Integrative Case 2

Track Software, Inc.

S even years ago, after 15 years in public accounting, Stanley Booker, CPA,
resigned his position as manager of cost systems for Davis, Cohen, and O’Brien
Public Accountants and started Track Software, Inc. In the 2 years preceding his
departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends
developing a sophisticated cost-accounting software program that became Track’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- to large-sized manufacturers.
Although Track experienced losses during its first 2 years of operation—2009
and 2010—its profit has increased steadily from 2011 to the present (2015). The
firm’s profit history, including dividend payments and contributions to retained
earnings, is summarized in Table 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 (2009), 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 only 40 percent of the firm, Stanley actively
manages all aspects of its activities; the other stockholders are not active in manage-
ment of the firm. The firm’s stock was valued at $4.50 per share in 2014 and at
$5.28 per share in 2015.

TABLE 1

Track Software, Inc.,

Profit, Dividends, and Retained Earnings, 2009–2015

Net profits after Dividends Contribution to

taxes paid retained earnings [(1) − (2)]
Year (1) (2) (3)

2009 ($50,000) $ 0 ($50,000)

2010 (20,000) 0 (20,000)
2011 15,000 0 15,000
2012 35,000 0 35,000
2013 40,000 1,000 39,000
2014 43,000 3,000 40,000
2015 48,000 5,000 43,000

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 Stanley has just prepared the firm’s 2015 income statement, balance sheet, and
statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014
balance sheet. In addition, he has compiled the 2014 ratio values and industry
average ratio values for 2015, which are applicable to both 2014 and 2015 and
are summarized in Table 5. He is quite pleased to have achieved record earnings of
$48,000 in 2015, but he is concerned about the firm’s cash flows. Specifically, he
is finding it more and 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 2015 operating
cash flow (OCF) and free cash flow (FCF).
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
to have “blockbuster” sales potential. Stanley began development of this package
2 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
$80,000 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 firm’s sales and earnings would significantly rise once
the 2- to 3-year development, production, and marketing process was completed.
With all these concerns in mind, Stanley set out to review the various data to
develop strategies that would help ensure a bright future for Track Software. Stanley
believed that as part of this process, a thorough ratio analysis of the firm’s 2015
results would provide important additional insights.

TABLE 2

Track Software, Inc., Income Statement ($000)

for the Year Ended December 31, 2015
Sales revenue $ 1,550
Less: Cost of goods sold $ 1,030
Gross profits $ 520
Less: Operating expenses  
Selling expense $ 150
General and administrative expenses 270
Depreciation expense 11
Total operating expense 431
Operating profits (EBIT) $ 89
Less: Interest expense 29
Net profits before taxes $ 60
Less: Taxes (20%) 12
Net profits after taxes $ 48

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TABLE 3

Track Software, Inc., Balance Sheet ($000)

  December 31
Assets 2015 2014
Cash $ 12 $ 31
Marketable securities 66 82
Accounts receivable 152 104
Inventories 191 145
Total current assets $421 $362
Gross fixed assets $195 $180
Less: Accumulated depreciation 63 52
Net fixed assets $132 $128
Total assets $553 $490

Liabilities and stockholders’ equity

Accounts payable $136 $126
Notes payable 200 190
Accruals 27 25
Total current liabilities $363 $341
Long-term debt $ 38 $ 40
Total liabilities $401 $381
Common stock (50,000 shares outstanding
at $0.40 par value) $ 20 $ 20
Paid-in capital in excess of par 30 30
Retained earnings 102 59
Total stockholders’ equity $152 $109
Total liabilities and stockholders’ equity $553 $490

TABLE 4

Track Software, Inc.,

Statement of Retained Earnings ($000)
for the Year Ended December 31, 2015
Retained earnings balance (January 1, 2015) $ 59
Plus: Net profits after taxes (for 2015) 48
Less: Cash dividends on common stock (paid during 2015) 5
Retained earnings balance (December 31, 2015) $102

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 TABLE 5

Actual Industry average

Ratio 2014 2015

Current ratio 1.06 1.82

Quick ratio 0.63 1.10
Inventory turnover 10.40 12.45
Average collection period 29.6 days 20.2 days
Total asset turnover 2.66 3.92
Debt ratio 0.78 0.55
Times interest earned ratio 3.0 5.6
Gross profit margin 32.1% 42.3%
Operating profit margin 5.5% 12.4%
Net profit margin 3.0% 4.0%
Return on total assets (ROA) 8.0% 15.6%
Return on common equity (ROE) 36.4% 34.7%
Price/earnings (P/E) ratio 5.2 7.1
Market/book (M/B) ratio 2.1 2.2

TO dO
a. (1) On what financial goal does Stanley seem to be focusing? Is it the correct
goal? Why or why not?
(2) Could a potential agency problem exist in this firm? Explain.
b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that the
number of shares of common stock outstanding has remained unchanged since
the firm’s inception. Comment on the EPS performance in view of your response
in part a.
c. Use the financial data presented to determine Track’s operating cash flow (OCF)
and free cash flow (FCF) in 2015. Evaluate your findings in light of Track’s cur-
rent cash flow difficulties.
d. Analyze the firm’s financial condition in 2015 as it relates to (1) liquidity, (2) ac-
tivity, (3) debt, (4) profitability, and (5) market, using the financial statements
provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to
evaluate the firm on both a cross-sectional and a time-series basis.
e. What recommendation would you make to Stanley regarding hiring a new soft-
ware developer? Relate your recommendation here to your responses in part a.
f. Track Software paid $5,000 in dividends in 2015. Suppose that an investor ap-
proached Stanley about buying 100% of his firm. If this investor believed that by
owning the company he could extract $5,000 per year in cash from the company
in perpetuity, what do you think the investor would be willing to pay for the firm
if the required return on this investment is 10%?
g. Suppose that you believed that the FCF generated by Track Software in 2015
could continue forever. You are willing to buy the company in order to receive
this perpetual stream of free cash flow. What are you willing to pay if you re-
quire a 10% return on your investment?

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314 PART 3   Valuation of Securities

Personal Finance Problem

LG 2 LG 5 P6–23 Bond valuation and yield to maturity  Mark Goldsmith’s broker has shown him two
bonds. Each has a maturity of 5 years, a par value of $1,000, and a yield to maturity
LG 6 of 12%. Bond A has a coupon interest rate of 6% paid annually. Bond B has a cou-
pon interest rate of 14% paid annually.
a. Calculate the selling price for each of the bonds.
b. Mark has $20,000 to invest. Judging on the basis of the price of the bonds, how
many of either one could Mark purchase if he were to choose it over the other?
(Mark cannot really purchase a fraction of a bond, but for purposes of this ques-
tion, pretend that he can.)
c. Calculate the yearly interest income of each bond on the basis of its coupon rate
and the number of bonds that Mark could buy with his $20,000.
d. Assume that Mark will reinvest the interest payments as they are paid (at the end
of each year) and that his rate of return on the reinvestment is only 10%. For
each bond, calculate the value of the principal payment plus the value of Mark’s
reinvestment account at the end of the 5 years.
e. Why are the two values calculated in part d different? If Mark were worried that
he would earn less than the 12% yield to maturity on the reinvested interest pay-
ments, which of these two bonds would be a better choice?
LG 4 LG 6 P7–23 Integrative: Risk and valuation Hamlin Steel Company wishes to determine the value
of Craft Foundry, a firm that it is considering acquiring for cash. Hamlin wishes to
determine the applicable discount rate to use as an input to the constant-growth
valuation model. Craft’s stock is not publicly traded. After studying the required returns
of firms similar to Craft that are publicly traded, Hamlin believes that an appropriate
risk premium on Craft stock is about 5%. The risk-free rate is currently 9%. Craft’s
dividend per share for each of the past 6 years is shown in the following table.

Year Dividend per share

2015 $3.44
2014 3.28
2013 3.15
2012 2.90
2011 2.75
2010 2.45
 ChAPTER 7   Stock Valuation 355

a. Given that Craft is expected to pay a dividend of $3.68 next year, determine the
maximum cash price that Hamlin should pay for each share of Craft.
b. Describe the effect on the resulting value of Craft of
(1) A decrease in its dividend growth rate of 2% from that exhibited over the
2010–2015 period.
(2) A decrease in its risk premium to 4%.
 ChAPTER 10   Capital Budgeting Techniques 477

Spreadsheet Exercise
The Drillago Company is involved in searching for locations in which to drill for oil.
The firm’s current project requires an initial investment of $15 million and has an
estimated life of 10 years. The expected future cash inflows for the project are as
shown in the following table.

Year Cash inflows

1 $ 600,000
2 1,000,000
3 1,000,000
4 2,000,000
5 3,000,000
6 3,500,000
7 4,000,000
8 6,000,000
9 8,000,000
10 12,000,000

The firm’s current cost of capital is 13%.

TO dO
Create a spreadsheet to answer the following questions.
a. Calculate the project’s net present value (NPV). Is the project acceptable under
the NPV technique? Explain.
b. Calculate the project’s internal rate of return (IRR). Is the project acceptable un-
der the IRR technique? Explain.
c. In this case, did the two methods produce the same results? Generally, is there a
preference between the NPV and IRR techniques? Explain.
d. Calculate the payback period for the project. If the firm usually accepts projects
that have payback periods between 1 and 7 years, is this project acceptable?

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