Financial statements and taxes Donna Jamison, a 2000 graduate of the University of Florida with 4 years of banking experience, was recently brought in as assistant to the chairman of the board of D’Leon Inc., a small food pro-
ducer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the snack-foods market. D’Leon’s president, Al Watkins, decided in 2004 to undertake a major expansion and to “go
national” in competition with Frito-Lay, Eagle, and other major snack-food companies. Watkins felt that D’Leon’s products were of a higher quality than the competition’s; that this quality differential would enable it to charge a
premium price; and that the end result would be greatly increased sales, profits, and stock price. The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. D’Leon’s results were not satisfactory, to put it mildly. Its board of directors,
which consisted of its president and vice president plus its major stockholders (who were all local businesspeo-
ple), was most upset when directors learned how the expansion was going. Suppliers were being paid late and
were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit.
As a result, Watkins was informed that changes would have to be made, and quickly, or he would be fired. Also,
at the board’s insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired
banker who was D’Leon’s chairman and largest stockholder. Campo agreed to give up a few of his golfing days and to help nurse the company back to health, with Jamison’s help. Jamison began by gathering the financial statements and other data given in Tables IC3-1, IC3-2, IC3-3, and IC3-4. Assume that you are Jamison’s assistant, and you must help her answer the following questions for
Campo. (Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis there, but answering these questions will help prepare you for Chapter 4. Provide clear explanations, not just yes no answers!)
a. What effect did the expansion have on sales, NOPAT, net operating working capital (NOWC), total operating capital, and net income?
b. What effect did the company’s expansion have on its net cash flow, operating cash flow, and free cash flow?
c. Looking at D’Leon’s stock price today, would you conclude that the expansion increased or decreased MVA?
d. D’Leon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30 days of receipt. Judging from its 2005 balance sheet, do you think D’Leon pays suppliers on time? Explain. If not, what problems might this lead to?
e. D’Leon spends money for labor, materials, and fixed assets (depreciation) to make products, and still more
money to sell those products. Then, it makes sales that result in receivables, which eventually result in cash inflows. Does it appear that D’Leon’s sales price exceeds its costs per unit sold? How does this affect the cash balance?
f. Suppose D’Leon’s sales manager told the sales staff to start offering 60-day credit terms rather than the 30 day terms now being offered. D’Leon’s competitors react by offering similar terms, so sales remain constant.What effect would this have on the cash account? How would the cash account be affected if sales doubled
as a result of the credit policy change?
g. Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of output, yet a dramatic increase in sales volume causes the cash balance to decline?
h. Did D’Leon finance its expansion program with internally generated funds (additions to retained earnings plus depreciation) or with external capital? How does the choice of financing affect the company’s financial
strength?
Refer to Tables IC3-2 and IC3-4. Suppose D’Leon broke even in 2005 in the sense that sales revenues equaled total operating costs plus interest charges. Would the asset expansion have caused the company to experience a cash shortage that required it to raise external capital?
j. If D’Leon started depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the physical stock of assets, (2) the balance sheet account for fixed assets, (3) the company’s reported net income, and (4) its cash position? Assume the same depreciation method is used for stockholder reporting and for tax calculations, and the accounting change has no effect on assets’ physical lives.
k. Explain how earnings per share, dividends per share, and book value per share are calculated, and what
they mean. Why does the market price per share not equal the book value per share?
l. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends received, (3) capital gains, and (4) tax loss carry-back and carry-forward. How might each of these items affect D’Leon’s taxes?
