The annual sales for Salco, Inc. were $4.56 million last year. The firm\'s end-o

Question

The annual sales for Salco, Inc. were $4.56 million last year. The firm's end-of-year balance sheet & Salco's income statement for the year was as follows:

c. Given that the plant renovation in part (b) occurs and Salco's interest expense rises by $52,000 per year, what will be the return earned on the common stockholders' investment?

Compare this rate of return with that earned before the renovation. Based on this comparison, did the renovation have a favorable effect on the profitability of the firm?

Current assets $507,000 Liabilities $995,500 Net fixed assets 1484000 Owners' equity 995500 Total Assets $1,991,000 Total $1,991,000 Sales $4,560,000 Cost of goods sold (3,494,000) Gross profit $1,066,000 Operating expenses (507,000) Net operating income $559,000 Interest expense (106,000) Earnings before taxes $453,000 Taxes (35%) (158,550) Net income $294,450

Explanation / Answer

Part (b) is not given in the question. So we use the existing data.

The idea is to calculate new net income (after renovation) and compare with previous net income (before renovation). To calculate the return on common shareholders' investment (also know as Return on Equity or ROE) we use the following formular:

ROE = Net Income/Book Value of Shareholders Equity

1. Before Renovation: Net Income = $ 294,450 & Book Value of Common Shareholders' Equity = 995500

So, ROE = 294450/995500 = 29.58%

2. After Renovation: Earning Before Taxes = 4,560,000 (Sales) - 3,494,000 (COGS) - 507,000 (Operating Expense) - 158,000 (interest expense) = 401,000 . Net Income = 401,000 (Earning Before Taxes) - 140,350 (Taxes) = 260,650.

Book Value of Common Shareholders' Equity = 995500.

ROE = 260650/995500 = 26.18%

So, renovation did not have favourable effect on profitability firm.

Note: The data on plant renovation ( Part (b)) is not given. So the calculations have been done using the data available in questions. In case there are differences due plant renovations the result may change.

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