Solutions Guide: Please do not present as your own.

I sometimes post solutions

that are totally mine, from the book’s solutions manual, or a mix of my work and
the books solutions manual. But this is only meant as a solutions guide for you to
answer the problem on your own. I recommend doing this with any content you buy
online whether from me or from someone else.

The annual sales for Salco Inc. were $4.5 million last year. The firm’s end-of-year
balance sheet was as follows: Current assets $ 500,000 Liabilities $1,000,000 Net fixed
assets 1,500,000 Owners’ equity 1,000,000 $2,000,000 $2,000,000 The firm’s
income statement for the year was as follows: Sales $ 4,500,000 Less cost of goods sold
(3,500,000) Gross profit $ 1,000,000 Less operating expenses (500,000) Operating
income $ 500,000 Less interest expense (100,000) Earnings before taxes $ 400,000
Less taxes (50%) (200,000) Net income $ 200,000 a. Calculate Salco’s total asset
turnover, operating profit margin, and operating return on assets. b. Salco plans to
renovate one of its plants, which will require an added investment in plant and equipment
of $1 million. The firm will maintain its present debt ratio of .5 when financing the new
investment and expects sales to remain constant. The operating profit margin will rise to
13 percent. What will be the new operating return on assets for Salco after the plant’s
renovation? c. Given that the plant renovation in part b occurs and Salco’s interest
expense rises by $50,000 per year, what will be the return earned on the common
stockholders’ investment? Compare this rate of return with that earned before the
renovation.

a. Salco’s total asset turnover, operating profit margin, and operating return on
assets.
Sales
Total Asset Turnover =
Total Assets
$4,500,000
= $2,000,000

= 2.25 times
Operating Income
Operating Profit Margin =
Sales
$500,000
= $4,500,000

= 11.11%
Operating Operating Income
=
return on assets Total Assets
 $500,000
= $2,000,000

= 25%
Operating Income Sales
or = x
Sales Total Assets
= .1111 X 2.25 = 25%

b. The new operating return on assets for Salco after the plant renovation:
Operating Operating Income Sales
= x
return on assets Sales Total Assets
$4,500,000
= .13 x
$3,000,000

= .13 x 1.5 = 19.5%

c. Return earned on the common stockholders’ investment:
Post-Renovation Analysis:
Return on common Net Income Available to Common
equity
= Common Equity

$217,500
= $1,000,000  $500,000

= 14.5%
Net Income Available to Common following the renovation was calculated
as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 + $50,000) (150,000)
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500)
Net Income Available to Common $ 217,500
Pre-renovation Analysis:
The pre-renovation rate of return on common equity (ROCE) is calculated
as follows:
$200,000
ROCE = $1,000,000
= 20%

Comparative Analysis:
A comparison of the two rates of return would argue that the renovation
not be undertaken. However, since investments in fixed assets generally
produce cash flows over many years, it is not appropriate to base decisions
about their acquisition on a single year’s ratios. There are additional
problems with this approach to fixed asset decision making which we will
discover when we discuss capital budgeting in a later chapter.