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Chapter 2

Chapter 2.doc

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ECON 4400

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CHAPTER 2FINANCIAL STATEMENTS TAXES AND CASH FLOWSLearning ObjectivesLO1The difference between accounting value or book value and market valueLO2The difference between accounting income and cash flowLO3How to determine a firms cash flow from its financial statementsLO4The difference between average and marginal tax ratesLO5The basics of Capital Cost Allowance CCA and Undepreciated Capital Cost UCCAnswers to Concepts Review and Critical Thinking Questions 1 LO1 Liquidity measures how quickly and easily an asset can be converted to cash without significant lossin value Its desirable for firms to have high liquidity so that they have a large factor of safety in meetingshortterm creditor demands However since liquidity also has an opportunity cost associated with itnamely 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 2LO2 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 3LO1 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 4LO3 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 5LO1 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 2000 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 6LO3 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 startLO3up so it depends 8LO3 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 longlived assets were liquidated than purchasedS219LO3 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 negativeIf a company borrows more than it pays in interest its cash flow to creditors will be negative10LO1 Enterprise value is the theoretical takeover price In the event of a takeover an acquirer would have to take on the companys 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 firms value In a takeover the value of a firms 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 calculationSolutions to Questions and Problems Basic1LO1To find owners equity we must construct a balance sheet as followsBalance SheetCA5100CL4300NFA23800LTD7400OETA28900TLOE28900We know that total liabilities and owners equity TLOE must equal total assets of 28900 We also know that TLOE is equal to current liabilities plus longterm debt plus owners equity so owners equity isOE289004300 740017200NWCCACL51004300800 2LO1 The income statement for the company is Income StatementSales586000Costs247000Depreciation43000EBIT296000Interest32000EBT264000Taxes 3592400Net income1716003LO1 One equations for net income isNet incomeDividendsAddition to retained earnings Rearranging we getAddition to retained earningsNet incomeDividends17160073000986004LO1EPS Net incomeShares171600850002019 per shareDPS DividendsShares7300085000086 per shareS22
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