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Answers and Solutions: 2 - 1
Chapter 2
Financial Statements, Cash Flow, and Taxes
2-1 a. The annual report is a report issued annually by a corporation to its stockholders. It
contains basic financial statements, as well as management’s opinion of the past
year’s operations and the firm’s future prospects. A firm’s balance sheet is a
statement of the firm’s financial position at a specific point in time. It specifically
lists the firm’s assets on the left-hand side of the balance sheet, while the right-hand
side shows its liabilities and equity, or the claims against these assets. An income
statement is a statement summarizing the firm’s revenues and expenses over an
accounting period. Net sales are shown at the top of each statement, after which
various costs, including income taxes, are subtracted to obtain the net income
available to common stockholders. The bottom of the statement reports earnings and
dividends per share.
b. Common Stockholders’ Equity (Net Worth) is the capital supplied by common
stockholders--capital stock, paid-in capital, retained earnings, and, occasionally,
certain reserves. Paid-in capital is the difference between the stock’s par value and
what stockholders paid when they bought newly issued shares. Retained earnings is
the portion of the firm’s earnings that have been saved rather than paid out as
dividends.
c. The statement of stockholders’ equity shows how much of the firm’s earnings were
retained in the business rather than paid out in dividends. It also shows the resulting
balance of the retained earnings account and the stockholders’ equity account. Note
the capital equipment used up in the production process. Amortization is a non-cash
charge against intangible assets, such as goodwill. EBITDA is earnings before
interest, taxes, depreciation, and amortization.
to a publicly accessible website, in whole or in part.
e. Operating current assets are the current assets used to support operations, such as
Operating current liabilities are the current liabilities that are a natural consequence of
the firm’s operations, such as accounts payable and accruals. It does not include
notes payable or any other short-term debt that charges interest. Net operating
working capital is operating current assets minus operating current liabilities. Total
cash adjustments. NOPAT, net operating profit after taxes, is the amount of profit a
company would generate if it had no debt and no financial assets. Free cash flow is
the cash flow actually available for distribution to investors after the company has
made all investments in fixed assets and working capital necessary to sustain ongoing
market values, then MVA is also equal to the difference between the market value of
equity and the amount of equity capital that investors supplied. Economic value
added represents the residual income that remains after the cost of all capital,
including equity capital, has been deducted.
i. Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less)
than its purchase price. Ordinary corporate operating losses can be carried backward
for 2 years or forward for 20 years to offset taxable income in a given year.
to a publicly accessible website, in whole or in part.
j. Improper accumulation is the retention of earnings by a business for the purpose of
is a small corporation which, under Subchapter S of the Internal Revenue Code, elects
to be taxed as a proprietorship or a partnership yet retains limited liability and other
benefits of the corporate form of organization.
2-2 The four financial statements contained in most annual reports are the balance sheet,
2-3 No, because the $20 million of retained earnings doesn’t mean the company has $20
and equipment.
2-5 Operating capital is the amount of interest bearing debt, preferred stock, and common
2-6 NOPAT is the amount of net income a company would generate if it had no debt and held
situation.
2-7 Free cash flow is the cash flow actually available for distribution to investors after the
2-8 If the business were organized as a partnership or a proprietorship, its income could be
taken out by the owners without being subject to double taxation. Also, if you expected
to have losses for a few years while the company was getting started, if you were not
incorporated, and if you had outside income, the business losses could be used to offset
your other income and reduce your total tax bill. These factors would lead you to not
incorporate the business. An alternative would be to organize as an S Corporation, if
requirements are met.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
2-1 Corporate yield = 9%; T = 35.5%
2-2 Corporate bond yields 8%. Municipal bond yields 6%.
%.25T
02.0T08.0
06.0T08.008.0
)T1(
%6
%8
)T1(
munion Yield
bond on taxable
yieldpretax Equivalent
2-3 NI = $6,000,000; EBIT = $13,000,000; T = 40%; Interest = ?
EBT $10,000,000 EBT =
2-4 EBITDA = $8,000,000; NI = $2,400,000; Int = $2,000,000; T = 40%; DA = ?
Int 2,000,000 (Given)
2-5 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?
NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.
6.0
T)(1
$2,400,000
$2,400,000
to a publicly accessible website, in whole or in part.
2-6 NI = $70,000,000; R/EY/E = $900,000,000; R/EB/Y = $855,000,000; Dividends = ?
$925,000,000 – Div = $900,000,000
2-7 Pre-tax operating earnings $365,000
Less Interest deduction (50,000)
Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 = $107,855.
Net income $222,145
bNon-taxable dividends are calculated as $15,000 x 0.7 = $10,500.
2-8 a. Tax = $3,400,000 + ($10,500,000 - $10,000,000)(0.35) = $3,575,000.
Answers and Solutions: 2 - 6
2-9 A-T yield on FLA bond = 5%.
A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%.
A-T yield = 6% - Taxes = 6% - 0.3(6%)(0.35) = 6% - 0.63% = 5.37%.
Therefore, invest in AT&T preferred stock. We could make this a harder problem by
2-10 EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%
NI = ?; NCF = ?; OCF = ?
EBT $750,000
Taxes (40%) 300,000
Answers and Solutions: 2 - 7
2-11 a. Income Statement
Sales revenues $12,000,000
Taxes (40%) 600,000
Net income $ 900,000
Menendez would save $600,000 in taxes, thus increasing its cash flow:
d. You should prefer to have higher depreciation charges and higher cash flows. Net
cash flows are the funds that are available to the owners to withdraw from the firm
to a publicly accessible website, in whole or in part.
2-12 a.
EBIT
$1,260
x (1-Tax rate)
60.0%
Net operating profit after taxes
(NOPAT)
$756
b.
2016
2015
Cash
$550
$500
+ Accounts receivable
2,750
2,500
+ Inventories
1,650
1,500
Operating current assets
$4,950
$4,500
Accounts payable
$1,100
$1,000
+ Accruals
550
500
Operating current liabilities
$1,650
$1,500
Operating current assets
$4,950
$4,500
- Operating current liabilities
1,650
1,500
Net operating working capital
(NOWC)
$3,300
$3,000
2016
2015
Net operating working capital
(NOWC)
$3,300
$3,000
+ Net plant and equipment
3,850
3,500
Total net operating capital
$7,150
$6,500
d.
2016
NOPAT
$756
- Investment in total net operating
capital
650
Free cash flow
$106
e.
2016
NOPAT
$756
÷ Total net operating capital
7,150
Return on invested capital
(ROIC)
10.57%
to a publicly accessible website, in whole or in part.
f.
Uses of FCF
2016
After-tax interest payment =
$72
Reduction (increase) in debt =
-$284
Payment of dividends =
$220
Repurchase (Issue) stock =
$88
Purchase (Sale) of short-term
investments =
$10
Total uses of FCF =
$106
2-13 Prior Years 2014 2015
Profit earned $150,000 $150,000
Tax refund: Taxes
previously paid $ 60,000 $ 60,000
Estimated
profit $150,000 $150,000 $150,000 $150,000 $150,000
Tax (at 40%) 0 $ 0 $ 40,000 $ 60,000 $ 60,000
to a publicly accessible website, in whole or in part.
SOLUTION TO SPREADSHEET PROBLEM
2-14 The detailed solution for the spreadsheet problem, Ch02 P14 Build a Model
2-15 The detailed solution for the spreadsheet problem, Ch02 P15 Build a Model
