Answers and Solutions: 2 – 1
Chapter 2
Financial Statements, Cash Flow, and Taxes
ANSWERS TO END-OF-CHAPTER QUESTIONS
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
b. Common Stockholders’ Equity (Net Worth) is the capital supplied by common
stockholders—capital stock, paid-in capital, retained earnings, and, occasionally,
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
d. Depreciation is a non-cash charge against tangible assets, such as buildings or
machines. It is taken for the purpose of showing an asset’s estimated dollar cost of
e. Operating current assets are the current assets used to support operations, such as
cash, accounts receivable, and inventory. It does not include short-term investments.
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
cash flow, as opposed to accounting net income, is the sum of net income plus non–
cash adjustments. NOPAT, net operating profit after taxes, is the amount of profit a
g. Market value added is the difference between the market value of the firm (i.e., the
sum of the market value of common equity, the market value of debt, and the market
value of preferred stock) and the book value of the firm’s common equity, debt, and
h. A progressive tax means the higher one’s income, the larger the percentage paid in
taxes. Taxable income is defined as gross income less a set of exemptions and
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.
2-2 The four financial statements contained in most annual reports are the balance sheet,
income statement, statement of stockholders’ equity, and statement of cash flows.
2-3 No, because the $20 million of retained earnings doesn’t mean the company has $20
million in cash. The retained earnings figure represents cumulative amount of net income
2-5 Operating capital is the amount of interest bearing debt, preferred stock, and common
equity used to acquire the company’s net operating assets. Without this capital a firm
cannot exist, as there is no source of funds with which to finance operations.
2-6 NOPAT is the amount of net income a company would generate if it had no debt and held
no financial assets. NOPAT is a better measure of the performance of a company’s
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
Answers and Solutions: 2 – 4
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
2-1 Corporate yield = 9%; T = 35.5%
2-2 Corporate bond yields 8%. Municipal bond yields 6%.
munion Yield
yieldpretax Equivalent
2-3 NI = $6,000,000; EBIT = $13,000,000; T = 40%; Interest = ?
Need to set up an income statement and work from the bottom up.
EBIT $13,000,000
2-4 EBITDA = $8,000,000; NI = $2,400,000; Int = $2,000,000; T = 40%; DA = ?
EBITDA $8,000,000
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.
Answers and Solutions: 2 – 5
2-6 NI = $70,000,000; R/EY/E = $900,000,000; R/EB/Y = $855,000,000; Dividends = ?
2-7 Income $365,000
Less Interest deduction (50,000)
Plus: Dividends receiveda 4,500
Taxable income $319,500
aFor a corporation, 70% of dividends received are excluded from taxes; therefore, taxable
dividends are calculated as $15,000(1 – 0.70) = $4,500.
The company’s marginal tax rate is 39 percent. The company’s average tax rate is
$107,855/$319,500 = 33.76%.
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%.
Check: Invest $10,000 @ 7.5% = $750 interest.
2-10 EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%
NI = ?; NCF = ?; OCF = ?
First, determine net income by setting up an income statement:
Answers and Solutions: 2 – 7
2-11 a. Income Statement
Sales revenues $12,000,000
Costs except
depreciation 9,000,000
b. If depreciation doubled, taxable income would fall to zero and taxes would be zero.
Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000.
Menendez would save $600,000 in taxes, thus increasing its cash flow:
∆CF = T(∆Depreciation) = 0.4($1,500,000) = $600,000.
c. If depreciation were halved, taxable income would rise to $2,250,000 and taxes to
d. You should prefer to have higher depreciation charges and higher cash flows. Net
Answers and Solutions: 2 – 8
2-12 a.
EBIT
$1,260
b.
2013
2012
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
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
c.
2011
2010
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.
2013
NOPAT
$756
capital
650
Free cash flow
$106
– Investment in total net operating
e.
2013
NOPAT
$756
÷ Total net operating capital
Return on invested capital
(ROIC)
10.57%
x (1-Tax rate)
Net operating profit after taxes
(NOPAT)
$756
Answers and Solutions: 2 – 9
f.
Uses of FCF
2011
After-tax interest payment =
$72
2-13 Prior Years 2011 2012
Profit earned $150,000 $150,000
Carry-back credit 150,000 150,000
Adjusted profit $ 0 $ 0
Tax previously
paid (40%) 60,000 60,000
Tax refund: Taxes
previously paid $ 60,000 $ 60,000
Total check from U.S. Treasury = $60,000 + $60,000 = $120,000.
Reduction (increase) in debt =
Payment of dividends =
Repurchase (Issue) stock =
$88
investments =
$10
Answers and Solutions: 2 – 10
SOLUTION TO SPREADSHEET PROBLEM
2-14 The detailed solution for the spreadsheet problem, Ch02 P14 Build a Model Solution.xls
is available at the textbook’s Web site.
Mini Case: 2 – 11
MINI CASE
Jenny Cochran, a recent graduate of the University of Tennessee with four years of
banking experience, was recently brought in as assistant to the chairman of the board of
Computron Industries, a manufacturer of computer components.
The company doubled its plant capacity, opened new sales offices outside its home
territory, and launched an expensive advertising campaign. Computron’s results were not
satisfactory, to put it mildly. Its board of directors, which consisted of its president and
Mini Case: 2 – 12
Balance Sheets
Assets
2012
2013
Cash
$ 9,000
$ 7,282
Short-term investments.
48,600
20,000
Accounts receivable
351,200
632,160
Inventories
715,200
1,287,360
Liabilities and equity
2010
2011
Accounts payable
$ 145,600
$ 324,000
Notes payable
200,000
720,000
Accruals
136,000
284,960
total current liabilities
$ 481,600
$ 1,328,960
Long-term debt
323,432
1,000,000
Common stock (100,000 shares)
460,000
460,000
Retained earnings
203,768
97,632
total equity
$ 663,768
$ 557,632
Total liabilities and equity
$ 1,468,800
$ 2,886,592
Income Statements
2012
2013
Sales
$ 3,432,000
$ 5,834,400
Cost of goods sold
2,864,000
4,980,000
Other expenses
340,000
720,000
Depreciation
18,900
116,960
total operating costs
$ 3,222,900
$ 5,816,960
EBIT
$ 209,100
$ 17,440
Interest expense
62,500
176,000
Pretax earnings
$ 146,600
$ (158,560)
Net income
$ 87,960
$ (95,136)
2011
2012
Stock price
$ 8.50
$ 6.00
Shares outstanding
100,000
100,000
EPS
$ 0.880
$ (0.951)
DPS
$ 0.220
$ 0.110
total current assets
$ 1,124,000
$ 1,946,802
Gross fixed assets
491,000
1,202,950
Less: accumulated depreciation
146,200
263,160
net fixed assets
$ 344,800
$ 939,790
Mini Case: 2 – 13
Statement of Cash Flows
Operating activities
Net income
$ (95,136)
Adjustments:
noncash adjustments:
depreciation
116,960
changes in working capital:
Investing activities
Cash used to acquire fixed assets
$ (711,950)
Cash due to change in short term investments
$ 28,600
Net cash provided by operating activities
$ (683,350)
Financing activities
change in notes payable
$ 520,000
change in long-term debt
$ 676,568
change in common stock
payment of cash dividends
$ (11,000)
Net cash provided by financing activities
$ 1,185,568
Summary
Net change in cash
$ (1,718)
Cash at beginning of year
9,000
Cash at end of year
$ 7,282
a. What effect did the expansion have on sales and net income? What effect did the
expansion have on the asset side of the balance sheet? What effect did it have on
liabilities and equity?
Answer: Sales increased by over by over $2.4 million, but net income fell by over $190,000.
change in accounts receivable
change in inventories
change in accounts payable
178,400
change in accruals
148,960
Net cash provided by operating activities
$ (503,936)
Mini Case: 2 – 14
b. What do you conclude from the statement of cash flows?
Answer: Net CF from operations = -$503,936, because of negative net income and increases in
c. What is free cash flow? Why is it important? What are the five uses of FCF?
Answer: FCF is the amount of cash available from operations for distribution to all investors
(including stockholders and debtholders) after making the necessary investments to
support operations. A company’s value depends upon the amount of FCF it can
generate.
Mini Case: 2 – 15
d. What is Computron’s net operating profit after taxes (NOPAT)? What are
operating current assets? What are operating current liabilities? How much net
operating working capital and total net operating capital does Computron have?
Answer: NOPAT = EBIT(1 – TAX RATE)
Current year:
NOPAT = $17,440(1 – 0.4)
= $10,464.
Mini Case: 2 – 16
e. What is Computron’s free cash flow (FCF)? What are Computron’s “net uses”
of its FCF?
Answer: FCF = NOPAT – Net investment in capital
= $10,464 – ($2,257,632 – $1,138,600)
f. Calculate Computron’s return on invested capital. Computron has a 10% cost
of capital (WACC). Do you think Computron’s growth added value?
ANSWER: ROIC = NOPAT / TOTAL NET OPERATING CAPITAL.
Mini Case: 2 – 17
g. Cochran also has asked you to estimate Computron’s EVA. She estimates that
the after-tax cost of capital was 10 percent in both years.
ANSWER: EVA = NOPAT- (WACC)(CAPITAL).
= $11,600.
h. What happened to Computron’s market value added (MVA)?
Answer: MVA = market value of the firm – book value of the firm.
Market value = (# shares of stock)(price per share) + value of debt.
Mini Case: 2 – 18
i. Assume that a corporation has $100,000 of taxable income from operations plus
$5,000 of interest income and $10,000 of dividend income. What is the
company’s tax liability?
Answer: Calculation of the company’s tax liability:
Taxable operating income $100,000
j. Assume that you are in the 25 percent marginal tax bracket and that you have
$5,000 to invest. You have narrowed your investment choices down to
California bonds with a yield of 7 percent or equally risky ExxonMobil bonds
with a yield of 10 percent. Which one should you choose and why? At what
marginal tax rate would you be indifferent to the choice between California and
ExxonMobil bonds?
Answer: After-tax return income at t = 25%:
ExxonMobil = 0.10($5,000) – (0.10)($5,000)(0.25) = $375.