FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS
LO1 The difference between accounting value (or “book” value) and market value.
LO2 The difference between accounting income and cash flow.
LO3 The difference between average and marginal tax rates.
LO4 How to determine a firm’s cash flow from its financial statements.
LO5 The basics of Capital Cost Allowance (CCA) and Undepreciated Capital Cost (UCC).
Answers to Concepts Review and Critical Thinking Questions
2. (LO2) 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.
4. (LO4) 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.
6. (LO4) For a successful company that is rapidly expanding, for example, capital outlays will be large,
possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent
wisely, not whether cash flow from assets is positive or negative.
8. (LO4) 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 would have this effect.
Negative net capital spending would mean more long-lived assets were liquidated than purchased.
10. (LO1) Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have
to take on the company's debt, but would pocket its cash. Enterprise value differs significantly from simple
market capitalization in several ways, and it may be a more accurate representation of a firm's value. In a
takeover, the value of a firm's debt would need to be paid by the buyer when taking over a company. This
enterprise value provides a much more accurate takeover valuation because it includes debt in its value
Solutions to Questions and Problems
2. (LO1) The income statement for the company is:
Taxes (35%) 88,900
S2-1 Net income $165,100
EPS = Net income / Shares = $165,100 / 30,000 = $5.50 per share
DPS = Dividends / Shares = $86,000 / 30,000 = $2.87 per share
Tax bill = 0.165 x $325,000 = $53,625
8. (LO4) To calculate OCF, we first need the income statement:
Taxable income $6,720
Taxes (35%) 2,352
Net income $4,368
OCF = EBIT + Depreciation – Taxes = $7,400 + 1,200 – 2,352 = $6,248
Net capital spending = NFA end– NFA beg+ Depreciation = $5.2M – 4.6M + 875K = $1.475M
Change in NWC = NWC end– NWC beg
Change in NWC = (CA end CL end (CA beg CL beg
Change in NWC = ($1,650 – 920) – ($1,400 – 870)
Change in NWC = $730 – 530 = $200
Cash flow to shareholders = Dividends paid – Net new equity
Cash flow to shareholders = $600K – [(Common end+ ARE )end(Common beg ARE )beg
Cash flow to shareholders = $600K – [($885K + 7.7M) – ($860K + 6.9M)]
Cash flow to shareholders = $600K – [$8.585M – 7.76M] = –$225K
Note, ARE is the additional retained earnings.
Cash flow from assets = Cash flow to creditors + Cash flow to shareholders
= $80K – 225K = –$145K
Cash flow from assets = –$145K = OCF – Change in NWC – Net capital spending
= –$145K = OCF – (–$165K) – 760K
Operating cash flow = –$145K – 165K + 760K = $450K
14. (LO4) To find the OCF, we first calculate net income.
S2-2 Other expenses 5,100
Taxable income $39,000
Taxes (38%) 14,820
Net income $24,180
Additions to RE $14,780
a. OCF = EBIT + Depreciation – Taxes = $55,500 + 8,400 – 14,820 = $49,080
b. CFC = Interest – Net new LTD = $16,500 – (–6,400) = $22,900
Note that the net new long-term debt is negative because the company repaid part of its long-
c. CFS = Dividends – Net new equity = $9,400 – 7,350 = $2,050
d. We know that CFA = CFC + CFS, so:
CFA = $22,900 + 2,050 = $24,950
CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF. Net
capital spending is equal to:
Net capital spending = Increase in NFA + Depreciation = $12,000 + 8,400 = $20,400
Now we can use:
CFA = OCF – Net capital spending – Change in NWC
$24,950 = $49,080 – 20,400 – Change in NWC
Solving for the change in NWC gives $3,730, meaning the company increased its NWC by $3,730.
16. (LO1) The balance sheet for the company looks like this:
Cash $210,000 Accounts payable $430,000
Accounts receivable 149,000 Notes payable 180,000
Inventory 265,000 Current liabilities $610,000
Current assets $624,000 Long-term debt 1,430,000
Total liabilities $2,040,000
Tangible net fixed assets 2,900,000
Intangible net fixed assets 720,000 Common stock ??
Accumulated ret. earnings 1,865,000
Total assets $4,244,000 Total liab. & owners’ equity $4,244,000
Total liabilities and owners’ equity is:
TL & OE = CL + LTD + Common stock + Retained earnings
Solving for this equation for equity gives us:
Common stock = $4,244,000 – 1,865,000 – 2,040,000 = $339,000
S2-3 18. (LO3)
a. Taxes Growth = 0.165($82,000) = $13,530
Taxes Income = 0.330($8,200,000) = $2,706,000
b. The firms have different marginal tax rates. Corporation Growth pays an additional $1,650 of taxes
and in general pays 16.5% of its next dollar of taxable income in taxes. Corporation Income pays
$3,300 of taxes and in general pays 33.0% of its next dollar of taxable income in taxes.
A&S expenses 120,000
Taxable income –$120,000
Taxes (35%) 0
a. Net income –$120,000
b. OCF = EBIT + Depreciation – Taxes = –$35,000 + 130,000 – 0 = $95,000
c. Net income was negative because of the tax deductibility of depreciation and interest expense.
However, the actual cash flow from operations was positive because depreciation is a non-cash
expense and interest is a financing expense, not an operating expense.
20. (LO4) A firm can still pay out dividends if net income is negative; it just has to be sure there is
sufficient cash flow to make the dividend payments.
Change in NWC = Net capital spending = Net new equity = 0. (Given)
Cash flow from assets = OCF – Change in NWC – Net capital spending
Cash flow from assets = $95K – 0 – 0 = $95K
Cash flow to shareholders = Dividends – Net new equity = $30K – 0 = $30K
Cash flow to creditors = Cash flow from assets – Cash flow to shareholders = $95K – 30K = $65K
Cash flow to creditors = Interest – Net new LTD
Net new LTD = Interest – Cash flow to creditors = $85K – 65K = $20K
Cost of goods sold 11,400
EBIT $ 1,100
Taxable income $ 580
Taxes (34%) 197
Net income $ 383
b. OCF = EBIT + Depreciation – Taxes