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Chapter 2

FIN300 Ross Westerfield Corporate Finance Solutions Chapter 2 (8th Edition).pdf

12 Pages
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Department
Finance
Course Code
FIN 300
Professor
John Currie

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CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS Learning Objectives LO1 The difference between accounting value (or “book” value) and market value. LO2 The difference between accounting income and cash flow. LO3 How to determine a firm’s cash flow from its financial statements. LO4 The difference between average and marginal tax rates. 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. (LO3) 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 market value. 6. (LO3) 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. (LO3) 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. (LO3) 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. (LO3) 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 calculation. Solutions to Questions and Problems Basic 1. (LO1) To find owner’s equity, we must construct a balance sheet as follows: Balance Sheet CA $5,100 CL $4,300 NFA 23,800 LTD 7,400 OE ?? TA $28,900 TL & OE $28,900 We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $28,900. 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 = $28,900 – 4,300 –7,400 = $17,200 NWC = CA – CL = $5,100 – 4,300 = $800 2. (LO1) The income statement for the company is: Income Statement Sales $586,000 Costs 247,000 Depreciation 43,000 EBIT $296,000 Interest 32,000 EBT $264,000 Taxes (35%) 92,400 Net income $171,600 3. (LO1) One equations for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,600 4. (LO1) EPS = Net income / Shares = $171,600 / 85,000 = $2.019 per share DPS = Dividends / Shares = $73,000 / 85,000 = $0.86 per share S2-2 5. (LO1) NWC = CA – CL; CA = $380K + 1.1M = $1.48M Book value CA = $1.48M Market value CA = $1.6M Book value NFA = $3.7M Market value NFA = $4.9M Book value assets= $1.48M + 3.7M = $5.18M Market value assets = $1.6M + 4.9M = $6.5M 6. (LO4) Tax bill = 0.14 x $236,000 = $33,040 7. (LO4) The average tax rate is the total tax paid divided by net income, so: Average tax rate = $33,040 / $236,000 = 14% The marginal tax rate is the tax rate on the next $1 of earnings, so again the marginal tax rate = 14% because corporations in Canada have a single tax bracket (whereas individuals are subject to progressive taxes in several tax brackets). 8. (LO3) To calculate OCF, we first need the income statement: Income Statement Sales $27,500 Costs 13,280 Depreciation 2,300 EBIT $11,920 Interest 1,105 Taxable income $10,815 Taxes (35%) $3,785.25 Net income $7,029.75 OCF = EBIT + Depreciation – Taxes = $11,920 + 2,300 – 3,785.25 = $10,434.75 9. (LO3) Net capital spending = NFA – NFA + Depreciation = $4.2M – 3.4M + 385K = $1.185M end beg 10. (LO3) Change in NWC = NWC end– NWC beg Change in NWC = (CA end– CL end – (CA beg– CLbeg) Change in NWC = ($2,250 – 1,710) – ($2,100 – 1,380) Change in NWC = $540 – 720 = -$180 11. (LO3) Cash flow to creditors = Interest paid – Net new borrowing = $170K – (LTD end LTD beg Cash flow to creditors = $170K – ($2.9M – 2.6M) = $170K – 300K = -$130K 12. (LO3) Cash flow to shareholders = Dividends paid – Net new equity Cash flow to shareholders = $490K – [Common end– Common beg Cash flow to shareholders = $490K – [$815K – $740K ] Cash flow to shareholders = $490K – [$75K] = $415K S2-3 Intermediate 13. (LO3) Cash flow from assets = Cash flow to creditors + Cash flow to shareholders = $-130K + 415K = $285 K Cash flow from assets = $285K = OCF – Change in NWC – Net capital spending = $285K = OCF – (–85K) – 940K Operating cash flow = $285K – 85K + 940K = $1,140K 14. (LO3) To find the OCF, we first calculate net income. Income Statement Sales $196,000 Costs 104,000 Depreciation 9,100 Other expenses 6,800 EBIT $76,100 Interest 14,800 Taxable income $61,300 Taxes 21,455 Net income $39,845 Dividends $10,400 Additions to RE $29,445 a. OCF = EBIT + Depreciation – Taxes = $76,100 + 9,100 – 21,455 = $63,745 b. CFC = Interest – Net new LTD = $14,800 – (–7,300) = $22,100 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 = $10,400 – 5,700 = $4,700 d. We know that CFA = CFC + CFS, so: CFA = $22,100 + 4,700 = $26,800 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 = $27,000 + 9,100 = $36,100 Now we can use: CFA = OCF – Net capital spending – Change in NWC $26,800 = $63745 – 36100 – Change in NWC Solving for the change in NWC gives $845, meaning the company increased its NWC by $845. 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 = $1,500 + 5,100 = $6,600 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) = $6,600 / (1 – 0.35) = $10,153.85 Now you can calculate: EBIT = EBT + Interest = $10,153.85 + 4,500 = $14,653.85 The last step is to use: EBIT = Sales – Costs – Depreciation EBIT = $41,000 – 19,500 – Depreciation = $14,653.85 Solving for depreciation, we find that depreciation = $6,846.15 16. (LO1) The balance sheet for the company looks like this: Balance Sheet Cash $195,000 Accounts payable $405,000 Accounts receivable 137,000 Notes payable 160,000 Inventory 264,000 Current liabilities $565,000 Current assets $596,000 Long-term debt 1,195,000 Total liabilities $1,760,000 Tangible net fixed assets 2,800,000 Intangible net fixed assets 780,000 Common stock ?? Accumulated ret. earnings 1,934,000 Total assets $4,176,000 Total liab. & owners’ equity $4,176,000 Total liabilities and owners’ equity is: TL & OE = CL + LTD + Common stock + Retained earnings Solving for this equation for equity gives us: Common stock = $4,176,000 – 1,934,000 – 1,760,000 = $482,000 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 $8,400, equity is equal to $1,100, and if TA is $6,700, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative. S2-5 18. (LO4) a. Taxes Growth = 0.14($88,000) = $12,320 Taxes Income = 0.25($8,800,000) = $2,200,000 b. The firms have different marginal tax rates. Corporation Growth pays an additional $1,400 of taxes and in general pays 14% of its next dollar of taxable income in taxes. Corporation Income pays $2,500 of taxes and in general pays 25.0% of its next dollar of taxable income in taxes. 19. (LO2) Income Statement Sales $730,000 COGS 580,000 A&S expenses 105,000 Depreciation 135,000 EBIT –$90,000 Interest 75,000 Taxable income –$165,000 Taxes (35%) 0 a. Net income –$165,000 b. OCF = EBIT + Depreciation – Taxes = –$90,000 + 135,000 – 0 = $45,000 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. (LO3) 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 = $45K – 0 – 0 = $45K Cash flow to shareholders = Dividends – Net new equity = $25K – 0 = $25K Cash flow to creditors = Cash flow from assets – Cash flow to shareholders = $45K – 25K = $20K Cash flow to creditors = Interest – Net new LTD Net new LTD = Interest – Cash flow to creditors = $75K – 20K = $55K 21. (LO2) a. Income Statement Sales $22,800 Cost of goods sold 16,050 Depreciation 4,050 EBIT $ 2,700 Interest 1,830 Taxable income $ 870 Taxes (34%) 295.80 Net income $ 574.20 b. OCF = EBIT + Depreciation – Taxes = $2,700 + 4,050
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