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
1. (LO1) 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 firm’s financial management staff to find a
reasonable compromise between these opposing needs.
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.
3. (LO1) 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. (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.
5. (LO1) 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
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.
7. (LO4) 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. (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.
S2-1 9. (LO4) 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.
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
1. (LO1) To find owner’s equity, we must construct a balance sheet as follows:
CA $4,000 CL $3,400
NFA 22,500 LTD 6,800
TA $26,500 TL & OE $26,500
We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $26,500. We
also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so
owner’s equity is:
OE = $26,500 – 6,800 – 3,400 = $16,300
NWC = CA – CL = $4,000 – 3,400 = $600
2. (LO1) The income statement for the company is:
Taxes (35%) 88,900
Net income $165,100
3. (LO1) One equation for net income is:
Net income = Dividends + Addition to retained earnings
Rearranging, we get:
Addition to retained earnings = Net income – Dividends = $165,100 – 86,000 = $79,100
EPS = Net income / Shares = $165,100 / 30,000 = $5.50 per share
DPS = Dividends / Shares = $86,000 / 30,000 = $2.87 per share
S2-2 5. (LO1)
NWC = CA – CL; CA = $410K + 1.3M = $1.7M
Book value CA = $1.7M Market value CA = $1.8M
Book value NFA = $2.6M Market value NFA = $3.7M
Book value assets= $1.7M + 2.6M = $4.3M Market value assets = $1.8M + 3.7M = $5.5M
Tax bill = 0.165 x $325,000 = $53,625
7. (LO3) The average tax rate is the total tax paid divided by net income, so:
Average tax rate = $53,625 / $325,000 = 16.5%
The marginal tax rate is the tax rate on the next $1 of earnings, so again the marginal tax rate = 16.5%
because corporations in Canada have a single tax bracket (whereas individuals are subject to
progressive taxes in several tax brackets).
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– CLbeg
Change in NWC = ($1,650 – 920) – ($1,400 – 870)
Change in NWC = $730 – 530 = $200
Cash flow to creditors = Interest paid – Net new borrowing = $340K – (LTD end LTD )beg
Cash flow to creditors = $280K – ($3.3M – 3.1M) = $280K – 200K = $80K
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.
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.
S2-4 15. (LO1) The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to ret. earnings = $1,200 + 4,300 = $5,500
Now, looking at the income statement:
EBT – EBT × Tax rate = Net income
Recognize that EBT × tax rate is simply the calculation for taxes. Solving this for EBT yields:
EBT = NI / (1– tax rate) = $5,500 / (1 – 0.35) = $8,462
Now you can calculate:
EBIT = EBT + Interest = $8,462 + 2,300 = $10,762
The last step is to use:
EBIT = Sales – Costs – Depreciation
EBIT = $34,000 – 16,000 – Depreciation = $10,762
Solving for depreciation, we find that depreciation = $7,238
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
17. (LO1) The market value of shareholders’ equity cannot be zero. A negative market value in this case
would imply that the company would pay you to own the stock. The market value of shareholders’
equity can be stated as: Shareholders’ equity = Max [(TA – TL), 0]. So, if TA is $6,700, equity is equal
to $600, and if TA is $5,900, equity is equal to $0. We should note here that the book value of
shareholders’ equity can be negative.
S2-5 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
= $1,100 + 2,700 – 197 = $3,603
S2-6 c. Change in NWC = NWC end NWC beg
= (CA end– CL end (CA beg– CL beg
= ($3,850 – 2,100) – ($3,200 – 1,800)
= $1,750 – 1,400 = $350
Net capital spending = NFA end– NFA beg Depreciation
= $9,700 – 9,100 + 2,700 = $3,300
CFA = OCF – Change in NWC – Net capital spending