3 CHAPTER Financial Statements, Cash Flows, and Taxes
(Difficulty: E = Easy, M = Medium, and T = Tough)
True-False Easy:
Annual report 1. Answer: a Diff: E
The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of retained earnings. a. True b. False
Annual report and expectations 2.
Answer: a
Diff: E
The key importance of annual report information is that it is used by investors when they form their expectations about the firm's future earnings and dividends and the riskiness of those cash flows. a. True b. False
Financial statements 3.
Answer: b
Diff: E
The balance sheet is a financial statement measuring the flow of funds into and out of various accounts over time while the income statement measures the progress of the firm at a point in time. a. True b. False
Balance sheet 4.
Answer: b
Diff: E
On the balance sheet, total assets must always equal total liabilities. The amount remaining is what is used to finance the firm and includes equity and long-term debt. a. True b. False
Income statement 5.
Answer: a
Diff: E
The income statement measures the flow of funds into (i.e., revenue) and out of (i.e., expenses) the firm over a certain time period. It is always based on accounting data. a. True b. False Chapter 3 Page 1
Non-cash assets 6.
Answer: a
Diff: E
Non-cash assets are expected to produce cash over time but the amount of cash they eventually produce could be higher or lower than the values at which the assets are carried on the books. a. True b. False
Interest income 7.
Answer: b
Diff: E
The fact that a percentage of the interest income received by a corporation is excluded from taxable income has encouraged firms to use more debt financing relative to equity financing. a. True b. False
Interest expense 8.
Answer: b
Diff: E
If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant. a. True b. False
Interest expense and dividends 9.
Answer: b
Diff: E
Interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability. a. True b. False
Net operating working capital 10.
Answer: a
Diff: E
Net operating working capital is equal to the operating current assets minus the operating current liabilities. a. True b. False
Total net operating capital 11.
Answer: b
Diff: E
Total net operating capital is equal to net fixed assets. a. True b. False
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Net operating profit after taxes (NOPAT) 12.
Answer: a
Diff: E
Net operating profit after taxes (NOPAT) is the amount of profit a company would have from its operations if it had no interest income or interest expense. a. True b. False
Medium:
Interest expense and dividends 13. Answer: a Diff: M
Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False
Retained earnings 14.
Answer: b
Diff: M
Retained earnings is the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and thus, these cash accounts, when added together, will always be equal to the total retained earnings of the firm. a. True b. False
Retained earnings 15.
Answer: a
Diff: M
The retained earnings account on the balance sheet does not represent cash and in fact, represents a claim against the existing assets of the firm. This implies that retained earnings are in fact the reinvested earnings of stockholders. a. True b. False
Time dimension 16.
Answer: b
Diff: M
The time dimension is important in financial statement analysis. While the balance sheet and income statements represent the firm's financial position at a point in time, the statement of cash flows reports changes that were made to the firm's accounts over a period of time. a. True b. False
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Future cash flows 17.
Answer: b
Diff: M
Current cash flow from existing assets is highly relevant to the investor. However, the value of the firm depends primarily upon its growth opportunities. As a result, profit projections from those opportunities are the only relevant future flows with which investors are concerned. a. True b. False
Cash flow 18.
Answer: a
Diff: M
In order to accurately estimate cash flow from operations, depreciation must be added back to net income. The reason for this is that even though depreciation is deducted from revenue it is really a non-cash charge. a. True b. False
Cash flow and net income 19.
Answer: b
Diff: M
In accounting, emphasis is placed on determining net income. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary consideration is cash flow because that's what is used to run the business. a. True b. False
Multiple Choice: Conceptual Easy:
Net cash flow 20. Answer: e Diff: E
Last year Aldrin Co. had negative net cash flow, yet its cash on the balance sheet increased. What could explain these events? a. b. c. d. e. Aldrin issued long-term debt. Aldrin repurchased some of its common stock. Aldrin sold some of its assets. Statements a and b are correct. Statements a and c are correct.
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Net cash flow 21.
Answer: d
Diff: E
Last year, Blanda Brothers had positive net cash flow, yet cash on the balance sheet decreased. Which of the following could explain the company's financial performance? a. b. c. d. e. The The The The The company company company company company issued new common stock. issued new long-term debt. sold off some of its assets. purchased a lot of new fixed assets. eliminated its dividend. Answer: b Diff: E
Net cash flow and net income 22.
Holmes Aircraft recently announced an increase in its net income, yet its net cash flow declined relative to last year. Which of the following could explain this performance? a. b. c. d. e. The company's interest expense increased. The company's depreciation expense declined. The company's operating income declined. All of the statements above are correct. None of the statements above is correct.
Net cash flow and net income 23.
Answer: a
Diff: E
Kramer Corporation recently announced that its net income was lower than last year. However, analysts estimate that the company's net cash flow increased. What factors could explain this discrepancy? a. b. c. d. e. The company's depreciation expense increased. The company's interest expense declined. The company had an increase in its noncash revenues. Answers a and b are correct. Answers b and c are correct. Answer: b Diff: E
EVA, cash flow, and net income 24. Which of the following statements is most correct?
a. Actions which increase net income will always increase net cash flow. b. One way to increase EVA is to maintain the same operating income with less capital. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. Answers a and b are correct. e. Answers a and c are correct.
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Taxes and financing 25. Which of the following statements is most correct?
Answer: e
Diff: E
a. Indexing tax brackets reduces the extent of "bracket creep." b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light. c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities. d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations. e. All of the statements above are true. Taxes 26. Which of the following statements is most correct? a. Corporations are allowed to exclude 70 percent of their interest income from corporate taxes. b. Corporations are allowed to exclude 70 percent of their dividend income from corporate taxes. c. Individuals pay taxes on only 30 percent of the income realized from municipal bonds. d. Answers a and b are correct. e. None of the answers above is correct. Taxes 27. Which of the following statements is most correct? a. 70 percent of a corporation's interest income is excluded from corporate income taxes. b. 70 percent of a corporation's dividend income is excluded from corporate income taxes. c. A municipal bond will generally trade at a higher yield than a corporate bond of equal risk. d. All of the answers above are correct. e. Answers b and c are correct. Carry back, carry forward 28. A loss incurred by a corporation a. Must be carried forward unless the company has had 2 loss years in a row. b. Can be carried back 2 years, then carried forward up to 20 years following the loss. c. Can be carried back 5 years and forward 3 years. d. Cannot be used to reduce taxes in other years except with special permission from the IRS. e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm. Chapter 3 - Page 6 Answer: b Diff: E Answer: b Diff: E Answer: b Diff: E
Balance sheet 29.
Answer: c
Diff: E
On its 1999 balance sheet, Sherman Books showed a balance of retained earnings equal to $510 million. On its 2000 balance sheet, the balance of retained earnings was also equal to $510 million. Which of the following statements is most correct? a. The company must have had net income equal to zero in 2000. b. The company did not pay a dividend in 2000. c. If the company's net income in 2000 was $200 million, dividends paid must have also equaled $200 million. d. If the company lost money in 2000, they must have paid a dividend. e. None of the statements above is correct.
Net operating working capital 30.
Answer: c
Diff: E
Which of the following would not cause an increase in net operating working capital? a. b. c. d. e. Inventory increases. Accounts receivable increases. Short-term investments increase. Accounts payables decrease. Accruals decrease. Answer: d Diff: E
Net operating profit after taxes (NOPAT) 31.
Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which of the following definitely cannot help explain this decline? a. b. c. d. e. Sales revenues decreased. Costs of goods sold increased. Depreciation increased. Interest expense increased. Taxes increased. Answer: a Diff: E
Free cash flow 32. Which of the following best describes free cash flow?
a. Free cash flow is the amount of cash flow available for distribution to all investors after all necessary investments in operating capital have been made. b. Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary investments in operating capital have been made. c. Free cash flow is the net change in the cash account on the balance sheet. d. Free cash flow is equal to net income plus depreciation. e. Free cash flow is equal to the cash flow from non-taxable transactions.
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Miscellaneous concepts 33. Which of the following statements is most correct?
Answer: c
Diff: E
a. Retained earnings, as reported on the balance sheet, represents the amount of cash a company has available to pay out as dividends to shareholders. b. 70 percent of the interest received by corporations is excluded from taxable income. c. 70 percent of the dividends received by corporations is excluded from taxable income. d. None of the answers above is correct. e. Answers a and c are correct.
Medium:
Financial statements 34. Which of the following statements is most correct? a. Cash flows and accounting profit are not at all related since no common elements are used in the calculation of either individual measure. b. Accounting profits are more important than free cash flow. c. High inflation can seriously distort firms' balance sheets, and since inflation also affects depreciation and inventory costs, profits can also be affected. d. When an action is taken at one point in time, but its full effects cannot be accurately measured until later, this has the potential to affect the firm's financial statements. However, as long as the firm keeps the same standard accounting period this timing problem can be avoided. e. None of the statements above is correct. After-tax returns 35. Answer: b Diff: M Answer: c Diff: M
Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2) invest the same funds in the preferred stock of Florida Power & Light (FPL), which should provide Allen with a before-tax return of 9 percent, all in the form of dividends. Assume that Allen's marginal tax rate is 25 percent, and that 70 percent of dividends received are excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximize Allen's effective return on the money invested? a. b. c. d. e. All All 60% 60% 50% in in in in in the plant project. FPL preferred stock. the project; 40% in FPL. FPL; 40% in the project. each.
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Changes in depreciation 36.
Answer: c
Diff: M
Which of the following are likely to occur if Congress passes legislation which forces Carter Manufacturing to depreciate their equipment over a longer time period: a. b. c. d. e. The company's physical stock of assets would increase. The company's reported net income would decline. The company's cash position would decline. All of the answers above are correct. Answers b and c are correct. Answer: d Diff: M
Changes in depreciation 37.
Assume that a company currently depreciates its fixed assets over 7 years. Which of the following would occur if a tax law change forced the company to depreciate its fixed assets over 10 years instead? a. b. c. d. e. The company's The company's The company's Answers a and Answers b and tax payment would increase. cash position would increase. net income would increase. c are correct. c are correct. Answer: d Diff: M
Changes in depreciation 38.
Solo Company has been depreciating its fixed assets over 15 years. It is now clear that these assets will only last a total of 10 years. Solo's accountants have encouraged the firm to revise its annual depreciation to reflect this new information. Which of the following would occur as a result of this change? a. b. c. d. e. The company's earnings per share would decrease. The company's cash position would increase. The company's EBIT would increase. Both a and b are correct. All of the answers above are correct. Answer: d Diff: M
Changes in depreciation 39.
A start-up firm is making an initial investment in new plant and equipment. Currently equipment is depreciated on a straight line basis over 10 years. Assume that Congress is considering legislation which will allow the corporation to depreciate the equipment over 7 years. If the legislation becomes law, and the firm implements the 7-year depreciation basis, which of the following will occur? a. b. c. d. e. The The The The The firm's firm's firm's firm's firm's tax payments will increase. net income will increase. taxable income will increase. net cash flow will increase. operating income (EBIT) will increase.
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Effects of changes in financial leverage 40.
Answer: a
Diff: M
The CFO of Mulroney Brothers has suggested that the company should issue $300 million worth of common stock and use the proceeds to reduce some of the company's outstanding debt. Assume that the company adopts this policy, and that total assets and operating income (EBIT) remain the same. The company's tax rate will also remain the same. Which of the following will occur: a. b. c. d. e. The company's net income will increase. The company's taxable income will fall. The company will pay less in taxes. All of the answers above are correct. Answers b and c are correct.
Multiple Choice: Problems Easy:
EVA 41. Answer: a Diff: E Scranton Shipyards has $20 million in total net operating capital. The company's WACC is 10 percent. The company has the following income statement: Sales Operating costs Operating income (EBIT) Interest expense Earnings before taxes (EBT) Taxes (40%) Net income What is Scranton's EVA? a. $ 400,000 b. -$ 800,000 c. $1,200,000 d. $2,000,000 e. $4,000,000 $10.0 6.0 $ 4.0 2.0 $ 2.0 0.8 $ 1.2 million million million million million million million
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Corporate taxes 42. Your corporation has the following cash flows: Operating income Interest received Interest paid Dividends received Dividends paid $250,000 10,000 45,000 20,000 50,000
Answer: b
Diff: E
If the applicable income tax rate is 40 percent (federal and state combined), and if 70 percent of dividends received are exempt from taxes, what is the corporation's tax liability? a. b. c. d. e. $ 74,000 $ 88,400 $ 91,600 $100,000 $106,500 Answer: b Diff: E
After-tax returns 43.
A corporation with a marginal tax rate of 35 percent would receive what after-tax dividend yield on a 12 percent coupon rate preferred stock bought at par, assuming a 70 percent dividend exclusion? a. 11.03% b. 10.74% c. 6.48% d. 7.31% e. 5.52%
After-tax returns 44.
Answer: b
Diff: E
Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6 percent, and Carter's marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would make Carter's treasurer indifferent between the two? a. b. c. d. e. 2.40% 3.60% 4.50% 5.25% 6.00%
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After-tax returns 45.
Answer: c
Diff: E
A corporation can earn 7.5 percent if it invests in municipal bonds. The corporation can also earn 8.5 percent (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate which makes the corporation indifferent between the two investments? a. b. c. d. e. 17.65% 24.88% 39.22% 44.15% 49.33% Answer: a Diff: E
After-tax returns 46.
A 5-year corporate bond yields 9 percent. A 5-year municipal bond of equal risk yields 6.5 percent. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds? a. b. c. d. e. 27.78% 38.46% 41.22% 54.33% 72.22% Answer: d Diff: E
After-tax returns 47.
A corporation recently purchased some preferred stock that has a before-tax yield of 7 percent. The company has a tax rate of 40 percent. What is the after-tax yield on the preferred stock? a. b. c. d. e. 4.20% 5.04% 5.65% 6.16% 7.00% Answer: a Diff: E
After-tax returns 48.
A corporate bond currently yields 8.5 percent. Municipal bonds with the same risk, maturity, and liquidity currently yield 5.5 percent. At what tax rate would investors be indifferent between the two bonds? a. b. c. d. e. 35.29% 40.00% 24.67% 64.71% 30.04%
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After-tax returns 49.
Answer: d
Diff: E
A seven-year municipal bond yields 4.8 percent. Your marginal tax rate (including state and federal taxes) is 28 percent. What interest rate on a seven-year corporate bond of equal risk would provide you with the same after-tax return? a. 3.46% b. 4.80% c. 6.14% d. 6.67% e. 17.14%
MVA 50.
Answer: d
Diff: E its The the
Hayes Corporation has $300 million worth of common equity on balance sheet, and 6 million shares of stock outstanding. company's Market Value Added (MVA) is $162 million. What is company's stock price? a. b. c. d. e. $ 23 $ 32 $ 50 $ 77 $138 Answer: c
MVA 51.
Diff: E
Byrd Lumber has 2 million shares of stock outstanding. On the balance sheet the company has $40 million worth of common equity. The company's stock price is $15 a share. What is the company's Market Value Added (MVA)? a. ($80 million) b. ($20 million) c. ($10 million) d. $20 million e. $80 million
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Medium:
Total operating capital 52. A company has the following balance sheet. capital? Cash $ 20 Short-term investments 30 Accounts receivable 20 Inventory 60 Current assets 130 Gross fixed assets 140 Accumulated deprec. 40 Net fixed assets 100 Total assets a. b. c. d. e. $ 90 $120 $150 $200 $230 Answer: c statement. What is Diff: M its net $230 Answer: b Diff: M What is its total operating $ 30 50 10 90 70 30 40 70 $230
Accounts payable Accruals Notes payable Current liabilities Long-term debt Common stock Retained earnings Total common equity Total liab. & equity
Net operating profit after taxes (NOPAT) 53. A company has the following income operating profit after taxes (NOPAT)? Sales Costs Depreciation EBIT Interest expense EBT Taxes (40%) Net income a. b. c. d. e. $ 60 $ 80 $ 90 $100 $120 $1,000 600 250 $ 150 50 $ 100 40 $ 60
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Free cash flow 54.
Answer: a
Diff: M
Giglio Inc. has the following information for the previous year: Net income = $400; Net operating profit after taxes (NOPAT) = $500; Total assets = $2,000; and Total operating capital = $1700. The information for the current year is: Net income = $800; Net operating profit after taxes (NOPAT) = $700; Total assets = $2,300; and Total operating capital = $2100. What is the free cash flow for the current year? a. b. c. d. e. $300 $400 $500 $600 $700 Answer: b Diff: M
Net operating working capital 55. A company has the following balance sheet. working capital? Cash $ 10 Short-term investments 30 Accounts receivable 50 Inventory 40 Current assets 130 Net fixed assets 100 Total assets a. $40 b. $60 c. $100 d. $130 e. $230 Total net operating capital 56. A company has the following balance sheet. operating capital? Cash $ 20 Short-term investments 30 Accounts receivable 50 Inventory 60 Current assets 160 Net fixed assets 100 Total assets a. b. c. d. e. $140 $150 $160 $230 $260 $260 $230
What is its net operating $ 30 10 50 90 60 30 50 $230
Accounts payable Accruals Notes payable Current liabilities Long-term debt Common equity Retained earnings Total liab. & equity
Answer: a
Diff: M
What is its total net $ 40 50 10 100 70 30 60 $260
Accounts payable Accruals Notes payable Current liabilities Long-term debt Common equity Retained earnings Total liab. & equity
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Net operating profit after taxes (NOPAT) 57. A company has the following income operating profit after taxes (NOPAT)? Sales Costs Depreciation EBIT Interest expense EBT Taxes (40%) Net income a. b. c. d. e. $120 $180 $280 $300 $420 $2,000 1,200 100 $ 700 200 $ 500 200 $ 300 statement.
Answer: e What is
Diff: M its net
Free cash flow 58.
Answer: b
Diff: M
Strother Inc. has the following information for the previous year: Net income = $400; Net operating profit after taxes (NOPAT) = $600; Total assets = $2,000; and Total net operating capital = $1800. The information for the current year is: Net income = $900; Net operating profit after taxes (NOPAT) = $800; Total assets = $2,300; and Total net operating capital = $2200. What is the free cash flow for the current year? a. b. c. d. e. $300 $400 $500 $600 $700 Answer: d Diff: M
Return on invested capital (ROIC) 59.
Tibbs Inc. has the following information for the current year: Net income = $300; Net operating profit after taxes (NOPAT) = $400; Total assets = $2,900; Short-term investments = $200; Stockholders equity = $1,800; Debt = $700; and Total net operating capital = $2300. What is the Return on invested capital (ROIC) for the current year? a. b. c. d. e. 13.0% 13.8% 16.0% 17.4% 22.2%
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Return on invested capital (ROIC) 60.
Answer: b
Diff: M
Spencer Inc. has the following information for the current year: Net income = $600; Net operating profit after taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments = $500; Stockholders equity = $2,000; Debt = $1,000; and Total net operating capital = $2500. What is the Return on invested capital (ROIC) for the current year? a. b. c. d. e. 15.0% 20.0% 24.0% 25.0% 30.0% Answer: a Diff: M
Economic value added (EVA) 61.
Spencer Inc. has the following information for the current year: Net income = $600; Net operating profit after taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments = $500; Stockholders equity = $2,000; Debt = $1,000; and Total net operating capital = $2500. If Spencer's cost of capital is 10%, what is its Economic value added (EVA)? a. b. c. d. e. $250 $300 $350 $375 $400 Answer: b Diff: M
After-tax returns 62.
Solarcell Corporation has $20,000 which it plans to invest in marketable securities. It is choosing between AT&T bonds which yield 11 percent, State of Florida muni bonds which yield 8 percent, and AT&T preferred stock with a dividend yield of 9 percent. Solarcell's corporate tax rate is 40 percent, and 70 percent of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security. a. b. c. d. e. 8.46% 8.00% 7.92% 9.00% 9.16%
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After-tax returns 63.
Answer: a
Diff: M
A bond issued by the State of Pennsylvania provides a 9 percent yield. What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 36 percent tax bracket? a. 14.06% b. 17.50% c. 7.00% d. 12.50% e. 9.00%
After-tax returns 64.
Answer: c
Diff: M
Mantle Corporation is considering two equally risky investments: (1) (2) A $5,000 investment in preferred stock which yields 7 percent. A $5,000 investment in a corporate bond which yields 10 percent. the company
What is the break-even corporate tax rate which makes indifferent between the two investments? a. b. c. d. e. 33.17% 34.00% 37.97% 42.15% 42.86%
After-tax returns 65.
Answer: a
Diff: M
West Corporation has $50,000 which it plans to invest in marketable securities. The corporation is choosing between the following three equally risky securities: Alachua County tax-free municipal bonds yielding 6 percent; Exxon bonds yielding 9.5 percent; GM preferred stock with a dividend yield of 9 percent. West's corporate tax rate is 35 percent. What is the after-tax return on the best investment alternative? (Assume the company chooses on the basis of after-tax returns.) a. b. c. d. e. 8.06% 7.13% 6.18% 6.55% 6.00%
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After-tax returns 66.
Answer: b
Diff: M
A municipal bond issued by the City of Gainesville provides a 7.6 percent after-tax return. For an individual investor in the 31 percent tax bracket, (1) what return on a corporate bond and (2) what return on a preferred stock would produce the same after-tax return to the investor as the municipal bond? a. b. c. d. e. 8.28% 11.01% 11.01% 24.52% 24.52% and 10.25%, respectively. and 11.01%, respectively. and 8.38%, respectively. and 11.01%, respectively. and 9.58%, respectively.
After-tax returns 67.
Answer: e
Diff: M
Arvo Corporation is trying to choose between three alternative investments. The three securities that the company is considering are as follows: (1) (2) (3) Tax-free municipal bonds with a return of 7 percent. Wooli Corporation bonds with a return of 10 percent. CFI Corp. preferred stock with a return of 9 percent. What is the after-tax return on
The company's tax rate is 28 percent. the best investment alternative? a. b. c. d. e. 7.00% 7.20% 6.48% 9.00% 8.24%
Rate of interest 68.
Answer: c
Diff: M
A firm has notes payable of $1,546,000, long-term debt of $13,000,000, and total interest expense of $1,300,000. If the firm pays 8 percent interest on its long-term debt, what rate of interest does it pay on its notes payable? a. b. c. d. e. 8.2% 13.1% 16.8% 18.0% 15.3%
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Corporate taxes 69.
Answer: d
Diff: M
Corporations face the following corporate tax schedule: Taxable Income $ 0 - $ 50,000 $ 50,000 - $ 75,000 $ 75,000 - $100,000 $100,000 - $335,000 Tax on Base $ 0 7,500 13,750 22,250 Rate 15% 25% 34% 39%
Company Z has $80,000 of taxable income from its operations, $5,000 of interest income, and $30,000 of dividend income from preferred stock it holds in other corporations. What is Company Z's tax liability? a. b. c. d. e. $12,250 $13,750 $16,810 $20,210 $28,100 Answer: a Diff: M
Carry back, carry forward 70.
Since its inception, Mays Industries has generated the following levels of earnings before taxes (EBT) (losses are shown in parentheses): Year 1999 2000 2001 2002 2003 2004 EBT 50,000 40,000 30,000 20,000 (60,000) 60,000
$
Assume that each year the company has faced a 40 percent income tax rate. Also, assume that current carry back and carry forward provisions were available in prior years. What is the company's tax liability for the most recent year? a. b. c. d. e. $20,000 $21,000 $22,000 $24,000 $26,000
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Carry back, carry forward 71.
Answer: c
Diff: M
Blass Brothers lost money its first year of operation, but has been profitable ever since. Specifically, its taxable income (EBT) has been as follows: Year 2000 2001 2002 2003 2004 Taxable Income (1,000,000) 100,000 200,000 500,000 600,000
The company's tax rate is 40 percent. Assume that current carry back and carry forward provisions were available in prior years. What is the amount of tax the company paid in the most recent year? a. b. c. d. e. $ 80,000 $120,000 $160,000 $200,000 $240,000 Answer: c Diff: M
Carry back, carry 72.
Sundowner forward Corporation taxable income since its inception has been as follows: Year 1998 1999 2000 2001 2002 2003 2004 Taxable Income ($200,000) 50,000 75,000 85,000 (90,000) 65,000 75,000
Assume the company faced a tax rate of 40 percent each year. Also, assume that current carry back and carry forward provisions were available in prior years. What was the tax liability for Sundowner Corporation in the most recent year? a. b. c. d. e. $36,000 $40,000 $24,000 $20,000 $30,000
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Carry back, carry forward 73.
Answer: c
Diff: M
Pierce Company lost $600,000 during 2004(its net income was -$600,000). The corporate tax rate is 40 percent. The company paid the following amount in taxes over the past five years: Year 1999 2000 2001 2002 2003 Assume that current carry available in prior years. payment for 2004? a. b. c. d. e. Payment of $240,000. Payment of $ 40,000. Credit of $200,000. Credit of $240,000. Credit of $600,000. Answer: b Diff: M Taxes Paid $ 50,000 75,000 60,000 40,000 160,000 back and carry forward provisions were What will be Pierce's tax credit or tax
Carry back, carry forward 74.
Below is the level of taxable income (EBT) reported by Indiana Iron Works since it was founded: Year 1999 2000 2001 2002 2003 2004 Taxable Income (EBT) $ 300,000 600,000 750,000 200,000 (1,150,000) 800,000
The corporate tax rate has been and will continue to be 40 percent. Assume that current carry back and carry forward provisions were available in prior years. What was the company's tax liability for the most recent year? a. b. c. d. e. $220,000 $240,000 $320,000 $360,000 $700,000
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Carry back, carry forward 75.
Answer: c
Diff: M
Garner Grocers has reported the following levels of taxable income (EBT) since its founding. The corporate tax rate was 40 percent each year. Assume that current carry back and carry forward provisions were available in prior years. Assuming that the company effectively utilized the carry back, carry forward provisions of the tax code, what is the amount of taxes the company paid in the most recent year? Year 2001 2002 2003 2004 a. b. c. d. e. $320,000 $100,000 $120,000 $ 40,000 $ 20,000 Answer: a Diff: M Taxable Income (EBT) -$3,200,000 200,000 500,000 2,800,000
Carry back, carry forward 76.
The table below contains Bradshaw Beverages' taxable income during each year since it began operations. Notice that the company lost money in each of its first three years. The corporate tax rate has been 40 percent each year. Year Taxable Income (EBT) 2000 ($ 700,000) 2001 ( 500,000) 2002 ( 200,000) 2003 800,000 2004 1,000,000 Assume that current carry back and carry forward provisions were available in prior years. Assuming that the company effectively used the allowed carry back, carry forward provisions of the tax code, how much did the company pay in taxes during the most recent year? a. b. c. d. e. $160,000 $240,000 $320,000 $520,000 $600,000
Chapter 3 Page 23
Calculating change in net income 77.
Answer: c
Diff: M
Garfield Industries is expanding its operations throughout the Southeast United States. Garfield anticipates that the expansion will increase sales by $1,000,000, and increase the costs of goods sold by $700,000. Depreciation expenses will rise by $50,000 and interest expense will increase by $150,000. The company's tax rate will remain at 40 percent. If the company's forecast is correct, how much will net income increase or decrease, as a result of the expansion? a. b. c. d. e. No change. $40,000 increase. $60,000 increase. $100,000 increase. $180,000 increase. Answer: d Diff: M
Net income 78. Moose Industries faces the following tax schedule: Taxable income is Up to $50,000 $50,000 - $75,000 $75,000 - $100,000 $100,000 - $335,000 $335,000 - $10,000,000 $10,000,000 - $15,000,000 $15,000,000 - $18,333,333 Over $18,333,333 Base amount $ 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 6,416,667
Percent over base 15% 25 34 39 34 35 38 35
Last year the company realized $10,000,000 in operating income (EBIT). Its annual interest expense is $1,500,000. What was the company's net income for the year? a. b. c. d. e. $3,450,175 $4,385,100 $5,100,000 $5,610,000 $8,386,100 Answer: b Diff: M
Net income 79.
Edge Brothers recently reported net income of $385,000. The tax rate is 40 percent. The company's interest expense was $200,000. What would have been the company's net income if they would have been able to double their operating income (EBIT), assuming that the company's tax rate and interest expense remain unchanged? a. b. c. d. e. $ 770,000 $ 890,000 $ 920,000 $1,100,000 $1,275,000
Chapter 3 - Page 24
Net cash flow 80.
Answer: d
Diff: M
Coolidge Cola is forecasting the following income statement: Sales Operating costs excluding depreciation Depreciation Operating income (EBIT) Interest expense Taxable income (EBT) Taxes (40%) Net income $30,000,000 20,000,000 5,000,000 $ 5,000,000 2,000,000 $ 3,000,000 1,200,000 $ 1,800,000
Assume that, with the exception of depreciation, all other non-cash revenues and expenses sum to zero. Congress is considering a proposal which will allow companies to depreciate their equipment at a faster rate. If this provision were put in place, Coolidge's depreciation expense would be $8,000,000 (instead of $5,000,000). This proposal would have no effect on the economic value of the company's equipment, nor would it affect the company's tax rate, which would remain at 40 percent. If this proposal were to be implemented, what would be the company's net cash flow? a. b. c. d. e. $2,000,000 $4,000,000 $6,800,000 $8,000,000 $9,800,000
Chapter 3 Page 25
Sales level 81.
Answer: e
Diff: M
Hebner Housing Corporation has forecast the following numbers for this upcoming year: Sales Cost of Goods Sold Interest Expense Net Income $1,000,000 600,000 100,000 180,000
The company is in the 40 percent tax bracket. Its cost of goods sold always represents 60 percent of its sales. That is, if the company's sales were to increase to $1.5 million, its cost of goods sold would increase to $900,000. The company's CEO is unhappy with the forecast and wants the firm to achieve a net income equal to $240,000. Assume that Hebner's interest expense remains constant. In order to achieve this level of net income, what level of sales will the company have to achieve? a. b. c. d. e. $ 400,000 $ 500,000 $ 750,000 $1,000,000 $1,250,000
Chapter 3 - Page 26
Sales level 82.
Answer: e
Diff: M
Swann Systems is forecasting the following income statement for the upcoming year: Sales Operating costs (excluding depreciation) Gross margin Depreciation EBIT Interest EBT Taxes (40%) Net income $5,000,000 3,000,000 $2,000,000 500,000 $1,500,000 500,000 $1,000,000 400,000 $ 600,000
The company's president is disappointed with the forecast and would like to see Swann generate higher sales and a forecasted net income of $2,000,000. Assume that operating costs (excluding depreciation) are always 60 percent of sales. Also, assume that depreciation, interest expense, and the company's tax rate, which is 40 percent, will remain the same even if sales change. What level of sales would Swann have to obtain to generate $2,000,000 in net income? a. b. c. d. e. $ 5,800,000 $ 6,000,000 $ 7,200,000 $ 8,300,000 $10,833,333 Answer: e Diff: M
Retained earnings 83.
Sanguillen Corp. showed retained earnings of $400,000 on its balance sheet last year. This year, the company's earnings per share (EPS) were $3.00 and its dividends paid per share (DPS) were $1.00. The company has 200,000 shares of stock outstanding. What is the level of retained earnings on the company's balance sheet this year? a. b. c. d. e. $400,000 $500,000 $600,000 $700,000 $800,000
Chapter 3 Page 27
Retained earnings 84.
Answer: b
Diff: M
New Hampshire Services reported $2.3 million of retained earnings on its balance sheet last year. This year, the company lost money---its net income was -$500,000 (negative $500,000). Despite the loss, the company still paid a $1.00 per share dividend this year. The company's earnings per share for this year were -$2.50 (negative $2.50). What was the level of retained earnings on the company's balance sheet this year? a. b. c. d. e. $1.2 $1.6 $1.8 $2.6 $2.8 million million million million million Answer: d Diff: M
Operating income 85. New Mexico Lumber recently reported that $3.00. The company has 400,000 shares company's interest expense was $500,000. percent. What was the company's operating a. b. c. d. e. $ 980,000 $1,220,000 $2,000,000 $2,500,000 $3,500,000
its earnings per share were of stock outstanding. The The corporate tax rate is 40 income (EBIT)?
Net operating working capital 86. A company has the following balance sheet. working capital? Cash $ 10 Short-term investments 20 Accounts receivable 30 Inventory 40 Current assets 100 Net fixed assets 80 Total assets a. b. c. d. e. $10 $20 $30 $40 $50 $180
Answer: c
Diff: M
What is its net operating $ 20 30 20 70 30 10 70 $180
Accounts payable Accruals Notes payable Current liabilities Long-term debt Common equity Retained earnings Total liab. & equity
Chapter 3 - Page 28
Net operating profit after taxes (NOPAT) 87. A company has the following income operating profit after taxes (NOPAT)? Sales Costs Depreciation EBIT Interest expense EBT Taxes (40%) Net income a. b. c. d. e. $ 90 $120 $150 $180 $200 $1,000 700 100 $ 200 50 $ 150 60 $ 90 statement.
Answer: b What is
Diff: M its net
Free cash flow 88.
Answer: c
Diff: M
Bates Motors has the following information for the previous year: Net income = $200; Net operating profit after taxes (NOPAT) = $300; Total assets = $1,000; and Total net operating capital = $800. The information for the current year is: Net income = $500; Net operating profit after taxes (NOPAT) = $400; Total assets = $1,300; and Total net operating capital = $900. What is the free cash flow for the current year? a. b. c. d. e. $100 $200 $300 $400 $500 Answer: b Casey Motors recently reported the following information: Net income = $600,000. Tax rate = 40%. Interest expense = $200,000. Operating capital = $9 million. After-tax cost of capital = 10%. What is the company's EVA? a. ($300,000) b. ($180,000) c. $ 0 d. $200,000 e. $400,000 Diff: M
EVA 89.
Chapter 3 Page 29
CHAPTER 3 ANSWERS AND SOLUTIONS
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. Annual report Annual report and expectations Financial statements Balance sheet Income statement Non-cash assets Interest income Interest expense Interest expense and dividends Net operating working capital Total net operating capital Net operating profit after taxes (NOPAT) Interest expense and dividends Retained earnings Retained earnings Time dimension Future cash flows Cash flow Cash flow and net income Answer: a Answer: a Answer: b Answer: b Answer: a Answer: a Answer: b Answer: b Answer: b Answer: a Answer: b Answer: a Answer: a Answer: b Answer: a Answer: b Answer: b Answer: a Answer: b Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M
Chapter 3 - Page 30
20.
Net cash flow
Answer: e
Diff: E
Long-term debt is a source of cash. Companies issue debt to get more cash. Therefore, statement a is true. If the company repurchases common stock, it must use cash to pay for the repurchases. So, cash on the balance sheet would decrease. Therefore, statement b is false. If the company sold assets total assets would be unchanged, but there would be an increase in cash and a decrease in other assets. Therefore, statement c is true. Since statements a and c are true, the correct choice is statement e. 21. Net cash flow Answer: d Diff: E
If the company issued new stock, cash on the balance sheet would increase. Therefore, statement a is false. If it issued long-term debt, cash on the balance sheet would increase. Consequently, statement b is also false. If it sold assets, cash on the balance sheet would increase. So, statement c is also false. If it bought assets, cash would decrease and net cash flow would not be affected. (So, if cash flow were positive before, it would stay positive.) Therefore, statement d is true. If the company eliminated its dividend, cash on the balance sheet would increase. So, statement e is also false. 22. Net cash flow and net income Answer: b Diff: E
Statement b is correct. Statement a is false, since it would reduce net income. Statement b is true; a decline in depreciation expense would increase net income but decrease net cash flow. Statement c is false; since a decline in operating income would cause net income to decline. The remaining statements are false. 23. 24. Net cash flow and net income EVA, cash flow, and net income Answer: a Answer: b Diff: E Diff: E
EVA = EBIT(1 - T) - (After-tax cost of capital)(Total capital). Therefore, if less capital is used with the same operating income, EVA will be increased. 25. 26. Taxes and financing Taxes Answer: e Answer: b Diff: E Diff: E
Statement b is correct. The other statements are false. Corporations cannot exclude interest income from corporate taxes and individuals pay no taxes on municipal bond income.
Chapter 3 Page 31
27.
Taxes
Answer: b
Diff: E
Statement b is correct. The other statements are false. cannot exclude interest income from corporate taxes. municipal bonds are not taxed.
Equivalent pre - tax yield on taxable bond Yield on muni (1 T)
Corporations Recall that
or Equivalent pre - tax yield on muni
Pre - tax yield 1 on taxable bond
T .
Munis trade at lower yields than equivalent corporate bonds because investors do not have to pay taxes on munis. 28. 29. Carry back, carry forward Balance sheet Statement c is correct; the others are change in retained earnings between the mean that net income was zero. Remember, Net income - Dividends = Ending retained because the change in retained earnings dividends were zero. 30. 31. 32. 33. Net operating working capital Net operating profit after taxes (NOPAT) Free cash flow Miscellaneous concepts Answer: b Answer: c Diff: E Diff: E
false. Simply because the two years was zero, doesn't Beginning retained earnings + earnings. In addition, just was zero, doesn't mean that Answer: c Answer: d Answer: a Answer: c Diff: E Diff: E Diff: E Diff: E
Statement c is correct. The other statements are false. Retained earnings do not represent cash and all of the firm's interest income is taxed. 34. 35. Financial statements After-tax returns After-tax return on the new project: 0.11(1 - T) = 0.11(0.75) = 0.0825 = 8.25%. After-tax return on the preferred stock: 0.09[1 - 0.3(0.25)] = 0.09(1 - 0.075) = 0.09(0.925) = 0.08325 = 8.325%. Therefore, invest 100 percent in the preferred stock. Answer: c Answer: b Diff: M Diff: M
Chapter 3 - Page 32
36.
Changes in depreciation
Answer: c
Diff: M
Statement c is correct. In the statement of cash flows, depreciation is a source of cash. Therefore, a decrease in depreciation means that cash will decrease. The other statements are false. The physical stock of assets would not change. In the income statement, the depreciable amount is deducted from sales; therefore, a decrease in the depreciable amount means that net income will increase. 37. Changes in depreciation Answer: d Diff: M
Statements a and c are correct; therefore statement d is the correct choice. Statement b is incorrect. The company would be paying more in taxes, a cash expense. Thus, the company's cash position would decrease. 38. Changes in depreciation Answer: d Diff: M
Statement a is correct, because an increase in depreciation would lower net income and, consequently, EPS. Statement b is also correct because Solo will pay less taxes because depreciation is higher. Therefore, statement d is the correct choice. Statement c is incorrect. Depreciation expense would increase; hence, EBIT would fall. 39. Changes in depreciation Answer: d Diff: M
Statement d is correct. The other statements are false. The tax paid by the firm will be less due to the larger non-cash expense of depreciation, which increases net cash flow. The firm's net income is lower because depreciation will be higher, and the firm will also have less taxable income due to higher depreciation expense. 40. Effects of changes in financial leverage Answer: a Diff: M
Statement a is correct. Net income will increase because less interest expense will be paid by the company. Statement b is incorrect because reducing interest expense will increase the amount of EBT (taxable income). Higher taxable income results in higher taxes; therefore, statement c is incorrect. 41. EVA EVA = = = = Answer: a EBIT (1 - T) - (WACC Total net operating capital) $4,000,000 (1 - 0.4) - (0.1 $20,000,000) $2,400,000 - $2,000,000 $400,000. Diff: E
Chapter 3 Page 33
42.
Corporate taxes Operating income $250,000 Interest received 10,000 Interest paid (45,000) Dividends received (taxable) 6,000* Taxable income $221,000 *$20,000(0.30) = $6,000. Taxes = 0.4($221,000) = $88,400.
Answer: b
Diff: E
43.
After-tax returns 12%[1 - 0.30(0.35)] = 10.74%.
Answer: b
Diff: E
44.
After-tax returns
Answer: b
Diff: E
Chicago municipal bonds = Tax Exempt; BT yield = AT yield. U.S. Treasury bonds = AT yield = 6%(1 - 0.4) = 3.60%. 3.60% = yield where indifferent between the two. 45. After-tax returns Answer: c Diff: E
70% of the preferred stock dividends are not taxable, thus we need to solve the following for t (the tax rate): 7.5% = 8.5% - 8.5%(1-0.7)(t) 1% = 2.55%t t = 0.3922 = 39.22%. 46. After-tax returns 9%(1 - T) = 6.5% (1 - T) = 6.5%/9% T = 1 6.5% 9%
Answer: a
Diff: E
T = 27.78%. 47. After-tax returns Answer: d Diff: E
After-tax yield = 7% - 7%[0.4(1 - 0.7)] = 6.16%. (Remember, 70 percent of preferred dividends are not taxable.) 48. After-tax returns Compare the two after-tax rates: 35.29%. 49. After-tax returns Equivalent pre-tax yield on corporate bond = Answer: a 0.085(1 - T) = 0.055. Diff: E
T = 0.3529 Diff: E
Answer: d
4.8% = 6.67%. (1 - 0.28)
Chapter 3 - Page 34
50.
MVA
Answer: d
Diff: E
MVA = (Shares outstanding)(Stock Price) - Total common equity. $162,000,000 = (6,000,000)P0 - $300,000,000 $462,000,000 = (6,000,000)P0 P0 = $77.00. 51. MVA Answer: c Diff: E
MVA = (Shares outstanding)(Stock Price) - Total common equity. MVA = (2,000,000)($15) - $40,000,000 MVA = -$10,000,000. 52. Total operating capital
Net operating working capital Operating Operating current assets current liabilitie s = (Cash + AR + Inc) (AP + Accruals) = ($20 + $20 + $60) ($30 + $50) = $100 - $80 = $20.
Answer: b
Diff: M
Total operating capital = NOWC + Net fixed assets = $20 + $100 = $120. 53. Net operating profit after taxes (NOPAT) NOPAT = EBIT(1 - T) = $150(1 - 0.6) = $90. 54. Free cash flow Answer: a Diff: M Answer: c Diff: M
Free cash flow = NOPAT - Net investment in total operating capital = $700 - ($2100 - $1700) = $700 - $400 = $300. 55. Net operating working capital
Net operating working capital Operating Operating current assets current liabilitie s = (Cash + AR + Inc) (AP + Accruals) = ($10 + $50 + $40) ($30 + $10) = $100 - $40 = $60.
Answer: b
Diff: M
56.
Total net operating capital
Net operating working capital Operating Operating current assets current liabilitie s = (Cash + AR + Inc) (AP + Accruals) = ($20 + $50 + $60) ($40 + $50) = $130 - $90 = $40.
Answer: a
Diff: M
Total net operating capital = NOWC + Net fixed assets = $40 + $100 = $140.
Chapter 3 Page 35
57.
Net operating profit after taxes (NOPAT) NOPAT = EBIT(1 - T) = $700(1 - 0.4) = $420.
Answer: e
Diff: M
58.
Free cash flow
Answer: b
Diff: M
Free cash flow = NOPAT - Net investment in total net operating capital = $800 - ($2200 - $1800) = $800 - $400 = $400. 59. Return on invested capital (ROIC) ROIC = NOPAT / Total net operating capital = $400 / $2,300 = 0.174 = 17.4% Answer: c Diff: M Answer: c Diff: M
60.
Return on invested capital (ROIC) ROIC = NOPAT / Total net operating capital = $500 / $2,500 = 0.200 = 20.0%
61.
Return on invested capital (ROIC) EVA
Answer: a
Diff: M
= NOPAT (WACC x Total net operating capital) = $500 (0.10)($2,500) = $500 - $250 = $250. Answer: b (The munis are tax exempt.) Diff: M
62.
After-tax returns Florida muni bond: After-tax yield on FLA bond = 8%.
AT&T bond: After-tax yield on AT&T bond = 11% - Taxes = 11% - 11%(0.4) = 6.6%. Alternative solution: Invest $20,000 @ 11% = $2,200 interest. Pay 40% tax, so after-tax income = $2,200(1 - T) = $2,200(0.6) = $1,320. After-tax rate of return = $1,320/$20,000 = 6.6%. AT&T preferred stock: After-tax yield = 9% - Taxes = 9% - 0.3(9%)(0.4) = 9% - 1.08% = 7.92%. Therefore, invest in the Florida muni bonds which yield 8% after taxes. 63. After-tax returns Before-tax return(1 - T) = 9% Before-tax return(0.64) = 9% Before-tax return = 9%/0.64 = 14.06%. Answer: a Diff: M
Chapter 3 - Page 36
64.
After-tax returns
Answer: c
Diff: M
The tax rate which equates the after-tax yields of the alternative investments will make the corporation indifferent between the securities. The after-tax yield of the alternatives are: Bond: Before-tax yield(1 - Tax rate) or 10%(1 - T). Preferred stock: Before-tax yield(1 - 0.3(Tax rate)) 7%(1 - 0.3T). 70% of corporate dividend income is exempt from taxes. Thus, solving 10%(1 - T) = 7%(1 - 0.3T) for T will give the tax rate that makes the firm indifferent. 10%(1 - T) 10% - 10%T 3% T 65. = = = = 7%(1 - 0.3T) 7% - 2.1%T 7.9%T 37.97%. Answer: a Diff: M
After-tax returns
The after-tax yield on the municipal bond is 6%. The after-tax yield on the Exxon bonds is 9.5%(1 - 0.35)= 6.18%. Finally, the after-tax yield on the preferred stock (remember 70% of dividends are excluded from taxes) is 9%(1 - (0.3)(0.35)) = 8.06%. Thus, the preferred stock is the best alternative based on after-tax returns. 66. After-tax returns Answer: b Diff: M
For individual investors, the tax rates on interest income and dividend income are identical. Therefore, without any calculations you may properly conclude that b is the correct answer. To prove that this is correct, consider the following: Muni yield = Bond yield(1 - Tax rate) and/or Muni yield = Preferred stock yield(1 - Tax rate) 7.6% = Before-tax yield(1 - 0.31) 7.6% = Before-tax yield(0.69) Before-tax yield = 11.01%. 67. After-tax returns Answer: e Diff: M
After-tax return on the municipal bond is 7%. (No federal tax on municipals). After-tax return on the Wooli Corp. bond is 10%(1 - 0.28) = 7.20%. After-tax return on the preferred stock is 9%(1 - (0.3)(0.28)) = 8.24%. 68. Rate of interest Answer: c Diff: M
Long-term interest = ($13,000,000)(0.08) = $1,040,000. Short-term interest = $1,300,000 - $1,040,000 = $260,000. Short-term interest rate = $260,000/$1,546,000 = 16.8%.
Chapter 3 Page 37
69.
Corporate taxes Calculate taxable income: Taxable inc. from oper. $80,000 Int. income + 5,000 Div. income + 9,000* Total income $94,000 *$30,000(1 - 0.7) = $9,000. taxable to corporations. Calculate Taxes: 0 - $75,000 + ($94,000 - $75,000) Only 30% of
Answer: d
Diff: M
preferred
dividends
are
= $13,750 0.34 = 6,460 $20,210 Answer: a Diff: M
70.
Carry back, carry forward
The tax loss in 2003 can be carried back two years. The tax credit available is $60,000 40% or $24,000. Taxes paid in 2001, and 2002 were $12,000 and $8,000, respectively. Thus, $50,000 of the 2003 tax loss can be carried back. That leaves $10,000 of the 2003 loss available to carry forward, and $10,000 40% = $4,000 of tax credit available to offset against the 2004 tax liability. The tax liability for 2004 before the carry forward is $60,000 40% = $24,000. Therefore, the 2004 tax liability net of the $4,000 tax carry forward is $20,000. 71. Carry back, carry forward Answer: c Diff: M
The loss in 2000 can be carried forward to offset taxes for up to 20 years. By 2004, $800,000 of the loss will have been used up leaving $200,000 that can be offset against the profit of $600,000. Tax = ($600,000 - $200,000) 0.4 = $160,000. 72. Carry back, carry forward Answer: c Diff: M
The $200,000 loss in 1998 can be carried forward to cover 1999, 2000, and all but $10,000 of 2001 income. $10,000 of the $90,000 loss in 2002 can be carried back to cover that portion of 2000 income not covered by the 1998 loss. Additionally, the remaining $80,000 of the 2002 loss can be carried forward to cover all of 2003 income and $15,000 of 2004 income. Thus, taxable income for 2004 is $75,000 $15,000 = $60,000. Given a 40 percent tax rate, Sundowner's tax liability is $60,000 0.4 = $24,000.
Chapter 3 - Page 38
73.
Carry back, carry forward
Answer: c
Diff: M
First, figure out the taxable income for the last two years: Year 2002 2003 Note: Taxes Paid $ 40,000 160,000 Taxable Income $100,000 400,000 Taxable income = $ 40,000/0.40 Taxable income = $160,000/0.40
Tax losses can be carried back only two years.
Next, add up the taxable income for the past two years. It sums to $500,000. Finally, compute the tax credit on the carry-back: ($500,000)(0.40) = $200,000. 74. Carry back, carry forward Answer: b Diff: M
Indiana can carry back its losses for 2 years. The total taxable income over 2001 and 2002 was $200,000 + $750,000 = $950,000. This leaves $1,150,000 - $950,000 = $200,000 that can be carried forward for up to 20 years. Applying this against the 2004 income of $800,000 leaves taxable income of $600,000. At a 40 percent tax rate, the tax owed for 2004 is 0.4($600,000) = $240,000. 75. Carry back, carry forward Answer: c Diff: M
The company has $3,200,000 taxable income with which it can offset future taxes. In 2002 and 2003, it uses up $700,000 of that income. It has $2,500,000 left. It can use all of this in 2004 to help offset the $2,800,000 taxable income. However, it still leaves $300,000 of income that will be taxed. At 40 percent, this yields $120,000 in taxes. 76. Carry back, carry forward Answer: a Diff: M
The total tax credit is ($700,000 + $500,000 + $200,000)0.4 = $560,000. Taxes owed in 2003 are ($800,000)0.4 = $320,000. $560,000 - $320,000 = $240,000 credit available for 2003. Taxes owed in 2004 are ($1,000,000)0.4 = $400,000. $400,000 - $240,000 = $160,000 taxes actually payable. 77. Calculating change in net income Set up an income statement: Sales $1,000,000 COGS (700,000) Depreciation (50,000) EBIT $ 250,000 Interest (150,000) EBT $ 100,000 Taxes (40,000) Net Income $ 60,000 Answer: c Diff: M
Taxes = 0.4($100,000) = $40,000.
Chapter 3 Page 39
78.
Net income EBIT Interest EBT Tax NI
Answer: d
Diff: M
$10,000,000 1,500,000 $ 8,500,000 2,890,000 = $113,900 + ($8,500,000 - $335,000)0.34 $ 5,610,000 Answer: b Diff: M
79.
Net income
We need to work backwards through the income statement to get the EBIT. EBIT $841,667 ($641,667 + $200,000) Interest 200,000 EBT $641,667 ($385,000/0.6) Tax (40%) NI $385,000 If EBIT doubles: EBIT $1,683,334 Interest 200,000 EBT $1,483,334 Tax (40%) 593,334 NI $ 890,000 80. Net cash flow The income statement would show: Sales Oper. costs (excl. depr.) Depreciation EBIT Interest exp. EBT Taxes NI NCF = NI + Dep NCF = 0 + $8,000,000 = $8,000,000. 81. Sales level Answer: e Diff: M $30,000,000 20,000,000 8,000,000 2,000,000 2,000,000 0 0 $ 0
($841,667
2)
($1,483,334
0.6) Answer: d Diff: M
This question requires working backwards through the income statement from net income to sales. The income statement will look like this: Sales CGS (60%) EBIT Interest EBT Tax (40%) NI $1,250,000 $ $ $ 500,000 100,000 400,000 240,000 $500,000/(1 - 0.6) $100,000 + $400,000 (Given) $240,000/(1 - 0.4)
Chapter 3 - Page 40
82.
Sales level
Answer: e
Diff: M
Working up the income statement to get sales you calculate the new sales level should be $10,833,333. Sales Operating costs (excl. depr.) Gross margin Depreciation EBIT Interest EBT Taxes (40%) Net income 83. Retained earnings $10,833,333 6,500,000 $ 4,333,333 500,000 $ 3,833,333 500,000 $ 3,333,333 1,333,333 $ 2,000,000 $4,333,333/0.4 $3,833,333 + $500,000 $3,333,333 + $500,000 $2,000,000/0.6
Answer: e
Diff: M
EPS = $3, but $1 per share is paid out as dividends. This means that $2 per share is added to retained earnings. Total amount retained in the year is $2(200,000) = $400,000. Add this to the amount already in the retained earnings account on the balance sheet and you get a total retained earnings of $400,000 + $400,000 = $800,000. 84. Retained earnings Answer: b Diff: M
EPS = NI/shares. EPS for this year, -$2.50 = -$500,000/Shares Shares = -$500,000/-$2.50 = 200,000. Dividends paid this year = $1.00 200,000 = $200,000. Looking at additions to retained earnings in for this year: Last year's retained earnings $2,300,000 This year's dividends (200,000) Last year's net income (500,000) This year's retained earnings $1,600,000 85. Operating income EPS = NI/Shares NI = EPS Shares = $3.00 400,000 = $1,200,000. EBT = NI/(1 - T) = $1,200,000/(1 - 0.4) = $2,000,000. EBIT = EBT + Interest expense = $2,000,000 + $500,000 = $2,500,000. 86. Net operating working capital
Net operating working capital Operating Operating current assets current liabilitie s = (Cash + AR + Inc) (AP + Accruals) = ($10 + $30 + $40) ($20 + $30) = $80 - $50 = $30.
Answer: d
Diff: M
Answer: c
Diff: M
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87.
Net operating profit after taxes (NOPAT) NOPAT = EBIT(1 - T) = $200(1 - 0.4) = $120.
Answer: b
Diff: M
88.
Free cash flow
Answer: c
Diff: M
Free cash flow = NOPAT - Net investment in total net operating capital = $400 - ($900 - $800) = $400 - $100 = $300. 89. EVA Answer: b Diff: M
EVA = EBIT(1 - T) - (Operating capital)(After-tax cost of capital). Note that EBIT = Earnings before taxes plus interest expense. Earnings before tax = EBT =
$600,000 0.6
= $1,000,000.
EBIT = $1,000,000 + $200,000 = $1,200,000. EVA = $1,200,000(0.6) - $9,000,000(0.10) = -$180,000.
Chapter 3 - Page 42