Modern Building Supply sells various building materials to retail outlets. The company has just

Modern Building Supply sells various building materials to retail outlets. The company has just approached Linden State Bank requesting a $300,000 loan to strengthen the Cash account and to pay certain pressing short-term obligations. The company’s financial statements for the most recent two years follow:

Modern Building Supply Comparative Balance Sheet
	This Year		Last Year
Assets
Current assets:
Cash	$	90,000	$	200,000
Marketable securities		0		50,000
Accounts receivable, net		650,000		400,000
Inventory		1,300,000		800,000
Prepaid expenses		20,000		20,000
Total current assets		2,060,000		1,470,000
Plant and equipment, net		1,940,000		1,830,000
Total assets	$	4,000,000	$	3,300,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	1,100,000	$	600,000
Bonds payable, 12%		750,000		750,000
Total liabilities		1,850,000		1,350,000
Stockholders' equity:
Preferred stock, $50 par, 8%		200,000		200,000
Common stock, $10 par		500,000		500,000
Retained earnings		1,450,000		1,250,000
Total stockholders' equity		2,150,000		1,950,000
Total liabilities and stockholder's equity	$	4,000,000	$	3,300,000

Modern Building Supply Comparative Income Statement and Reconciliation
		This Year		Last Year
Sales	$	7,000,000	$	6,000,000
Cost of goods sold		5,400,000		4,800,000
Gross margin		1,600,000		1,200,000
Selling and administrative expenses		970,000		710,000
Net operating income		630,000		490,000
Interest expense		90,000		90,000
Net income before taxes		540,000		400,000
Income taxes (40%)		216,000		160,000
Net income		324,000		240,000
Dividends paid:
Preferred dividends		16,000		16,000
Common dividends		108,000		60,000
Total dividends paid		124,000		76,000
Net income retained		200,000		164,000
Retained earnings, beginning of year		1,250,000		1,086,000
Retained earnings, end of year	$	1,450,000	$	1,250,000

During the past year, the company has expanded the number of lines that it carries in order to stimulate sales and increase profits. It has also moved aggressively to acquire new customers. Sales terms are 2/10, n/30. All sales are on account.

Assume that the following ratios are typical of companies in the building supply industry:

Current ratio	2.5
Acid-test ratio	1.2
Average collection period	18	days
Average sale period	50	days
Debt-to-equity ratio	0.75
Times interest earned ratio	6.0
Return on total assets	10	%
Price-earnings ratio	9

Assume that you have just inherited several hundred shares of Modern Building Supply stock. Not being acquainted with the company, you decide to do some analytical work before making a decision about whether to retain or sell the stock you have inherited.

Required:
1.	You decide first to assess the well-being of the common stockholders. For both this year and last year, compute the following:

a.	The earnings per share. (Round your answers to 2 decimal places. Omit the "%" sign in your response.)

	This year	Last year
Earnings per share	$	$

b.	The dividend yield ratio for common stock. The company’s common stock is currently selling for $45 per share; last year it sold for $36 per share. (Do not round intermediate calculations. Round your answers to 2 decimal places. Omit the "%" sign in your response.)

	This year	Last year
Dividend yield ratio	%	%

c.	The dividend payout ratio for common stock. (Do not round intermediate calculations. Round your answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Dividend payout ratio	%	%

d.	The price-earnings ratio. How do investors regard Modern Building Supply as compared to other companies in the industry? (Do not round intermediate calculations. Round your answers to 1 decimal place.)

	This year	Last year
Price-earnings ratio

e.	The book value per share of common stock. Does the difference between market value and book value suggest that the stock at its current price is too high? (Omit the "$" sign in your response.)

	This year	Last year
Book value per share	$	$

 

2.	You decide next to assess the company’s rate of return. Compute the following for both this year and last year:

a.	The return on total assets. (Total assets at the beginning of last year were $2,700,000.) (Round your answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Return on total assets	%	%

b.	The return on common stockholders’ equity. (Stockholders’ equity at the beginning of last year was $1,786,000.) (Round your answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Return on common stockholders' equity	%	%

c.	Is the company’s financial leverage positive or negative?
	Positive

Explanation:

1.
a.

	This Year		Last Year
Net income	$	324,000	$	240,000
Less preferred dividends		16,000		16,000
Net income remaining for common (a)	$	308,000	$	224,000
Average number of common shares (b)		50,000		50,000
Earnings per share (a) ÷ (b)		$ 6.16		$ 4.48

b.

	This Year		Last Year
Dividends per share (a)*	$	2.16	$	1.20
Market price per share (b)	$	45.00	$	36.00
Dividend yield ratio (a) ÷ (b)		4.8 %		3.33 %

*$108,000 ÷ 50,000 shares = $2.16;

$60,000 ÷ 50,000 shares = $1.20

c.

	This Year		Last Year
Dividends per share (a)	$	2.16	$	1.20
Earnings per share (b)	$	6.16	$	4.48
Dividend payout ratio (a) ÷ (b)	35.1%		26.8%

d.

	This Year		Last Year
Market price per share (a)	$	45.00	$	36.00
Earnings per share (b)	$	6.16	$	4.48
Price-earnings ratio (a) ÷ (b)		7.3		8.0

Investors regard Modern Building Supply less favorably than other companies in the industry. This is evidenced by the fact that they are willing to pay only 7.3 times current earnings for a share of the company’s stock, as compared to 9 times current earnings for other companies in the industry. If investors were willing to pay 9 times current earnings for Modern Building Supply’s stock, then it would be selling for about $55 per share (9 × $6.16), rather than for only $45 per share.

e.

	This Year		Last Year
Total stockholders' equity	$	2,150,000	$	1,950,000
Less preferred stock		200,000		200,000
Common stockholders' equity (a)	$	1,950,000	$	1,750,000
Number of common shares outstanding (b)		50,000		50,000
Book value per share (a) ÷ (b)		$ 39.00		$ 35.00

The market value is above book value for both years. However, this does not necessarily indicate that the stock is overpriced. Market value reflects investors’ perceptions of future earnings, whereas book value is a result of already completed transactions.

2.
a. 

		This year		Last year
Net income		$ 324,000		$ 240,000
Add after-tax cost of interest paid:       [$90,000 × (1 – 0.40)]		54,000		54,000
Total (a)		$ 378,000		$ 294,000
Average total assets (b)	$	3,650,000	$	3,000,000
Return on total assets (a) ÷ (b)		10.4%		9.8%

b.

		This Year		Last Year
Net income	$	324,000	$	240,000
Less preferred dividends		16,000		16,000
Net income remaining for common (a)		308,000		224,000
Average total stockholders' equity*		2,050,000		1,868,000
Less average preferred stock		200,000		200,000
Average common stockholders' equity (b)	$	1,850,000	$	1,668,000
Return on common stockholders' equity (a) ÷ (b)		16.6%		13.4%

*1/2($2,150,000 + $1,950,000); 1/2($1,950,000 + $1,786,000)

c.

Financial leverage is positive in both years because the return on common equity is greater than the return on total assets. This positive financial leverage is due to three factors: the preferred stock, which has a dividend of only 8%; the bonds, which have an after-tax interest cost of only 7.2% [12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable, which may bear no interest cost.