Chapter 2

Financial Statements, Cash Flow, and Taxes

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

2-1 NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ?

Need to set up an income statement and work from the bottom up.

EBIT $6,000,000
Interest 1,000,000 $3,000,000 $3,000,000

EBT $5,000,000 EBT = (1  T) 0.6
Taxes (40%) 2,000,000
NI $3,000,000

Interest = EBIT - EBT = $6,000,000 - $5,000,000 = $1,000,000.

2-2 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?

NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.

2-3 EBIT = $170,000; Operating capital = $800,000; kA-T = 11.625%; T = 40%;

EVA = ?

EVA = EBIT(1 - T) - AT dollar cost of capital

= $170,000(1 - 0.4) – ($800,000  0.11625)
= $102,000 - $93,000
= $9,000.

2-4 NI = $50,000,000; R/EY/E = $810,000,000; R/EB/Y = $780,000,000; Dividends =

?

R/EB/Y + NI – Div = R/EY/E

$780,000,000 + $50,000,000 – Div = $810,000,000
$830,000,000 – Div = $810,000,000
$20,000,000 = Div.

2-5 EBITDA = $7,500,000; NI = $1,800,000; Int = $2,000,000; T = 40%; DA = ?

EBITDA $7,500,000
DA 2,500,000 EBITDA – DA = EBIT; DA = EBITDA – EBIT
EBIT $5,000,000 EBIT = EBT + Int = $3,000,000 + $2,000,000
Int 2,000,000 (Given) $1,800,000 $1,800,000
EBT $3,000,000 
(1  T) 0.6
Taxes (40%) 1,200,000

2-1
 NI $1,800,000 (Given)

2-6 EBIT = $750,000; DEP = $200,000; AMORT = 0; 100% Equity; T = 40%; NI = ?;

NCF = ?; OCF = ?

First, determine net income by setting up an income statement:

EBIT $750,000
Interest 0
EBT $750,000
Taxes (40%) 300,000
NI $450,000

NCF = NI + DEP and AMORT = $450,000 + $200,000 = $650,000.

OCF = EBIT(1 - T) + DEP and AMORT = $750,000(0.6) + $200,000 = $650,000.

Note that NCF = OCF because the firm is 100 percent equity financed.

2-7 Statements b, c, and d will all decrease the amount of cash on a

company’s balance sheet, while Statement a will increase cash through the
sale of common stock. This is a source of cash through financing
activities.

2-8 a. NOPAT = EBIT(1 – T)

= $4,000,000,000(0.6)
= $2,400,000,000.

b. NCF = NI + DEP and AMORT

= $1,500,000,000 + $3,000,000,000
= $4,500,000,000.

c. OCF = NOPAT + DEP and AMORT

= $2,400,000,000 + $3,000,000,000
= $5,400,000,000.

d. FCF = NOPAT – Net Investment in Operating Capital

= $2,400,000,000 - $1,300,000,000
= $1,100,000,000.

 Total Investor-Supplied  A-T Cost 

e. EVA = NOPAT –    of Capital
 Operating Capital  
= $2,400,000,000 – [($20,000,000,000)(0.10)]
= $400,000,000.

2-9 MVA = (P0  Number of common shares)  BV of equity

$130,000,000 = $60X  $500,000,000
$630,000,000 = $60X

2-2
X = 10,500,000 common shares.

2-3
2-10 First, determine the firm’s total operating capital:
Total operating capital = Net operating working capital  Net fixed
assets
= $5,000,000  $37,000,000
= $42,000,000.

Now, you can calculate the firm’s EVA:

EVA = EBIT (1  T)  (WACC)(Total operating capital)
= $6,375,000 (1  0.40)  (0.085)($42,000,000)
= $3,825,000  $3,570,000
= $255,000.

2-11 Ending R/E = Beg. R/E  Net income  Dividends

$278,900,000 = $212,300,000  Net income  $22,500,000
$278,900,000 = $189,800,000  Net income
Net income = $89,100,000.

2-12 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:

Cash at the end of the year $25,000

Cash at the beginning of the year 55,000
Change in cash -$30,000

The sum of cash flows generated from operations, investment, and

financing must equal a negative $30,000. Therefore, we can calculate
the cash flow from operations as follows:

CF from operations  CF from investing  CF from financing =  in cash

CF from operations  $250,000  $170,000 = -$30,000
CF from operations = $50,000.

b. To determine the firm’s net income for the current year, you must
realize that cash flow from operations is determined by adding sources of
cash (such as depreciation and amortization and increases in accrued
liabilities) and subtracting uses of cash (such as increases in
accounts receivable and inventories) from net income. 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:

Depreciation Increase in Increase in CF from

NI  and amortization  accrued  A/R and = operations
liabilities inventory
NI + $10,000 + $25,000 - $100,000 = $50,000
NI - $65,000 = $50,000
NI = $115,000.

2-4
2-13 Working up the income statement you can calculate the new sales level
would be $12,681,482.

Sales $12,681,482 $5,706,667/(1  0.55)

Operating costs (excl. D&A) 6,974,815 $12,681,482  0.55
EBITDA $ 5,706,667 $4,826,667 + $880,000
Depr. & amort. 880,000 $800,000  1.10
EBIT $ 4,826,667 $4,166,667 + $660,000
Interest 660,000 $600,000  1.10
EBT $ 4,166,667 $2,500,000/(1  0.4)
Taxes (40%) 1,666,667 $4,166,667  0.40
Net income $ 2,500,000

2-14 a. Because we’re interested in net cash flow available to common

stockholders, we exclude common dividends paid.

CF02 = NI available to common stockholders + Depreciation and

amortization
= $364 + $220 = $584 million.

The net cash flow number is larger than net income by the current
year’s depreciation and amortization expense, which is a noncash
charge.

b. Balance of RE, December 31, 2001 $1,302

Add: NI, 2002 364
Less: Div. paid to common stockholders (146)
Balance of RE, December 31, 2002 $1,520

The RE balance on December 31, 2002 is $1,520 million.

c. $1,520 million.

d. Cash + Marketable securities = $15 million.

e. Total current liabilities = $620 million.

2-15 a. Income Statement

Sales revenues $12,000,000
Costs except deprec. and amort. (75%) 9,000,000
EBITDA $ 3,000,000
Depreciation and amortization 1,500,000
EBT $ 1,500,000
Taxes (40%) 600,000
Net income $ 900,000
Add back deprec. and amort. 1,500,000
Net cash flow $ 2,400,000

b. If depreciation and amortization doubled, taxable income would fall to

zero and taxes would be zero. Thus, net income would decrease to

2-5
 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 and amortization) = 0.4($1,500,000) = $600,000.

c. If depreciation and amortization were halved, taxable income would
rise to $2,250,000 and taxes to $900,000. Therefore, net income would
rise to $1,350,000, but net cash flow would fall to $2,100,000.

d. You should prefer to have higher depreciation and amortization charges

and higher cash flows. Net cash flows are the funds that are
available to the owners to withdraw from the firm and, therefore, cash
flows should be more important to them than net income.

e. In the situation where depreciation and amortization doubled, net

income fell by 100 percent. Since many of the measures banks and
investors use to appraise a firm’s performance depend on net income, a
decline in net income could certainly hurt both the firm’s stock price
and its ability to borrow. For example, earnings per share is a
common number looked at by banks and investors, and it would have
declined by 100 percent, even though the firm’s ability to pay
dividends and to repay loans would have improved.

2-16 This involves setting up the income statement and working from the bottom
up.

Sales Revenue* $2,500,000

Cost of Goods Sold (60%) 1,500,000 2,500,000  0.6
EBITDA $1,000,000 EBITDA = EBIT + DEP and
AMORT
Deprec. and amort. 500,000 (Given)
EBIT $ 500,000 EBIT = EBT + Interest
Interest 100,000 (Given)$240,000 $240,000
EBT $ 400,000 EBT = 
Taxes (40%) 160,000 (1  T) 0.6
NI $ 240,000 (Given)$ 240,000 $240,000

(1  T) 0.6
* Sales Revenue - COGS = EBITDA
Revenue - 0.6(Revenue) = $1,000,000
0.4 Revenue = $1,000,000
Revenue = $2,500,000.

2-17 a. NOPAT = EBIT(1 - T)

= $150,000,000(0.6)
= $90,000,000.

Net operating Non-interest charging

b. working capital = Current assets - current liabilities
01

= $360,000,000 - ($90,000,000 + $60,000,000)

= $210,000,000.

2-6
 Net operating
working capital02 = $372,000,000 - $180,000,000 = $192,000,000.

Net plant Net operating

c. Operating capital01 = and equipment  working capital
= $250,000,000 + $210,000,000
= $460,000,000.

Operating capital02 = $300,000,000 + $192,000,000

= $492,000,000.

d. FCF = NOPAT - Net investment in operating capital

= $90,000,000 - ($492,000,000 - $460,000,000)
= $58,000,000.

e. The large increase in dividends for 2002 can most likely be attributed
to a large increase in free cash flow from 2001 to 2002, since FCF
represents the amount of cash available to be paid out to stockholders
after the company has made all investments in fixed assets, new
products, and operating working capital necessary to sustain the
business.

2-7