Answers to Text Discussion Questions

2-1.

The price-earnings ratio will be influenced by the earnings and sales growth of the firm,
the risk or volatility in performance, the debt-equity structure of the firm, the dividend
payment policy, the quality of management, and a number of other factors. The ratio tends
to be future-oriented, and the more positive the outlook, the higher it will be.

2-2.

Book value per share is arrived at by taking the cost of the assets and subtracting out
liabilities and preferred stock and dividing by the number of common shares outstanding.
It is based on the historical costs of the assets. Market value per share is based on current
assessed value of the firm in the marketplace and may bear little relationship to original
cost. Besides the disparity between book and market value caused by the historical cost
approach, other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or positive,
market value may differ widely from book value.

2-3.

The only way amortization generates cash flows for the company is by serving as a tax
shield against reported income. This non-cash deduction may provide cash flow equal to
the tax rate times the amortization charged. This much in taxes will be saved, while no
cash payments occur.

2-4.

Accumulated amortization is the sum of all past and present amortization charges, while
amortization expense is the current year's charge. They are related in that the sum of all
prior amortization expense should be equal to accumulated amortization (subject to some
differential related to asset write-offs).

2-5.

The balance sheet is based on historical costs. When prices are rising rapidly, historical
cost data may lose much of their meaning; particularly for plant and equipment and
inventory.

2.6.

The income statement and balance sheet are based on the accrual method of accounting,
which attempts to match revenues and expenses in the period in which they occur.
However, accrual accounting does not attempt to properly assess the cash flow position of
the firm. The statement of cash flows fulfills this need.

2-7.

The sections of the statement of cash flows are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The payment of cash dividends falls into the financing activities category.

2-8.

We can examine the various sources that were utilized by the firm as indicated on the
statement. Possible sources for the financing of an increase in assets might be profits,
increases in liabilities, or decreases in other asset accounts.

Foundations of Fin. Mgt.

17

5/E Cdn. Block, Hirt, Short

2-9.

Free cash flow is equal to cash flow from operating activities:
Minus:

Capital expenditures required to maintain the productive capacity of the
firm.

Minus:

Dividends (required to maintain the payout on common stock and to cover
any preferred stock obligation).

The analyst or banker normally looks at free cash flow to determine whether there are
sufficient excess funds to pay back the loan associated with the leveraged buy-out.
2.10. Interest expense is a tax-deductible item to the corporation, while dividend payments are
not. The net cost to the corporation of interest expense is the amount paid multiplied by
the difference of (one minus the applicable tax rate). The firm must bear the full burden of
the cost of dividend payments.
Internet Resource and Questions
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www.cica.ca/cica\cicawebsite.nsf/Public/CICAPublicAffairs
www.cica.ca/cica\cicawebsite.nsf/Public/CICAWhatsNew
www.iasc.org.uk/frame/cen1.htm
www.iasc.org.uk/frame/cen1_10.htm
www.cominco.com/InvRel/IR-pubs.htm

Foundations of Fin. Mgt.

18

5/E Cdn. Block, Hirt, Short

....................................................200 Foundations of Fin... 200............... $124...... Block..................800 Taxes = $160...............................000 Selling and administrative expense .... Hirt... 140.......000 Earnings before taxes ............. Hanson Auto Parts Income Statement Sales . Mgt..........................000 Interest expense .......... 160...........200 Earnings aftertaxes .........................000 Cost of goods sold ......... Short .000  ............................ 70.Solutions to Text Problems 2-1................. 19 5/E Cdn..................................................000 Taxes ...…........................ 35........... $470..22 = $35... 60......000 Operating profit ......................................................... 40....000 Amortization expense . 330......................................................000 Gross Profit .….............

Mgt. Hirt.000 Gross Profit ………………………………….000 Earnings aftertaxes ………………………….000 Earnings per share $1. 40. Foundations of Fin. 20..000 Earnings before taxes ………………………. Virginia Slim Wear Income Statement Sales ……………………………………………….30 2-3. Short . $210.2-2.000 Cost of goods sold ………………………………… 200. 310. Block..000 Earnings available to common shareholders …………… $130.000 Interest expense …………………………………… 30. 340.000 Taxes ……………………………………………… 100.000 Operating profit …………………………….000 Amortization expense …………………………….000 Selling and administrative expense ………………. $600. Aztec Book Company 20 5/E Cdn.000 Preferred stock dividends ………………………… 80.000 Shares outstanding 100. 400.

400 Interest expense …………………………………… 5..400 Taxes @ 20% ……………………………………… 3.000 Amortization expense …………………….400 books at $84 each) …………………. 29.. $ 117.400 books at $63 each) …….Income Statement For the Year ended December 31.. 88.600 Cost of goods sold (1.480 Earnings aftertaxes …………………………. 21 5/E Cdn. $ 13.000 Operating profit ……………………………...000 Earnings before taxes ………………………. 1999 Sales (1. Hirt..400 Selling expense …………………………………… 2.920 Foundations of Fin. 17.200 Gross Profit …………………………………. Block. Mgt.. 22.……… 5. Short .

....................... $900................000 Amortization expense ................................. Hirt.. $1.......000 Taxes @ 30% ..................... Block....... 315.......... 216................................000 Amortization expense ............ $151..… 76...000 Operating profit ...................................................... 22 5/E Cdn.................................................….. 81...........................................….................….......................000 Taxes @ 30% ........ Sales Foundations of Fin............................ 585............800 Earnings aftertaxes ..... Sales .................................................. 255.............000 Gross Profit .....000 Selling and administrative expense ................000..000 Earnings before taxes ...................................…..… 64......500 Earnings aftertaxes .... Short ................... 224.. $178........000 Interest expense ......000 Cost of goods sold ........................................................... 270.......................... 120.....................000 Selling and administrative expense ............................................... 400..... 10...200 2-4b......................... Mgt.................500 2-5..................... 600................ 10........................000 Earnings before taxes ............. 15..................2-4a............... Carr Auto Wholesalers Income Statement Sales ..............................000 Interest expense ................ 8...............000 Gross Profit ...000 Cost of goods sold ..........000 Operating profit ...............

Mgt.Cost of goods sold Gross profit Selling and administrative expense Amortization expense Operating profit Interest expense Earnings before taxes Taxes Earnings aftertaxes Preferred stock dividends Earnings available to common shareholders Shares outstanding Earnings per share Foundations of Fin. 23 5/E Cdn. Block. Short . Hirt.

.. David’s Magic Stores a) Operating profit (EBIT) .000 Thermo Dynamics Retained earnings....... 24..000/16..... $ 96............... Mgt....... $210........... = $60.......... 24 5/E Cdn.2-6.000 Increase in retained earnings .......000/16.......... 1999 ...............000 shares = $6. $120....000 Earnings per Share = Earnings available to common shareholders Number of shares of common stock outstanding = $ 96.$450..000 Common dividends . 36........000 Foundations of Fin.....000 Interest expense .......300 Earnings aftertaxes (EAT) ... $180.. Block..........700 Preferred dividends ................ Hirt.......25 per share Increase in retained earnings 2-7.......... 30........ 59...........................000 Earnings before taxes (EBT) . Short .....700 Available to common shareholders ....... $ 60......000 shares = $2........ December 31.00 per share Dividends per Share b) = $36............000 Taxes ......

.... $75... Mgt.000 / 20..... 1998 .................current Accounts receivable -..........Less: Retained earnings....000 Earnings available to common shareholders .........000 shares = $3... 25 5/E Cdn. December 31. Assets Current assets: Cash. $ 10...noncurrent Accrued wages payable -...........noncurrent Retained earnings -.......................75 per share 2-8. Block.. 400.000 Change in retained earnings .current Bonds payable -..000 Add: Common stock dividends .current Plant and equipment -...current 2-9.noncurrent Prepaid expenses -...... Hirt.....000 Marketable securities .. Short .....noncurrent Marketable securities -......current Accounts payable -.... $50...000 Earnings per share = $75.....000 Foundations of Fin.....current Preferred stock -.. 25. 20... Inventory -..

.....000 Total Assets ……….... 380......................000 Total current assets ................................... Short ....000 Less: Accumulated amortization 300......Accounts receivable ...................000 Foundations of Fin..............000 Inventory ... 42. 26 5/E Cdn...........000 Other assets: Investments ... Block......000 Capital assets: Plant and equipment ....... $48............. $538... Hirt...... $138........... Mgt. $680..000 66.....000 Net plant and equipment .000 Less: Allowance for bad debts ............... 6...... 20..............

.000 Total shareholders' equity ..........000 Total current liabilities ...... 33.................... $204.……….......000 Long-term liabilities ......... Bonds payable............... $538..000 shares outstanding .......... 136...000 Total liabilities .……........... 1.....000 ............................. 100......000 Retained earnings ..................Liabilities and Shareholders' Equity Current liabilities: Accounts payable ..........000 shares outstanding ...... 50.......... $ 68....000 Common stock.......... $ 35.....000 Total Liabilities and Shareholders' Equity …….............. 188...000 Shareholders' equity: Preferred stock. 96. $334............000 Notes payable ..................

.......… $600........000 Shareholders' equity ..... 75.............50 = 1.....................000 Net worth assigned to common .... $255.… 30.......50 Earnings available to common ..............000 Current liabilities ...000 Long-term liabilities .....000 Preferred stock ...................44/$8.........................................000 Book value (net worth) per share ....................................58 ........000 Common shares outstanding ... $1....… $330..............12 = price $13.......2-10....600 Shares outstanding .. $33....... Monique’s Boutique a) b) c) Total assets .. $8. 120......... 150.......... 30....12 P/E ratio  earnings per share = 12  $1.........44 Market value per share (price) to book value per share $13...........000 Earnings per share ….

Phelps Labs a) b) c) Total assets ... $2...........................… 20........50 = 1..000 Shareholders' equity ....25 Market value per share (price) to book value per share $29...........................000 Shares outstanding .............800..25 P/E ratio  earnings per share = 13  $2. $410.… $1...... 20. 630.… $575... $20.... 165..............................25/$20.000 Book value (net worth) per share .........................50 Earnings available to common .......43 ..000 Current liabilities ...000 Preferred stock ...............000 Net worth assigned to common ....25 = price $29........... 595.........000 Earnings per share ….000 Long-term liabilities .....2-11............. $45..........000 Common shares outstanding ..........................................

2-12.50 = $41 P/E ratio = $41/$2.25 = 18. Current Assets (CA) 4.22 1. 2-13. Shareholders Equity (SE) . Long-Term Liabilities (LL) 7. Income Statement (IS) 3. Current Liabilities (CL) 6. Balance Sheet (BS) 2. Phelps Labs (Continued) 2  book value = price 2  $20. Capital Assets (Cap A) 5.

Item Interest expense CL Income tax payable . expenses BS CA Inventories BS CL Accrued expenses BS CA Cash BS CAP A Plant & equipment IS Sales IS Operating expenses BS CA Marketable securities BS CL Accounts payable IS BS 2-14.Indicate Whether the Item is on Income Statement or Balance Sheet If the Item is on Balance Sheet. Designate Which Category BS SE IS Retained earnings Income tax expense BS CA Accounts receivable BS SE Common Stock BS LL Bonds payable maturity 2009 BS CL Notes payable (6 months) IS Net income IS Selling and adm.

increases cash flow (source) Decrease in accounts payable -.Increase in inventory -.decreases cash flow (use) Decrease in prepaid expenses -.increases cash flow (source) Increase in cash -.decreases cash flow (use) .decreases cash flow (use) Increase in long-term investments -.decreases cash flow (use) Increase in short-term notes payable -.increases cash flow (source) Decrease in accounts receivable -.increases cash flow (source) Amortization expense -.increases cash flow (source) Dividend payment -.decreases cash flow (use) Decrease in inventory -.

000 $420.000 $484.000 Taxes (40%) 120.000 Amortization 240.2-15.000) more in cash flow.000 (0. Jupiter Corporation . .000 more in amortization.000 Gross profit Cash flow Saturn had $160.000 $700.000 160.000 Selling and adm.000 84.000 Plus amortization expense 240.000 140.000 400.40  $160. which provided $64. expense 160.Saturn Corporation Jupiter Saturn $700.000 Operating profit 300.000 56.000 Earnings aftertaxes 180.000 400.

. 7.800 Change in retained earnings ……………….000 Gross profit …………………………… 88.000) …… 20.000 Amortization expense (10%  200.000 Cost of goods sold (60%) …………………..000 Interest expense …………………………….200 Earnings aftertaxes (EAT) …………… $ 32. $ 20.2-16. 132.000 .000) + (8%  $50.000 Taxes (18%) ……………………………….000 1 Earnings before taxes ………………… 40.000 Selling and administrative expense ………… 22.000) = $6.000 Operating profit (EBIT) ……………….000 (10%  $20. 6.. 12.. 46.. a) 1 Gardner Corporation 1999 Income Statement Sales ………………………………………… $220.800 Common stock dividends ………………….

000 Capital Assets $81.000 3 $281.000 Shareholders' Equity Gross plant $285.000 3 $75.500 Notes payable 26.000 Total liabilities & equity $281.000 = $70.000 Inventory 27.000 = $125.000 + $20.000 Total assets 2 $50.b) 1999 Balance Sheet Current Assets Cash Liabilities $10.000 $105.000 Accounts receivable 16.000 .000 + $20.000 $66.000 Retained earnings 125.500 Bonds payable 40.000)2 Net plant 215.000 Accounts payable $15.000 Common stock Accumulated amortization (70.000 Prepaid expenses 12.

000 Cash and cash equivalents. 1999 Operating activities: Net income (earnings aftertaxes) ………….800 (35. end of year $ 10.000 6. beginning of year $ 10.. Common stock dividends paid …………… $52.500) 3. Increase in inventory ………………… Increase in accounts payable ………… Increase in notes payable …………….000 (1.000 Solitude Corporation Statement of cash flows For the Year Ended December 31. $ 32.000 ($ 35.800 ( $22..500) (2.800) $ 0 Cash and cash equivalents.000 $ 57... Investing activities: Increase in plant and equipment ………….000) (10.000) Cash used in investing activities ………….. 5. Financing activities: Decrease of bonds payable ………………. Add items not requiring an outlay of cash: Amortization Cash flow from operations Changes in non-cash working capital: Increase in accounts receivable ……. 1999 .800 $20.000) (12.800) Cash used in financing activities ………… Net increase in cash and equivalents during the year 2-17.Gardner Corporation Statement of cash flows For the Year Ended December 31. Net change in non-cash working capital Cash provided by operating activities …….

$ 88.900) Cash used in financing activities ………… ($ 14. (25. 7.970 Cash and cash equivalents.490 .380) Net change in non-cash working capital 3.760) Net increase in cash and equivalents during the year $47.830) Cash used in investing activities ………….... $ 73. Financing activities: Issue of common stock …………………… Common stock dividends paid …………… ($ 25.140 (36.560 Investing activities: Increase in plant and equipment ………….830 Decrease in taxes payable …………….140) Increase in accounts payable ………… 25. beginning of year $ 29. (7.690 Cash provided by operating activities ……..800 Add items not requiring an outlay of cash: Amortization $11.870 Changes in non-cash working capital: Decrease in accounts receivable ……. end of year $ 77..Operating activities: Net income (earnings aftertaxes) ………….070 Cash flow from operations $84.830) 22.520 Cash and cash equivalents.380 Increase in inventory ………………… (22.

30.000 Cash provided by operating activities …….000 Cash and cash equivalents.000) Cash used in investing activities ………….000) Cash used in financing activities ………… ($ 90.000) Decrease in prepaid expenses ………...000 Increase in plant and equipment ………….000) Net change in non-cash working capital 220.000 Investing activities: Decrease in investments ………………….000 .000 Cash flow from operations $480. end of year $120. (10.000 Add items not requiring an outlay of cash: Amortization $230... 10. (600.000 Cash and cash equivalents.000) Common stock dividends paid …………… (140..000 Preferred stock dividends paid …………… (10.000) Increase in inventory ………………… (30.000 Changes in non-cash working capital: Increase in accounts receivable …….000) Net increase in cash and equivalents during the year $ 20. 1999 Operating activities: Net income (earnings aftertaxes) …………. beginning of year $100.000 Increase in accounts payable ………… 250. Maris Corporation Statement of cash flows For the Year Ended December 31. $700. $250. ($590.000 Decrease in accrued expenses ………… (20..000) Financing activities: Increase in bonds payable ………………… 60.2-18.

Cash flows provided by operating activities exceeds net income by $450. The buildup in plant and equipment of $600.8  P/E ratio $9. Short-term sources of funds can always dry up.000) = $1.000 (net) has been financed.000) = $1.60 = 16. 2-21. while capital asset needs are permanent in nature.000 150. and the addback of amortization. by the large increase in accounts payable (250. the increase in bonds payable.000 .490.000.390.$90. Market value = 2. The firm may wish to consider more long-term financing.67 per share 150.000 (1999) 2-22. This is not a very satisfactory situation.000.000 150. the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations.000).33 or 16x $26.$90.000 (1998) Book value = ($1.12/$1.000 and accounts payable increase by $250. to go along with profits.300.400. 2-20.2-19. Thus.000 (gross) and $370.000 = $8.000 = $9. Book value = Shareholders' equity Preferred stock per share Common shares outstanding Book value = ($1.124 . This occurs primarily because we add back amortization of $230. such as a mortgage.33 per share 150. in part.33 = = $26.000 .

...........750) Purchase of land (see note) ..........400 Cash at year end $ 1...625 Increase in accrued expenses ... (1....... 1999 Operating activities: Net income (earnings aftertaxes) …………........500 Changes in non-cash working capital: Increase in accounts receivable ............750 Proceeds from the sale of equipment . (6. (5.300) Financing activities: Increase in bonds payable .....750....500 Cash flow from operations $24...050 Subtotal (9. $14.. Winfield Corporation Statement of cash flows for the Year Ended December 31........750 Issued note of $8.........250) Increase in prepaid expenses ..... ($ 13........... $ (1........650) Cash provided by financing activities …………...........050 Investing activities: Proceeds from the sale of stock ... 1.. (5...750) Cash used in investing activities ………..750) *Increase in notes payable ...450) Cash provided by operating activities ..... (5.......... $15.250) Gain on sale of investment ……......... $8..2-23............. . 2. 2000.... (15.....000 Add items not requiring an outlay of cash: Amortization $10.........400) Net increase in cash $ 350 Cash at beginning of year $ 1.. (8..... for land purchase (non-cash)............. *There is difference of opinion on whether this item is better placed in financing activities. (175) Net change in non-cash working capital .........250) Loss on sale of equipment .... 1...............450) Increase in inventory .. (2.. $2.925 Decrease in interest payable .250 Common stock dividends paid ...... due June 30........ 5............. (175) Decrease in accounts payable ..................450 Purchase of equipment ..

...... 1998 Net income Taxes @ 22..............000 31....000 .1%.. The average tax rate is 22..................028 $52..........382 $110...... Selling and administrative expense ................... Earnings before taxes.......6% ..............6% $485.............000 25....000 60............000 27................... 2-26............... Earnings aftertaxes ..........................1% Income aftertaxes $142........ Gross Profit . Operating profit ................... Taxes @ 21...........972 1999 Net income Taxes @ 22........................000 x 21........ Nix Corporation (Continued) Tax savings on amortization = $60..............................000 150.... Interest expense ...1% Income aftertaxes $68... a.....000 280............................ Nix Corporation Income Statement Sales ....000 15.......................000 205..........000 70..000 $ 98.618 b................................ Ron’s Aerobics Ltd.2-24..................... Cost of goods sold . 2-25........ Amortization expense ..............000 125............

000 16. Forms Ltd.800 .6% Income aftertaxes $75.1% Income aftertaxes $75.960 2-27. Alberta Net income Taxes @ 19.325 $60.E.= $12.200 $58. R.000 14.675 Ontario Net income Taxes @ 21.

25) 1.91% Share return @ 5% $ 900.57/$18.20 Provincial tax @ 53% (of federal tax payable)161. This makes them riskier.79% The bond provides a slightly better aftertax return. Share dividends may not be paid and shares are subject to capital gains and losses.97/$18.000 Bond return @ 6. but with greater upside potential.000 x 100% = 3. Investment $18.5% $1. E. Lickzer a.125) -150.00 Federal tax @ 26% 304.2-28.97 Aftertax return $681.23 Total tax payable 465.170. b. Bond interest is a fixed payment. Mrs.43 Aftertax bond return $ 704.00 Federal tax payable 142.03 Aftertax share (dividend) return (900  218.03) $681.00 Federal tax @ 26% 292.57 Aftertax return $704.50 Dividend tax credit (13 1/3% of 1.53 Total tax payable 218.125.00 Gross up (1. .50 Provincial tax @ 53% 75.000 x 100% = 3.

.... $9..... Total tax payable ..............22 ($3..................34 1.. Provincial tax payable .....78 Federal tax payable ..........................56 Net tax loss $0.........................................78 ..........00 3.2-29.....56) ...............22 $3..$3. 2............ Jasper Corporation Yield is 9% On each $100 investment Interest paid ...... Tax savings @ 42% ...............