The following information is available on Toy Inc. There are 100 shares outstanding, each selling for $25

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1 The following information is available on Toy Inc. There are 100 shares outstanding, each selling for $25 Corporate tax 34.00% Interest rate 4.25% Retention ratio 65.00% Case A. Toy Inc. Zero growth in sales Today Sales $5, $5, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $80.75 $ % (Interest) $80.75 $ % EBT $0.00 $ % (Tax) $0.00 $ % Net income $0.00 $ % Addition to RE $0.00 $ % Dividend $0.00 $0.00 0% Toy Inc. Zero growth in sales Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Total CL $ $ Current assets $1, $1, LT debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Shares $1, $1, Net fixed assets $2, $1, Retained earnings $0.00 $0.00 Other assets $ $ Total equity $1, $1, Total assets $3, $2, Total L&E $3, $3, $1, What happens if we repurchase 40 shares at $25 each? Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Total CL $ $ Current assets $1, $1, LT debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Shares $1, $1, Net fixed assets $2, $1, Retained earnings $0.00 -$1, Other assets $ $ Total equity $1, $ Total assets $3, $2, Total L&E $3, $2,

2 Today NWC $ $ Curent ratio Quick ratio Cash ratio TAT FAT D/E TIE % Cash coverage Profit margin 0.00% 0.00% ROA 0.00% 0.00% ROE 0.00% 0.00% Dividend per share $0.00 $0.00 EPS $0.00 $0 Book value per share $13.00 $5.00 Dividend yield $0.00 $0.00 Cash flows CF to creditors $80.75 CF to shareholders $1, CF from assets $1, Discussion: In this example sales are such that they barely cover the costs of goods sold, depreciation, and interest. The firm has zero net income: no earnings, and no loss either. This is what accountants call break-even. Notice that in spite of posting no profit, the firm still has a financing surplus. This is so because depreciation (for tax purposes) is not a cash outlay, rather a mere deduction aimed at matching cash outlays incurred earlier to current revenues. We could have invested the surplus in various assets, but if one repurchases shares every year, in the long run one will just recover the value of the initial capital invested in the firm. 2

3 Case B Toy Inc. Zero growth in sales Today Change Sales $5, $5, % (Costs) $4, $4, % (Depreciation) $1, $1, % EBIT -$ $ % (Interest) $80.75 $ % EBT -$1, $1, % (Tax) $0.00 $ % Net income -$1, $1, % Addition to RE -$1, $1, % Dividend $0.00 $ % Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $2, $2, Net fixed assets $2, $1, Retained earnings ($1,000.00) ($2,000.00) Other assets $ $ Owner's equity $1, $ Total assets $3, $2, Total L&E $3, $2, Discussion In this example sales are such that they barely cover the costs of good sold, and interest. The firm has posted a loss. At first glance, it appears that there is no financing deficit (yet). However, the stock of equity capital and productive assets are slowly depleting and the firm will go out of business in the long-run. This particular case offers an insight into the predicament of large corporate dinosaurs that continue to operate in spite of routinely posting losses: the managers keep those companies running (so that they can get their multi-million compensation packages) by barely meeting interest payments. Meanwhile, they are hopelessly depleting the capital of common shareholders (and that of taxpayers, when the government steps in to bail them out). Note how misleading some performance metric can be even here (TAT for example). 3

4 Today NWC $ $ NWC change from last period $0.00 $0.00 Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover InventTurnover Day's Sales in Inventory ReceivTurnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin % % ROA % % ROE % % Dividend per share $0.00 $0.00 EPS -$ $10.00 Book value per share $13.00 $3.00 Dividend yield 0.00% 0.00% CF to creditors $80.75 CF to shareholders $0.00 CF from assets $

5 Case C. Toy Inc at 99% capacity utilization and 10% growth in sales. Costs, current assets, and accounts payable increase proportional to sales. An additional plant costs $2,000. Today Change Sales $5, $5, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $5, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $2, Retained earnings $ $82.44 Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Surplus/Deficit Total L&E $3, $3, $

6 Finance with long-term debt Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $2, Gross fixed assets $3, $5, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $2, Retained earnings $ $82.44 Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, Today NWC $ $ NWC change from last period $0.00 $70.00 Curent ratio Quick ratio Cash ratio TAT FAT D/E Profit margin 5.53% -1.77% ROA 7.91% -2.48% ROE 21.29% -8.10% Dividend per share $0.97 $0.00 EPS $2.77 -$0.97 Book value per share $13.00 $12.03 Dividend yield 3.87% 0.00% CF to creditors -$ CF to shareholders $0.00 CF from assets -$