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study guide

11 Pages
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Department
Finance
Course Code
FIN 300
Professor
Scott Anderson

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CHAPTER 2
FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS
Answers to Concepts Review and Critical Thinking Questions
1. 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 have a large factor of safety in meeting
short-term creditor demands. However, since liquidity also has an opportunity cost associated with it
namely that higher returns can generally be found by investing the cash into productive assets—low
liquidity levels are also desirable to the firm. It’s up to the firms financial management staff to find a
reasonable compromise between these opposing needs.
2. 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.
3. 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 (book values).
4. 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.
5. 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.
6. 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.
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it
depends.
8. 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.
9. If a company raises more money from 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.
21
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Solutions to Questions and Problems
Basic
1. Balance Sheet
CA$5,000 CL$4,300 OE = $28,000 – 17,300 = $10,700
NFA 23,000 LTD13,000 NWC=$5,000 – 4,300 = $700
TA$28,000 OE 10,700
TL + OE$28,000
2. Income Statement
Sales $527,000
Costs 280,000
Depreciation 38,000
EBIT$209,000
Interest 15,000
EBT$194,000
Taxes 67,900
Net income$126,100
3. Net income = divs + add. to ret. earnings; add. to ret. earnings = $126,100 – 48,000 = $78,100
4. EPS = NI / shares = $126,100 / 30,000 = $4.20 per share
DPS = divs / shares = $48,000 / 30,000 = $1.60 per share
5. NWC = CA – CL; CA = $900K + 2.2M = $3.1M
Book value CA = $3.1M Market value CA = $2.8M
Book value NFA= $4.0M Market value NFA = $3.2M
Book value assets= $3.1M + 4.0M = $7.1M Market value assets = $2.8M + 3.2M = $6.0M
6. Tax bill = .186 x $273,000 = $50,778
7. To calculate OCF, we first need the income statement:
Income Statement
Sales $13,500
Costs 5,400
Depreciation 1,200
EBIT$6,900
Interest 680
Taxable income$6,220
Taxes (35%) 2,177
Net income$4,043
OCF = EBIT + Depreciation – Taxes = $6,900 + 1,200 – 2,177 = $5,923
8. Net capital spending = NFAend – NFAbeg + Depreciation= $4.7M – 4.2M + 925K = $1.425M
22
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9. Change in NWC = NWCend – NWCbeg
Change in NWC = (CAend – CLend) – (CAbeg – CLbeg)
Change in NWC = ($1,720 – 1,180) – ($1,600 – 940)
Change in NWC = $540 – 660 = –$120
10. Cash flow to creditors = Interest paid – Net new borrowing = $340K – (LTDend – LTDbeg)
Cash flow to creditors = $340K – ($3.1M – 2.8M) = $340K – 300K = $40K
11. Cash flow to stockholders = Dividends paid – Net new equity
Cash flow to stockholders = $600K – [(Commonend + APISend) – (Commonbeg + APISbeg)]
Cash flow to stockholders= $600K – [($820K + 6.8M) – ($855K + 7.6M)]
Cash flow to stockholders= $600K – [$7.62M – 8.455M] = –$235K
Note, APIS is the additional paid-in surplus.
12. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
= $40K – 235K = –$195K
Cash flow from assets = –$195K = OCF – Change in NWC – Net capital spending
= OCF – (–$165K) – 760K = –$195K
Operating cash flow = –$195K – 165K + 760K = $400K
Intermediate
13. To find the OCF, we first calculate net income.
Income Statement
Sales $145,000
Costs 86,000
Depreciation 7,000
Other expenses 4,900
EBIT$47,100
Interest 15,000
Taxable income$32,100
Taxes (40%) 12,840
Net income $19,260
Dividends $8,700
Additions to RE$10,560
a. OCF = EBIT + Depreciation– Taxes = $47,100 + 7,000 – 12,840 = $41,260
b. CFC = Interest – Net new LTD = $15,000 – (-$6,500) = $21,500.
Note that the net new long-term debt is negative because the company repaid part of its long-
term debt.
c. CFS = Dividends – Net new equity = $8,700 – 6,450 = $2,250
d. We know that CFA = CFC + CFS, so:
CFA = $21,500 + 2,250 = $23,750
23
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Description
CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS Answers to Concepts Review and Critical Thinking Questions 1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. Its desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it namely that higher returns can generally be found by investing the cash into productive assetslow liquidity levels are also desirable to the firm. Its up to the firms financial management staff to find a reasonable compromise between these opposing needs. 2. 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; its the way accountants have chosen to do it. 3. 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 (book values). 4. 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 its a financing cost, not an operating cost. 5. 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. 6. 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. 7. Its probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it depends. 8. 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. 9. If a company raises more money from 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. 21 www.notesolution.comSolutions to Questions and Problems Basic 1. Balance Sheet CA $5,000 CL $4,300 OE = $28,000 17,300 = $10,700 NFA 23,000 LTD 13,000 NWC= $5,000 4,300 = $700 TA $28,000 OE 10,700 TL + OE $28,000 2. Income Statement Sales $527,000 Costs 280,000 Depreciation 38,000 EBIT $209,000 Interest 15,000 EBT $194,000 Taxes 67,900 Net income $126,100 3. Net income = divs + add. to ret. earningadd. to ret. earnings = $126,100 48,000 = $78,100 4. EPS = NI shares = $126,100 30,000 = $4.20 per share DPS = divs shares = $48,000 30,000 = $1.60 per share 5. NWC = CA CL; CA = $900K + 2.2M = $3.1M Book value CA = $3.1M Market value CA = $2.8M Book value NFA = $4.0M Market value NFA = $3.2M Book value assets= $3.1M + 4.0M = $7.1M Market value assets = $2.8M + 3.2M = $6.0M 6. Tax bill = .186 x $273,000 = $50,778 7. To calculate OCF, we first need the income statement: Income Statement Sales $13,500 Costs 5,400 Depreciation 1,200 EBIT $6,900 Interest 680 Taxable income $6,220 Taxes (35%) 2,177 Net income $4,043 OCF = EBIT + Depreciation Taxes = $6,900 + 1,200 2,177 = $5,923 8. Net capital spending = NFAend NFA beg+ Depreciation= $4.7M 4.2M + 925K = $1.425M 22 www.notesolution.com
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