### 1. i.The balance sheet at the end of

1.

Calculate the effect on the financial statements in Tables 1 and 2 if the accounting system were changed to incorporate the cost of barrels ($31. 50 each) into the inventory accounts. a. What would pretax profit be in 1961? Booker Jones increased production by 20,000 barrels. If the cost of barrels is $31.

50, then these 20,000 barrels would cost $630,000. This will be added to inventory account and hence will generate pretax profit of $630,000 – 407,000 = $223,000. b. If the change were made retroactively as of July 1, 1959 (by adding the cost of barrels to all whiskey in inventory), what would be the effect on i.The balance sheet at the end of 1960? Compared to 1959, balance sheet in 1960 will include the cost of barrels in inventory accounts. As of June 30, 1960 the number of gallons of whisky was 4,506,000 / $0. 52 = 8,665,484.

62 gallons. Add $31. 5 / 50 gal/bbl = $0. 63 to the $0. 52 cost to get bulk whiskey inventory of 8,665,484. 62 * $1. 15 = $9,965,192.

31. Next, we would have to gross up the value of Bottled and Cased Whiskey by the costs of aging barrels. For this account, there are only 35 gallons / bbl (due to evaporation), so the cost increase would be $31. / 35 = $0.

90. Applying this increase gives $1,969,000 / $11. 20 * (11. 20 + 0. 90) = $2,127,223. 21.

Total change in whiskey inventories would be 9,965,192. 31 – 4,506,000. 00 = $5,459,192.

31 for bulk whiskey and $158,223. 21 for a grand total incrase in inventories of $5,617,415. 52. Since this asset class would go up with no corresponding increase in liabilities, Shareholder’s Equity would increase by the same amount. ii. The balance sheet at the end of 1961? Following the same logic as (i. ) above, bulk whiskey would become 5,030,000 / .

52 * 1. 5 = $11,124,038. 46 and finished whiskey would become 1,969,000 / 11. 20 * 12.

10 = $2,127,223. 21. This leads to a grand total increase in inventories of $6,252,261. 67, and an identical increase in Shareholder’s Equity. iii. The operating statement for 1960? Operating statement will exclude cost of barrels (a $1,354,000 expense). However, COGS will increase by the cost of barrels used to produce whiskey sold in 1960 (also $1,354,000).

The bottom line for 1960 will not change, but this is a coincidence due to production volume and sales volume being equivalent. . Do you believe that Jones went from a profit in 1960 to a loss for 1961, despite the fact that sales were the same and production increased? No.

We have already seen in 1) that when barrels are treated as inventory, Jones end up with a profit of $223,000. Warehousing costs can be also treated as investment in inventories (economically). Therefore, economic profit will be even higher. 3. What method of accounting would you recommend that Jones use in preparing the annual financial statements for submission to Ridgeview Bank and the family shareholders?If legal, Jones should treat the cost of aging barrels as direct production costs and put them into inventory.

This change makes more economic sense and results in reporting profit, rather than loss in 1961. 4. Based on the accounting method you think best approximates “economic reality,” calculate the Return on Equity for the business for 1960. How are they doing? Are they earning their cost of capital? Return on Equity = Net Income / Shareholder’s Equity.

Net income in 1960 is $752,000 and shareholder’s equity is the common stock plus the retained earnings (1,800,000 + 3,256,000.Therefore, return on equity = 14. 87%. With their Long-Term notes at 5. 5%, the rest of their liabilities would need to have an average interest rate above about 28.

5% in order to drive their cost of capital above their ROE. This seems unlikely; therefore it appears that Booker Jones is beating its cost of capital in 1960. 5. Can you estimate the cash flows for the business for 1961? What about for the 3 year period, 1962, 1963, 1964, combined? (Assume Jones does not change its tax accounting method. ) Now, so what? Cash Flow Statement: Operating ActivitiesNet Income-407 Depreciation1394 Change in Receivables-404 Change in Bulk Whisky-524 Change in Bottled Whisky0 Change in Barrels-630 Change in Payables-441 Change in Other Current Liabilities-496 Change in Short-term Notes400 Investing Activities Increase in PPE-147 Financing Activities Increase in Long-term liabilities853 Increase in S/H equity-1407 Cash Beginning of Year1274 Cash at End of Year316 Change in Cash958 We don’t have information about years 1962, 1963, 1964.

We know though that there will be additional sales in 1964 after 1960’s whisky ages. 6.Can you estimate the economic return for the expansion decision? Economic return for the expansion decision is equal to discounted profit in 4 years due to sale of extra whisky produced divided by amount invested today.

Assuming the cost of capital of 6% and that cost are proportional to number of barrels, discounted profit is 1. 06-4 * 20,000/43,000 * ($21,000 – $15,802 – $229 – $987 – $564) = $1,260. I assumed that price does not change in 4 years and Jones will spend money on taxes, bottling, selling and advertising, and administrative & general expenses at the time of sale.Cost of investment as of today is $2,036 – $1,144 = $892.

The economic return is then $1260 / $892 = 40%. 7. Is the loan to expand production “bankable? ” That is, do you believe Ridgeview Bank should be willing to lend Booker Jones the money they need now to complete the four year inventory buildup? Yes. First of all, if barrels are treated as inventories, profit today is positive.

So is expected profit in years 2, 3, 4. In year 4, profit is expected to rise substantially. Second, we have seen in 6) that economic profit is substantial.

. What recommendations do you have for Mr. Jones regarding the business problems he faces (product positioning; production expansion; capital structure; working capital management; etc. )? Jones’ decision to expand is economically justified.

Sales seem to be solid and prospects due to investment are good. Upon clearly conveying his position to the bank, he should not have problems in obtaining financing. I would recommend Mr. Jones to maintain his course and continuing doing a profitable business.

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