4. The Alabaster Corp. reported Net sales of 6.7 million, operating costs of 4.3
ID: 2732219 • Letter: 4
Question
4. The Alabaster Corp. reported Net sales of 6.7 million, operating costs of 4.3 million, and depreciation of $480,000 in 2009. Their interest charges were $325,000. They had cash, accounts receivable and inventories of $1.8 million, $5.6 million and $4.2 million, respectively, at the end of 2009. At the end of 2008, those three accounts were $1.9 million, $4.5 million, and $3.4 million respectively. Accounts payable and accruals were $3.0 million and $1.4 million, respectively, at the end of 2009, while at the end of 2008 they were $2.9 million and $1.3 million, respectively. Net plant and equipment was $12.8 million at the end of 2009 and $12.2 million at the end of 2008. Calculate Alabaster’s Net Income, Free Cash Flow and Return on Invested Capital for 2009. Assume a flat tax rate of 40%. How is the Free Cash Flow interpreted? In other words, what does it measure? (12 pts.)
Explanation / Answer
a) Calculation of Alabaster's net income for 2009 :-
Net income = Total revenues - Total expenses
Here, Total revenues = Net sales = $ 67,00,000
Now, calculation of total expenses :
Total expenses = Operating costs + Depreciation + Interest charges + Taxes
Here, operating costs = $43,00,000
Depreciation = $4,80,000
Interest charges = $3,25,000
since the taxes are not given directly, we will have to calculate the amount of taxes.
Amount of tax = Net income before tax*Tax rate
Here, net income before tax = 67,00,000 - (43,00,000 + 4,80,000 + 3,25,000) = $15,95,000
Hence, amount of tax = 15,95,000*40% = $6,38,000
Using the above formula,
Net income = $67,00,000 - (43,00,000 + 4,80,000 + 3,25,000 + 6,38,000) = $9,57,000
b) Calculation of free cash flow for 2009 :
Free cash flow can be calculated from net income using the following formula :
Free cash flow = Net income + Interest expense + Depreciation - Capital expenditure - Net changes in working capital - Tax shield on interest expense
Here, Net income $9,57,000 (calculated above)
Interest expense = $3,25,000 (given)
Depreciation = $4,80,000 (given)
Calculation of changes in working capital
Capital expenditure = Closing net plant and equipment - Opening net plant and equipment
= $12.8 million - $12.2 million = $6,00,000
Net changes in working capital = Closing working capital - Opening working capital
Working capital = Current assets - Current liabilities
Therefore, working capital = (Cash + Accounts receivables + Inventories) - (Accounts payables + Accruals)
Now, closing working capital =$ (1.8 + 5.6 + 4.2) - (3 + 1.4)million = $7.2 million = $72,00,000
Opening working capital = (1.9 + 4.5 + 3.4) - (2.9 + 1.3) = $5.6 million = $56,00,000
Therefore net changes in working capital = $72,00,000 - 56,00,000 = $16,00,000
Now, tax shield on interest expense = Interest charges*Tax rate = 3,25,000*.40 = $1,30,000
Therefore using the above formula, free cash flow =
9,57,000 + 3,25,000 + 4,80,000 - 6,00,000 - 16,00,000 - 1,30,000 = $(5,68,000)
c) Calculation of Return on invested capital for 2009 :
Return on Invested capital = Net income / Invested capital
Invested capital = Operating assets + Fixed assets - Operating liabilities
Here, operating assets = Accounts receivable + Inventories = 56,00,000 + 42,00,000 = $98,00,000
Fixed assets = $1,28,00,000
Operating liabilities = Accounts payable + Accruals = 30,00,000 + 14,00,000 = $ 44,00,000
Therefore, Invested capital = 98,00,000 + 1,28,00,000 - 44,00,000 = $1,82,00,000
Hence, Return on invested capital = 957,000 / 1,82,00,000 = 5.25%
Interpretation of free cash flow :
Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Since, in the given question the free cash flow turns out to be negative, it can be interpreted that the company is making large investments and expanding its asset base.
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