 2018, the following financial information is available for consolidation:

1. How should Allan allocate Sysinger’s total acquisition-date fair value (January 1, 2018) to the assets acquired and liabilities assumed for consolidation purposes?

2. Calculate the following as they would appear in Allan's pre-consolidation 2018 statements.

3. Prepare a worksheet to consolidate the financial statements of these two companies as of December 31, 2018.

At year-end, there were no intra-entity receivables or payables.