Question

Lemon Auto Wholesalers had sales of $1,040,000 last year, and cost of goods sold represented 74 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was $11,000 and interest expense for the year was $14,000. The firm’s tax rate is 30 percent.

a. Compute earnings after taxes.

b-1. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to $1,090,200. The extra sales effort will also reduce cost of goods sold to 70 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at $11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to $21,200. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. (Round taxes and earnings after taxes to 1 decimal place.)

b-2. Will her ideas increase or decrease profitability?

Answer 1

a.

Sales = $1,040,000

EBITDA = $1,040,000 × (1 - 74% - 12%)

= $1,040,000 × 14%

= $145,600

EBITDA is $145,600.

Profit after tax = ($145,000 - $11,000 - $14,000) × (1 - 30%)

= $120,000 × 70%

= $84,000

Profit after tax in first case is $84,000.

b-1

Sales = $1,090,200

EBITDA = $1,090,200 × (1 - 70% - 14%)

= $1,090,200 × 16%

= $174,432

EBITDA is $174,432.

Profit after tax = ($174,432 - $11,000 - $21,200) × (1 - 30%)

= $142,232 × 70%

= $99,562.40

Revised Profit after tax is $99,562.40.

b-2

Profitability in first case = $84,000 / $1,040,000

= 8.08%

Profitability in first case is 8.08%.

Profitability in revised screnario = $99,562.40 / $1,090,200

= 9.13%

Profitability in revised scenario is 9.13%.

So, profitability will increase.