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Integrative Case 2 - principles of managerial finance page 225




Question;Seven years ago, after 15 years in public accounting, Stanley Booker, CPA,resigned his position as manager of cost systems for Davis, Cohen, and O?BrienPublic Accountants and started Track Software, Inc. In the 2 years preceding hisdeparture from Davis, Cohen, and O?Brien, Stanley had spent nights and weekendsdeveloping a sophisticated cost-accounting software program that became Track?sinitial product offering. As the firm grew, Stanley planned to develop and expandthe software product offerings, all of which would be related to streamlining theaccounting processes of medium- to large-sized manufacturers.Although Track experienced losses during its first 2 years of operation?2009and 2010?its profit has increased steadily from 2011 to the present (2015). Thefirm?s profit history, including dividend payments and contributions to retainedearnings, is summarized in Table 1.Stanley started the firm with a $100,000 investment: his savings of $50,000 asequity and a $50,000 long-term loan from the bank. He had hoped to maintain hisinitial 100 percent ownership in the corporation, but after experiencing a $50,000loss during the first year of operation (2009), he sold 60 percent of the stock to agroup of investors to obtain needed funds. Since then, no other stock transactionshave taken place. Although he owns only 40 percent of the firm, Stanley activelymanages all aspects of its activities, the other stockholders are not active in managementof the firm. The firm?s stock was valued at $4.50 per share in 2014 and at$5.28 per share in 2015.Integrative Case 2YearNet profits aftertaxes(1)Dividendspaid(2)Contribution toretained earnings [(1)? (2)](3)2009 ($50,000) $ 0 ($50,000)2010 (20,000) 0 (20,000)2011 15,000 0 15,0002012 35,000 0 35,0002013 40,000 1,000 39,0002014 43,000 3,000 40,0002015 48,000 5,000 43,000Track Software, Inc.,Profit, Dividends, and Retained Earnings, 2009?2015TABLE 1ISBN 1-269-86847-0Principles of Managerial Finance, Fourteenth Edition, by Lawrence J. Gitman and Chad J. Zutter. Published by Prentice Hall. Copyright ? 2015 by Pearson Education, Inc.222Stanley has just prepared the firm?s 2015 income statement, balance sheet, andstatement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014balance sheet. In addition, he has compiled the 2014 ratio values and industryaverage ratio values for 2015, which are applicable to both 2014 and 2015 andare summarized in Table 5. He is quite pleased to have achieved record earnings of$48,000 in 2015, but he is concerned about the firm?s cash flows. Specifically, heis finding it more and more difficult to pay the firm?s bills in a timely manner andgenerate cash flows to investors, both creditors and owners. To gain insight intothese cash flow problems, Stanley is planning to determine the firm?s 2015 operatingcash flow (OCF) and free cash flow (FCF).Stanley is further frustrated by the firm?s inability to afford to hire a softwaredeveloper to complete development of a cost estimation package that is believedto have ?blockbuster? sales potential. Stanley began development of this package2 years ago, but the firm?s growing complexity has forced him to devote more ofhis time to administrative duties, thereby halting the development of this product.Stanley?s reluctance to fill this position stems from his concern that the added$80,000 per year in salary and benefits for the position would certainly lower thefirm?s earnings per share (EPS) over the next couple of years. Although the project?ssuccess is in no way guaranteed, Stanley believes that if the money were spent to hirethe software developer, the firm?s sales and earnings would significantly rise oncethe 2- to 3-year development, production, and marketing process was completed.With all these concerns in mind, Stanley set out to review the various data todevelop strategies that would help ensure a bright future for Track Software. Stanleybelieved that as part of this process, a thorough ratio analysis of the firm?s 2015results would provide important additional insights.Sales revenue $ 1,550Less: Cost of goods sold $ 1,030Gross profits $ 520Less: Operating expensesSelling expense $ 150General and administrative expenses 270Depreciation expense 11Total operating expense 431Operating profits (EBIT) $ 89Less: Interest expense 29Net profits before taxes $ 60Less: Taxes (20%) 12Net profits after taxes $ 48Track Software, Inc., Income Statement ($000)for the Year Ended December 31, 2015TABLE 2ISBN 1-269-86847-0Principles of Managerial Finance, Fourteenth Edition, by Lawrence J. Gitman and Chad J. Zutter. Published by Prentice Hall. Copyright ? 2015 by Pearson Education, Inc.223December 31Assets 2015 2014Cash $ 12 $ 31Marketable securities 66 82Accounts receivable 152 104Inventories 191 145Total current assets $421 $362Gross fixed assets $195 $180Less: Accumulated depreciation 63 52Net fixed assets $132 $128Total assets $553 $490Liabilities and stockholders? equityAccounts payable $136 $126Notes payable 200 190Accruals 27 25Total current liabilities $363 $341Long-term debt $ 38 $ 40Total liabilities $401 $381Common stock (50,000 shares outstandingat $0.40 par value) $ 20 $ 20Paid-in capital in excess of par 30 30Retained earnings 102 59Total stockholders? equity $152 $109Total liabilities and stockholders? equity $553 $490Track Software, Inc., Balance Sheet ($000)TABLE 3Retained earnings balance (January 1, 2015) $ 59Plus: Net profits after taxes (for 2015) 48Less: Cash dividends on common stock (paid during 2015) 5Retained earnings balance (December 31, 2015) $102Track Software, Inc.,Statement of Retained Earnings ($000)for the Year Ended December 31, 2015TABLE 4ISBN 1-269-86847-0Principles of Managerial Finance, Fourteenth Edition, by Lawrence J. Gitman and Chad J. Zutter. Published by Prentice Hall. Copyright ? 2015 by Pearson Education, Inc.224TO DOa. (1) On what financial goal does Stanley seem to be focusing? Is it the correctgoal? Why or why not?(2) Could a potential agency problem exist in this firm? Explain.b. Calculate the firm?s earnings per share (EPS) for each year, recognizing that thenumber of shares of common stock outstanding has remained unchanged sincethe firm?s inception. Comment on the EPS performance in view of your responsein part a.c. Use the financial data presented to determine Track?s operating cash flow (OCF)and free cash flow (FCF) in 2015. Evaluate your findings in light of Track?s currentcash flow difficulties.d. Analyze the firm?s financial condition in 2015 as it relates to (1) liquidity, (2) activity,(3) debt, (4) profitability, and (5) market, using the financial statementsprovided in Tables 2 and 3 and the ratio data included in Table 5. Be sure toevaluate the firm on both a cross-sectional and a time-series basis.e. What recommendation would you make to Stanley regarding hiring a new softwaredeveloper? Relate your recommendation here to your responses in part a.f. Track Software paid $5,000 in dividends in 2015. Suppose that an investor approachedStanley about buying 100% of his firm. If this investor believed that byowning the company he could extract $5,000 per year in cash from the companyin perpetuity, what do you think the investor would be willing to pay for the firmif the required return on this investment is 10%?g. Suppose that you believed that the FCF generated by Track Software in 2015could continue forever. You are willing to buy the company in order to receivethis perpetual stream of free cash flow. What are you willing to pay if you requirea 10% return on your investment?


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