Accounting Question

Part1 and 2: Overview

Part I) Complete the following case study for Chem Med by answering the 6 questions at the end of the write-up.

Part II) Complete the following case study for Allison Boone, MD., by answering the questions at the end of the write-up.

Please see attached for the two part assignment.

Part 1: Situation
Dr. Nathan Swan, chairman of the board of directors, chief executive officer, and founder of the Chem-Med Company, sat back in his chair and wondered if he
wouldn’t have been better off staying in his old job of teaching biochemistry at Harvard University. This business, he thought, was getting to be a headache. Just a
short time ago, it seemed, he was able to spend most of his time in the company’s lab comfortably working with test tubes and formulas. Lately, though, all his
waking hours (or so it seemed) were taken up with columns of figures, dollars, and spreadsheets. It was true that he wanted the company to make money and
grow; but he had no idea that the financial end of the business, about which he knew so little, would take up so much of his time.
Dr. Swan was a little mystified by financial matters. How did one describe a company in financial terms anyway? How did one tell if the company was in good or
bad shape? (The amount of cash in the company’s checking account didn’t seem to be a sufficient indicator.) What on earth would one use to convince a bunch
of hard-nosed investors that the company was capable of making a lot of money in the next few years if it just had some more money now? (Dr. Swan was always
puzzled by the fact that Chem-Med was growing and making money, but it never seemed to have enough cash.)
Dr. Swan reflected back over Chem-Med’s origins and the events that led up to today. Chem-Med began operations in 2001 after Dr. Swan completed the
development of commercial-scale isolation of sodium hyaluronate (hereafter referred to as HA), a naturally occurring biological fluid that is useful in eye surgery
and other medical and veterinary uses. The isolation process, complex and proprietary to the company, involves extracting and purifying HA from rooster combs.
Initial seed money for the enterprise came from research grants from Harvard University and the U.S. Department of Agriculture (Food and Drug Administration), plus contributions from Dr. Swan’s colleague and associates, who were now classified as the company’s stock- holders (254 as of April 2016, all closely
held—not traded publicly).
In mid-2009, Chem-Med commenced the manufacture and distribution of its first product, VISCAM, which is used to hold tissues in place during and after surgery
of the retina. In late 2010, Chem-Med received regulatory approval to market another HA product known as VISCHY, which is used for the treatment of
degenerative joint diseases in horses. The two products, VISCHAM and VISCHY, are the only ones Chem-Med currently produces; however, the company has an
active R&D program that is currently investigating other applications.
There are only two other manufacturers of FDA-approved HA products in the world: AB Fortia, a Swedish corporation, which manufactures a product called
Healon in Sweden and distributes it in the United States through a subsidiary, Pharmacia, Inc.; and Cilco, Inc., of Huntington, West Virginia. Chem-Med has about
a 25 percent share of the market (for HA products in eye surgery) against Cilco’s 16 percent and Pharmacia’s 59 percent. Pharmacia, with the power of giant AB
Fortia behind it, waged a continuing marketing war with Chem-Med, undercutting Chem-Med’s prices and wooing its costumers away at every opportunity. The
matter came to a head in September, when Chem-Med filed a $13 million suit against Pharmacia, charging unfair trade practices. Dr. Swan was reasonably
confident that Chem-Med would prevail in the suit, and, in fact, Pharmacia had recently offered to settle out of court for $500,000.
Dr. Swan’s primary problem, he said, was that, although he was convinced the company was sound and would grow, he wasn’t sure how to communicate that to
potential investors in the financial community in a way that would convince them. Just handing out past income statements and balance sheets that he received
from the accountants didn’t seem to be enough. Further, he wasn’t even sure the company needed outside financing, let alone how much. He just felt that they
would need it, since they had always had to ask for money in the past.
Figure 1
CHEM-MED COMPANY, Income Statements
2013—2015 (in 000s)
Pro Forma Income Statements
Years
2013
2014
2015
2016
2017
2018
Net sales (all credit)
$777
$3,051
$3,814
$5,340
$7,475
$10,466
Cost of goods sold
257
995
1,040
1,716
2,154
3,054
Gross profit
520
2,056
2,774
3,624
5,321
7,412
Selling, etc., expenses
610
705
964
1,520
2,120
2,645
Other inc (exps)*
0
0
0
500
0
0
Operating profit
(90
1,351
1,810
2,604
3,201
4,767
Interest expense
11
75
94
202
302
434
Income before tax
(101
1,276
1,716
2,402
2,899
4,333
0
510
566
793
957
1,430
($101)
$ 766
$1,150
$1,609
$1,943
$ 2,903
0
0
0
0
0
0
Increase in retained earnings
($101
$ 766
$1,150
$1,609
$1,943
$2,903
Average number of shares**
2,326
2,326
2,347
2,347
2,347
2,347
Earnings per share
($0.04
$ 0.33
$0.49
$ 0.69
$ 0.83
$
Income taxes (40% in 1986; 33%
thereafter)
Net income
Dividends paid
Other Inc (Exps) refers to extraordinary gains and losses. In 2016, $500,000 is expected from Pharmacia, Inc., in settlement of their suit.
** Shares are not publicly traded.
1.24
Figure 2
CHEM-MED COMPANY Balance Sheets
Pro Forma Balance Sheets
As of Dec. 31, years ended:
As of Dec. 31, years ended:
2013
2014
2015
2016
2017
2018
Cash and equivalents
$124
$103
$167
$205
$422
$101
Accounts receivable.
100
409
564
907
1,495
2,351
Inventories
151
302
960
1,102
1,443
798
Assets:
Other current
Total current assets
Property, plant, and
equipment
Less: accumulated
depreciation
Property, plant, and
equipment, net
Other fixed assets
Total assets
28
59
29
41
57
11
403
873
1,720
2,255
3,417
3,261
1,901
2,298
2,917
4,301
5,531
8,923
81
82
346
413
522
588
1,820
2,216
2,571
3,888
5,009
8,335
0
101
200
200
215
399
$2,223
$3,190
$4,491
$6,343
$8,641
$11,995
210
$405
$551
$771
$1,080
$1,512
Liabilities:
Accounts payable
Short-term debt
35
39
42
59
82
135
245
444
593
830
1,162
1,647
17
19
21
27
50
17
262
463
614
857
1,212
1,664
Common stock
2,062
2,062
2,062
2,062
2,062
2,062
Retained earnings
(101
665
1,815
3,424
5,366
8,269
Total current liabilities
Long-term debt
Total liabilities
Equity:
Total equity
Total liabilities and equity
1,961
2,727
3,877
5,486
7,428
10,331
$2,223
$3,190
$4,491
$6,343
$8,641
$11,995
Dr. Swan had lunch with his banker just recently, and the banker mentioned several restrictive covenants that the company would have to meet if it came to the
bank for financing. Dr. Swan pulled a sheet of paper from his desk drawer and glanced at it. There were three covenants listed:
•
•
•
The current ratio must be maintained above 2.25 to 1.
The debt-to-assets ratio must be less than .3 to 1.
Dividends cannot be paid unless earnings are positive.
Dr. Swan didn’t think he would have any trouble with those, but he wasn’t sure. Then he suddenly remembered he was supposed to meet a representative from
one of the local supermarket chains (who supplied Chem-Med with rooster combs) in five minutes. He hurriedly put his papers away and wished he had more
time to analyze the numbers before the next board of directors meeting. (The financial information is presented in Figures 1, 2, and 3.)
Figure 3
Biotechnology Industry Statistics
Median Company in SIC 2831
Biological Products*
2013
2014
2015
Current ratio
2.5
2.3
2.4
Quick ratio
1.2
1.1
1.3
Inventory turnover
5.5
5.6
5.7
Total asset turnover
1.15
1.16
1.18
Return on sales
4.00%
4.00%
5.00%
Return on assets
4.60%
4.64$
5.90%
Return on equity
7.64%
8.44%
12.29%
Total debt to assets
0.4
0.45
0.52
Selected Statistics Pharmacia Company
2013
2014
2015
Current ratio
2.8
2.7
2.8
Quick ratio
1.5
1.3
1.6
Inventory turnover
5.6
5.7
5.8
Total asset turnover
1.9
2
1.9
Return on sales
6.00%
6.50%
7.00%
Return on assets
11.40%
13.00%
13.30%
Return on equity
19.04%
27.66%
29.56%
Total debt to assets
0.4
0.53
0.55
Price-earnings ratio
13.7
14
15
Average stock price
$21.78
$24.92
$31.50
Source: Dun’s Industry Ratios. The data have been adjusted for this case.
Part 1: Questions
You are an investor who is considering adding Chem-Med to your portfolio. As such, you are interested in the company’s record of profitability, prospects
for the future, degree of risk, and how it compares with others in the industry. From that point of view, answer the following questions:
Complete the following questions based on the information above:
1. What was Chem-Med’s rate of sales growth in 2015? What is it forecasted to be in 2016, 2017, and 2018?
2. What was Chem-Med’s net income growth in 2015? What is it forecasted to be in 2016, 2017, and 2018? Is projected net income growing
faster or slower than projected sales? After computing these values, take a hard look at the 2016 income statement data to see if you want to
make any adjustments.
3. How does Chem-Med’s current ratio for 2015 compare to Pharmacia’s? How does it compare to the industry average? Compute Chem-Med’s
current ratio for 2018. Is there any problem with it?
4. What is Chem-Med’s total debt-to-assets ratio for 2015, 2016, 2017, 2018? Is any trend evident in the four-year period? Does Chem-Med in
2015 have more or less debt than the average company in the industry?
5. What is Chem-Med’s average accounts receivable collection period for 2015, 2016, 2017, 2018? Is the period getting longer or shorter? What
are the consequences?
6. How does Chem-Med’s return-on-equity ratio (ROE) compare to Pharmacia’s and the industry for 2015? Using the Du Pont method, compare
the positions of Chem-Med and Pharmacia. Compute ROE for each company using the following formula:
ROE = Profit margin × Asset turnover/(1—Debt to assets)
Compare the results to determine the sources of ROE for each company.
Part 2: Situation
Allison Boone had been practicing medicine for seven years. Her specialty was neurology. She had received her bachelor’s degree in chemistry from Kent
State University and her M.D. from Washington University in St. Louis. She did her residency at Columbia Presbyterian Hospital in New York. Allison
practiced neurology in a clinic with three other doctors in Hurst, Texas.
Her husband, Samuel L. Boone, held an administrative position for Harris Methodist HMO in Arlington, Texas. Allison and Samuel had been married for five
years and were parents of young twin sons, Todd and Trey. They lived in Arlington in a beautiful four-room house overlooking Lake Arlington.
Allison normally left for work at 7:30 a.m. and closed her office at 5:30 p.m. to return home. On Tuesday, March 6th, 2016 at 5:15 p.m., she received an
emergency call from Arlington General Hospital and immediately went to the hospital to help a patient who had suffered serious brain damage. By the time
she had administered aid and helped prepare the patient for surgery it was 11:00 p.m.
On her way home as she passed the Ballpark in Arlington (home of the Texas Rangers baseball team), she was confronted head on by a drunken driver going
over 80 miles an hour. A crash was inevitable and Allison and the other driver were killed instantly. The drunken driver was making a late delivery for
Wayland Frozen Foods, Inc.
Legal Considerations
The families of both drivers were devastated by the news of the accident. After the funeral and explaining the situation to the children, Samuel Boone knew
he must seek legal redress for his family’s enormous loss. Following interviews with a number of lawyers, he decided to hire Sloan Whitaker.
Sloan was with a Dallas law firm (Hanson, Sloan, and Thomason) that specialized in plaintiff’s lawsuits. He had been in practice for over 20 years since
graduating from Southern Methodist University (SMU) law school in 1996.
When Sloan began his investigation on behalf of Samuel Boone and his family, he was surprised to find out the driver of the delivery vehicle had a prior
record of alcohol abuse and that Wayland Frozen Foods, Inc. had knowledge of the problem when they hired him. It appears the driver was a relative of the
owner and at the time of employment he revealed what he termed “a past alcoholic problem that was now under control.” In any event, he was acting as an
employee for Wayland Frozen Foods in using their truck to make a business related delivery at the time of the accident. The fact that he was speeding and
intoxicated at the time of the impact only increased the legal exposure for Wayland Frozen Foods.
After much negotiating with the law firm that represented Wayland Frozen Foods (and its insurance company), Sloan Whitaker received three proposals for
an out-of-court settlement to be paid to Allison Boone’s family. The intent of the proposals was to replace the future earning’s power of Allison Boone, less
any of the earnings she would have personally needed for her normal living requirements. Also, the value that she provided for her family as a wife and
mother, quite aside from her earning power, had to be considered. Finally, there was the issue of punitive damages that Wayland Frozen Foods was exposed
to as a result of letting an unqualified driver operate its truck. If the case went to court, there was no telling how much a jury might assign to this last
factor. The three proposals are listed below. An actuarial table indicated that Allison, age 37 at the time of the accident, had an anticipated life expectancy
of 40 more years.
Proposal 1
Pay the family of Allison Boone $300,000 a year for the next 20 years, and $500,000 a year for the remaining 20 years.
Proposal 2
Pay the family a lump sum payment of $5 million today.
Proposal 3
Pay the family of Allison Boone a relatively small amount of $50,000 a year for the next 40 years, but also guarantee them a final payment
of $75 million at the end of 40 years.
In order to analyze the present value of these three proposals, attorney Sloan Whitaker called on a financial expert to do the analysis. You will aid in the
process.
Part 2: Questions
1. Assume a discount rate of 6 percent is used, which of the three projects has the highest present value?
In analyzing the first proposal, take the present value of the 20-year $300,000 annuity. Then take the present value of the deferred annuity of $500,000
that will run from the 21st through the 40th year. The answer you get for the second annuity will represent the value at the beginning of the 21st year (the
same as the end of the 20th year). You will need to discount this lump sum value back for 20 years as a single amount to get its present value. You then add
together the present value of the first and second annuity.
The second and third proposals are straight forward and require no further explanation.
2. Now assume that a discount rate of 11 percent is used instead of 6 percent. Which of the three alternatives provides the highest present value?
3. Explain why the change in outcome takes place between question 1 and question 2.
4. If Sloan Whitaker thinks additional punitive damages are likely to be $4 million in a jury trial, should he be more likely to settle out-of-court or go
before the jury?