Chapter 3: Financial Statements, Cash Flow, and Taxes
Learning Objectives
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Chapter 3
Financial Statements, Cash Flow, and Taxes
Learning Objectives
After reading this chapter, students should be able to:
◆ List each of the key financial statements and identify the kinds of information they provide to
corporate managers and investors.
◆ Estimate a firm’s free cash flow and explain why free cash flow has such an important effect on firm
value.
◆ Discuss the major features of the federal income tax system.
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Lecture Suggestions
Chapter 3: Financial Statements, Cash Flow, and Taxes
Lecture Suggestions
The goal of financial management is to take actions that will maximize the value of a firm’s stock. These
actions will show up, eventually, in the financial statements, so a general understanding of financial
statements is critically important.
Note that Chapter 3 provides a bridge between accounting, which students have just covered,
and financial management. Unfortunately, many non-accounting students did not learn as much as they
DAYS ON CHAPTER: 2 OF 56 DAYS (50-minute periods)
Chapter 3: Financial Statements, Cash Flow, and Taxes
Answers and Solutions
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Answers to End-of–Chapter Questions
3-2 Bankers and investors use financial statements to make intelligent decisions about what firms to
3-4 The balance sheet shows the firm’s financial position on a specific date, for example, December
3-5 Investors need to be cautious when they review financial statements. While companies are
required to follow GAAP, managers still have quite a lot of discretion in deciding how and when
b. Although not broken down on a per-household level, updated information on aggregate
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Answers and Solutions
Chapter 3: Financial Statements, Cash Flow, and Taxes
3-7 Free cash flow is the amount of cash that could be withdrawn without harming the firm’s ability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. It is calculated as after-tax operating income plus
3-9 MVA is the difference between a firm’s market value and the book value of its equity. The higher
a firm’s MVA, the better the job management is doing for the firm’s shareholders. EVA is the
3-11 Double taxation refers to the fact that corporate income is subject to an income tax, and then
Chapter 3: Financial Statements, Cash Flow, and Taxes
Answers and Solutions
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Solutions to End-of–Chapter Problems
3-1 From the data given in the problem, we know the following:
Current assets $ 500,000c Accounts payable and accruals $ 100,000e
a. Total debt = Short-term debt + Long-term debt
Total debt = $900,000.
b. We are given that the firm’s total assets equal $2,500,000. Since both sides of the balance
e. Current liabilities = Accounts payable and accruals + Notes payable
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Answers and Solutions
Chapter 3: Financial Statements, Cash Flow, and Taxes
3-3 EBITDA $7,500,000 (Given)
3-6 Book value of equity = $35,000,000.
Chapter 3: Financial Statements, Cash Flow, and Taxes
Answers and Solutions
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3-7 EVA = EBIT(1 – T) –
capital
ofcost
%tax –After
capital
inv ested
Total
3-8 a. Federal tax liability = $28,925.00 + ($165,000 – $148,850)0.28
3-9 Statements b and d will decrease the amount of cash on a company’s balance sheet.
3-12 a. From the statement of cash flows the change in cash must equal cash flow from operating
activities plus long-term investing activities plus financing activities. First, we must identify
the change in cash as follows:
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Answers and Solutions
Chapter 3: Financial Statements, Cash Flow, and Taxes
b. Since we determined that the firm’s cash flow from operations totaled $50,000 in Part a of
this problem, we can now calculate the firm’s net income as follows:
3-13 Statement of Cash Flows
I. Operating Activities
Chapter 3: Financial Statements, Cash Flow, and Taxes
Answers and Solutions
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c. Statement of Stockholders’ Equity, 2015
Common Stock Retained Total Stockholders’
Shares Amount Earnings Equity
Balances, 12/31/14 5,000 $50,000 $20,850 $70,850
3-15 Working up the income statement you can calculate the new sales level would be $12,681,482.
Sales $12,681,482 S – 0.55S – Deprec. = EBIT
3-16 a. Common Stock Retained Total Stockholders’
Shares Amount Earnings Equity
Balances, 12/31/14 100,000,000 $260,000,000 $1,374,000,000 $1,634,000,000
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Answers and Solutions
Chapter 3: Financial Statements, Cash Flow, and Taxes
3-17 a.
capital working
capital working
operatingNet
= Current assets – (Current liabilities – Notes payable)
b. FCF2015 = [EBIT(1 – T) + Deprec.] – [Cap. expend. + NOWC]
Note that depreciation must be added to Net P&E to arrive at capital expenditures.
c. The large increase in dividends for 2015 can most likely be attributed to a large increase in
3-18 a. First, you need to calculate taxable income. Note, we need to treat the tax on dividend
income and long-term capital gains separately.
Be careful to use the Individual Tax Rate Table:
Chapter 3: Financial Statements, Cash Flow, and Taxes
Answers and Solutions
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Comprehensive/Spreadsheet Problem
Chapter 3: Financial Statements, Cash Flow, and Taxes
Comprehensive/Spreadsheet Problem
Note to Instructors:
The solution to this problem is not provided to students at the back of their text. Instructors
can access the
Excel
file on the textbook’s website.
3-19
a.
The input information required for the problem is outlined in the “Key Input Data“ section below. Using
Laiho Industries December 31 Balance Sheets
(in thousands of dollars)
2015 2014
Assets