Chapter 02 IM 10th Ed | Free Cash Flow | Dividend

CHAPTER 2

Understanding Financial Statements, Taxes, and Cash Flows
CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and balance sheet. We also look very carefully at how to compute a firm’s cash flows from a finance perspective, which is called free cash flows.

CHAPTER OUTLINE
I. Basic Financial Statements A. The Income Statement 1. 2. The income statement reports the results from operating the business for a period of time, such as a year. It is helpful to think of the income statement as comprising five types of activities: a. b. c. Selling the product The cost of producing or acquiring the goods or services sold The expenses incurred in marketing and distributing the product or service to the customer along with administrative operating expenses The financing costs of doing business: for example, interest paid to creditors and dividend payments to the preferred stockholders The taxes owed based on a firm’s taxable income

d.

e. 3.

An example of an income statement is provided in Table 2-1 for the Harley-Davidson Corporation.

9

B.

The Balance Sheet 1. The balance sheet provides a snapshot of the firm’s financial position at a specific point in time, presenting its asset holdings, liabilities, and owner-supplied capital. a. Assets represent the resources owned by the firm (1) Current assets - consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses Fixed or long-term assets – comprising equipment, buildings, and land Other assets – all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long-term investments in securities, and goodwill

(2) (3)

b.

The liabilities and owners’ equity indicate how the assets are financed. (1) (2) The debt consists of such sources as credit extended from suppliers or a loan from a bank. The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.

2.

The balance sheet is not intended to represent the current market value of the company, but rather reports the historical transactions recorded at their costs. Balance sheets for the Harley-Davidson Corporation are presented in Table 2-2.

3. II

Computing a Company’s Taxes A. Types of taxpayers 1. Sole proprietors a. b. 2. a. b. Report business income on personal tax returns Pay taxes at personal tax rate The partnership reports income but does not pay taxes Each partner reports his or her portion of income and pays the corresponding taxes.

Partnerships

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profits are not the same as cash flows. Depreciation C. b. rather than from an accounting view. we could use the conventional accountant’s presentation called a statement of cash flows. b. 2. In measuring cash flows. Corporations a. Our focus is on corporate taxes. B. While an income statement measures a company’s profits. both debt and equity investors. Tax rates used to calculate tax liability are marginal tax rates. 3. Corporation reports income and pays taxes Owners do not report these earnings except when all or part of the profit is paid out as dividends. The cash flows that are generated through a firm’s operations and investments in assets will always equal its cash flows paid to – or received from – the company’s investors (both creditors and stockholders). or what we will call free cash flows. C.3. Computing Taxes Owed 1. Taxable income is based on gross income less tax-deductible expenses a. b. Average tax rate is calculated by dividing taxes owed by the firm’s total income Marginal tax rate is used in financial decision making III. 4. a. or the rate applicable to the next dollar of income. However. profits are calculated on an accrual basis rather than a cash basis. 2. Measuring Free Cash Flows A. we are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors. Computing Taxable Income 1. Interest expense is tax deductible Dividend payments are not tax deductible Modified accelerated cost recovery system used for computing depreciation for tax purposes We use straight-line depreciation to reduce complexity. B. We will instead measure the cash flow that is free and available to be distributed to the firm’s investors. 11 . Taxes paid are based on corporate tax structure. c.

from an asset perspective. That is. taxes. Investments in fixed assets includes the change in gross fixed assets and any other balance sheet assets not already considered. After-tax cash flows from operations as follows: Operating income (earnings before interest and taxes) + depreciation = Earnings before interest. a firm's free cash flows for a given period is equal to: After-tax cash flow from operations less the investment (increase) in net operating working capital less investments in fixed assets (plant and equipment) and other assets. depreciation and amortization (EBITDA) cash tax payments = After-tax cash flows from operations 3. 2.bearing   change in   current assets  .D. A firm's free cash flows. Calculating Free Cash Flows: An Asset Perspective 1. It is this same amount that will be available for distributing to the firm’s investors. current liabilitie s     4. is the after-tax cash flows generated from operations less the firm's investments in assets. The increase in net operating working capital is equal to the: change in noninteres t . 12 .

it is because the firm’s free cash flow from assets is negative. At this time. For example. Free cash flows from a financing perspective are equal to: Interest payments to creditors + or decrease in debt principal increase in debt principal plus dividends paid to stockholders + or decrease in stock increase in stock 2. Free cash flow from an asset perspective must equal free cash flow from a financing perspective.S.10 Euro (the equivalent of a U. foreign companies seeking to list their shares in the United States must follow U. accounting standards. Calculating Free Cash Flows: A Financing Perspective 1. a $1 of earnings in the United States is not the same as 1. the U.E. 3. dollar based on the exchange rate).S. or if negative. IV. the International Accounting Standards Committee (IASC). As a result of this situation. B. In spite of the work to standardize accounting practices around the world. the cash flows that the investors are paying into the firm. Many countries have different guidelines for firms to use in preparing financial statements. Free cash flows from a financing perspective are simply the net cash flows received by the firm’s investors.S. is trying to develop international financial-reporting standards that will minimize the problem. Financial Statements and International Finance A. The differences are due to the two countries having different Generally Accepted Accounting Principles which guide their firms’ financial reporting. thereby requiring an infusion of capital by the investors. 13 . In the latter situation where the investors are putting money into the firm. a private body supported by the worldwide accounting profession. accounting profession has rejected efforts toward international standards.

so that the preferred stockholder gets a constant dividend each year. then our interest expense will be $60.000. We instead measure the cash flow that is free and available to be distributed to the firm’s investors. on the other hand. both debt and equity investors. However. The balance sheet represents an enumeration of a firm’s resources (assets) along with its liabilities and owners’ equity at a given date. Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes. But it does not present it in a way that makes clear the cash flows the firm’s creditors and investors are providing to or receiving from the firm. which consist of distributing the product or service to the customer (namely. but “not exactly. we choose to reformat the presentation to show the firm’s free cash flows—the cash available to distribute to the creditors and investors. The income statement summarizes the net results of the operation of a firm over a specified time interval. Gross profits is sales less the cost of producing or acquiring the firm’s product or service. The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date.ANSWERS TO END-OF-CHAPTER QUESTIONS 2-1. b. If we borrow $500. Operating profits is the gross profits less the operating expenses. whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time. Interest expense is the cost of borrowing money from a banker or another lender. Common stockholders. typically once a dividend has been paid to common stockholders. dividends are paid to the firm’s stockholders. Thus. Preferred stock typically has a fixed dividend rate. 2-2. While interest is paid for the use of debt capital. 2-3. There typically is a fixed interest rate so that the interest expense is computed as the interest rate times the amount borrowed. 14 . We are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors. marketing expenses) and any general and administrative expenses in operating the business. Thus.” We also make the distinction between the cash flows generated by the firm’s assets and the financing free cash flows. management is reluctant to decrease it or cease paying a dividend. or what we will call free cash flows. rather than from an accounting view. a. what we use is similar to a conventional cash flow statement presented as part of a company’s financial statements.000 at an interest rate of 12 percent. The conventional cash flow statement as prepared by accountants provides the information we need to know about what has happened to the firm’s cash and why. usually receive dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits.

. Free cash flows from a financing perspective looks at the cash flows from the investors’ viewpoint. A firm could have positive cash flows but still be in trouble because it has negative cash flows from operations. which is a critical issue for any company. while net working capital is the difference between current assets and current liabilities.5 2-6. such as accounts payables and accruals. Such a situation means that the company is not earning a satisfactory rate of return on its investments. Free cash flows from assets equal the cash flows that are generated by the company that are then distributed to (if positive) or received from (if negative) the firm’s creditors and investors. Thus. They have to be equal. 15 . these dividends affect the income statement only. 2-8. The positive cash flows would then be the result of the firm reducing its investments in working capital or long-term assets. With this latter method. The former is debt where the lender is paid interest for providing us the money. Noninterest-bearing debt charges no interest because the “lender” is really a supplier or an employee to whom we owe money. dividends are paid or accrued each year based upon preferred dividends (i. the percentage of the preferred stock’s par value paid as dividends) agreed to at the selling date. Gross working capital is the sum of current assets. Another company could have very attractive rates of return on its assets. 2-7. That is. Common stock dividends. Accountants include all short-term debt when computing net working capital. we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business—beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer. but be growing so fast that the large investments in working capital and long-term assets result in negative cash flows. management is simply investing in the future. debt repayment or stock repurchase and how the investor infused cash in the form of additional debt or stock purchase. Net working capital is the firm’s liquid assets (current assets) less its short-term debt. Examining only the income statement and the balance sheet fails to tell us how the firm is using its cash. then the investors must receive $100 as well. Whatever the company does is the exact opposite of what the investor receives or pays. It indicates how the investor received cash in the form of interest. positive cash flows will occur. It looks at cash flows from the firm’s perspective. the common equity section of the balance sheet (par value of common stock. if a company distributes $100 in cash to the investors. In this latter case. however. we only subtract the noninterest-bearing debt. dividends. also affect the income statement. the investment of common shareholders varies with the net addition to (or reduction from) retained earnings from year to year. however. The net addition to retained earnings equals the difference in the period’s net income and common dividends paid.2-4 Once preferred shares are sold. As already suggested. 2. we have both interest-bearing debt and noninterest-bearing debt. As the rate of growth slows. paid-in capital and retained earnings) varies from year to year due to changes in the retained earnings portion of the firm’s common equity. in computing free cash flows. which may vary from year to year. but they are not requiring the firm to pay interest.e. However.

000 $ 60.440 3.250 $ 60.400 55. Belmond.400 $ 45.500 $ 32.000 (34.550 9.000) $ 88.650 $ 600 4.600 6.SOLUTIONS TO END-OF-CHAPTER PROBLEMS Solutions to Problem Set A 2-1A. Inc. Inc. Balance Sheet December 31.750 $ 7.050 $ 850 500 $ $ $ $ 1.000 15.800 1. Income Statement For the Year Ended December 31.700 900 4.650 $122.350 5. 2003 ASSETS Current assets Cash Accounts receivable Inventory Total current assets Gross buildings & equipment Accumulated depreciation Net buildings & equipment Total assets LIABILITIES AND EQUITY Liabilities Current Liabilities Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total liabilities and equity $ 16.000 $120.360 .800 5.650 Belmond.250 $120.800 $ 5. 2003 Sales Cost of goods sold Gross profits General & admin expense Depreciation expense Total operating expense Operating income (EBIT) Interest expense Earnings before taxes Taxes Net income 16 $ 12.

000 $ 20.000 100.000 (236.000 $ 326.2-2A. Company Income Statement For the Year Ended December 31.000 120.000 160. Company Balance Sheet December 31.000 280.000 17 .000 $ 300.000 $ 350.000 $ 700.000 $ 190.000 $ 790.000 110.000 Sharpe Mfg. Sharpe Mfg. 2003 Sales Cost of goods sold Gross profits Operating expense Net income (Assume no interest accrued or taxes) $ 800.000 500.000) 464.000 20.000 $ 440. 2003 ASSETS Cash Accounts receivable Inventory Total current assets Machinery and equipment Accumulated depreciation Net fixed assets Total assets LIABILITIES & EQUITY Liabilities Current Liabilities Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Prior year Current year Total equity Total liabilities and equity 96.000 $ $ 100.000 $ 790.000 $ 320.000 90.

500 91.000 235. Inc.000 35. Delaney.000 $1.Corporate Income Tax Sales Cost of goods sold and cash operating expenses Depreciation expense Operating profit Interest expense Taxable Income Tax Liability: $50.000 150.000 $1.400.2-3A. .34 = = = = = $7.000.34 0.500.100 $459.000 5.000 x x x x x 0.015.39 0.25 0.350.000 25.000 25.34 = = = = = $7.000 235. Inc.000 2.500 91. .000 30.15 0.000 18 .900 $125.000.Corporate Income Tax Sales Cost of goods sold and cash operating expenses Operating profit Interest expense Taxable Income Tax Liability: $50.650 11.000 $1.600.250 8.000 $370. Potts.000 1.000 $4.000 $ 400.000 x x x x x 0.500 6.350.000 100.000 25.34 0.000 $ 370.000 25.500 6.250 8.000 2-4A.650 345.39 0.15 0.800 $ 6.25 0.

000 $ 440.000) 75. Inc.000 $ 120.000) (25.000. Pamplin. Net income was $180.2-5A. Inc.000.000 $ 560.asset perspective Free cash flows from a financing perspective: Interest expense $ (60. The remainder was used to decrease payables to suppliers by $50. Additionally.financing perspective $ 360.000.000 Note: The dividends were computed by comparing net income against the change in retained earnings.000 (80.000.000) $ (50. 19 .000.000 $ 120. but retained earnings increased only by $100.000.000 $ $ (50.000) $ 10.000) Less change in interest payable Interest paid to lenders Repayment of long-term debt Increase in short-term debt Common stock dividends paid to owners Free cash flows . Pamplin. This cash was mainly used to purchase fixed assets of $400. thus the balance was distributed in the form of dividends. pay interest of $60. had an after-tax operating cash flow of $440.000.000 $ (50. Free cash flows from an asset perspective: Operating income (EBIT) Depreciation EBITDA Tax expense Less change in tax payable Cash taxes After-tax cash flows from operations Change in net working capital Change in current assets: Change in cash Change in accounts receivable Change in inventory Change in current assets Change in noninterest-bearing current debt: Change in accounts payable Change in net operating working capital Change in long-term assets: Purchase of fixed assets Free cash flows .000) $ (60. Pamplin acquired further financing though increasing short-term debt by $150.000 200.000. and pay dividends back to the investors of $80.000) 150.000) $ (10.000) (400.

2-6A. however.000 Change in prepaid rent (100) Change in marketable securities 200 Change in current assets $ 23.000) Less change in interest payable Interest received by investors Decrease in long-term debt Decrease in notes payable Common stock dividends Financing free cash flows $ 70.000 27.000) Change in inventory 33. by $12. Debt was decreased. Interest of $10.000 (Change in net fixed assets + depr.900 $ (15.000) (2. T. To increase cash flow further. Jarmon had a successful year. generating an after-tax cash flow of $82.100 $ 82.000) (31.800 in dividends. Finally.000) (10.000 Change in accrued expenses (1.000 30. investors were paid $31. both long-term and short-term.100 Change in noninterest-bearing current debt: Change in accounts payable $ 9. 20 .000 Change in net operating working capital Step 3: Change in long-term assets Purchase of fixed assets $ 14.000) Change in accounts receivable (9. Part of this cash was consumed when current assets were increased by $23. The substantial part of the cash flow.000) Change in noninterest-bearing current debt: $ 8.100) $ (14.000.000 80.800) T.000 was also paid on this debt.000.P.800 $ (10.000) $ 53. Fixed assets of $14.800) $ (53.100 (of which inventory increased by $33.900. expense) Change in other assets Net cash used for investments Asset free cash flows Free cash flows from a financing perspective: Interest paid to investors $(10. Jarmon Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes Plus interest expense EBIT Depreciation EBITDA Tax expense $ 27. noninterest-bearing debt increased by $8.100 Less change in tax payable Cash taxes After-tax cash flows from operations Step 2: Change in net operating working capital Change in current assets: Change in cash $ (1.000 10.P.000 were also purchased.000 $ 110.000). was distributed back to the investors.

000 and purchase fixed assets of $73.000 16.000 (12.000) Less change in interest payable Interest received by investors Decrease in long-term debt (mortgage payable) Increase in preferred stock Preferred stock dividends Common stock dividends Financing free cash flows $ (4. This cash was primarily used to pay down debt of $70. 21 .000) $ 5.000) $ 14.000 $ (73. Abrams also increased current assets in total by $5.000) $ $ (5.000 Abrams generated cash through an after-tax operating profit of $64.000 26.000 by increasing cash and accounts receivable while decreasing inventory.000.000 and issuing preferred stock of $120.000) (70. Abrams Manufacturing Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Operating Income Depreciation EBITDA Tax expense $ 16.000 (5.000 $ 64.000 6.2-7A.000 $ 11.000.000.000) $ (14.000 (10.000) $ 73.000) (22.000 Less change in tax payable Cash taxes After-tax cash flows from operations Step 2: Change in net operating working capital Change in current assets: Change in cash Change in accounts receivables Change in inventories Change in prepaid expenses Change in current assets Change in noninterest-bearing current debt: Change in accounts payables Change in accrued liabilities Change in noninterest-bearing current debt: Change in net operating working capital Step 3: Change in long-term assets Purchase of fixed assets Change in other assets Net cash used for investments Asset free cash flows $ 54.000 $ 80.000) 120.000 $ 5.000 and interest of $4. Investors also received cash back through dividends of $32.000) Free cash flows from a financing perspective: Interest paid to investors $ (4.

Davis & Howard decreased their debt principal(including long-term debt. To further increase cash flow.380. and other assets increased in net by $1.336 in fixed assets. Accounts payable to suppliers were also increased by $349. investors and creditors infused $99. Inc. and other assets. increased short-term debt and other current liabilities by $227. Johnson increased their longterm debt by $1.210 in after-tax operating cash flows(including other income). In addition.577.062 to help finance the increase in current assets. and notes payable) by a total of $27. Davis & Howard used their free cash flows to repurchase common stock for $29. However. inventory and other current assets by $587. Finally.607.881.467 in accounts receivable.2-8A.297 in inventory and other current assets and purchased $308. The noninterest-bearing current debt also increased by $59. Johnson incurred a loss of $450. Johnson should look for ways to decrease debt.113.034. investments. and provide an acceptable rate of return to its investors. produce positive future cash flows.420. Williams Williams generated $224.912. They also increased their short-term debt by $30. Interest expense of $17. Fixed assets. investments.966 was paid to cover the company’s current debt.198.873. 22 . This money was used in part to increase current assets and fixed assets of $77. While Williams generated a positive after-tax cash flow from operations. It should be careful not to become over-capitalized during this time of rapid growth. Johnson.100 and $61. respectively.730 and other assets were sold for $9. Stockholders were paid dividends of $26.T. Management should take measures to reduce the average collection period or utilize other tools to maintain control of this asset.662 and $32. Free cash flows of $101. To finance this negative free cash flow. J. 2-9A. SOLUTION TO INTEGRATIVE PROBLEM Davis & Howard had a successful year bringing in positive after-tax cash flows from operations(including other income) of $174.024 was paid for the current debt. interest expense of $87. The company increased their cash reserve. While investors in Internet companies have been satisfied with repeated annual losses.018 and issued more common stock for $61. and issued more common stock in the amount of $851. increased their long-term debt by $7.958.274 were distributed to investors.806. Williams needs to analyze whether the investors are receiving an acceptable return on their investments.753. They used the operating cash flow and increased financing to purchase $58. accounts payable and accrued expenses were increased by $1.118.283. Investments also increased $2.016. respectively. other liabilities.571 in after-tax operating cash flows(including other losses).401 into the operations to finance the increases in assets.924. the increase in current assets was substantially due to an increase of $57.

000 $ 571.000 $ $ $ $ 145.900 $1.000 53. Warner Company Balance Sheet December 31. 2003 ASSETS Current assets Cash Accounts receivable Inventory Prepaid expenses Total current assets Gross buildings & equipment Accumulated depreciation Net buildings & equipment Total assets LIABILITIES AND EQUITY Liabilities Current Liabilities Accounts payable Notes payable Taxes payable Accrued expense Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total liabilities and equity $ 225.000 262.500 $ 491.800 $ 895.000 75.000) $ 632.000 153.900 334.000 131.000 7.000 (263.123.000 .900 $ 551.800 $ 102.300 14.000 4.000 $1.900 $ 289.000 297.750 126.500 75.750 573.Solutions to Problem Set B 2-1B.000 99.123.000 276.250 50.800 Warner Company Income Statement For the Year Ended December 31. 2003 Sales Cost of goods sold Gross profits General & admin expense Depreciation expense Total operating expense Operating income (EBIT) Interest expense Earnings before taxes Taxes Net income 23 $ $ $ 79.900 $ 237.000 66.

000 350.000 84. 2003 Net Sales Cost of goods sold Gross profits Operating expense Net income $ $ $ 900. Sabine Mfg.000 $ 814.000 $ 814. Company Balance Sheet December 31.2-2B.000 150.000 $ Sabine Mfg.000 $ 350.000 70.000 160.000) $ 464.000 $ 180.000 $ 340.000 (236.000 $ 474. Company Income Statement For the Year Ended December 31.000 24 .000 550.000 $ 700.000 90. 2003 ASSETS Current assets Cash Accounts receivable Inventory Total current assets Machinery and Equipment Accumulated depreciation Net buildings & equipment Total assets LIABILITIES AND EQUITY Liabilities Current Liabilities Accounts payable Short-term notes payable Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Prior year Current year Total equity Total liabilities and equity $ 90.000 110.000 70.000 280.000 $ 320.000 90.

000 25.000 $400. Inc.650 8.000 25.Corporate Income Tax Sales Cost of goods sold and cash operating expenses Depreciation expense Operating profit Interest expense Taxable Income Tax Liability: $50.000 165.000 40. Rose.Corporate Income Tax Sales Cost of goods sold and cash operating expenses Operating profit Interest expense Taxable Income Tax Liability: $50.000 25.39 0.250 8.2-3B.500 6.000 $ 360.000 25 .000 $735.000 235.900 $ 3.500 $122.000 $ 735.500 91.000 100.650 136.000.500.34 0.000 400.15 0.000 $ 900.500 91.15 0. .000 $249.000 235.000 x x x x x 0.000 x x x x x 0.39 0.34 = = = = = $ 7.34 0. Cook.600.34 = = = = = $ 7.000 6. Inc.250 8.000 25.400 $7.000 $ 360.000 2.500 6.000 25.25 0.500.000 2-4B.25 0. .

000 (62.000 were paid to investors.000) $ 270. RPI. 26 . Inc.000 $ 530.000) Change in noninterest-bearing current debt: Change in accounts payable Change in accrued expenses Change in noninterest-bearing current debt: Change in net operating working capital Step 3: Change in long-term assets Purchase of fixed assets Change in other assets Net cash used for investments Asset free cash flows Free cash flows from a financing perspective: Interest expense $ (60.000 60.000 $ (300.000 $ 422.000) $ (115.000 200.000 Change in current assets $ (20.000) After-tax cash flows from operations of $422.2-5B.000) $(135.000) Change in inventory 50.000) $ 7.000 Less change in tax payable Cash taxes After-tax cash flows from operations Step 2: Change in net operating working capital Change in current assets: Change in cash $ (50.000 108.000.000) $ (7. J.000) Change in accounts receivable (20.000 and $300. Chavez Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes Plus interest expense EBIT Depreciation EBITDA Tax expense $ 108.000 and an increase in notes payable of $115. respectively.000 were used to pay down the accounts payable by $135.000) Less change in interest payable Interest paid to lenders Increase in notes payable Common stock dividends Financing free cash flows $ 300.000 and common stock dividends of $62.B.000 $ (60. Interest of $60.000 330. 2-6B.000) 115.000 and increase our inventory and fixed assets by $50.000 $(135.

100 Less change in tax payable Cash taxes After-tax cash flows from operations Step 2: Change in net operating working capital Change in current assets: Change in cash $ Change in marketable securities Change in accounts receivable Change in prepaid rent Change in inventory Change in current assets $ Change in noninterest-bearing current debt: Change in accounts payable $ Change in accrued expenses Change in noninterest-bearing current debt: $ Change in net operating working capital Step 3: Change in long-term assets Purchase of fixed assets (Change in net fixed assets + depreciation expense) Change in other assets Net cash used for investments Asset free cash flows $ $ 110.100) 34.000) (10.Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes Plus interest expense EBIT Depreciation EBITDA Tax expense $ 27.000 (1.000) (3.000 27.000 200 (4.000) $ 54.000 40.000 $ 150.000 $ (34.900 1.100 7.800) $ (54.000) (31.000 $ (34.000 10.800 Free cash flows from a financing perspective: Interest expense $ (10.000 30.000) 6.800) 27 .000 120.000) (100) 43.000) Less change in interest payable Interest paid to lenders Decrease in notes payable Decrease in long-term debt Common stock dividends Financing free cash flows $ (10.100 $ 122.

000 Free cash flows from a financing perspective: Interest expense $ (5.000) 70.000) $ (35.000) Change in current assets $ (35.000 $ 103. Fixed assets of $34.800. and dividends of $31.000) (60. mostly in the area of inventory which increased by $43.000) Change in net operating working capital Step 3: Change in long-term assets Purchase of fixed assets Change in other assets Net cash used for investments Asset free cash flows $ 63. RPI made a decision to evenly split the cash flow between distribution to investors and investing back into the company.000 were also purchased.000 $ 72.000.100.000) Less change in interest payable Interest paid to lenders Decrease in mortgage payable Increase in preferred stock Preferred stock dividends Common stock dividends Financing free cash flows 28 $ (5.000.000 26. The asset free cash flow of $54.000) Change in noninterest-bearing current debt: $ (10.000) Change in noninterest-bearing current debt: Change in accounts payable $ (5.000 Change in prepaid expenses Change in inventory (22. debt repayments of $13.000 (8.000) Change in accrued liabilities (5.000 77.000) $ 35.RPI had positive after-tax operating cash flows of $122. 2-7B.900.800 was distributed back to investors through interest of $10. As a result. Net operating capital increased by $34.000 5. Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes Plus interest expense EBIT Depreciation EBITDA Tax expense $ 30.000) Change in accounts receivable 6.000.000 $ $ 25.000) . Cameron Co.000 73.000 $ (63.000) (32.000 Less change in tax payable Cash taxes After-tax cash flows from operations Step 2: Change in net operating working capital Change in current assets: Change in cash $ (19.000 30.

com also sought to increase their liquidity by increasing current assets by $84. The remainder of the common stock issue was paid back to investors through a dividend of $23.495.000 in dividends and $5.463 and increased current liabilities by $9. However.822 in long-term debt principal.634 in interest.953. Retail.657. In future years. it should be noted that current assets increased by $5.000 of preferred stock. For many years. Cameron also decreased current assets of $35.000 in fixed assets. This increase was offset by increasing accounts payable by $5.962.000 in interest to investors. It has been more important to grow quickly than to create profits.038 of which accounts receivable increased by $7. $3. created cash flows through after-tax profits of $73. Retail.456. 29 .9B Retail. This cash was used. It is possible that Hilary’s thought it wise to lower long term debt and repurchase stock rather than make investments in further growth. consisting mainly of a $76. respectively.609.000 in a mortgage payable and distributed $40. The asset free cash flow of $9.com mainly used the cash to increase growth by purchasing fixed assets and other investments of $31.689. Retail. to cover an after-tax operating loss(including other income) of $63.108. in part. Cameron also eliminated $60. This cash was used to decrease $10. 2-8B Hilary’s Ice Cream Hilary’s had a profitable year generating after-tax operating cash flows(including other losses) of $10.000 through inventory and cash.688 was distributed to the investors in the form of $1. 2. which was offset in part by increasing payables by $4. Retail.593 in common stock.971 and $178.com In need of cash.612.Cameron Co.060.000 and issuing $70.com issued common stock for $368.com must turn these losses into profits and create true value for their investors. Hilary’s used some of the above operating cash flow to purchase other assets for $3. and repurchasing $4.680 increase in their cash reserve.000 in noninterestbearing current debt and to purchase $63. Hilary’s should be concerned with the substantial increase in payables and the even greater threat of aging receivables. it has been fairly easy for innovative Internet companies to raise money through the stock market.

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