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“The trade-off we are considering is typical of many companies,” Ellen noted. “One
alternative results in higher fixed costs than the other. Fixed costs are costs that do not
increase in proportion to increases in sales. Variable costs are those that do increase in
proportion to increases in sales. In our situation, if we go with automated equipment,
most of our costs will be fixed. We can’t cut costs much if sales are lower than expected,
but we don’t increase costs much if sales increase. Consequently, we lose more money
if sales are low and make more money if sales are high than we would with an alterna-
tive that has fewer fixed costs. If we use manual equipment, our costs increase more
rapidly as sales increase, but they also decrease more rapidly as sales decrease.”
Ellen continued, “The use of fixed costs to increase net income as sales increase
is known as operating leverage. Automation often results in higher operating leverage
because a larger portion of total operating expenses is fixed. Other common causes of
high operating leverage are large investments in plant assets and labor costs that don’t
change much in proportion to sales. High operating leverage increases risk, but it also
increases the potential for high profits.”


Case in Point
In
The Effect of High Operating Leverage
Airlines are an example of companies with high operating leverage. It costs an airline
about the same amount to fly an airplane whether it is full or empty. The cost of the
airplane, the flight crew, maintenance, and fuel are largely fixed when a plane flies be-
tween two cities. The amount of revenue the airline earns depends on the number of
tickets it sells. If the plane is full, the airline earns a good profit. If it is empty, the air-
line loses a lot of money. Other industries with high operating leverage are utilities, be-
cause they require a large investment in equipment regardless of how much they sell,
and publishing companies. It costs almost as much to publish a book or magazine if
one copy is sold as it does if a thousand copies are sold.
F452 SECTION F2: Analysis and Interpretation of Financial Accounting Information
455
Analysis of Investing Activities

“We’ll have to be sure our sales projections are accurate if we decide on automated
equipment,” Stan remarked. “But, I think it’s the best choice for us.”
“We know we have a good product,” Maria added. “I think the advantages of au-
tomation are worth the risk. We’ll have the production capacity we expect to need in
the future.”
“More importantly,” Stan observed, “we will have a higher quality product. Once
the equipment is working properly, it doesn’t make many mistakes. We will save on
waste from defective products, and we won’t run as much risk of losing customers be-
cause of poor quality.”
Ellen completed the conversation. “I agree. Also, we will be able to produce our
product faster and deliver it to customers in a shorter period. I think the advantages of
the automated equipment outweigh the risks of higher operating leverage. In addition,
the company’s financial leverage will be low because we are financing primarily with
equity. Because our financial risk is low, we can afford higher operating risk. If sales are
lower than expected, we won’t run a major risk of not being able to pay creditors. In-
vestors will expect high growth in profits. We have a better chance of achieving high
growth with automated equipment because profits increase more rapidly as sales in-
crease. If our revenues are much less than we expect or if we can’t increase revenues
each year, we probably won’t be in business very long anyway.”




1 SELF-STUDY PROBLEM Financial statement information is presented below for Alchemy
Corporation, a producer of pharmaceuticals. The company ex-
pects sales to increase by about 10% in 2004.


2003 2004
(In millions) Actual Expected

Sales $988 $1,087
Cost of goods sold (660) (726)
Operating expenses (294) (300)
Operating income 34 61
Interest expense (6) (6)
Pretax income 28 55
Income taxes (10) (19)
Net income $ 18 $ 36




Alchemy’s management is considering automating much of the company’s production
process. The automation would result in about half of the company’s cost of goods sold
being fixed. Currently, most of these costs vary in proportion to sales, as shown in the
financial numbers presented above.

Required
A. Assume that half ($330 million) of Alchemy’s cost of goods sold in 2003 is fixed
and that the other half increases in proportion to sales, an increase of 10%. Com-
pute the company’s expected cost of goods sold and net income in 2004. Assume
that income taxes are 35% of pretax income. Round to the nearest million.
B. Compare your results with those presented above, which assume that cost of goods
sold varies in proportion to sales. What effect would the automation have on
Alchemy’s profitability? What effect would it have on the company’s risk? Explain
your answer.
The solution to Self-Study Problem 1 appears at the end of the chapter.
F453
CHAPTER F12: Analysis of Investing Activities
456 Analysis of Investing Activities


INTERPRETATION INVESTING ACTIVITIES
OF
The first part of this chapter examined the investing decisions of managers and the ef-
OBJECTIVE 3
fects of these decisions on a company’s financial statements. This section examines fi-
Use financial statements nancial statement information provided by actual corporations. We use this information
to evaluate investing to demonstrate how decision makers interpret the investing activities of companies and
activities for various make decisions about companies’ risk, return, and value attributes.
companies. In the remaining sections of this chapter, we will consider the following issues as
we look at the analysis of accounting information for the purpose of evaluating invest-
ing activities:
1. Identification of investing activities for one or more companies and fiscal periods
2. Consideration of asset growth for company profits and value
3. Measurement of the effects of asset growth
4. Examination of the effects of investing activities and growth on risk
5. Examination of creditors’ use of accounting information about investing activities

Identifying Investing Activities
Exhibit 7 provides selected financial statement information for Krispy Kreme Dough-
nuts, Inc., and Starbucks Corporation. Because the companies are in similar businesses,
their assets and investment activities are similar. As a first step in our analysis, we want
to identify the companies’ long-term assets and the changes in these assets resulting
from investing activities.


Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks

Krispy Kreme Starbucks
(In thousands) 2001 2000 2001 2000

Balance Sheet
Current assets $ 67,611 $ 41,038 $ 593,925 $ 458,234
Long-term assets:
Property and equipment, cost 116,896 93,243 1,741,031 1,377,162
Accumulated depreciation (38,556) (32,659) (605,247) (446,403)
Plant and equipment, net 78,340 60,584 1,135,784 930,759
Long-term investments 22,572 — 63,097 55,839
Other assets 2,970 3,336 58,233 46,714
Total assets $171,493 $104,958 $1,851,039 $1,491,546
Income Statement
Total revenues $300,715 $220,243 $2,648,980 $2,177,614
Depreciation and amortization expenses 6,457 4,546 163,501 130,232
Net income 14,725 5,956 181,210 94,564
Statement of Cash Flows
Cash flow from (for) investing activities:
Purchase of property and equipment $ (25,655) $ (11,335) $ (384,215) $ (316,450)
Proceeds from disposal of property and equipment 1,419 830 — —
(Increase) decrease in other assets (1,348) 479 (9,071) (6,318)
Purchase of investments, net (41,704) — (39,767) (53,686)
Net cash used for investing activities: $ (67,288) $ (10,026) $ (433,053) $ (376,454)




It is apparent from Exhibit 7 that Starbucks is larger than Krispy Kreme in terms
of total assets. In 2001, Starbucks was more than 10 times as large as Krispy Kreme.
The size difference also is apparent from a comparison of long-term assets. For exam-
ple, Starbucks’ net property and equipment was more than 14 times greater than that
of Krispy Kreme in 2001.
F454 SECTION F2: Analysis and Interpretation of Financial Accounting Information
457
Analysis of Investing Activities

Plant assets account for most of the long-term assets of both companies. Long-term
investments and other assets are not especially important for either company. Neither
company has been active in acquiring other companies, which would result in long-
term investments or other assets such as goodwill.
Though Krispy Kreme was smaller than Starbucks, it grew at a faster rate from 2000
to 2001. Krispy Kreme’s total assets increased 63% [($171,493 $104,958) $104,958]
during this period while Starbucks’ total assets increased 24% [($1,851,039
$1,491,546) $1,491,546]. Krispy Kreme’s property and equipment grew by 29%
[($78,340 $60,584) $60,584] relative to Starbucks’ growth of 22% [($1,135,784
$930,759) $930,759]. The more rapid growth was associated with a larger increase
in revenues for Krispy Kreme relative to Starbucks. Krispy Kreme’s revenues grew 37%
[($300,715 $220,243) $220,243], and Starbucks’ revenues grew 22% [($2,648,980
$2,177,614) $2,177,614].
Other information about changes in long-term assets is provided by the investing
activities section of the statement of cash flows. During 2001, Krispy Kreme paid $25.7
million for additional property and equipment. Krispy Kreme reported depreciation
and amortization expenses for 2001 of $6.5 million. Therefore, Krispy Kreme’s new
purchases of plant assets were $19.2 million ($25.7 $6.5) more than the amount of
long-term assets allocated to expenses during 2001. For a company to grow, it must ac-
quire assets in addition to those necessary to replace assets that are being consumed
during a period.
Starbucks’ capital expenditures for new plant assets amounted to $384 million in
2001. This amount was much larger than the amount of depreciation and amortization
expense Starbucks recorded in 2001 ($163.5 million).


The Importance of Asset Growth
Growth in assets is important to the value of a company and the wealth of its stock-
OBJECTIVE 4
holders. For most companies, the ability to produce and sell products depends on hav-
Explain how investing ing the necessary assets to support these activities. A manufacturing company must have
activities affect company equipment and facilities to produce goods. A merchandising company must have equip-
value, and use accounting ment and facilities to store, transport, display, and sell its goods. The amount a com-
information to measure pany can sell depends on how much it can produce or on how much it can make
value-increasing activities.
available to customers.
Both Krispy Kreme and Starbucks sell merchandise to customers through stores.
The number and size of the stores limits the amounts that can be sold. When Krispy
Kreme opens new stores, asset growth results. The investment in these stores adds to
the company’s total assets. It also provides the basis for additional sales and profits. As
we noted in the previous section, revenues grew for both Krispy Kreme and Starbucks
from 2000 to 2001. In addition, Krispy Kreme reported an increase in net income of
147% [($14,725 $5,956) $5,956] and Starbucks reported an increase of 92%
[($181,210 $94,564) $94,564]. Starbucks opened 1,208 new stores during its 2001
fiscal year, ending the year with 4,709 stores. Krispy Kreme opened 26 new stores, end-
ing the year with 174 stores.


Measuring the Effects of Growth
Additional investment and asset growth are valuable when a company uses these assets
to generate higher profits. Additional investment is not valuable for its own sake. For
example, if a company pays $1 million for an additional store, but it is not able to make
a profit from the store, the investment is not a good decision.
A common measure of the outcome of a company’s investment decisions is return
on assets (ROA).

Return on Assets Net Income Total Assets
F455
CHAPTER F12: Analysis of Investing Activities
458 Analysis of Investing Activities

Return on assets compares profits from producing and selling goods and services with
the total amount invested in assets.
From Exhibit 7, we see that Krispy Kreme’s return on assets for 2001 was 8.5%.

0.085 $14,725 $171,493

Starbucks’ return on assets for 2001 was 9.8%.

0.098 $181,210 $1,851,039

Thus, compared with Krispy Kreme, Starbucks was creating a higher return on its
investment in assets. For every dollar invested in assets by Starbucks, the company
earned 9.8¢ of profit. For every dollar invested in assets by Krispy Kreme, it earned 8.5¢.
One way to examine events that affect a company’s return on assets is to separate
return on assets into components. Two primary components of return on assets are as-
set turnover and profit margin. Asset turnover is the ratio of revenues to total assets:.

Asset Turnover Revenues Total Assets

It is a measure of the ability of a company to use its assets to sell its products. Rev-
enues include sales and service revenues that result from a business’s primary opera-
tions. A company with a high asset turnover is more effective in using its assets than
one with a low asset turnover.
Profit margin (or return on sales) is the ratio of net income to sales.

Profit Margin (or Return on Sales) Net Income Revenues

It is a measure of the ability of a company to produce profits from its sales. A company
with a high profit margin is more efficient in controlling costs than one with a low
profit margin.
Return on assets is the product of asset turnover and profit margin.

Return on Assets Asset Turnover Profit Margin

We can determine Krispy Kreme’s and Starbucks’ asset turnover and profit mar-
gin from information in Exhibit 7. These amounts are provided in Exhibit 8.


Exhibit 8 Krispy Kreme Starbucks
Asset Turnover and
2001 2000 2001 2000
Profit Margin for Krispy
Kreme and Starbucks Asset Turnover 1.754 2.098 1.431 1.460
Profit Margin 4.90% 2.70% 6.84% 4.34%
Return on Assets 8.59% 5.67% 9.79% 6.34%




A practical way to interpret asset turnover is to translate the ratio into dollars. Krispy
Kreme’s asset turnover of 1.75 in 2001 means that the company was able to generate $1.75
of sales for every $1 it had invested in assets. In 2001, Starbucks was able to generate $1.43
of sales for each dollar of investment. Therefore, Krispy Kreme was more effective than
Starbucks in using its assets in 2001. Krispy Kreme also had a higher asset turnover ratio
than Starbucks in 2000. Both companies, particularly Krispy Kreme, were less effective in
2001 than in 2000, as measured by the decrease in their asset turnover ratios.
Similarly, we can translate profit margin into dollars. Krispy Kreme’s profit mar-
gin of 4.9% in 2001 means that the company was able to generate 4.9¢ of net income
F456 SECTION F2: Analysis and Interpretation of Financial Accounting Information
459
Analysis of Investing Activities

for every $1 of sales. This ratio was an increase from 2.7¢ for every $1 of sales in 2000.
Starbucks’ profit margin in 2001 was 6.8%, an increase from 4.3% the prior year.
A small change in profit margin can have a major effect on a company’s perfor-
mance. Though Krispy Kreme’s and Starbucks’ asset turnover ratios decreased, their
profit margins increased from 2000 to 2001. The increase in profit margins resulted in
higher return on assets for both companies because they were doing a better job of con-
trolling costs in 2001 than in 2000.
Comparing asset turnover with profit margin provides information about why Star-
bucks was earning a higher return on assets than Krispy Kreme. Starbucks earned a
higher profit margin, which more than offset the effect of its lower asset turnover. Prof-
itability depends on the ability of a company to use its assets to sell products and on
the ability of a company to earn a profit from those sales. Krispy Kreme was doing a
relatively good job of selling its products but was not earning as much profit on those
sales as Starbucks.




2 SELF-STUDY PROBLEM Accounting information is provided below for two hardware
companies that compete for customers.

Moreco DealRight
(In millions) 2004 2003 2004 2003

Total assets $48.3 $44.7 $120.6 $118.4
Revenues 67.9 61.0 159.1 143.2
Net income 5.3 4.2 9.5 10.0



Required
A. Compute asset turnover, profit margin, and return on assets for each year and com-
pany. Also, compute asset, revenue, and net income growth rates for each com-
pany from 2003 to 2004.
B. Evaluate the performance of each company with respect to the other and also in terms
of changes from 2003 to 2004. Identify reasons for the differences in performance.
The solution to Self-Study Problem 2 appears at the end of the chapter.




THE EFFECT INVESTMENT EFFECTIVENESS EFFICIENCY
OF ON AND
Investment is important for a company. As a company acquires additional assets, it
OBJECTIVE 5
should be able to produce and sell more products and earn higher profits. Asset growth
Identify ways in which a can increase a company’s profits and return on assets if the additional assets improve
company can use its assets the company’s effectiveness and/or efficiency. Effectiveness increases when the dollar
to improve effectiveness amount of sales increases more rapidly than the dollar amount of additional invest-
and efficiency. ment. As discussed in the previous section, we can observe this increase in effectiveness
by examining the asset turnover ratio. Increases in asset turnover result when a com-
pany invests in new locations that produce large increases in sales. Asset turnover also
increases when a company sells products in high demand. If Starbucks has products in
its stores that customers are not willing to buy, its sales will be low relative to the amount
it has invested in assets. If it replaces these products with others that customers are in-
terested in buying, its asset turnover will increase. Also, it can increase asset turnover
by closing locations that do not create high sales and moving its assets to locations that
produce higher sales.
Efficiency increases when a company is able to earn greater profit for each additional
dollar of product it sells. Efficiency depends on reducing costs relative to the amount sold.
F457
CHAPTER F12: Analysis of Investing Activities
460 Analysis of Investing Activities

Effectiveness and efficiency often go together. For example, assume that Mom’s
Cookie Company invests $5 million in assets. It pays employees $700,000 in wages and
benefits each year. Utilities and other costs amount to $300,000 per year. Average cost
of goods sold for its products is 60% of sales revenues, and income taxes are 30% of
pretax income. In 2004, the store sold $3.0 million of goods. Therefore, its net income
would be as follows:
Sales $ 3,000,000
Cost of goods sold (1,800,000) 60% of sales
Other operating expenses (1,000,000)
Pretax income 200,000
Income taxes (60,000)
Net income $ 140,000

Suppose that by changing some of its product line, the company can increase sales
to $3.3 million without any additional asset investment and without hiring additional
employees or increasing utilities or other costs. Its net income would then be as follows:
Sales $ 3,300,000
Cost of goods sold (1,980,000) 60% of sales
Other operating expenses (1,000,000)
Pretax income 320,000
Income taxes (96,000)
Net income $ 224,000

Observe that an increase in sales of 10% (from $3 million to $3.3 million) results
in an increase in net income of 60% (from $140,000 to $224,000). Exhibit 9 describes
the effects of the increase in sales on the company’s asset turnover, profit margin, and
return on assets.

Exhibit 9 Before After
The Effect of a Sales
Sales Revenues (in millions) $3 $3.3
Increase on Return on
Asset Turnover 0.600 0.660
Assets
Profit Margin 4.67% 6.79%
Return on Assets 2.80% 4.48%



The increase in sales improves the company’s asset turnover. It is using its assets more
effectively to generate more sales. No additional investment was made to create the ad-
ditional sales. Company management found a better way to use the company’s assets.
Profit margin increased 60% (from 2.8% to 4.48%) as a result of the sales increase. This
increase in profit margin resulted because many of the company’s costs did not change
in proportion to the increase in sales. Only cost of goods sold increased as sales increased.
Therefore, the company’s profits grew much more rapidly than its sales as a result of op-
erating leverage. The more effective use of assets produced a dramatic increase in profits.
Thus, a primary management decision involves finding the best locations and assets in
which to invest and then using those assets effectively and efficiently to generate profits.
If a company’s sales decrease, its profits often decrease more rapidly than its sales.
Each dollar of lost sales is not matched by a dollar’s decrease in expenses. For example,
a company must employ sufficient workers to conduct its business, and so a decrease
in sales often does not result in a proportional decrease in wages and benefits. Equip-
ment and building costs often cannot be reduced in the short run. Therefore, profits
decrease more rapidly than sales.
If sales decrease for any length of time, a company must find ways to reduce its in-
vestment so that it can eliminate unnecessary costs. Companies sell buildings, equip-
ment, and other assets that are not being used effectively. Often these assets must be
F458 SECTION F2: Analysis and Interpretation of Financial Accounting Information
461
Analysis of Investing Activities

sold at less than their book values (cost minus accumulated depreciation), resulting in
losses that reduce the company’s already low net income. Also, a company may have
to incur separation or relocation costs for employees who are terminated or moved to
other locations. Thus, in the short run, downsizing a company usually results in extra
costs and low net income or a net loss. If a company can close stores that are not prof-
itable or get rid of assets it does not need, it may be able to become profitable and earn
a return on assets that is competitive with those of other companies in its industry. If
a company is not successful in these efforts, it is likely to be purchased by another com-
pany or to go out of business.
Thus, although asset growth is important to creating company value, growth must
be accompanied by increases in sales and profits that compensate the company and its
owners for the additional investment. If a company’s growth is not effective, its addi-
tional investments reduce its return on assets. Eventually, the company is forced to sell
assets that are not productive in an effort to return to a satisfactory level of profitabil-
ity. This process often is costly and difficult. Investment in assets is essential. Effective
asset growth increases company value. Growth also is risky. Investment in the wrong
assets, investment in too many assets, or improper management of assets generally leads
to poor profitability and can jeopardize a company’s existence.



INVESTING ACTIVITIES CREDITOR DECISIONS
AND
A company’s investing activities may be particularly important to its creditors. Com-
OBJECTIVE 6
panies often borrow money to acquire long-term assets. Accordingly, the ability of a
Explain why accounting company to repay creditors and pay interest usually is connected to its ability to use its
information about long- long-term assets to generate profits and cash flows. If a company is unsuccessful in cre-
term assets is useful for ating profits from its assets, it usually must sell a portion of its assets to create cash to
creditors. repay its creditors. If the company is very unsuccessful and goes out of business, it sells
its assets and uses the cash to pay off its debts. In some cases, specific debts are con-
nected to particular assets that are used as security for the debts. If a company cannot
repay these debts, the assets securing the debts must be transferred to creditors or sold
to repay creditors.
Because of these relationships, the value of a company’s long-term assets is partic-
ularly important to creditors. When a company’s assets decrease in value, its debt be-
comes riskier. Consequently, accounting measurement rules traditionally are very
conservative in the measurement of the value of assets, particularly tangible assets such
as property, plant, and equipment. These rules attempt to ensure that a company does
not overvalue assets on its balance sheet. Assets are recorded at cost and, except for cer-
tain financial assets that can be sold at market value, are not written up to a higher
value, even if their market value increases. Thus, a building that is purchased for $1
million in 2003 is recorded at cost and is depreciated over its useful life. The amount
reported on the balance sheet for the building will always be less than $1 million, re-
gardless of how much the owner could receive if the building were sold.
Accounting standard setters in the United States have been reluctant to permit com-
panies to write up their assets to market value for fear the amounts recorded would be
highly subjective and might overstate asset value. In many cases, it is difficult to deter-
mine the market value of an asset. Further, the market value of an asset that is being
used productively may be much higher than the market value of the same asset if it
must be sold to repay debts.
Accounting measurement rules require companies to write down their assets, how-
ever, if the market values of the assets decrease below their book values. For example,
assume that a company owns a building that it purchased for $1 million. Accumulated
depreciation on the building at the end of 2004 was $600,000. Therefore, the book value
at the end of 2004 was $400,000. At this time, the company determined that the mar-
ket value of the building was $250,000. Accounting rules require the company to write
down the asset by $150,000 ($400,000 $250,000), recognizing a loss for this amount.
459
CHAPTER F12: Analysis of Investing Activities
462 Analysis of Investing Activities

This measurement rule, known as lower of cost or market, is intended to protect in-
vestors, particularly creditors, by ensuring that assets are not overstated.
Accounting rules in the United States differ from those of certain other countries
with respect to the amount reported for long-term assets. Some countries—Great
Britain, for example—permit companies to recognize increases in the market values of
many assets. These increases in values also increase the stockholders’ equities of these
companies.




3 SELF-STUDY PROBLEM Information is provided below for two paper products compa-
nies.


Tenix Company Beson Company
(In millions) 2004 2003 2004 2003

Property and equipment $471 $523 $214 $203
Total assets 654 708 323 308
Current liabilities 112 124 86 79
Long-term debt 435 440 125 130
Stockholders’ equity 107 144 112 99
Asset impairment charge (30) — — —
Operating income 8 12 30 24
Interest expense (38) (39) (10) (9)




Required If you were a creditor of these companies, would you be concerned about
the ability of either company to repay its debts? Explain your answer.
The solution to Self-Study Problem 3 appears at the end of the chapter.



REVIEW SUMMARY of IMPORTANT CONCEPTS


1. The assets in which a company invests affect its profitability.
a. Assets are necessary for a company to produce products and sell them to customers.
b. Managers must determine the particular assets a company needs and how much of
each type of asset it needs.
c. Managers may have to choose among different assets that provide the same function.
d. Choices concerning the amount and type of asset affect the capacity of a company
to produce and sell products and the costs of those products.

2. Investing decisions often affect the proportion of a company’s costs that are fixed or
variable.
a. High operating leverage results when a company has a lot of fixed costs.
b. Costs that may be fixed are depreciation costs on assets and labor costs for workers
who use those assets.
c. A company with high fixed costs is riskier than one with low fixed costs because its
profits change more rapidly as sales change.
d. High operating leverage is an advantage when a company’s sales are relatively high
and when they increase. It is a disadvantage when sales are low or when they decrease.

3. A company’s balance sheet and cash flow statement provide information about its in-
vesting activities.
a. The balance sheet identifies the types and amounts of long-term assets that a com-
pany controls. Also, it provides a basis for determining increases and decreases in
these amounts.
F460 SECTION F2: Analysis and Interpretation of Financial Accounting Information
463
Analysis of Investing Activities

b. The cash flow statement identifies amounts invested in long-term assets during a
period and amounts received from the sale of these assets.
c. Financial statement information is useful for measuring growth and change in a
company’s assets and, therefore, change in its ability to produce and sell products.

4. Asset growth increases a company’s value by permitting it to increase sales and profits.
a. Return on assets is a commonly used measure of a company’s success in using its assets.
b. Return on assets is affected by a company’s effectiveness and efficiency.
c. Asset turnover is a measure of effectiveness that considers the ability of a company
to use its assets to create sales.
d. Profit margin is a measure of efficiency that considers the ability of a company to
create profits from its sales.
e. Return on assets is the product of asset turnover times profit margin.

5. How a company uses its assets affects its effectiveness and efficiency.
a. A company uses its assets effectively when it acquires the amounts of assets it needs
to produce products it can sell and when it places these assets in locations that per-
mit it to sell large quantities of products.
b. If a company acquires too many assets, it can attempt to sell some assets to increase
its profits and return on assets. In the short run, downsizing by selling unproductive
assets usually is costly. In the long run, it may permit a company to survive and be-
come competitive.
c. A company uses its assets efficiently when it uses these assets to increase sales so
that revenues increase faster than expenses.

6. Accounting information uses conservative values for most long-term assets.
a. Conservatism results when increases in asset values above their cost or book value
are not recorded but decreases in value are recorded.
b. Conservatism protects the interests of creditors by ensuring that asset values are not
overstated.
c. If a company is unable to repay its debts, it may have to sell its assets to make these
payments.



DEFINE TERMS and CONCEPTS DEFINED in this CHAPTER


asset turnover (F455) profit margin (F455)
operating leverage (F451) return on sales (F455)




SELF-STUDY PROBLEM SOLUTIONS
SSP12-1 A. Expected cost of goods sold for 2004 $693

$660 2 $330 (half is fixed)
($660 2) 1.10 363 (half varies with sales, increasing by 10%)
Total cost of goods sold $693

2003 2004
(In millions) Actual Expected
Sales $988 $1,087
Cost of goods sold 660 693
Operating expenses 294 300
Operating income 34 94
Interest expense (6) (6)
Pretax income 28 88
Income taxes (35%) (10) (31)
Net income $ 18 $ 57
F461
CHAPTER F12: Analysis of Investing Activities
464 Analysis of Investing Activities

B. Because a portion of the cost of goods sold is fixed, these costs do not increase with
sales. Therefore, the cost of goods sold is lower if the production process is automated
and sales increase. Lower cost of goods sold results in higher net income.
Higher fixed costs increase operating leverage and increase the company’s risk.
Though profits are higher if sales increase, if sales decrease they will be lower than they
would be with the nonautomated option. Fixed costs do not decrease in proportion to
sales when sales decrease. Therefore, profits decrease more rapidly for companies with
high operating leverage when sales decrease. Expenses that vary in proportion to sales
decrease as sales decrease and, consequently, do not affect net income as much as fixed
expenses do.
A.
SSP12-2

Moreco DealRight
2004 2003 2004 2003
Asset turnover 67.9 48.3 1.406 61.0 44.7 1.365 159.1 120.6 1.319 143.2 118.4 1.209
Profit margin 5.3 67.9 0.078 4.2 61.0 0.069 9.5 159.1 0.060 10.0 143.2 0.070
Return on assets 1.406 0.078 0.110 1.365 0.069 0.094 1.319 0.060 0.079 1.209 0.070 0.085
Asset growth (48.3 44.7) 44.7 0.081 (120.6 118.4) 118.4 0.019
Revenue growth (67.9 61.0) 61.0 0.113 (159.1 143.2) 143.2 0.111
Net income growth (5.3 4.2) 4.2 0.262 (1.319 1.209) 1.209 0.091


B. Moreco’s return on assets increased from 2003 to 2004, while DealRight’s return on as-
sets decreased. Moreco’s return on assets is higher in both years than DealRight’s. Ac-
cordingly, Moreco is making better use of its assets to create profits.
Moreco’s asset turnover increased from 2003 to 2004, as did DealRight’s asset
turnover. Therefore, both companies became more effective in using their assets to
produce sales. Moreco’s asset growth was higher than DealRight’s, however. Therefore,
Moreco was more successful in investing in productive assets, leading to higher sales
and profits.
DealRight’s major problem was a decrease in profit margin. DealRight became less
efficient than Moreco. Moreco’s profit margin increased. The greater increase in
Moreco’s profit margin could result from higher operating leverage. Moreco has more
fixed costs that did not increase in proportion to sales. Another reason could be greater
cost control. Some of DealRight’s costs increased more rapidly than its sales, thus re-
ducing profits.

Creditors should be more concerned about Tenix Company than about Beson Company. Tenix
SSP12-3
reported a sizable decrease in plant assets. Much of this decrease was due to a writedown of
assets because their market value was below their book value. Total plant assets are not much
higher than long-term debt. Accordingly, the ability of Tenix to repay its debts in the event it
went out of business is questionable. In addition, Tenix’s profits are negative after deducting
interest expense. The company is not earning sufficient profits to meet interest requirements.
Tenix’s performance is poor. Therefore, the likelihood that it could go out of business is rel-
atively high, in which case it may have difficulty paying off all of its creditors.
Beson, in contrast, appears to be in relatively good shape. Its performance is strong, and
its plant assets are large in proportion to long-term debt.
F462 SECTION F2: Analysis and Interpretation of Financial Accounting Information
465
Analysis of Investing Activities


Thinking Beyond the Question
How do assets create value for our business?


Investing decisions affect a company’s profits, risk, and value. Investment de-
cisions that result in fixed costs increase risk and the ability of a company to
create higher profits and sales. Managing risk involves selecting the amounts
and types of long-term assets a company uses. Those decisions also affect per-
formance measures such as return on assets. Asset costs affect net income as
assets are consumed and total assets increase as more assets are acquired. A
low return on assets is an indicator of poor investing decisions. If a company is
not satisfied with its investing decisions and the performance of its assets, what
can it do to improve that performance?




QUESTIONS
Q12-1 Why are investing activities critical to the success of a company?
Obj. 1
Q12-2 How do investing activities affect a company’s growth?
Obj. 1
How do investing choices affect the choices available to a company in the future? Explain.
Q12-3
Obj. 1
A friend who is approaching retirement is discussing her investment plan. She tells you that she
Q12-4
wants to find a mutual fund that invests in stock of companies with high fixed costs, such as air-
Obj. 2
lines, software developers, and publishers. “The higher fixed costs should make expenses more pre-
dictable, and earnings should be more reliable.” What is your analysis of your friend’s strategy?
The balance sheet and statement of cash flows provide information about a company’s access
Q12-5
to and use of cash. What differences would you expect to see in the information related to
Obj. 3
cash on these statements for a company reporting strong financial performance and a com-
pany reporting weak financial performance?
Q12-6 In reviewing a company’s financial statements you observe that the company is consistently
profitable and has consistent positive cash flows from operations and investing activities. Its
Obj. 3
cash flow from financing activities is consistently negative. What does this suggest to you about
the company?
Q12-7 Why do some companies have a very large portion of total assets invested in property, plant, and
equipment while other companies have just a small portion of assets invested in this manner?
Obj. 3

Q12-8 What useful information can be obtained by comparing a firm’s cost of plant, property, and
equipment to the amount of its accumulated depreciation?
Obj. 3

Q12-9 Why might a company wishing to increase its asset turnover acquire new assets? Wouldn’t the
greater amount of assets merely decrease asset turnover?
Obj. 4

How do investing activities affect company value?
Q12-10
Obj. 4
How is return on assets related to investing decisions?
Q12-11
Obj. 4
Asset turnover is a measure of effectiveness. How can a firm increase its effectiveness?
Q12-12
Obj. 5
How is it possible that profits can increase by 40% when sales increase by a much smaller
Q12-13
amount?
Obj. 5
F463
CHAPTER F12: Analysis of Investing Activities
466 Analysis of Investing Activities

Q12-14 Why is information about investing activities of interest to creditors?
Obj. 6
Malcolm Greenlees is a friend who is planning to be a business manager. In a recent discus-
Q12-15
sion about financial matters, Malcolm made the following statement. “A company’s balance
Obj. 6
sheet measures the value of a company’s resources. Investors can use this value for pricing the
company’s stock and for comparing the values of different companies. Creditors can use it for
evaluating loan risk.” How would you respond to Malcolm?


If your instructor is using Personal Trainer in this course, you may complete online the assign-
EXERCISES ments identified by .
Note: Financial measurements have been presented in their simplest form in this chapter in or-
der to place emphasis on thinking about the measurement and its connection with accounting,
rather than on the complexities of calculation. Simplified calculations are also used in these end-
of-chapter materials. In other texts, for example, return on assets may be calculated based on av-
erage total assets for the year, rather than on ending assets, and the income figure used may have
the effects of interest and taxes removed.
Write a short definition for each of the terms listed in the Terms and Concepts Defined in this
E12-1
Chapter section.
E12-2 Sanders Company recorded sales revenues of $10 million for the year just ended. It recorded
expenses totaling $9 million. Of these expenses, $4 million were expenses that would not have
Obj. 2
been different if sales revenue had been different. They were fixed expenses.
a. Prepare a table showing how much net income Sanders would have earned on sales of
$8 million, $10 million, and $12 million.
b. Suppose the company’s total expenses had been $9 million, and of that amount, the
fixed expenses had been $6 million. The remaining expenses would have varied propor-
tionately with sales revenue. Prepare a table showing how much net income Sanders
would have earned on sales of $8 million, $10 million, and $12 million.
c. What conclusions about the effect of operating leverage on net income can you draw
from this analysis?
The Kolby and Kent companies both increased sales by 30% this year when compared with last
E12-3
year’s results. Kolby’s net income increased 40% as a result of the increased sales. Kent’s net in-
Obj. 2
come increased 20%. Explain why differences in operating leverage may have resulted in a higher
increase in net income for Kolby than for Kent. Provide a diagram to illustrate your explanation.
Given below is selected information about two companies.
E12-4
Obj. 2
Company A Company B
Sales $10,000 $10,000
Fixed costs 4,000 7,000
Variable costs 5,000 2,000
a. Calculate net income for each company.
b. What is operating leverage? Is it present in the operations of these two companies? If
so, which company uses the greater amount of operating leverage?
c. If sales decrease by 10%, which company will report the higher net income?
d. If sales increase by 10%, which company will report the higher net income?
Selected accounting information is provided below for two companies.
E12-5
Obj. 3
(In millions) 2001 2000 1999 1998
Total assets:
Sara Lee $10,167 $11,611 $10,292 $10,989
Merck & Co. 44,007 40,155 35,934 31,853
Depreciation and amortization:
Sara Lee 599 602 533 618
Merck & Co. 1,464 1,277 1,145 1,015
Capital expenditures:
Sara Lee 532 647 535 474
Merck & Co. 2,725 2,728 2,561 1,973
(Continued)
F464 SECTION F2: Analysis and Interpretation of Financial Accounting Information
467
Analysis of Investing Activities

What trends in asset investments are apparent from the data presented? (Hint: Compare to-
tal assets, capital expenditures to total assets, and capital expenditures to depreciation and
amortization for each year.)

At the end of its most recent fiscal year, Shangri-La Company owned the following investments.
E12-6
Obj. 3
Investment Historical Cost Fair Market Value
A $650,000 $765,000
B 840,000 730,000

Other assets had a book value of $2.4 million and liabilities had a book value of $2.8 mil-
lion. Shangri-La’s net income for 2004 was $280,000. If the company sold investment A at the
end of the year for cash, what effect would the sale have on its financial statements and re-
turn on assets (ignoring the effect of income taxes)? Assume that assets are reported on the
financial statements at historical cost. What effect would the sale of investment B have on the
company’s financial statements and return on assets? Compare these amounts to those that
would be reported if no investments were sold. Does this example help explain why mark-to-
market accounting is often required by GAAP? Discuss.

E12-7 Selected financial information is reported below for two companies in the computer manu-
facturing business. The information was taken from the firms’ 2001 annual reports.
Obj. 3

(In millions) Compaq IBM
Plant assets, at cost $7,098 $38,395
Depreciation expense 1,036 4,195
Net cash outflow for plant assets 927 4,495

a. Compute the ratio of depreciation expense to plant assets at cost for both firms. What
do your results suggest?
b. Compute the ratio of cash invested for plant assets to plant assets at cost for both
firms. What do your results suggest?

Following is selected information from Dell Computer Corporation.
E12-8
Objs. 3, 4
Fiscal Year Ended February 1, February 2, January 28,
(In millions) 2002 2001 2000
Net revenue $31,168 $31,888 $25,265
Net income 1,246 2,177 1,666
Cash from operations 3,797 4,195 3,926
Cash used in investing (2,260) (757) (1,183)
Cash used in financing (2,702) (2,305) (695)
Capital expenditures (303) (482) (401)

With the information provided, calculate whatever ratios you can and describe the trends
you observe.

The following information is for McDonald’s Corporation from its 2001 annual report.
E12-9
Obj. 4
(In millions) 2001 2000 1999
Revenues $14,870 $14,253 $13,259
Net income 1,637 1,977 1,948
Total assets 22,535 21,684 20,983

Evaluate McDonald’s Corporation’s investing decisions by computing and analyzing its asset
turnover, profit margin, and return on assets for 1999 through 2001.

The following information was reported by McDonald’s Corporation in its 2001 annual re-
E12-10
port.
Obj. 4

(In millions) 2001 2000 1999
Cash flow from
operating activities $ 2,688 $ 2,752 $ 3,009
Total assets 22,535 21,684 20,983
F465
CHAPTER F12: Analysis of Investing Activities
468 Analysis of Investing Activities

Evaluate McDonald’s Corporation’s investing decisions by computing the ratio of cash flow
from operating activities to total assets for 1999 through 2001. Compare the cash flow ratio
with return on assets from E12-9. What do you conclude, given this information?

Information is provided below for two companies that produce similar jewelry items for the
E12-11
same market.
Obj. 4

Lucy’s Lockets Desi’s Delights
(In thousands) 2005 2004 2005 2004
Sales $630 $550 $650 $675
Net income 59 50 59 64
Total assets 500 450 875 880

Compute the asset turnover, profit margin, and return on assets for each company for
each of the two years. Compare the performances of the two companies. Look at changes
within each company and consider differences between the two companies.

Given below is information about four companies.
E12-12
Obj. 4
Able Co. Baker Co. Charlie Ltd. Dilbert Inc.
Sales $1,000 $2,000 $2,000 $600
Profit margin 0.18 0.06 0.11 0.24
Asset turnover 1.30 1.60 1.20 1.15

a. Which company generated the greatest profit?
b. Which company is the most efficient? Why?
c. Which company is the most effective? Why?
d. Which company has the greatest total assets?

Following is information about current and projected sales and expenses for Squiggy Com-
E12-13
pany. The company’s total assets are also given.
Obj. 4

Current Decrease Increase
Sales of 20% of 20%
Sales $ 50,000 $ 40,000 $ 60,000
Less: Fixed costs (10,000) (10,000) (10,000)
Variable costs (10,000) (8,000) (12,000)
Net income $ 30,000 $ 22,000 $ 38,000
Total assets $ 25,000 $ 25,000 $ 25,000

a. Calculate the percentage changes in net income that would occur under each projection.
b. Calculate the percentage changes in return on assets, profit margin, and asset turnover
that would occur under each projection.

At a meeting of the top managers in your company, President Anne Thompson points out
E12-14
that stockholders have been pressuring the organization to increase return on assets. She asks
Obj. 4
for suggestions. Four of your colleagues respond in the following manner:
• “Sales, sales, sales. You’ve got to have more revenue to increase return.”
• “Cut the expenses. How can you get a higher return if you don’t keep more of your sales
dollar?”
• “Expansion! More productive assets! Growth is the way to go.”
• “No, no! Cut the assets! Sell those that will bring the best price!”
Evaluate your coworkers’ comments. Will these strategies produce a definite increase in re-
turn on assets? What are the risks and rewards of each strategy?

In a continuation of E12-14, another member of the group comments that to maximize re-
E12-15
turn on assets, both efficiency and effectiveness are necessary. Explain what is meant by “ef-
Obj. 5
ficiency” and “effectiveness,” how they relate to return on assets, and whether you agree with
your colleague’s comment.
F466 SECTION F2: Analysis and Interpretation of Financial Accounting Information
469
Analysis of Investing Activities

E12-16 Bumblebee Enterprises is considering adding another product line. Below are results from last
year and pro forma (expected) results with the addition of the new line. Little change in sales
Obj. 5
from the current product lines is expected.

(In millions) Last Year Pro Forma
Sales $260 $322
Net income 24 32
Total assets 300 372

Analyze the changes in effectiveness, efficiency, and return on assets that would be expected
if the product line were added. Would you recommend addition of the product line?
The following information is available for Cello Company:
E12-17
Obj. 5
2005 2004 2003
Sales $15,000 $ 8,000 $ 4,000
Net income 5,250 2,800 1,200
Average assets 30,000 20,000 10,000

Calculate the return on assets, profit margin, and asset turnover for each year and discuss the
reasons for the change in return on assets over the three years.
Winger, Inc. is in the business of renting medical equipment for home health care. New gov-
E12-18
ernment standards for lifts for disabled patients have rendered some equipment obsolete.
Obj. 6
Winger owns 10 four-year-old machines, each with a cost of $6,000. They have been depre-
ciated using the straight-line method over an estimated life of 10 years. Since some parts can
be used, they still have a resale value of approximately $1,000 each. Explain what accounting
measure is required, what the effects on the financial statements will be (including amounts),
and why this measure is important to creditors of Winger.
Yarrow Company increased its investment in long-term assets by 20% in the past three years.
E12-19
This investment was financed by rapid increases in cash generated from operating activities.
Obj. 6
Cash from operating activities also was used to repay about 30% of Yarrow’s long-term debt
and to repurchase 10% of its common stock. What effect would you expect these events to
have on the company’s return on assets and return on equity? Does the company appear to
be a good prospect for additional debt financing?
Abdullah Company reported the following information on its statement of cash flows.
E12-20
Objs. 3, 6
(In millions) 2005 2004 2003
Net cash provided by operating activities $ 3,195 $ 2,869 $ 2,688
Net cash from (used by) investing activities:
Capital expenditures (2,661) (1,358) (523)
Sales of equipment and property 293 305 257
Investments in other companies (272) 0 0
Other 392 (627) (924)
Total investing activities $(2,248) $(1,680) $(1,190)
Net cash from (used by) financing activities:
Payments on long-term debt (547) (648) (2,130)
Repurchase of common stock (994) (740) 0
Other 627 200 614
Total financing activities $ (914) $(1,188) $(1,516)

Interest expense for the past three years has been $372, $420, and $514. The company
does not pay dividends. What information about the company’s future prospects is commu-
nicated by its investing and financing activities during this period? Does the company appear
to be a good prospect for new debt financing to be spent on additional capital assets?
F467
CHAPTER F12: Analysis of Investing Activities
470 Analysis of Investing Activities

If your instructor is using Personal Trainer in this course, you may complete online the assign-
PROBLEMS ments identified by .

Determining Investment Strategy for a New Company
P12-1
Objs. 1, 2 You have graduated with a business degree, and you have worked for three years for a small
management consulting firm. Ivan Steeger (1352 Bull Run Road, Milltown, OR 97111) is a
client who has been involved with several businesses in the past. He expects to be the major
provider of equity capital for a new mail-order low-fat cookie business. His co-owners, who
have baking expertise and a talent for developing recipes, will run the business.
The owners are about to meet to determine what equipment they will purchase for the
business. Ivan gives you the following information about the business and their plans:
• Ivan will be providing about 25% of the financing; the remainder will be debt. Ivan will
probably have to give his personal guarantee for much of the debt. The exact amount of
debt will depend on the price of the equipment they decide to purchase.
• They expect business growth of about 20% for each of the first five years.
• All of the equipment has an expected life of at least five years. They will definitely pur-
chase mixing and baking equipment. They must decide whether to add equipment that
will shape cookies automatically, or hire employees to do the shaping.
• They also must decide what capacity they prefer in their initial equipment purchase.
Smaller-capacity equipment would handle their expected demand for the first two years,
operating eight hours a day. Equipment with twice the capacity would cost approximately
50% more.
Ivan asks for recommendations about discussion items for the meeting.

Required Write Ivan a letter in which you suggest major issues the owners should consider
in making decisions about investments in equipment. You can assume that Ivan has some un-
derstanding of business terminology.

The Effect of Investment Strategy and Operating Leverage on Risk
P12-2
and Profits
Objs. 1, 2
Following is a set of pro forma (or projected) income statements for a company. The columns
labeled A are projected results for the company if it follows Strategy A. The columns labeled
B are projected results for the company if it follows Strategy B.

Low sales Medium sales High sales
A B A B A B
Sales $3,000 $3,000 $4,000 $4,000 $5,000 $5,000
Cost of sales (180) (180) (240) (240) (300) (300)
Depreciation (315) (450) (355) (450) (395) (450)
Wages expense (1,300) (1,500) (1,600) (1,500) (1,800) (1,500)
Other operating expenses (1,000) (1,000) (1,000) (1,000) (1,000) (1,000)
Operating income 205 (130) 805 810 1,505 1,750
Income tax (expense) or savings (72) 46 (282) (284) (527) (613)
Net income $ 133 $ (84) $ 523 $ 526 $ 978 $1,137

Required Study the information given and discuss each of the following.
A. The comparative risk of Strategy A versus Strategy B, as shown in the projected net in-
come results
B. The company’s operating leverage
C. The company’s investment strategy

Evaluating the Effects of Operating Leverage on Profits
P12-3
Obj. 2 Yamhill County currently provides garbage removal services for two of the four small towns
within its boundaries. In addition, it provides garbage removal services for residents who live
in outlying rural areas. Each town has the option of contracting for garbage removal service
F468 SECTION F2: Analysis and Interpretation of Financial Accounting Information
471
Analysis of Investing Activities

from the county or providing service itself. Garbage volume and the resulting revenue from
each town served is approximately the same; garbage volume for those who live in outlying
rural areas is approximately that of two towns. Under the current situation, the following rev-
enues and costs are incurred.

Revenue from garbage removal services $2,000,000
Fixed expenses (don’t change when revenues change) 600,000
Variable expenses (change proportionately when sales change):
Wages 1,100,000
Truck maintenance 100,000

The Yamhill County commissioners are considering purchase of new garbage trucks that
lift and crush the garbage more efficiently. This would double the fixed expenses and cut the
existing variable expenses in half.

Required
A. Prepare a three-column pro forma income statement for the Yamhill County garbage
service assuming the existing equipment continues in use. Show (1) the amount of pro-
jected net income if only outlying rural areas are served, (2) income if outlying rural
areas plus those of two towns are served, and (3) income if outlying rural areas and
four towns are served. Use the following format.

Outlying rural Outlying rural areas Outlying rural areas
areas only plus two towns plus four towns
Revenues
Fixed expenses
Variable expenses
Net income

B. Using the same format, prepare another three-column pro forma income statement
showing garbage service with the new equipment under each of the three income situa-
tions listed in the first requirement.
C. Explain the effects that changing to new trucks could have on Yamhill County’s profits
and risks from the garbage service.

Comparing Operating Leverage
P12-4
Obj. 2 Information is provided below from the annual reports of two manufacturing companies op-
erating in different industries.

Solution Software, Inc. Fashion Clothing Co.
(In millions) Sales Earnings Sales Earnings
2001 $ 4,600 $1,150 $3,800 $300
2002 6,000 1,500 4,800 400
2003 8,700 2,200 6,500 550
2004 11,400 3,500 9,200 800
2005 14,500 4,500 9,500 850

Required Prepare a graph to illustrate the relationship between each company’s earnings
and its sales over the five years. Which company has the higher operating leverage? What ef-
fect does operating leverage have on the companies’ operating income?
F469
CHAPTER F12: Analysis of Investing Activities
472 Analysis of Investing Activities

P12-5 Comparing Operating Leverage
Obj. 2
Information is provided below from the 2002 annual reports of Dell Computer Corporation
and Tommy Hilfiger Corporation.

(In millions) Dell Hilfiger
Net revenue $ 31,168 $ 1,877
Cost of goods sold (25,661) (1,073)
Gross margin 5,507 804
Operating expenses (3,236) (618)
Operating income $ 2,271 $ 186

Assume the cost of goods sold is variable and the operating expenses are half fixed and half
variable.

Required
A. Compute Dell’s projected operating income if sales decreased to 80% of current sales
or increased to 120% of current sales.
B. Compute Hilfiger’s projected operating income if sales decreased to 80% of current
sales or increased to 120% of current sales.
C. Compare and discuss the results of your projections. Identify the company that has the
higher operating leverage.

Operating Leverage and Risk
P12-6
Obj. 2 Financial statement information is presented below for Hillary Corporation, a producer of
mountain climbing gear. The company expects sales to increase by about 20% in 2004.

2003 2004
(In millions) Actual Expected
Sales $692 $830
Cost of good sold 462 554
Operating expenses 206 247
Operating income 24 29
Interest expense (5) (5)
Pretax income 19 24
Income taxes (7) (8)
Net income $ 12 $ 16

Hillary’s management is considering automating much of the company’s production
process. The automation would result in about half of the company’s cost of goods sold be-
ing fixed. Currently, most of these costs vary in proportion to sales, as shown in the financial
numbers presented above.

Required
A. Assume that half ($231 million) of Hillary’s cost of goods sold in 2003 is fixed and that
the other half increases in proportion to sales, an increase of 20%. Compute the com-
pany’s expected cost of goods sold.
B. Using the same assumptions as part A, compute expected net income for 2004. Assume
that income taxes are 35% of pretax income. Round to the nearest million.
C. Compare your results with those presented above, which assume that cost of goods
sold varies in proportion to sales. What effect would the automation have on Hillary’s
profitability? What effect would it have on the company’s risk? Explain your answer.
F470 SECTION F2: Analysis and Interpretation of Financial Accounting Information
473
Analysis of Investing Activities

Assessing the Effects of Operating Leverage
P12-7
Objs. 2, 3 Information is provided below from the financial statements of two companies for 2004.

2004 Jekle Hyde
Total assets $30,000 $80,000
Total debt 10,000 50,000
Total equity 20,000 30,000
Sales 28,000 75,000
Operating expense 20,000 60,000
Operating income 8,000 15,000
Interest expense 800 5,000
Pretax income 7,200 10,000
Income taxes (30%) 2,160 3,000
Net income 5,040 7,000

Jekle’s operating expenses include fixed costs of $5,000. Hyde’s operating expenses in-
clude fixed costs of $50,000. All other operating expenses vary in proportion to sales for both
companies. Assume that during 2005 sales for both companies increased by 20% from the
amount reported, to $33,600 for Jekle and to $90,000 for Hyde.

Required
A. Compute the net income Jekle and Hyde would report for 2005 if sales increased by 20%.
B. Compute return on assets for Jekle and Hyde in 2004 and 2005, assuming the increase
in sales and no change in total assets.
C. Explain why the increase in sales would affect Jekle and Hyde differently and explain
which company is riskier.

Comparing Cash Flows
P12-8
Obj. 3 Cash flow information is provided below for two companies in the health-care products in-
dustry. Cash outflows are shown in parentheses.

(In millions) 2001 2000 1999 Total
Johnson & Johnson
Operating activities $ 8,864 $ 6,903 $ 5,920 $ 21,687
Investing activities (4,093) (2,665) (3,093) (9,851)
Financing activities (5,251) (2,425) (2,347) (10,023)
Warner-Lambert
Operating activities $ 9,080 $ 7,687 $ 6,131 $ 22,898
Investing activities (4,312) (3,641) (2,817) (10,770)
Financing activities (5,071) (3,447) (3,869) (12,387)

Required Analyze the companies’ cash flows for 1999 to 2001 and for the three years in to-
tal. Explain how the two companies compare in terms of their cash flow trends.

Assessing Asset and Investment Strategy
P12-9
Obj. 3 Widgets, Inc. and Gizmos, Inc. both manufacture accessories for computer users. The table
below shows their investment policies and operating results for the past two years.

Widgets, Inc. Gizmos, Inc.
(In thousands) 2004 2003 2004 2003
Plant and equipment $2,400 $2,200 $4,300 $4,400
Accumulated depreciation 600 580 2,200 1,900
Total assets 5,000 4,300 8,000 8,100
Net income 432 320 (615) (140)
Depreciation 320 290 520 541
Cash flow from operations 710 644 (105) 376
Cash flow from investing activities (305) (274) 205 56
New investment in plant and
equipment 316 280 180 220
F471
CHAPTER F12: Analysis of Investing Activities
474 Analysis of Investing Activities

Required Explain what the preceding numbers tell you about the two companies’ assets and
investment policies. Include any information you find that would indicate financial problems
within either company.

Comparing Cash Flows
P12-10
Obj. 3 Cash flow information is provided below for two companies in the food products industry.
Cash outflows are shown in parentheses.

(In millions) 2001 2000 1999 Total
Earthgrains Co.
Operating activities $ 165 $ 107 $ 130 $ 402
Investing activities (123) (742) (216) (1,081)
Financing activities (39) 608 93 662
Campbell Soup Co.
Operating activities $ 1,106 $1,165 $ 954 $ 3,225
Investing activities (1,122) (204) (322) (1,648)
Financing activities 15 (943) (636) (1,564)

Required Analyze the companies’ cash flows for 1999 through 2001 and for the three years
in total. Explain how the two companies compare in terms of their cash flow trends.

Comparing Investment Activities
P12-11
Objs. 3, 4 Information is provided below from the 2001 annual reports of PepsiCo, Inc. and The Coca-
Cola Company.

(In millions except per share amounts) PepsiCo Coca-Cola
Current assets $ 5,853 $ 7,171
Investments and other assets 4,125 8,214
Plant assets, at cost 12,180 7,105
Plant assets, net 6,876 4,453
Intangibles, net 4,841 2,579
Total assets 21,695 22,417
Current liabilities 4,998 8,429
Long-term debt 2,651 1,219
Shareholders’ equity 8,648 11,366
Net income 2,662 3,969
Net sales 26,935 20,092
Interest expense 219 289
Depreciation and amortization 1,082 803
Net cash provided by operating activities 4,201 4,110
Net cash from (used) in investing activities (2,637) (1,188)
Net cash from (used) in financing activities (1,919) (2,830)
Earnings per share 1.51 1.60
Market value of equity 86,475 117,226

Required Use appropriate accounting ratios discussed in this chapter and any other ratios
you think are helpful to compare the investing activities and performances of the two com-
panies for 2001. What important differences exist in the investing and financing activities of
the companies? How do these differences affect the risk and return of the companies? How
would you expect these differences to affect the market-to-book value and book value-to-cash
flow from operating activities ratios of the two companies?
F472 SECTION F2: Analysis and Interpretation of Financial Accounting Information
475
Analysis of Investing Activities

P12-12 Measuring the Results of Investing Activities
Obj. 4
Accounting information is provided below for two companies in the hair care products industry.

Faucett Company Danson Industries
(In millions) 2004 2003 2004 2003
Total assets $33.8 $26.8 $84.4 $71.0
Sales 40.7 30.5 95.5 71.6
Net income 3.7 2.5 6.7 6.0

Required
A. Compute asset turnover, profit margin, and return on assets for each year and com-
pany. Also, compute asset growth for each company from 2003 to 2004.
B. Evaluate the performance of each company with respect to the other and also in terms
of changes from 2003 to 2004. Identify reasons for the differences in performance.

Evaluating Investment Decisions
P12-13
Objs. 4, 5 The information below was reported by PepsiCo, Inc. in its 2001 annual report.

(In millions) 2001 2000 1999
Net sales $26,935 $25,479 $25,093
Net income 2,662 2,543 2,505
Cash flow from operating activities 4,201 3,330 3,605
Cash invested in other companies (432) (98) (430)
Cash purchases of plant assets (1,324) (1,352) (1,341)
Cash flow from financing activities (1,919) (2,648) (1,828)
Cash dividends paid (994) (949) (935)
Total assets 21,695 20,757 19,948

Required Identify and evaluate PepsiCo’s investment decisions over the three years shown.
Include in your analysis an examination of changes in efficiency and effectiveness.

Comparing Investment Performance
P12-14
Objs. 4, 5 The information below is for two companies in the same industry.

Griffith, Inc. Johnson, Inc.
(In millions) 2005 2004 2005 2004
Sales $8,223 $7,338 $9,430 $9,400
Net income 817 701 822 840
Total assets 7,250 6,490 8,347 8,350
Total liabilities 3,200 3,030 5,230 4,960
Market value 9,200 7,650 5,220 5,790

Required
A. Compute the asset turnover, profit margin, return on assets, and market to book value for
each year and company. Also compute asset growth for each company from 2004 to 2005.
B. Compare the performances of the two companies over the two-year period with respect
to effectiveness and efficiency.
C. Explain what reasons you find for the differences in the market value of the two compa-
nies. Could there be additional explanatory factors that do not appear in these numbers?

Investing Decisions Regarding Product Lines
P12-15
Objs. 4, 5 The company for which you work has a significant investment in the stock of Star-Beasts,
Inc. (SBI), which currently manufactures one kind of toy, a large and lovable stuffed mon-
ster. SBI is considering expansion of its production facilities and would finance the expan-
sion with long-term borrowing at an expected interest rate of 10%. The market would seem
to support the manufacture and sale of 20% more monsters at the current profit margin. The
added facilities would cost approximately $3.4 million. Alternatively, SBI could add one of
two new lines: a mechanical dragon or a game called Starship Troopers.
F473
CHAPTER F12: Analysis of Investing Activities
476 Analysis of Investing Activities

The numbers below indicate current operating results and projections for the effects of
added facilities for manufacturing the new lines. The numbers do not include interest on the
new facilities or the company’s 35% income tax rate.

Current Addition of Addition of
(In thousands) Operations Dragons Games
Sales $9,860 $3,300 $2,900
Operating expenses 7,240 2,450 2,300
Interest expense 1,100 ? ?
Total assets 8,422 ? ?
Capital expenditures ? 3,450 1,800

Required
A. In addition to showing the current income statement, prepare pro forma income state-
ments for SBI under each of the three strategies: expanding manufacturing of the cur-
rent product and adding each of the new lines.
B. Determine the return on assets for the current situation and for each of the three
strategies.
C. Indicate under which strategy you would feel most confident about the value of your
company’s investment, and explain why.

Evaluating Investment Decisions
P12-16
Objs. 3, 4, 5 Creative Technology, Inc. reported the following information in its 2004 annual report.

Additions
(In millions Long-Term to Plant Earnings
except EPS) Total Assets Debt Assets Net Income per Share
2004 $31,471 $702 $4,032 $6,068 1.73
2003 28,880 448 4,501 6,945 1.93
2002 23,735 728 3,024 5,157 1.45
2001 17,504 400 3,550 3,566 1.01
2000 13,816 392 2,441 2,288 0.65

Required Using appropriate accounting ratios discussed in this chapter and any other ra-
tios you think are helpful, evaluate the firm’s investment decisions for the period from 2000
to 2004.

Comparing Investment Performance
P12-17
Objs. 4, 5 Information is provided below for Tommy Hilfiger Corporation and Nike, Inc.

Hilfiger Nike
(In millions) 2002 2001 2002 2001
Total assets $2,594 $2,343 $6,443 $5,820
Total liabilities 1,097 994 2,604 2,325
Revenues 1,877 1,881 9,893 9,489
Operating income 186 197 1,068 1,014
Net income 135 131 663 590
Depreciation and amortization 114 107 277 214
Cash from operations 353 191 1,082 657
Cash from investing (302) (74) (303) (342)
Cash from financing 18 (108) (478) (350)
Additions to plant assets (97) (74) (283) (318)

Required
A. Compute the asset turnover, profit margin, and return on assets for each year and
company.
B. Compare the effectiveness and efficiency of the two companies.
C. Compare the investing activities of the two companies over the two years and discuss
your findings.
F474 SECTION F2: Analysis and Interpretation of Financial Accounting Information
477
Analysis of Investing Activities

P12-18 Analyzing Ability to Meet Debt Payments
Obj. 6
Sporting Life, Inc., is a large retail chain of sporting goods stores. In a recent annual report,
the following information was presented.

(In millions) 2004 2003 2002
Sales $15,833 $15,668 $15,229
Operating income 1,455 1,341 893
Net income 662 536 266
Interest expense 304 418 499
Total assets 13,464 13,738 14,264
Long-term debt 3,057 3,919 4,606
Shareholders’ equity 5,709 5,256 4,669
Cash provided by operating activities 1,690 1,573 1,220
Cash (used) by investing activities (445) (318) (650)
Cash provided (used) by financing activities (1,080) (1,262) (594)

Cash for investing activities was used primarily for property and equipment purchases. Cash
used by financing activities was primarily to pay off long-term debt and acquire treasury stock.

Required
A. Assume that you work for an investment firm that has an opportunity to invest in
notes that are part of Sporting Life’s long-term debt. Write a short report in which you
analyze the firm’s ability to meet its debt payments, based on the information given.
B. Prepare a list of the most important additional pieces of information you would want
before making a final decision about the investment. This list should include some
accounting information; it might also include nonaccounting and nonquantitative
items.

Assessing Credit-Worthiness
P12-19
Obj. 6 Year-end financial information is provided below for two companies that make baseball caps.

Cobb Industries Speaker, Inc.
(In millions) 2004 2003 2004 2003
Property, plant, and equipment $283 $314 $171 $162
Total assets 392 424 259 246
Current liabilities 67 74 69 63
Long-term debt 261 264 100 104
Stockholders’ equity 64 86 90 79
Asset impairment charge (18) — — —
Operating income 5 7 24 19
Interest expense (23) (24) (8) (7)

Required Study the information provided. If you were a creditor of these companies, would
you be concerned about the ability of either company to repay its debts? Explain your answer.

Excel in Action
P12-20
The Book Wermz reported sales for 2005 of $6,230,000. Cost of goods sold was 55% of sales,
and operating expenses were $2,155,000. Interest expense was $190,000. Income taxes were
35% of pretax income. Total assets at the end of 2005 were $5,623,000.

Required Use the information provided to produce an income statement for The Book
Wermz for the year ended December 31, 2005. Enter appropriate captions for the statement
SPREADSHEET at the top of the spreadsheet and appropriate captions in column A. Enter amounts in col-
umn B. Use equations to calculate subtotals and totals. Calculate cost of goods sold as sales
0.55 and income taxes as pretax income 0.35.
Following the income statement, enter the total assets data and calculate asset turnover,
profit margin, and return on assets. Enter captions in column A and calculations in column
B. Use cell references to the income statement and total assets in these calculations.
F475
CHAPTER F12: Analysis of Investing Activities

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