Computron Industries, a manufacturer of electronic calculators, has been going through some growth over the course of the 2007 and 2008 years. Some components of this growth include new sales offices, additional plant capacity and a costly advertising campaign. However, execution of this growth is subpar, and has led to suppliers and lenders being paid late, bank complaints, and threats to cut off credit from lenders.
To add insult to injury, Computron Industry’s stockholders are unhappy because of these complaints, and an overall unhealthy balance sheet. As such, the intent of this document is to indentify the financial impact of this expansion to Computron, and determine if expansion has provided any Market Value Added, (MVA), for Computron shareholders. The expansion of Computron industries, according to the Balance Sheet found in appendix A, yielded a negative net income for 2008 of ($95,136). This is a change from 2007’s positive net income of $87,960 or a net income difference between 2007 and 2008 of ($183,096).
However, sales between years 2007 and 2008 increased by over $2. 4 million, (see Sales under Income Statements on the Balance sheet found in appendix A). Similarly, according the Computron’s Balance Sheet, (appendix A), fixed assets increased by over $1. 4 million between 2007 and 2008. It is important to note that cash and short-term investments fell. It is likely that this decrease is because Computron choose to fund part of its expansion with cash from the sale of these assets. It is also important to note that the Balance Sheet shows that between 2007 and 2008 current liabilities increased by $847,360.
This increase, coupled with an increase in long-term debt from 2007 to 2008 by $676,568, is indicative of debt financed as part of the expansion. To add a bit more clarity of how Computron funded its expansion, take a look at the Statement of Cash Flows for 2008, (see Appendix A). Under the Financing Activities section, notice the positive value shown for notes payable, $520,000, and long-term debt, $676,568. This positive value indicates Computron cash coming into the business in the form of debt financed, or debt borrowed.
Conversely, under this same section, the payment of cash dividends line item shows a negative value, ($11,000) – indicative of cash Computron spent. In the case of dividends, the ($11,000), is cash paid out to stockholders. There is, also, compelling evidence showing that even after all of the debt financed, and cash spent to acquire assets and payout dividends, Computron’s cash account only fell by $1,718. Or, the difference between cash at the beginning of year, $9,000 and cash at the end of the year, $7,282.
This positive cash value is indicative of cash assets Computron has on hand or in the bank. With Computron showing a positive 2008, end of year cash balance from the Statement of Cash Flow balance sheet, (appendix a), does not necessarily indicate that the company is still able to generate cash after it has expanded its asset base. This cash generation ability is called Computron’s Free Cash Flow, or the amount of cash available from operations for distribution to all investors after capital expenditures like asset expansions, debt financed and dividend payouts.
There are fundamental uses of free cash flow:
- pay interest on debt,
- pay back principal on debt,
- pay dividends,
- buy back stock,
- buy non-operating assets.
In Computron’s case, Free Cash Flow was used to expand sales offices, payoff dividends and pay back principal and interest on debt for loans acquired to support current operations and expansion. The expansion of Computron yielded an overall increase in operating current assets like cash, inventory and receivables. Where operating current assets are the assets used in normal business operations.
In Computron’s case, these assets are its sales offices, production plants, and manufacturing equipment, etc.. Similarly, Computron also yielded an overall increase in operating current liabilities, or business debt like bonds, mortgages and loans that need to be settled in cash within the current operating year. The importance between operating current assets and operating current liabilities is the difference between the two value that yields Net Operating Working Capital, NOWC: NOWC = (Operating Current Assets) – (Operating Current Liabilities).
That being said, the 2008 NOWC for Computron is calculated as follows: NOWC = [(cash at end of year) + (accounts receivable) + (inventories)] – [(accounts payable) + (accruals)] NOWC = [($7,282) + ($632,160) + ($1,287,360)] – [($324,000) +($284,960)] = $1,317,842 Similarly, Computron’s 2008 Total Operating Capital, for financial liquidity, is $2,257,632 or the sum of NOWC and net fixed assets, (found on balance sheet, see appendix a). As mentioned earlier in this document, Free Cash Flows, FCF, is a company’s ability to generate cash after it has addressed its current liabilities.
FCF, is calculated by first determining a company’s Net Operating Profit After Taxes, (NOPAT or [Earnings Before Interest and Taxes] * [1 – Tax Rate]), and its net investment in operating capital, (difference between Total Operating Capital of actual year and Total Operating Capital of previous year). That being said, Computron’s 2008 FCF is as follows: FCF_2008 = NOPAT – net investment in operating capital = [($17,440)(1 – 0. 4)] – [($2,257,632 – $1,138,600)] = -$1,108,568 Computron’s negative FCF value for 2008, is a strong indicator that company did not generate cash for 2008.
This negative FCF value can also explain why some of Computron accounts payable are delinquent, delayed and in some instances unable to satisfy debts. This now begs the question as to whether or not Computron’s growth is adding financial value back to the company. One way to understand this, is by taking a look at Computron’s 2008 Return on Invested Capital, or (ROIC). Where ROIC is the ratio of NOPAT to the total operating capital. In general if the ROIC exceeds the rate of return required by investors, then a negative FCF is a normal condition of the health of the business and overall growth. For 2008, Computron saw an ROIC of 0. % vs an ROIC for 2007 of 11. 0%. Coupled with a year over year decline in ROIC, and Computron’s Weighted Average Cost of Capital being 10%, could explain shareholder dissatisfaction. Simply put, investors did not get the return they require: (2008 ROIC) < (WACC). However, it can be generally said that in 2007, investors were satisfied because the 2007 ROIC exceed the WACC of 10%. Another performance indicator that can be used to understand Computron’s shareholder value is by calculating the Market Value Added, (MVA). Simply put, the MVA is the difference between the Market Value of the Computron – Book Value of Computron.
Calculation of Computron’s MVA is as follows, (stock values can be found on balance sheet, see appendix a): MVA_2008 = [(# share of stock)(Price per share) + value of debt] – [(Total common equity) + (value of debt)] = [(100,000)(6) – ($557,632)] = $42,368 The $42,368 2008 MVA, vs the 2007 MVA calculated to be $186,232, shows a 3x decline. This means that Computron, between 2007 and 2008, performance yielded less wealth for its shareholders. So far, document has spent some time reviewing Computron’s FCF, and performance indicators like MVA and ROIC. Throughout the document, there has been some mention regarding taxes.
More notably, most corporations, including Computron, have something called a tax liability. Fundamentally, tax liabilities are “the total amount of tax that an entity is legally obligated to pay to an authority as a result of the occurrence of a taxable event” (Investopedia 2009). In Computron’s case, the authority could be the federal government taxes due on income during the 2008 tax year. Here is an example: assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income. The taxable income can be calculated as follows:
Taxable Income = (operating income) + (interest income) + (dividends – exclusions) = ($100,000) + ($5,000) + [($10,000) – (. 7*$10,000)] = $108,000 As such, Example Corporation has a total taxable income of $108,000. It is important to note that the exclusion calculation is based on the Corporate tax rule of excluding 70% of dividend income if corporation owns less than 20% of the company’s stock. It is also important to note that since corporation has a taxable income of $108,000, it falls into the corporate tax rate of 39%, and a tax on base at $22,250, see table 1 below. Table 1 2007 Corporate Tax Rates
Taxable Income Tax on Base Rate on amount above base 0 -50,000 0 15% 50,000 – 75,000 7,500 25% 75,000 – 100,000 13,750 34% 100,000 – 335,000 22,250 39% 335,000 – 10M 113,900 34% 10M – 15M 3,400,000 35% 15M – 18. 3M 5,150,000 38% 18. 3M and up 6,416,667 35% Now knowing what tax rate Example Corporation falls under, the Tax Liability due company can be calculated as follows: Tax = (tax on base) + (effective tax rate)(amount over base) = $22,250 = [(. 39)($108,000 – $100,000)] = $25,370 Based on table 1 above, and Example Corporations income of $108,000, the effective tax due is $25,370.
In conclusion, this document indentified the financial impact of Computron’s expansion, and determined if expansion has provided any Market Value Added, (MVA). Over the course of 2008, Computron created a good deal of debt to grow its business and add fixed assets like office buildings, equipment and inventory. However, this debt equity also yielded some negative performance indicators, specifically ROIC and MVA. These values highlight why Computron shareholders are not satisfied with the overall growth of the business and their heighted concern.
That being said, a reduction in cash flow, negative performance indicators, and late debt payments suggest that overall Computron expansion, at least for the 2008 year, is unhealthy and leaves shareholders with an uncertain future for 2009.
References
- Ehrhardt, M. C. , & Brigham, E. F. (2009). Chapter 3: An Overview of Corporate Finance and the Financial Environment. Financial Statements, Cash Flow, and Taxes (3rd ed. , pp. 79-115).
- Mason: South-Western, a part of Cengage Learning. Investopedia, (2009). Tax Liability. Retrieved November 4, 2009 from http://www. investopedia. com/terms/t/taxliability. asp.
