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Six years ago, after 14 years in public accounting, Stanley, CPA, resigned his position as manager of cost

 

systems for Davis, Cohen and O?Brien Accountants and started National Software, Inc. In the 2 years

 

preceding his departure from Davis, Cohen and O?Brien Accountants, Stanley had spent nights and

 

weekends developing a sophisticated cost-accounting software program that became National Software?s

 

initial product offering. As the firm grew, Stanley planned to develop and expand the software product

 

offerings?all of which would be related to streamlining the accounting processes of medium and largesized manufacturers.

 

Although National experienced loses during its first two years of operation--2010 and 2011?its profit has

 

increased steading from 2012 to the present (2016). The firm?s history, including dividend payments and

 

contributions to retained earnings, is summarized in Exhibit 1.

 

Stanley started the firm with a $100,000 investment?his savings of $50,000 as equity and a $50,000

 

long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the

 

corporation, but after experiencing a $50,000 loss during the first year of operation (2010), he sold 60

 

percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions

 

have taken place. Although he owns 40% of the firm, Stanley actively manages all aspects of its activities;

 

the other stockholders are not active in management of the firm. The stock?s value was estimated to be

 

$4.50 per share in 2014 and at $5.28 in 2015.

 

Stanley has just prepared the firm?s 2016 income statement, balance sheet, and statement of retained

 

earnings, shown in Tables 2,3, and 4, along with the 2015 balance sheet. In addition, he has compiled the

 

2015 ratio values and industry for 2016, which are summarized in table 5. He is quite pleased to have

 

achieved record earnings of $48,000 in 2016, but he is concerned about the firm?s cash flows.

 

Specifically, he is finding it more difficult to pay the firm?s bills in a timely manner and generate cash

 

flows to investors?both creditors and owners. To gain insight into these cash flow problems, Stanley is

 

planning to determine the firm?s 2016 operating cash flows and free cash flows.

 

Stanley is further frustrated by the firm?s inability to afford to hire a software developer to complete

 

development of a cost estimation package that is believed have ?blockbuster? sales potential. Stanley

 

began development of this package two years ago, but the firm?s growing complexity has forced him to

 

devote more of his time to administrative duties, thereby halting the development of this product.

 

Stanley?s reluctance to fill this position stems from his concern that the added $90,000 per year in salary

 

and benefits for the position would certainly lower the firm?s earnings per share (EPS) over the next

 

couple of years. Although the project?s success is in no way guaranteed, Stanley believes that if the

 

money were spent to hire the software developer, the firms? sales and earnings would significantly rise

 

once the 2- to3-year development, production, and marketing process were completed.

 

Jeff Jones has recently approached Stanley with an offer to buy National Software for $200,000. Through

 

discussion with Mr. Jones, Stanley found out that he uses a ten percent discount rate on projects with this

 

level of risk. By comparison, Stanley uses a nine percent required rate of return on new projects. TABLE 1

 

National Software

 

Profit, Dividends, and Retained Earnings, 2010-2016

 

Year

 

Net Profit

 

Dividend

 

Contributions to

 

after taxes

 

s Paid

 

Retained Earnings

 

[1]

 

[2]

 

[{1] ? [2]}

 

2010

 

-50,000

 

$0

 

-50,000

 

2011

 

-20,000

 

0

 

-20,000

 

2012

 

15,000

 

0

 

15,000

 

2013

 

35,000

 

0

 

35,000

 

2014

 

40,000

 

1,000

 

39,000

 

2015

 

43,000

 

3,000

 

40,000

 

2016

 

48,000

 

5,000

 

43,000 TABLE 2

 

National Software, Inc.

 

Income Statement for the Fiscal-Year Ended March 31, 2016 ($000)

 

Sale Revenue

 

$ 1,550

 

Less: Cost of goods sold

 

1,030

 

Gross profit

 

$ 520

 

Less: Operating expenses

 

Selling expense

 

$150

 

General and administrative expenses

 

270

 

Depreciation expense

 

11

 

Total operating expenses

 

$ 431

 

Operating Profit (EBIT)

 

$89

 

Less: Interest expenses

 

29

 

Net profit after taxes

 

$ 60

 

Less: Taxes

 

12

 

Net profit after taxes

 

$ 48 TABLE 3

 

National Software, Inc.

 

Balance Sheet ($000)

 

Assets

 

Cash

 

Marketable securities

 

Accounts payable

 

Inventories

 

Total current assets

 

Gross fixed assets

 

Less: Accumulated depreciation

 

Net fixed assets

 

Total Assets

 

Liabilities and Stockholders? Equity

 

Accounts payable

 

Notes payable

 

Accruals

 

Total current liabilities

 

Long-term debt

 

Total liabilities

 

Common stock (50,000 shares outstanding at $0.10)

 

Paid-in capital in excess of par

 

Retained earnings

 

Total stockholders? equity

 

Total liabilities and stockholders? equity 3/31/2016

 

$12

 

66

 

152

 

191

 

$421

 

$195

 

63

 

$132

 

$553 3/31/2015

 

$31

 

82

 

104

 

145

 

$362

 

$180

 

52

 

$128

 

$490 $136

 

200

 

27

 

$363

 

$38

 

$401

 

$5

 

45

 

102

 

$152

 

$553 $126

 

190

 

25

 

$341

 

$40

 

$381

 

$5

 

45

 

59

 

$109

 

$490 TABLE 4

 

National Software, Inc.

 

Statement of Retained Earnings ($000)

 

For the Year Ended Mach 31, 2016

 

Retained earnings balance (3/31/2015)

 

Plus: Net profit after taxes (2016)

 

Less: Cash dividends paid on common stock

 

Retained earnings balance (3/31/2016) $59

 

48

 

5

 

$102 TABLE 5

 

Ratio

 

Current ratio

 

Quick ratio

 

Inventory turnover

 

Average collection period

 

Total asset turnover

 

Debt ratio

 

Times interest earned

 

Gross profit margin

 

Operating profit margin

 

Net profit margin

 

Return on total assets (ROA)

 

Return on common equity (ROE)

 

Price/earnings (P/E) ratio

 

Market/book (M/B) ratio Actual

 

2015

 

1.06

 

0.63

 

10.40

 

29.6 days

 

2.66

 

0.78

 

3.0

 

32.1%

 

5.5%

 

3.0%

 

8.0%

 

36.4%

 

5.5

 

2.1 Industry Average

 

2016

 

1.82

 

1.1

 

12.45

 

20.2 days

 

3.92

 

0.55

 

5.6

 

42.3%

 

12.4%

 

4.0%

 

15.6%

 

34.7%

 

7.1

 

2.2 With all of these concerns in mind, Stanley set out to review the various data and develop strategies that

 

would help to ensure a bright future for National Software. Stanley believed that as part of this process, a

 

thorough analysis of 2016?s financial statements would provide important additional insights. You have

 

been hired to assist in this evaluation.

 

A. Analysis of Company Objectives.

 

1. On what financial goals does Stanley seem to be focusing? It is the correct goal? (Why or

 

why not?)

 

2. Could an agency problem exist at this firm? Devise a scenario in which agency problems

 

would become a greater issue at National Software. B. EPS Performance Assessment

 

1. Calculate the firm?s earnings per share (EPS) for each year. (Hint: The number of shares have

 

remained unchanged since inception.) Integrate analysis of EPS performance with company

 

objective analysis (i.e., Part A).

 

2. Detect reasons for the causes of changes in EPS Performance. Use online resources to

 

discuss software industry factors and general economic factors. C. Cash Flow Statement 1. Construct cash flow statements, and estimate National Software?s operating cash flow and free

 

cash flow in 2016. Evaluate your findings in light of National Software?s current cash flow

 

difficulties.

 

2. Hypothesize the impact of a reduction in gross fixed assets on free cash flow and run

 

appropriate experiments to judge the accuracy of your hypotheses. D. Financial Statement Ratio Analysis

 

1. Analyze the firm?s financial condition in 2016 as it relates to (1) liquidity, (2) activity, (3) deb

 

t, (4) profitability, and (5) market, using the financial statements provided in Table 2 and Table 3

 

and the ratio data included in Table 5.

 

2. Critique the firm?s performance on a cross-sectional basis and a time-series basis. E. Hiring a New Employee

 

1. Check the internet to find information on the relative costs and benefits of software

 

developers.

 

2. Recommend a course of action to Stanley regarding the hiring of a new software developer. F. Firm Valuation: Discount rate focused

 

1. In light of the cash flows and dividend payments, critique Jones? offer.

 

2. Justify the10% required return of return assigned by the investor. G. Firm Valuation: Cash Flow Focused

 

1. Assume a free cash flow growth rate going forward that equates to zero, at what price would

 

Stanley place the value of National Software? Attribute the difference in Part F and Part G to

 

differences in the definition of return. 2. Construct a diagram showing how the amount you are willing to pay varies with the firm?s

 

anticipated free-cash flow.

 







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