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Unformatted text preview: _ a: ti ﬁr ’3’ ii.
93?: . mag/gm war/egg W; (vi—3%) Erma CHAPTER 2
FINANCIAL STA T EMEN T S,
TAXES, AND CASH FLOW CRITICAL THINKING AND CONCEPTS REVIEW 2.1 Liquidity. What does liquidity measure? Explain the tradeoff a ﬁrm faces between
highliquidity and lowliquidity levels.
Answer:
Liquidity measures how quickly and easily an asset can be converted to cash without
signiﬁcant loss in value. It’s desirable for ﬁrms to have high liquidity so that they can
more safely meet shortterm creditor demands. However, liquidity also has an
opportunity cost. Firms generally reap higher returns by investing in illiquid, productive
assets. It’s up to the ﬁrm’s ﬁnancial management staff to ﬁnd a reasonable compromise between these opposing needs. 2.2 Accounting and Cash Flows. Why is it that the revenue and cost ﬁgures shown on a
standard income statement may not be representative of the actual cash inﬂows and
outﬂows that occurred during a period? Answer: The recognition and matching principles in ﬁnancial accounting call for revenues, and
the costs associated with producing those revenues, to be “booked” when the revenue
process is essentially complete, not necessarily when the cash is collected or bills are
paid. Note that this way is not necessarily correct; it’s the way accountants have chosen
to do it. 2.3 Book Values versus Market Values. In preparing a balance sheet, why do you think
standard accounting practice focuses on historical cost rather than market value?
Answer: Historical costs can be objectively and precisely measured, whereas market values can be
difﬁcult to estimate, and different analysts would come up with different numbers. Thus,
there is a tradeoff between relevance (market values) and objectivity anok values). CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21 _ __ a: ti ﬁr *5” rt.
93?: . mag/gm wax/aye We (aw—3%) amt:2 2.4 Operating Cash Flow. In comparing accounting net income and operating cash ﬂow,
what two items do you ﬁnd in net income that are not in operating cash ﬂows? Explain
what each is and why it is excluded in operating cash ﬂows. Answer:
Depreciation is a noncash deduction that reﬂects adjustments made in asset book values
in accordance with the matching principle in ﬁnancial accounting. Interest expense is a cash outlay, but it’s a ﬁnancing cost, not an operating cost. 2.5 Book Values versus Market Values. Under standard accounting rules, it is possible for a
company's liabilities to exceed its assets. When this occurs, the owners' equity is negative. Can this happen with market values? Why or why not?
Answer:
Market values can never be negative. Imagine a share of stock selling for —$20. This
would mean that if you placed an order for 100 shares, you would get the stock along
with a check for $2,000. How many shares do you want to buy? More generally, because
of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 2.6 Cash Flow from Assets. Suppose a company's cash ﬂow ﬁom assets was negative for a
particular period. Is this necessarily a good sign or a bad sign?
Answer:
For a successﬁll company that is rapidly expanding, capital outlays would typically be
large, possibly leading to negative cash ﬂow ﬁom assets. In general, what matters is
whether the money is spent wisely, not whether cash ﬂow ﬁom assets is positive or negative. 2.7 Operating Cash Flow. Suppose a company's operating cash ﬂow was negative for
several years running. Is this necessarily a good sign or a bad sign?
Answer:
It’s probably not a good sign for an established company, but it would be fairly ordinary
for a startup, so it depends. 2.8 Net Working Capital and Capital Spending. Could a company's change in NWC be
negative in a given year(Hint: Yes.)? Explain how this might come about. What about
net capital spending? Answer: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 22 2.9 2.1 2.1 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW g; tiﬁ‘ﬁ’ﬁ. ..'..9‘ each“ If EsauI'm «awe/gm ﬁéﬁﬁnﬁ Effie: (Vi3%) ﬁﬁﬂﬁ' For example, if a company were to become more efﬁcient in inventory management, the
amount of inventory needed would decline. The same might be true if it becomes better
at collecting its receivables. In general, anything that leads to a decline in ending NWC
relative to beginning NWC would have this effect. Negative net capital spending would
mean more longlived assets were liquidated than purchased. Cash Flow to Stockholders and Creditors.
stockholder be negative in a given years (Hint2Yes). Explain how this might come about. Could a company's cash ﬂow to What about cash ﬂow to creditors?
Answer:
If a company raises more money ﬂom selling stock than it pays in dividends in a
particular period, its cash ﬂow to stockholders will be negative. If a company borrows
more than it pays in interest, its cash ﬂow to creditors will be negative.
0 Firm Values. Look back at the Ford example we discussed at the beginning of the
chapter. Did stockholders in Ford lose $2.7 billion as a result of the accounting changes?
What is the basis ﬁom your conclusion?
Use the following information to answer the next two questions:
In June 2002, WorldCom, the telecommunications giant, surprised investors when it
announced that it had overstated net income in the prior two years by $3.8 billion. At the
center of the controversy was Scott D. Sullivan, the former CFO. WorldCom had leased
telephone lines ﬁom local companies with the expectation of reselling the use of the lines
at a higher price. Under GAAP, these costs should have been reported as an expense on
the income statement. Reportedly, however, Mr. Sullivan ordered that the costs be
treated as money spent to purchase a ﬁxed asset, so they were to be shown on the balance
sheet as an asset and subsequently depreciated.
Answer:
The adjustments discussed were purely accounting changes; they had no cash ﬂow or
market value consequences unless the new accounting information caused stockholders to revalue the company. 1 Corporate Ethics. In the wake of this scandal, Mr. Sullivan was charged with fraud.
Do you think this should be considered ﬂaud? Why? Why was this unethical?
Answer:
The legal system thought it was ﬁaud. Mr. Sullivan disregarded GAAP procedures,
which is ﬁaudulent. That ﬁaudulent activity is unethical goes without saying. 2.12 Net Income and Cash Flows. g; his9‘ each“ If EsauI'm ﬁﬁ‘ﬁ’ﬁ. «Z‘rﬁé‘ﬁm ﬁéﬁﬁnﬁ Effie: (Vi3%) ﬁlﬁﬂﬁ' How did Mr. Sullivan's reclassifying some costs as
asset purchases affect net income at the time? In the future? How did this action affect
cash ﬂows? What does this tell you about the importance of examining cash ﬂow relative
to net income? Answer: By reclassifying costs as assets, it lowered costs when the lines were leased. This
increased the net income for the company. It probably increased most future net income
amounts, although not as much as you might think. Since the telephone lines were ﬁxed
assets, they would have been depreciated in the future. This depreciation would reduce
the effect of expensing the telephone lines. The cash ﬂows of the ﬁrm would basically be unaffected no matter what the accounting treatment of the telephone lines. Solutions to Questions and Problems
Basic (Questions 113) 1. Building a Balance Sheet. Romo,Inc., has current assets of $1,850, net ﬁxed assets of
$8,600, current liabilities of $1,600,and longterm debt of $6,100. What is the value of
the shareholders' equity account for this ﬁrm? How much is net working capital?
Solution: The balance sheet for the company will look like this: Balance sheet Current assets $1,850 Current liabilities $1,600
Net ﬁxed assets 8,600 Longterm debt 6,100 Owner's equity 2,750
Total assets $ 10,450 Total liabilities & Equity $ 10,450 The owner’s equity is a plug variable. We know that total assets must equal total
liabilities & owner’s equity. Total liabilities and equity is the sum of all debt and equity,
so if we subtract debt ﬁom total liabilities and owner’s equity, the remainder must be the
equity balance, sorOwner’s equity = Total liabilities & equity — Current liabilities —
Longterm debt Owner’s equity = $10,450 — 1,600 — 6,100 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 24 =7 75: 553‘ ‘3’ 5'5.
93% . mag/gm wax/egg W; (vi—3%) elem Owner’s equity = $2,750
Net working capital is current assets minus current liabilities, so:
NWC = Current assets — Current liabilities
NWC = $1,850 — 1,600
NWC = $250 2. Building an Income Statement. Fyre, Inc., has sales of $625.000, costs of $260.000,
depreciation expense of $79,000, interest expense of $43,000, and a tax rate of 35 percent.
What is the net income for this ﬁrm? Solution:
The income statement starts with revenues and subtracts costs to arrive at EBIT. We then
subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales $625,000
Costs 260,000
Depreciation 79,000
EBIT $286,000
Interest 43,000
Taxable income $243,000
Taxes 85,050
Net income $i_ﬂ,9_50 3. Dividends and Retained Earnings. Suppose the ﬁrm in Problem 2 paid out $60,000 in
cash dividends, what is the addition to retained earnings?
Solution:
The dividends paid plus addition to retained earnings must equal net income, so:
Net income = Dividends + Addition to retained earnings
Addition to retained earnings = $157,950 — 60,000
Addition to retained earnings = $97,950 4. PerShare Earnings and Dividends. Suppose the ﬁrm in Problem 3 had 40,000 shares
of common stock outstanding. What is the earnings per share, or EPS, ﬁgure? What is the
dividends per share ﬁgure? Solution:
Earnings per share is the net income divided by the shares outstanding, so: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 25 =7 g: 553‘ ‘3’ 5'5.
93% a mag/gm wax/egg W; (vi—3%) email EPS = Net income / Shares outstanding EPS = $157,950 / 40,000 EPS = $3.95 per share
And dividends per share are the total dividends paid divided by the shares outstanding,
so: DPS = Dividends / Shares outstanding DPS = $60,000 / 40,000 DPS = $1.50 per share 5. Market Values and Book Values. Klingon Widgets,Inc., purchased new cloaking
machinery three years ago for $6 million. The machinery can be sold to the Romulans
today for $5.6 million. Klingon's current balance sheet shows net ﬁxed assets of $4.8
million, current liabilities of $780,000, and net working capital of $100,000. If all the
current assets were liquidated today, the company would receive $805,000 cash. What
is the book value of Klingon's assets today? What is the market value? Solution:
To ﬁnd the book value of assets, we ﬁrst need to ﬁnd the book value of current assets.
We are given the NWC. NWC is the difference between current assets and current
liabilities, so we can use this relationship to ﬁnd the book value of current assets. Doing
so, we ﬁnd:
NWC = Current assets — Current liabilities
Current assets = $100,000 + 780,000 = $880,000
Now we can construct the book value of assets. Doing so, we get:
Book value of assets
Current assets $ 880,000
Fixed assets 4 800 000
Total assets $5,680,0ﬂ1 All of the information necessary to calculate the market value of assets is given, so: Market value of assets
Current assets $ 805,000 Fixed assets 5,600,000
Total assets $6,405,000 6. Calculating taxes. The ﬂy Leaf Co. had $315,000 in taxable income. Using the rates
ﬁom Table 2.3 in the chapter, calculate the company's income taxes.
Solution: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 26 =7 75: 553‘ ‘3’ 5'5.
93% . mag/gm ﬂaw/aw W; (aw—55%) amtLat: Using Table 2.3, we can see the marginal tax schedule. The ﬁrst $25,000 of income is
taxed at 15 percent, the next $50,000 is taxed at 25 percent, the next $25,000 is taxed at
34 percent, and the next $215,000 is taxed at 39 percent. So, the total taxes for the
company will be:
Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($315,000 — 100,000)
Taxes = $106,100 7. Tax Rates. In problem 6, what is the average tax rate? What is the marginal tax rate? Solution:
The average tax rate is the total taxes paid divided by net income, so: Average tax rate = Total tax / Net income Average tax rate = $106,100 / $315,000 Average tax rate = .3368 or 33.68%
The marginal tax rate is the tax rate on the next dollar of income. The company has net
income of $315,000 and the 39 percent tax bracket is applicable to a net income of
$335,000, so the marginal tax rate is 39 percent. 8. Calculating OCF. Stone Sour, Inc., has sales of $16,550, costs of $5,930, depreciation
expense of $1,940, and interest expense of $1,460. If the tax rate is 35%, what is the
operating cash ﬂow, or OCF? Solution: To calculate the OCF, we ﬁrst need to construct an income statement. The income
statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out
interest to get taxable income, and then subtract taxes to arrive at net income. Doing so,
we get: Income Statement Sales $16,550 Costs 5,930
Depreciation 1,940
EBIT $8,680 Interest M
Taxable income $7,220
Taxes (35%) 2,527
Net income M Now we can calculate the OCF, which is: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 27 _ r ti ﬁr *5” it.
93% w mag/gm waxes W; (gm—3%) 47:62:12 OCF = EBIT + Depreciation — Taxes
OCF = $8,680 + 1,940 — 2,527
OCF = $8,093 9. Calculating Net Capital Spending. Rotweiler Obedience School's December 21,2007,
balance sheet showed net ﬁxed assets of $1.875 million, and the December 31,2008,
balance sheet showed net ﬁxed assets of $2.12 million. The company's 2008 income
statement showed a depreciation expense of $220,000. What was Rotweiler Obedience's
net capital spending for 2008? Solution:
Net capital spending is the increase in ﬁxed assets, plus depreciation. Using this
relationship, we ﬁnd: Net capital spending = NFAend — NFAb,g + Depreciation Net capital spending = $2,120,000 — 1,875,000 + 220,000 Net capital spending = $465,000 10. Calculating Additions to NWC. The December 31,2007, balance sheet of Anna's
Tennis Shop, Inc., showed current assets of $840 and current liabilities of $320. The
December 31,2008, balance sheet showed current assets of $910 and current liabilities of
$335. What was the company's 2008 change in net working capital, or NWC? Solution:
The change in net working capital is the end of period net working capital minus the
beginning of period net working capital, so: Change in NWC = NWCend — NWCbcg Change in NWC = (CAend — CLend) — (CAMg — CLbeg) Change in NWC = ($910 — 335) — (840 — 320) Change in NWC = $55 11. Cash Flow to Creditors. The December 31, 2007, balance sheet of Butterﬂy Wings,
Inc., showed longterm debt of $1.65 million,and the December 31, 2008, balance sheet
showed longterm debt of $1.8 million. The 2008 income statement showed an interest
expense of $49,000. What was the ﬁrm's cash ﬂow to creditors during 2008? Solution: The cash ﬂow to creditors is the interest paid, minus any new borrowing, so:
Cash ﬂow to creditors = Interest paid — Net new borrowing
Cash ﬂow to creditors = Interest paid — (LTDend — LTDbeg) CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 28 _ r ti ﬁr *5” ti.
93% a mag/am ﬁéfﬁng W; (aw—3%) amt: Cash ﬂow to creditors = $49,000 — ($1,800,000 — 1,650,000)
Cash ﬂow to creditors = —$101,000 12. Cash Flow to Stockholders. The December 31, 2007, balance sheet of Butterﬂy
Wings,Inc., showed $150,000 in common stock account and $2.9 million in the additional
paidin surplus account. The December 31, 2008, balance sheet showed $160,000 and
$3.2 million in the same two accounts, respectively. If the company paid out $70,000 in
cash dividends during 2008, what was the cash ﬂow to stockholders for the year?
Solution: The cash ﬂow to stockholders is the dividends paid minus any new equity raised. So, the
cash ﬂow to stockholders is: (Note that APIS is the additional paidin surplus.) Cash ﬂow to stockholders = Dividends paid — Net new equity = Dividends paid — (Commonend + APISend) — (Commonb‘,g + APISbeg) = $70,000 — [($160,000 + 3,200,000) — ($150,000 + 2,900,000)] = —$240,000 13. Calculating Total Cash Flows. Given the information for Butterﬂy Wings,Inc., in
problems 11 and 12, suppose you also know that that the ﬁrm's net capital spending for
2008 was $760,000, and that the ﬁrm reduced its net working capital investment by
$135,000. What was the ﬁrm's 2008 operating cash ﬂow, or OCF? Solution:
We know that cash ﬂow ﬁom assets is equal to cash ﬂow to creditors plus cash ﬂow to
stockholders. So, cash ﬂow ﬁom assets is: Cash ﬂow ﬁom assets = Cash ﬂow to creditors + Cash ﬂow to stockholders Cash ﬂow ﬁom assets = —$101,000 — 240,000 Cash ﬂow ﬁom assets = —$341,000
We also know that cash ﬂow ﬁom assets is equal to the operating cash ﬂow minus the
change in net working capital and the net capital spending. We can use this relationship to
ﬁnd the operating cash ﬂow. Doing so, we ﬁnd: Cash ﬂow ﬁom assets = OCF — Change in NWC — Net capital spending —$341,000 = OCF — (—$135,000) — (760,000) OCF = —$341,000 — 135,000 + 760,000 OCF = $284,000 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 29 =7 75: 553‘ ‘3’ 5'5.
93% q mere/gm agree We (vi—3%) amtLat: Intermediate (questi0n1423 ) 14. Calculating Total Cash Flows. Greene Co. shows the following information on its
2008 income statement; sales=$138,000; costs=$71,500; other expenses=$4,100; depre
ciation expense=$10,100; interest expense=$7,900;taxes=$17,760;dividends=$5,400. In
addition, you're told that the ﬁrm issued $2,500 in new equity during 2008, and redeemed
$3,800 in outstanding longterm debt. a. What is the 2008 operating cash ﬂow? b. What is the 2008 cash ﬂow to creditors? c. What is the 2008 cash ﬂow to stockholders? d. If ﬁxed assets increased by $17,400 during the year, what was the addition to NWC? Solution: a. To calculate the OCF, we ﬁrst need to construct an income statement. The income
statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract
out interest to get taxable income, and then subtract taxes to arrive at net income.
Doing so, we get: Income Statement Sales $138,000
Costs 71,500
Other Expenses 4, 100
Depreciation 10,100
EBIT $52,300
Interest 7,900
Taxable income $44,400
Taxes 17, 760
Net income $26,640
Dividends $5,400 Addition to retained earnings 21,240
Dividends paid plus addition to retained earnings must equal net income, so:
Net income = Dividends + Addition to retained earnings
Addition to retained earnings = $26,640 — 5,400= $21,240
So, the operating cash ﬂow is:
OCF = EBIT + Depreciation — Taxes
OCF = $52,300 + 10,100 — 17,760 = $44,640 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 210 93% a mag/gm waxes W; (vi—3%) elemtr: b. The cash ﬂow to creditors is the interest paid, minus any new borrowing. Since the
company redeemed longterm debt, the new borrowing is negative. So, the cash ﬂow to
creditors is: Cash ﬂow to creditors = Interest paid — Net new borrowing
Cash ﬂow to creditors = $7,900 — (—$3,800) = $11,700 c. The cash ﬂow to stockholders is the dividends paid minus any new equity. So, the cash
ﬂow to stockholders is: Cash ﬂow to stockholders = Dividends paid — Net new equity
Cash ﬂow to stockholders = $5,400 — 2,500= $2,900 d. In this case, to ﬁnd the addition to NWC, we need to ﬁnd the cash ﬂow ﬁom assets.
We can then use the cash ﬂow ﬁom assets equation to ﬁnd the change in NWC. We
know that cash ﬂow ﬁom assets is equal to cash ﬂow to creditors plus cash ﬂow to
stockholders. So, cash ﬂow ﬁom assets is: Cash ﬂow ﬁom assets = Cash ﬂow to creditors + Cash ﬂow to stockholders
Cash ﬂow ﬁom assets = $11,700 + 2,900= $14,600 Net capital spending is equal to depreciation plus the increase in ﬁxed assets, so:
Net capital spending = Depreciation + Increase in ﬁxed assets
Net capital spending = $10,100 + 17,400= $27,500 Now we can use the cash ﬂow ﬁom assets equation to ﬁnd the change in NWC. Doing so, we ﬁnd: Cash ﬂow ...
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