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Chapter 03: Financial Statements, Cash Flow, and Taxes
d.
Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues
less Operating costs. Operating costs do not include interest or taxes.
e.
Depreciation is not a cash charge, so it does not have an effect on a firm’s reported profits.
49. Which of the following factors could explain why Michigan Energy's cash balance increased even though it had a
negative cash flow last year?
a.
The company sold a new issue of bonds.
b.
The company made a large investment in new plant and equipment.
c.
The company paid a large dividend.
d.
The company had high depreciation expenses.
e.
The company repurchased 20% of its common stock.
50. Analysts who follow Howe Industries recently noted that, relative to the previous year, the company's net cash
provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors
could explain this situation?
a.
The company cut its dividend.
b.
The company made large investments in fixed assets.
c.
The company sold a division and received cash in return.
d.
The company issued new common stock.
e.
The company issued new long-term debt.
Chapter 03: Financial Statements, Cash Flow, and Taxes
51. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash
provided from operations declined. Which of the following could explain this performance?
a.
The company’s dividend payment to common stockholders declined.
b.
The company’s expenditures on fixed assets declined.
c.
The company’s cost of goods sold increased.
d.
The company’s depreciation expense declined.
e.
The company’s interest expense increased.
52. Which of the following statements is CORRECT?
a.
The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or
selling fixed assets.
b.
The statement of cash flows shows where the firm’s cash is located; indeed, it provides a listing of all banks
and brokerage houses where cash is on deposit.
c.
The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects
of changes in working capital.
d.
The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect
cash obtained by selling new common stock.
e.
The statement of cash flows shows how much the firm’s cash--the total of currency, bank deposits, and short-
term liquid securities (or cash equivalents)--increased or decreased during a given year.
Chapter 03: Financial Statements, Cash Flow, and Taxes
53. Which of the following statements is CORRECT?
a.
In the statement of cash flows, a decrease in accounts receivable is subtracted from net income in the operating
activities section.
b.
Dividends do not show up in the statement of cash flows because dividends are considered to be a financing
activity, not an operating activity.
c.
In the statement of cash flows, a decrease in accounts payable is subtracted from net income in the operating
activities section.
d.
In the statement of cash flows, depreciation is subtracted from net income in the operating activities section.
e.
In the statement of cash flows, a decrease in inventories is subtracted from net income in the operating
activities section.
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
Chapter 03: Financial Statements, Cash Flow, and Taxes
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.
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 it 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 it is defined as follows:
Chapter 03: Financial Statements, Cash Flow, and Taxes
EVA = NOPAT – (Total invested capital)(AT cost of capital %)
57. Which of the following statements is most correct?
a.
Corporations are allowed to exclude 70% of their interest income from corporate taxes.
b.
Corporations are allowed to exclude 70% 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 70% of their interest income from their taxes.
e.
Individuals are allowed to exclude 70% of their dividend income from their taxes.
58. A loss incurred by a corporation
a.
Must be carried forward unless the company has had 2 loss years in a row.
b.
Can be carried back 2 years, then carried forward up to 20 years following the loss.
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.
Chapter 03: Financial Statements, Cash Flow, and Taxes
59. Which of the following statements is CORRECT?
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 2015 could go up to 39.6%, but qualified dividends received were taxed at a
maximum rate of 15% for individuals earning less than $411,500 and married taxpayers filing jointly earning
less than $464,850.
c.
The maximum federal tax rate on corporate income in 2015 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 2015 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
Chapter 03: Financial Statements, Cash Flow, and Taxes
taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was
first 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.
61. Which of the following statements is most correct?
a.
Retained earnings, as reported on the balance sheet, represents the amount of cash a company has available to
pay out as dividends to shareholders.
b.
70% of the interest received by corporations is excluded from taxable income.
c.
70% 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?
Chapter 03: Financial Statements, Cash Flow, and Taxes
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.
63. Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue,
passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating
costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder
reporting purposes.
a.
Companies’ after-tax operating profits would decline.
b.
Companies’ physical stocks of fixed assets would increase.
c.
Companies’ cash flows would increase.
d.
Companies’ cash positions would decline.
e.
Companies’ reported net incomes would decline.
64. Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to double its
depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate. Prior to the new
provision, BBI’s net income was forecasted to be $4 million. Which of the following best describes the impact of the new
provision on BBI’s financial statements versus the statements without the provision? Assume that the company uses the
same depreciation method for tax and stockholder reporting purposes.
Chapter 03: Financial Statements, Cash Flow, and Taxes
a.
The provision will reduce the company’s cash flow.
b.
The provision will increase the company’s tax payments.
c.
The provision will increase the firm's operating income (EBIT).
d.
The provision will increase the company’s net income.
e.
Net fixed assets on the balance sheet will decrease.
65. The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate
the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to
depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will
occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and
stockholder reporting purposes.
a.
Nantell’s taxable income will be lower.
b.
Nantell’s operating income (EBIT) will increase.
c.
Nantell’s cash position will improve (increase).
d.
Nantell’s reported net income for the year will be lower.
e.
Nantell’s tax liability for the year will be lower.
66. Assume that Besley Golf Equipment commenced operations on January 1, 2015, and it was granted permission to use
the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate
its fixed assets over 15 years, but in December 2015 management realized that the assets would last for only 10 years. The
firm's accountants plan to report the 2015 financial statements based on this new information. How would the new
depreciation assumption affect the company’s financial statements?
Chapter 03: Financial Statements, Cash Flow, and Taxes
a.
The firm’s reported net fixed assets would increase.
b.
The firm’s EBIT would increase.
c.
The firm’s reported 2015 earnings per share would increase.
d.
The firm’s cash position in 2015 and 2016 would increase.
e.
The provision will increase the company's tax payments.
67. A start-up firm is making an initial investment in 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, this will
cause a decline in its current assets as shown on the balance sheet.
c.
If a company issues new long-term bonds to purchase fixed assets during the current year, this will increase
Chapter 03: Financial Statements, Cash Flow, and Taxes
both its reported current assets and current liabilities at the end of the year.
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. After all, future cash flows tells us 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.
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
Chapter 03: Financial Statements, Cash Flow, and Taxes
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.
72. The CFO of Daves Industries plans to have the company issue $300 million of new common stock and use the
proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume that the company, which does not
pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant.
Which of the following would occur?
Chapter 03: Financial Statements, Cash Flow, and Taxes
a.
The company’s taxable income would fall.
b.
The company’s interest expense would remain constant.
c.
The company would have less common equity than before.
d.
The company’s net income would increase.
e.
The company would have to pay less taxes.
73. Which of the following statements is CORRECT?
a.
Assume that two firms are both following generally accepted accounting principles. Both firms commenced
operations two years ago with $1 million of identical fixed assets, and neither firm either sold any of those
assets or purchased any new fixed assets. The two firms would be required to report the same amount of net
fixed assets on their balance sheets as those statements are presented to investors.
b.
Assets other than cash are expected to produce cash over time, and the amount of cash they eventually produce
must be the same as the amounts at which the assets are carried on the books.
c.
The income statement shows the difference between a firm's income and its costs--i.e., its profits--during a
specified period of time. However, all reported income comes in the form of cash, and reported costs likewise
are consistent with cash outlays. Therefore, there will not be a substantial difference between a firm's reported
profits and its actual cash flow for the same period.
d.
The primary reason the annual report is important in finance is that it is used by investors when they form
expectations about the firm's future earnings and dividends, and the riskiness of those cash flows.
e.
EPS stands for earnings per share, while DPS stands for dividends per share. We would normally expect to see
DPS exceed EPS.
74. Which of the following statements is CORRECT?
Chapter 03: Financial Statements, Cash Flow, and Taxes
a.
An increase in accounts receivable is added to net income in the operating activities section because if
accounts receivable increase, then when they are collected cash will come into the firm.
b.
In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is
calculated as after-tax operating income plus depreciation less the sum of capital expenditures and the change
in net operating working capital. Free cash flow is the amount of cash that could be withdrawn without
harming the firm's ability to operate and to produce future cash flows.
c.
The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this
section is "Net Income." Then, also in the first section, we show some items that add to or subtract from cash,
and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or
negative, but if it is negative, the firm is almost certain to soon go bankrupt.
d.
The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends
the company paid. Therefore, the dividends are frequently called "the bottom line."
e.
Most rapidly growing companies have positive free cash flows because cash flows from existing operations
will exceed fixed assets and working capital needed to support the growth.
75. Which of the following statements is CORRECT?
a.
Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the
company has made the investments in current and fixed assets that are necessary to sustain ongoing
operations.
b.
After-tax operating income is calculated as EBIT(1 - T) + Depreciation.
c.
Two firms with identical sales and operating costs but with different amounts of debt and tax rates will have
different operating incomes by definition.
d.
If a firm is reporting its income in accordance with generally accepted accounting principles, then its net
income as reported on the income statement should be equal to its free cash flow.
e.
Retained earnings as reported on the balance sheet represent cash and, therefore, are available to distribute to
stockholders as dividends or any other required cash payments to creditors and suppliers.
Chapter 03: Financial Statements, Cash Flow, and Taxes
76. Which of the following statements is CORRECT?
a.
The current cash flow from existing assets is highly relevant to investors. However, since the value of the firm
depends primarily upon its growth opportunities, accounting net income projections from those opportunities
are the only relevant future flows with which investors are concerned.
b.
Two metrics that are used to measure a company's financial performance are net income and free cash flow.
Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting
principles. Finance people generally put at least as much weight on free cash flows as they do on net income.
c.
To estimate the net cash provided by operations, depreciation must be subtracted from net income because it is
a non-cash charge that has been added to revenue.
d.
Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not
deductible. This treatment, other things held constant, tends to discourage the use of debt financing by
corporations.
e.
If Congress changed depreciation allowances so that companies had to report higher depreciation levels for tax
purposes in 2015, this would lower their free cash flows for 2015.
Multiple Choice: Problems
A good bit of relatively simple arithmetic is involved in some of these problems, and although the calculations are simple,
it will take students some time to set up the problem and do the arithmetic. We allow for this when assigning problems for
a timed test.
Also, students must use a number of definitions to answer some of the questions. To avoid excessive memorization, we
provide students with a list of formulas and definitions for use on exams. Problems with * in the topic line are
nonalgorithmic.
77. Bauer Software's current balance sheet shows total common equity of $5,125,000. The company has 430,000 shares of
stock outstanding, and they sell at a price of $27.50 per share. By how much do the firm's market and book values per
share differ? (Round your intermediate and final answer to two decimal places.)
a.
$12.31
b.
$17.61
c.
$17.30
d.
$15.58
e.
$15.11
Chapter 03: Financial Statements, Cash Flow, and Taxes
78. Brown Fashions Inc.'s December 31, 2015 balance sheet showed total common equity of $4,050,000 and 225,000
shares of stock outstanding. During 2015, the firm had $450,000 of net income, and it paid out $100,000 as dividends.
What was the book value per share at 12/31/15, assuming no common stock was either issued or retired during 2015?
(Round your final answer to two decimal places.)
a.
$24.44
b.
$17.01
c.
$24.25
d.
$20.73
e.
$19.56
Chapter 03: Financial Statements, Cash Flow, and Taxes
79. Prezas Company's balance sheet showed total current assets of $3,000, all of which were required in operations. Its
current liabilities consisted of $975 of accounts payable, $600 of 6% short-term notes payable to the bank, and $250 of
accrued wages and taxes. What was its net operating working capital?
a.
$1,935
b.
$1,438
c.
$1,651
d.
$1,544
e.
$1,775
80. Rao Construction recently reported $18.00 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 40%. What was Rao's operating income, or EBIT, in millions?
a.
$2.78
b.
$2.88
c.
$1.90
d.
0$2.40
Chapter 03: Financial Statements, Cash Flow, and Taxes
e.
$2.11
81. Brown Office Supplies recently reported $19,500 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 40%. How much was the firm's earnings before taxes (EBT)?
a.
$10,378
b.
$10,201
c.
$8,870
d.
$9,580
e.
$8,515
Chapter 03: Financial Statements, Cash Flow, and Taxes
82. Vasudevan Inc. recently reported operating income of $4.80 million, depreciation of $1.20 million, and had a tax rate
of 40%. The firm's expenditures on fixed assets and net operating working capital totaled $0.6 million. How much was its
free cash flow, in millions?
a.
$3.17
b.
$2.68
c.
$3.48
d.
$3.38
e.
$4.28
83. Over the years, O'Brien Corporation's stockholders have provided $20,000,000 of capital, when they purchased new
issues of stock and allowed management to retain some of the firm's earnings. The firm now has 1,000,000 shares of
Chapter 03: Financial Statements, Cash Flow, and Taxes
common stock outstanding, and it sells at a price of $43.50 per share. How much value has O'Brien's management added
to stockholder wealth over the years, i.e., what is O'Brien's MVA?
a.
$21,150,000
b.
$28,200,000
c.
$25,850,000
d.
$29,375,000
e.
$23,500,000
84. Wu Systems has the following balance sheet. How much net operating working capital does the firm have?
Cash
$ 100
Accounts payable
$ 200
Accounts receivable
650
Accruals
135
Inventory
550
Notes payable
565
Current assets
$ 1,300
Current liabilities
$ 900
Net fixed assets
$ 1,000
Long-term debt
600
Common equity
300
Retained earnings
500
Total assets
$ 2,300
Total liab. & equity
$ 2,300
a.
$965
b.
$1,177
c.
$772
d.
$1,033
e.
$1,042
