Question

(Comparison of Alternative Forms of Financing) Shown below is the liabilities and stockholders’ equity section of the balance sheet for Jana Kingston Company and Mary Ann Benson Company. Each has assets totaling \(4,200,000.

Jana Kingston Co.
Current liabilities	\) 300,000
Long-term debt, 10%	1,200,000
Common stock (\(20 par)	2,000,000
Retained earnings (Cash dividends, \)328,000)	700,000
	\(4,200,000

Mary Ann Benson Co.
Current liabilities	\) 600,000
Common stock (\(20 par)	2,900,000
Retained earnings (Cash dividends, \)328,000)	700,000
	\(4,200,000

For the year, each company has earned the same income before interest and taxes.

	Jana Kingston Co.	Mary Ann Benson Co.
Income before interest and taxes	\)1,200,000	\(1,200,000
Interest expense	120,000	0
	1,080,000	1,200,000
Income taxes (45%	486,000	540,000
Net income	\) 594,000	\( 660,000

At year end, the market price of Kingston’s stock was \)101 per share, and Benson’s was $63.50.

Instructions

1. Which company is more profitable in terms of return on total assets?
2. Which company is more profitable in terms of return on common stockholders’ equity?
3. Which company has the greater net income per share of stock? Neither company issued or reacquired shares during the year.
4. From the point of view of net income, is it advantageous to the stockholders of Jana Kingston Co. to have the long-term debt outstanding? Why?
5. What is the book value per share for each company?

Short answer

Mary Ann Benson Company is more profitable in terms of return on total assets, while Jana Kingston Company is more profitable in terms of return on common stock equity.

Step-by-step solution

Meaning of Stockholders’ Equity

Shareholder equity is the value that a company has left after liquidating all assets and paying off all outstanding obligations. In the balance sheet, shareholder equity is divided into three categories (a) Common shares, (b) Preferred shares, and (c) Retained Earnings

Explaining which company is more profitable in terms of return on total assets.

Mary Ann Benson Company is more profitablein terms of return on total assets.

Calculation of Return of Total Assets of Mary Ann Benson Company

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{of}\mathbf{}\mathbf{Total}\mathbf{}\mathbf{Assets}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Total}\mathbf{}\mathbf{Asset}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{15}\mathbf{.}\mathbf{71}\mathbf{\%}\end{array}$

Calculation of Return of Total Assets of Jana Kingston Company

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{on}\mathbf{}\mathbf{Total}\mathbf{}\mathbf{Asset}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Total}\mathbf{}\mathbf{Asset}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{594}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{14}\mathbf{.}\mathbf{14}\mathbf{\%}\end{array}$

It should be noted that these returns are based on net income related to total assets, where the ending amount of total assets is considered representative. If the return on total assets uses net income before interest, but after taxes in the numerator, the rates of return on total assets are the same as shown below:

$\begin{array}{rcl}\mathbf{Mary}\mathbf{}\mathbf{Ann}\mathbf{}\mathbf{Bension}\mathbf{}\mathbf{Company}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Total}\mathbf{}\mathbf{Assets}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{15}\mathbf{.}\mathbf{71}\mathbf{\%}\end{array}$

$\begin{array}{rcl}\mathbf{Jana}\mathbf{}\mathbf{Kingston}\mathbf{}\mathbf{company}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}\mathbf{+}\mathbf{Interest}\mathbf{}\mathbf{Expense}\mathbf{-}\mathbf{Taxes}}{\mathbf{Total}\mathbf{}\mathbf{Asset}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{594}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{120}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{54}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{15}\mathbf{.}\mathbf{71}\mathbf{\%}\\ & & \end{array}$

Explaining which company is more profitable in terms of return on common stockholders’ equity?

Jana Kingston Company is more profitablein terms of return on common stock equity. This may be shown as follows:

Calculation of Return on Common Stock Stockholders’ Equity of Jana Kingston Company

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{on}\mathbf{}\mathbf{Common}\mathbf{}\mathbf{Stock}\mathbf{}\mathbf{Equity}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Common}\mathbf{}\mathbf{Stock}\mathbf{+}\mathbf{Retained}\mathbf{}\mathbf{Earnings}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{594}\mathbf{,}\mathbf{000}}{\mathbf{2}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{700}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{594}\mathbf{,}\mathbf{000}}{\mathbf{2}\mathbf{,}\mathbf{700}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{22}\mathbf{\%}\end{array}$

Calculation of Return on Common Stock Stockholders’ Equity of Mary Ann Benson Company

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{on}\mathbf{}\mathbf{common}\mathbf{}\mathbf{Stock}\mathbf{}\mathbf{Equity}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Common}\mathbf{}\mathbf{stock}\mathbf{+}\mathbf{Retained}\mathbf{}\mathbf{Earnings}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{2}\mathbf{,}\mathbf{900}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{700}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{3}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{18}\mathbf{.}\mathbf{33}\mathbf{\%}\end{array}$

Note: Explaining why the difference in return on assets and return on common stock equity occurs.

Kingston company
Funds Supplied	Funds Supplied	Rate of Return on Funds at 15.71%	Cost of Funds	Accruing to common stock
Current Liabilities	$ 300,000	$ 47,130	$ 0	$ 47,130
Long-term debt	1,200,000	188,520	66,000	122,520
Common Stock	2,000,000	314,200	0	314,200
Retained Earnings	700,000	109,970	0	109,970
	$4,200,000	$659,820	$66,000	$593,820

Determined in Step 2:15.71%

The cost funds are the interest of $120,000.This cost must be reduced by the tax saving (45%) related to the interest.

The schedule indicates that the income earned on the total assets (before interest cost) was $659,820.This income's interest cost (net of tax) was $66,000, which indicates a net return to the common equity of $593,820.

Explaining the company that has the greater net income per share of stock

The Jana Kingston Company earned a net income per share, that is:

$\begin{array}{rcl}\mathbf{Net}\mathbf{}\mathbf{income}\mathbf{}\mathbf{per}\mathbf{}\mathbf{share}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Share}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{594}\mathbf{,}\mathbf{000}}{\mathbf{100}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{.}\mathbf{94}\end{array}$

While the Benson Company’s net income per share is

$\begin{array}{rcl}\mathbf{Net}\mathbf{}\mathbf{Income}\mathbf{}\mathbf{per}\mathbf{}\mathbf{share}\mathbf{}\mathbf{of}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Share}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{660}\mathbf{,}\mathbf{000}}{\mathbf{145}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{4}\mathbf{.}\mathbf{55}\end{array}$

The Kingston Company has borrowed a substantial portion of its assets at the cost of 10% and has used these assets to represent additional income for the stockholders. This has resulted in a higher income per share. Due to the debt financing, Kingston has fewer shares of stock outstanding.

Explaining whether it is advantageous to the stockholders of Jana Kingston Co. to have the long-term debt outstanding.

Yes, from the point of view of income, it is advantageous for the stockholders of the Kingston Company to have long-term debt outstanding. These assets obtained from the incurrence of this debt are earning a higher return than the cost of the Kingston Company.

Determining book value per share of the company

Book Value per Share of Jana Kingston Company

$\begin{array}{rcl}\mathbf{Book}\mathbf{}\mathbf{value}\mathbf{}\mathbf{per}\mathbf{}\mathbf{share}& \mathbf{=}& \frac{\mathbf{Common}\mathbf{}\mathbf{stock}\mathbf{+}\mathbf{Retained}}{\mathbf{100}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{700}\mathbf{,}\mathbf{000}}{\mathbf{100}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{27}\mathbf{.}\mathbf{00}\end{array}$

Book Value per Share of Marry Ann Benson Company

$\begin{array}{rcl}\mathbf{Book}\mathbf{}\mathbf{valueper}\mathbf{}\mathbf{share}& \mathbf{=}& \frac{\mathbf{Common}\mathbf{}\mathbf{stock}\mathbf{+}\mathbf{Retained}}{\mathbf{145}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{900}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{700}\mathbf{,}\mathbf{000}}{\mathbf{145}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{24}\mathbf{.}\mathbf{83}\end{array}$