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 “other operating costs” increased from 1960 to 1961 primarily because of the cost of the barrels used, the occupancy costs and the warehousing costs. This is understandable because Booker Jones decided to increase production which would require 20,000 more barrels. If the cost of barrels is $31.50, then these 20,000 barrels would have cost $630,000. This is precisely why the cost of barrels used went up from 1960 to 1961. If these barrels were not considered an “Other Operating Cost” but instead …show more content…
Jones should capitalize the barrels and put them in inventory. This makes the financial accounting numbers look more palatable because the loss changes to a profit and it is arguably a better reflection of the business’s economics.

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 $462,000 and shareholder’s equity is the common stock plus the retained earnings (1,800,000 + 3,256,000. Therefore, return on equity = 9.14%. This return on equity seems to be pretty decent. For most of the twentieth century, the S&P 500, a measure of the biggest and best public companies in America, averaged ROE's of 10% to 15%. In the 1990's, the average return on equity was in excess of 20%. So by those measures, I suppose the 9% isn’t that great. I’m not sure what their cost of capital is so it is difficult for me to say whether they are earning their cost of capital.

It is suggested that you spend no more than one half your preparation time on Questions one through four.

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?

6) Can you estimate the economic return for the expansion