Chapter 03: Financial Statements, Cash Flow and Taxes
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46. Which of the following statements is CORRECT?
a. Typically, a firm’s DPS should exceed its EPS.
b. Typically, a firm’s net income should exceed its EBIT.
c. If a firm is more profitable than average, we would normally expect to see its stock price exceed its book value
per share.
d. If a firm is more profitable than most other firms, we would normally expect to see its book value per share
exceed its stock price, especially after several years of high inflation.
e. The more depreciation a firm has in a given year, the higher its EPS, other things held constant.
47. On its 12/31/19 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same amount
was shown the previous year. Assuming that no earnings restatements were issued, which of the following statements is
CORRECT?
a. If the company lost money in 2019, it must have paid dividends.
b. The company must have had zero net income in 2019.
c. The company must have paid out half of its 2019 earnings as dividends.
d. The company must have paid no dividends in 2019.
e. Dividends could have been paid in 2019, but they would have had to equal the earnings for the year.
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54. Which of the following statements is CORRECT?
a. Most rapidly growing companies have positive free cash flows because cash flows from existing operations
generally exceed fixed asset purchases and changes to net operating working capital.
b. Changes in working capital have no effect on free cash flow.
c. Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 – T)
+ Depreciation
– Capital expenditures required to sustain operations
– Required changes in net operating working capital.
d. Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 – T) + Capital expenditures.
e. Managers should be less concerned with free cash flow than with accounting net income. Accounting net income
is the “bottom line” and represents how much the firm can distribute to all its investors—both creditors and stockholders.
55. Which of the following statements is CORRECT?
a. Actions that increase reported net income will always increase cash flow.
b. One way to increase EVA is to generate the same level of operating income but with less total invested capital.
c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free.
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d. One way to increase EVA is to achieve the same level of operating income but with more total invested capital
obtained at a higher cost of capital.
e. If a firm reports positive net income, its EVA must also be positive.
56. Which of the following statements is CORRECT?
a. MVA stands for “market value added” and is defined as follows:
MVA = (Shares outstanding)(Stock price) + Book value of common equity.
b. The primary difference between EVA and accounting net income is that when net income is calculated, a
deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the
cost of the equity capital the firm uses.
c. MVA gives us an idea about how much value a firm’s management has added during the last year.
d. EVA gives us an idea about how much value a firm’s management has added over the firm’s life.
e. EVA stands for “economic value added” and is defined as follows:
EVA = NOPAT – (Total invested capital)(AT cost of capital %)
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57. Which of the following statements is CORRECT?
a. Corporations are allowed to exclude 50% of their interest income from corporate taxes.
b. Corporations are allowed to exclude 50% of their dividend income from corporate taxes.
c. Individuals pay taxes on only 30% of the income realized from municipal bonds.
d. Individuals are allowed to exclude 50% of their interest income from their taxes.
e. Individuals are allowed to exclude 50% of their dividend income from their taxes.
58. A loss incurred by a corporation
a. must be carried back 2 years before being carried forward for 5 years.
b. can be carried forward indefintely.
c. can be carried back 5 years and forward 3 years.
d. cannot be used to reduce taxes in other years except with special permission from the IRS.
e. can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.
59. Which of the following statements is CORRECT?
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a. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing
over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were
both deductible.
b. Interest paid to an individual is counted as income for federal tax purposes and taxed at the individual’s regular
tax rate, which in 2018 could go up to 37%, but qualified dividends received are taxed at a maximum rate of 15% for most
individuals.
c. The maximum federal tax rate on corporate income in 2018 was 50%.
d. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling
new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the
equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax
purposes.
e. The maximum federal tax rate on personal income in 2018 was 50%.
60. Which of the following statements is CORRECT?
a. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate
income taxes. Thus, the federal government receives no tax revenue from these businesses, even though they report high
accounting profits.
b. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the
Internal Revenue Code.
c. Small corporations that qualify under the Tax Code can elect not to pay corporate taxes, but then each stockholder
must report his or her pro rata shares of the firm’s income as personal income and pay taxes on that income.
d. Congress recently changed the tax laws to make dividend income received by individuals exempt from income
taxes. Prior to the enactment of that law, corporate income was subject to double taxation, whereby the firm was taxed on
the corporation’s income and stockholders were taxed again on this income when it was paid to them as dividends.
e. All corporations other than non-profits are subject to corporate income taxes, which are 15% for the lowest
amounts of income and 38% for the highest income amounts.
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61. Which of the following statements is CORRECT?
a. Retained earnings, as reported on the balance sheet, represent the amount of cash a company has available to pay
out as dividends to shareholders.
b. 50% of the interest received by corporations is excluded from taxable income.
c. 50% of the dividends received by corporations is excluded from taxable income.
d. Because taxes on long-term capital gains are not paid until the gain is realized, investors must pay the top
individual tax rate on that gain.
e. The corporate tax system favors equity financing, as dividends paid are deductible from corporate taxes.
62. Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and (3) an
increase in cash as reported on its balance sheet. Which of the following factors could explain this situation?
a. The company had a sharp increase in its inventories.
b. The company had a sharp increase in its accrued liabilities.
c. The company sold a new issue of common stock.
d. The company made a large capital investment early in the year.
e. The company had a sharp increase in depreciation expenses.
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e. The provision will increase the company’s tax payments.
67. A start-up firm is making an initial investment in a new plant and equipment. Assume that currently its equipment
must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the
firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the
year following the change?
a. The firm’s operating income (EBIT) would increase.
b. The firm’s taxable income would increase.
c. The firm’s cash flow would increase.
d. The firm’s tax payments would increase.
e. The firm’s reported net income would increase.
68. Which of the following statements is CORRECT?
a. Dividends paid reduce the net income that is reported on a company’s income statement.
b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, its current
assets as shown on the balance sheet will decline.
c. If a company issues new long-term bonds to purchase fixed assets during the current year, its reported current
assets and current liabilities at the end of the year will increase.
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d. Accounts receivable are reported as a current liability on the balance sheet.
e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the
balance sheet will decline from the previous year’s balance.
69. For managerial purposes, i.e., making decisions regarding the firm’s operations, the standard financial statements as
prepared by accountants under generally accepted accounting principles (GAAP) are often modified and used to create
alternative data and metrics that provide a somewhat different picture of a firm’s operations. Related to these
modifications, which of the following statements is CORRECT?
a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments
are normally carried into any adjustment that managers make to the standard statements.
b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be
quite different during any given accounting period. However, the firm’s value is based on its future cash flows because
future cash flows indicate how much the firm can distribute to its investors.
c. The standard statements provide useful information on the firm’s individual operating units, but management
needs more information on the firm’s overall operations than the standard statements provide.
d. The standard statements focus on cash flows, but managers should be less concerned with cash flows than with
accounting income as defined by GAAP.
e. The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent
from firm to firm. Thus, under GAAP, there is no room for accountants to “adjust” the results to make earnings look
better.
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70. Which of the following statements is CORRECT?
a. Since depreciation increases the firm’s net cash provided by operating activities, the more depreciation a company
has, the larger its retained earnings will be, other things held constant.
b. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make
required payments.
c. Common equity includes common stock and retained earnings, less accumulated depreciation.
d. The retained earnings account as reported on the balance sheet shows the amount of cash that is available for
paying dividends.
e. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet
will be negative.
71. Last year Besset Company’s operations provided a negative cash flow, yet the cash shown on its balance sheet
increased. Which of the following statements could explain the increase in cash, assuming the company’s financial
statements were prepared under generally accepted accounting principles (GAAP)?
a. The company repurchased some of its common stock.
b. The company dramatically increased its capital expenditures.
c. The company retired a large amount of its long-term debt.
d. The company sold some of its fixed assets.
e. The company had high depreciation expenses.
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80. Rao Construction recently reported $30.00 million of sales, $12.60 million of operating costs other than depreciation,
and $3.00 million of depreciation. It had $8.50 million of bonds outstanding that carry a 7.0% interest rate, and its federal-
plus-state income tax rate was 25%. What was Rao’s operating income, or EBIT, in millions?
a. $11.09
b. $16.70
c. $14.54
d. $14.40
e. $16.56
81. Brown Office Supplies recently reported $15,500 of sales, $8,250 of operating costs other than depreciation, and
$1,750 of depreciation. It had $9,000 of bonds outstanding that carry a 7.0% interest rate, and its federal-plus-state income
tax rate was 25%. How much was the firm’s earnings before taxes (EBT)?
a. $3,799
b. $5,211
c. $4,870
d. $5,649
e. $5,065