Chapter 1 Revision Exercises + Solutions

Q1) A company has $5 billion in assets, $4 billion in equity, and earned a profit of $100 million
last year as the economy boomed. Senior management proposes paying themselves a large cash
bonus in recognition of their performance. As a member of its board of directors, how would you
respond to this proposal?

Solution:
Management is either dumb or thinks its board is. Earning $100 million on a $4 billion equity
investment is a return of 2.5%, a figure well below any reasonable cost of equity. As a board
member, I would vote to cut management’s compensation, not raise it. I would also criticize
them sharply for apparently attempting to deceive the board.

Q2) Explain briefly how each of the following transactions would affect a company’s balance
sheet.
a. Sale of used equipment with a book value of $300,000 for $500,000 cash.
b. Purchase of a new $80 million building, financed 40 percent with cash and 60 percent
with a bank loan.
c. Purchase of a new building for $60 million cash.
d. A $40,000 payment to trade creditors.
e. A firm’s repurchase of 10,000 shares of its own stock at a price of $24 per share.
f. Sale of merchandise for $80,000 in cash.
g. Sale of merchandise for $120,000 on credit.
h. A dividend payment to shareholders of $50,000.

Solution:

a. Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000.
b. Net plant and equipment rises $80 million; cash falls $32 million; bank debt rises $48 million.
c. Net plant and equipment rises $60 million; cash falls $60 million.
d. Cash falls $40,000; accounts payable falls $40,000.
e. Cash falls $240,000; owners’ equity falls by $240,000 (via an increase in treasury stock).
f. Cash rises $80,000; inventory falls; accrued taxes, owners’ equity, and possibly other cost
categories rise such that the algebraic sum equals $80,000.
g. Accounts receivable rise $120,000; other categories change as described in part f.
h. Cash falls $50,000; owners’ equity falls by $50,000 (via RE).
Q3) The table below presents financial statements over the period 2014–2017 for R&E Supplies,
Inc.

Financial Statements for R&E Supplies, Inc., December 31, 2014–2017 ($

thousands)
Income Statements
  2014 2015 2016 2017*
$11,19
Net sales 0  $13,764  $16,104 $20,613
Cost of goods sold  9,400 11,699   13,688   17,727
Gross profit  1,790     2,065      2,416    2,886
Expenses:        
General, selling, and administrative
expenses  1,019     1,239     1,610    2,267
    
Net interest expense 100       103     110      90
Earnings before tax      671        723        696       529
Tax      302     325      313     238
$  
Earnings after tax 369 $  398 $     383 $  291

Balance Sheets
Assets
Current assets:
$     
Cash and securities 671  $     551 $    644 $  412
Accounts receivable   1,343     1,789    2,094    2,886
Inventories   1,119     1,376    1,932    2,267
Prepaid expenses     14      12      15   18
Total current assets   3,147     3,728    4,685    5,583
       12            124 
Net fixed assets 8               295         287 
$  3,27
Total assets 5 $ 3,852 $ 4,980 $ 5,870
Liabilities and Owners’ Equity
Current liabilities:
$   
Bank loan 50  $   50 $   50  $      50
Accounts payable  1,007     1,443    2,426      3,212
Current portion long-term debt       60         50         50        100
       
Accrued wages 5       7     10        18 
Total current liabilities   1,122    1,550    2,536     3,380
Long-term debt      960       910       860        760
Common stock     150       150        150        150
 Income Statements
    1,04
Retained earnings 3  1,242  1,434  1,580
$  3,27
Total liabilities and owners’ equity 5 $ 3,852 $ 4,980 $ 5,870
*Estimate
 a. Construct a sources and uses statement for the company over this period (one statement
for all three years).
b. What insights, if any, does the sources and uses statement give you about the financial
position of R&E Supplies?

Solution:

a. R&E Supplies, Inc. Sources and Uses Statement 2014–2017 ($000)

__________________________________________________________________
Sources of cash:
Decrease in cash and securities $259
Increase in accounts payable 2,205
Increase in current portion long-term debt 40
Increase in accrued wages 13
Increase in retained earnings 537
Total $3,054
Uses of cash:
Increase in accounts receivable $1,543
Increase in inventories 1,148
Increase in prepaid expenses 4
Increase in net fixed assets 159
Decrease in long-term debt 200
Total $3,054
__________________________________________________________________

b. Insights:

i. R&E is making extensive use of trade credit to finance a buildup in current assets. The
increase in accounts payable equals almost three fourths of total sources of cash. Increasing
accounts receivable and inventories account for almost 90% of the uses of cash.
ii. External long-term debt financing is a use of cash for R&E, meaning that it is repaying its
loans. A restructuring involving less reliance on accounts payable and more bank debt
appears appropriate.

Q4) You manage a real estate investment company. One year ago, the company purchased 10
parcels of land distributed throughout the community for $10 million each. A recent appraisal of
the properties indicates that five of the parcels are now worth $8 million each, while the other
five are worth $16 million each. Ignoring any income received from the properties and any taxes
paid over the year, calculate the investment company’s accounting earnings and its economic
earnings in each of the following cases:
a. The company sells all of the properties at their appraised values today.
b. The company sells none of the properties.
c. The company sells the properties that have fallen in value and keeps the others.
d. The company sells the properties that have risen in value and keeps the others.
e. After returning from a property management seminar, an employee recommends that the
company adopt an end-of-year policy of always selling properties that have risen in value
since purchase and always retaining properties that have fallen in value. The employee
explains that, with this policy, the company will never show a loss on its real estate
investment activities. Do you agree with the employee? Why, or why not?

Solution:

Accounting income will be the value of the parcels sold, less their original purchase price. So if
all parcels are sold; the income is 5 × $16 million + 5 × $8 million – $100 million = $20 million.
Economic income will be the increase in the market value of the land, whether sold or not, over
the period. At the end of the first year, this will be $20 million. Answers to each part of the
question appear below.

Question Accounting Income Economic Income

a. $20 million $20 million
b. $0 $20 million
c. –$10 million $20 million
d. $30 million $20 million

e. Too many companies have tried this. If the market value of a piece of land falls, the
owner loses whether he sells or not. The market price of the land fell because people
thought the future income stream to the owners was worth less. Continuing to hold the
property forces the owner to accept the lower income. Whether the loss is recognized or
not might affect accounting earnings, but has nothing to do with reality.

Q5) Suppose that you make $62,000 at a company. You expect that the company will have
annual revenues of $230,000, and total annual operating expenses, outside of any payments made
to you, will be $190,000. Your financial advisor comes to you with his idea. He believes that you
would be equally happy with either option, but that starting your own company is the right
decision in light of its profitability. Ignoring what might happen beyond the first year, do you
agree with him? Why or why not?
Solution:

The accounting profits from the company are expected to be $40,000. These accounting profits
do
not include the implicit cost of the entrepreneur’s time. Your time is worth at least $62,000, the
current income he will have to forego to manage the company. When these implicit opportunity
costs are included net income falls to:

$230,000 – $190,000 – $62,000 = –$22,000

This new venture will reduce your income, not increase it.

Q6) Below are summary cash flow statements for three roughly equal-sized companies.

  ($ millions)
  A B C
Net cash flows from operating (300
activities (300) ) 300
Net cash used in investing activities (900) (30) (90)
Net cash from financing activities 1,200 210 (240)
Cash balance at beginning of year 150 150 150

a. Calculate each company’s cash balance at the end of the year.

b. Explain what might cause company C’s net cash from financing activities to be
negative.
c. Looking at companies A and B, which company would you prefer to own? Why?
d. Is company C’s cash flow statement cause for any concern on the part of C’s
management or shareholders? Why or why not?

Solution:

a.

Company A B C
End-of-year cash
Balance $150 million $30 million $120 million

b. It appears that company C retired more debt than it issued, repurchased more stock than it
issued, or some combination of the two.
c. I'd prefer to own company A; it appears to be a growing company as evidenced by the
sizable net cash used in investing activities, and its negative net cash flow from
operations may well be due to increasing accounts receivable and inventories that
 naturally accompany sales growth. Company B appears not to be growing, so its
negative net cash flows from operations are probably due to losses or to increasing
receivables and inventories relative to sales, a trend denoting poor management of current
assets.
d. I don't think there is necessarily any cause for concern. It appears company C is a
mature, slow-growth company that is returning its unneeded operating cash flows to
investors in the form of debt repayment, share repurchase, dividends, or some
combination of these. This is a perfectly viable strategy in the absence of attractive
investment opportunities.

Q7) a. Prepare a sources and uses statement for ABC Company for fiscal year 2017.
b. Prepare a cash flow statement for ABC Company for fiscal year 2017.

ABC COMPANY
BALANCE SHEET
2016 2017
Cash $47,500 $76,700
Accounts receivable 0 43,100
Inventories 49,000 36,500
Total current assets 96,500 156,300
Land 15,800 15,800
Buildings 103,600 164,600
Equipment 63,200 65,500
Patents 5,200 5,200
Less: Accumulated depreciation 10,800 12,200
Total assets 273,500 395,200

Accounts payable to suppliers 48,000 25,900

Income taxes payable 0 10,700
Total current liabilities 48,000 36,600
Long term debt 100,100 134,000
Total liabilities 148,100 170,600
Shareholders’ equity
Common stock 125,400 177,400
Retained earnings 0 47,200
Total shareholders’ equity 125,400 224,600
Total liabilities and shareholders' equity 273,500 395,200
 ABC COMPANY INCOME STATEMENT
2017
Sales 165,300
Cost of goods sold 46,200
Depreciation expense 1,400
Net interest expense 2,000
Other expense 5,600
Income before taxes 110,100
Provision for income taxes 40,900
Net income 69,200

Dividends paid 22,000

Addition to RE 47,200

Solution:

ABC COMPANY
BALANCE SHEET
2016 2017 Changes
Cash $47,500 $76,700 29,200
Accounts receivable 0 43,100 43,100
Inventories 49,000 36,500 (12,500)
Total current assets 96,500 156,300
Land 15,800 15,800 0
Buildings 103,600 164,600 61,000
Equipment 63,200 65,500 2,300
Patents 5,200 5,200 0
Less: Accumulated depreciation 10,800 12,200 1,400
Total assets 273,500 395,200

Accounts payable to suppliers 48,000 25,900 (22,100)

Income taxes payable 0 10,700 10,700
Total current liabilities 48,000 36,600
Long term debt 100,100 134,000 33,900
Total liabilities 148,100 170,600
Shareholders’ equity
Common stock 125,400 177,400 52,000
Retained earnings 0 47,200 47,200
Total shareholders’ equity 125,400 224,600
Total liabilities and shareholders' equity 273,500 395,200
 ABC COMPANY INCOME STATEMENT
2017
Sales $165,300
Cost of goods sold 46,200
Depreciation expense 1,400
Net interest expense 2,000
Other expense 5,600
Income before taxes 110,100
Provision for income taxes 40,900
Net income 69,200

Dividends paid 22,000

Addition to RE 47,200

a. Sources and Uses Statement:

Sources of cash
Reduction in inventories 12,500
Increase in accumulated depreciation 1,400
Increase in taxes payable 10,700
Increase in long-term debt 33,900
Increase in common stock 52,000
Increase in retained earnings 47,200
Total sources of cash 157,700

Uses of cash
Increase in cash 29,200
Increase in accounts receivable 43,100
Increase in buildings 61,000
Increase in equipment 2,300
Reduction in accounts payable 22,100
Total uses of cash 157,700

b. Cash flow statement:

Operating activities
Net income 69,200
Add back depreciation 1,400
(Increase) decrease in receivables (43,100)
(Increase) decrease in inventories 12,500
Increase (decrease) in accounts payable (22,100)
Increase (decrease) in income taxes payable 10,700
Cash flow from operations 28,600
Investing activities
(Increase) decrease in building (61,000)
(Increase) decrease in equipment (2,300)
Cash flow from investing (63,300)
Financing activities
Increase (decrease) in long-term debt 33,900
Increase (decrease) in common stock 52,000
Subtract dividends paid (22,000)
Cash flow from financing 63,900

Net change in cash 29,200

Beginning cash balance 2017 47,500
Ending cash balance 2017 76,700