See attached! It contains all the details and the question itself.Year 1 Year 2 Year 3
Estimate
Net sales
$50.6 $42.3
$29.0
Net income (loss)
$ 2.0 $(5.7)
$ 0.1
Net profit margin
4.0%
0.3%
Dividends
$ 0.7
$ 0.6
$ 0.00
Return on assets
7.2%
0.4%
Return on equity
11.3%
0.9%
Current assets
$17.68
$14.8
$14.5
Current liabilities
$ 6.6
$ 4.9
$ 4.5
Long-term debt
$ 2.0
$ 6.1
$ 8.1
Shareholders’ equity
$17.7
$11.41
$11.5
Shares outstanding (000s)
226.8
170.5
150.5
Per common share:
Book value
$78.05 $66.70
$76.41
Market price range
$42-$34$65-$45 $62-$55*
*Year to date
Please give me your reaction to my proposals as soon as possible.
Required:
Assume you are Robert Kinkaid, the financial vice president. Appraise the president’s rationale for each of the proposals.
You should place special emphasis on how each accounting or business Sig. incr. in debt-to-equity decision affects
earnings quality. Support your response with ratio analysis.
Canada Steel Co. produces steel casting and metal fabrications for sale to manufacturers of heavy construction machinery
and agricultural equipment. Early in Year 3, the company’s president sent the following memorandum to the financial vice
president:
TO: Robert Kinkaid, Financial Vice President
FROM: Richard Johnson, President
SUBJECT: Accounting and Financial Policies
Fiscal Year 2 was a difficult year for us, and the recession is likely to continue into Year 3. While the entire industry is
suffering, we might be hurting our performance unnecessarily with accounting and business policies that are not
appropriate. Specifically:
(1) We depreciate most fixed assets (foundry equipment) over their estimated useful lives on the “tonnage-of-production”
method. Accelerated methods and shorter lives are used for income tax purposes. A switch to straight-line for financial
reporting purposes could (a) eliminate the deferred tax liability on our balance sheet, and (b) leverage our profits if
business picks up in Year 4.
(2) Several years ago you convinced me to change from the FIFO to LIFO inventory method. Since inflation is now down
to a 4 percent annual rate, and balance sheet strength is important in our current environment, l estimate we can increase
shareholders’ equity by about $2.0 million, working capital by $4.0 million, and Year 3 earnings by $0.5 million if we return
to FIFO in Year 3. This adjustment is real-these profits were earned by us over the past several years and should be
recognized.
(3) If we make the inventory change, our stock repurchase program can be continued. The same shareholder who sold us
50,000 shares last year at $100 per share would like to sell another 20,000 shares at the same price. However, to obtain
additional bank financing, we must maintain the current ratio at 3:1 or better. It seems prudent to decrease our
capitalization if return on assets is unsatisfactory and our industry is declining. Also, interest rates are lower (11 percent
prime) and we can save $60,000 after taxes annually once our $3.00 per share dividend is resumed.
These actions would favorably affect our profitability and liquidity ratios as shown in the pro forma income statement and
balance sheet data for Year 3 ($ millions).
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attachment
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