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Ryerson University
FIN 300
Scott Anderson

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
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