Chapter 3

Financial Statements, Cash Flows, and Taxes

Before You Go On Questions and Answers

Section 3.1

1. What types of information does a firm’s annual report contain?

A firm’s annual report is typically divided into three sections: financial tables with an

accompanying verbal explanation of the firm’s performance over the past year; a

corporate public relations section discussing the firm’s operations, and the audited

financial statements (balance sheet, income statement, statement of cash flows, and

statement of retained earnings).

2. What is the realization principle, and why may it lead to a difference in the timing of

when revenues are recognized on the books and cash is collected?

According to the realization principle, revenue should only be recognized when the

earning process is completed and the exchange of goods or services can be determined by

an arm’s length transaction. Although this principle works in theory, it still does not

specify whether this is the point when the goods are ordered, when they are shipped, or

when the payment is actually received from the customer. Also, not many purchases are

paid for in cash any more. Therefore, even if the transaction is recognized at the point at

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 which the customer receives the goods, the actual cash flow might not occur until days

later (depending what the terms are).

Section 3.2

1. What is net working capital? Why might a low value for this number be considered

undesirable?

Net working capital is the difference between total current assets and total current

liabilities. A low value for this number is undesirable, for it indicates that the company

may not have enough cash on hand to cover its immediate expenses.

2. Explain the accounting concept behind depreciation.

Depreciation in accounting is a noncash expense that helps to allocate the cost of an item

over its expected life. It reflects the estimated decrease in the value of an asset due to

wear and tear and obsolescence.

3. What is treasury stock?

Treasury stock is the stock that the company purchased back from its investors. These

shares do not pay dividends, have no voting rights, and should not be included in shares-

outstanding calculations.

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Section 3.3

1. What is the difference between book value and market value?

Book value is the price you paid for a particular asset. This price does not change as long

as you own the asset. On the other hand, market value is the price at which you can sell

an asset today, as it takes into account how much it can earn in the future.

2. What are some objections to the preparation of marked-to-market balance sheets?

Marked-to-market balance sheets list the firm’s assets and liabilities at their current

market prices. Even though a balance sheet constructed with actual market values might

paint a more accurate picture of the company’s financial situation, current values are

difficult to estimate, and a lot of the complicated models are potentially open to abuse.

Therefore, as of the present, the norm is to use book values.

Section 3.4

1. How do you compute net income?

Net income is calculated as revenues minus expenses. It is the most comprehensive

accounting measure of a company’s performance because it reflects the firm’s

accomplishments (revenues) relative to its efforts (expenses) during a time period.

2. What is EBITDA, and what does it measure?

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 EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBIT

is defined as earnings before taxes and interest. The main difference between these two

figures is that EBITDA shows the income earned purely from operations and reflects how

efficiently a firm can manufacture and sell its products without taking into account the

cost of the productive asset base.

3. What accounting events trigger changes to the retained earnings account?

Two events will trigger changes to the retained earnings account: (1) a firm’s report of a

net income or loss and (2) the board of directors’ declaration of a cash dividend.

Section 3.5

1. How do increases in fixed assets from one period to the next affect cash holdings for the

firm?

An increase in fixed assets from one period to the next is a use of cash. If a company

purchases fixed assets during the year, it decreases cash because it must use cash to pay

for the purchase.

2. Name two working capital accounts that represent sources of cash for the firm.

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 An increase in current liabilities is a source of cash. Two common current liabilities are

accounts and notes payable. An increase in either of these accounts from one period to

the next will represent a source of cash for the firm.

3. Explain the difference between cash flows from financing and investing activities.

Cash flows from financing activities occur when cash is obtained from or repaid to

creditors or owners (stockholders). Cash flows from investing activities relate to the

buying and selling of long-term assets.

Section 3.6

1. Explain how the four financial statements are related.

The four financial statements are linked together as follows: the ending cash balance

from the statement of cash flows is used as the cash balance on the balance sheet, and the

net income reported in the income statement is transferred to retained earnings on the

balance sheet. So as you can see, the balance sheet is the one financial statement that ties

all four statements together.

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Section 3.7

1. What is the difference between the computation of net income and the computation of

cash flow from operating activity for the cash flow to investors?

Net income is computed as the difference between revenues and expenses from the

income statement. Cash flow from operating activity is equal to the firm’s earnings

before interest and taxes (EBIT) minus taxes paid in cash plus the firm’s noncash

expenses including depreciation and amortization.

2. All else equal, if a firm increases its accounts payable, what will the effect be on the cash

flow to investors?

An increase in a current liability such as accounts payable from one period to the next

will reduce the cash flow from net working capital and will, therefore, increase cash flow

to investors.

3. What does it mean when a firm’s cash flow to investors is negative?

When a firm’s investment of cash flow from net working capital and long-term assets

exceed the firm’s cash flow from operating activity, the cash flow to investors will be

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 negative. A negative cash flow to investors means that the firm must raise money from

new issues of debt or equity.

Section 3.8

1. Why is it important to consider the consequences of taxes when financing a new project?

When financing a new project, it is important to consider the consequences of taxes

because ultimately they have a significant impact on the company’s income.

2. Which type of tax rate, marginal or average, should be used in analyzing the expansion of

a product line, and why?

When analyzing the expansion of a product line, the marginal tax rate should be the type

to consider because it is the amount paid on an additional dollar of income earned. Since

expansion of a product line is expected to generate new cash flows, the company will be

taxed based on the additional earnings. Average tax rate is not as relevant when making

financing decisions because it is simply the total taxes paid divided by taxable income.

3. What are the tax implications of a decision to finance a project using debt rather than new

equity?

The difference between debt financing and financing through new equity is in the tax

treatment of interest and dividends. While interest payments on debt are tax-deductible

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 business expenses, dividends paid to common or preferred stockholders are not

deductible.

Self-Study Problems

3.1 The going concern assumption of GAAP implies that the firm:

a. Is going under and needs to be liquidated at historical cost.

b. Will continue to operate and its assets should be recorded at historical cost.

c. Will continue to operate and that all assets should be recorded at their cost rather

than at their liquidation value.

d. Is going under and needs to be liquidated at liquidation value.

Solution: c

One of the key assumptions under GAAP is the going concern assumption, which

states that the firm (c) will continue to operate and that all assets should be

recorded at their cost rather than at their liquidation value.

3.2 The Ellicott City Ice Cream Company management has just completed an assessment of

the company’s assets and liabilities and has obtained the following information. The firm

has total current assets worth $625,000 at book value and $519,000 at market value. In

addition, its long-term assets include plant and equipment valued at market for $695,000,

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 while their book value is $940,000. The company’s total current liabilities are valued at

market for $543,000, while their book value is $495,000. Both the book value and the

market value of long-term debt is $350,000. If the company’s total assets are equal to a

market value of $1,214,000 (book value of $1,565,000), what are the book value and

market value of its stockholders’ equity?

Solution: The book value and market value of stockholders’ equity are shown below (in

thousands of dollars):

Assets Liabilities and Equity

Book Market Book Market

Total current assets $ 625 $ 519 Total current liabilities $ 495 $ 543

Fixed assets 940 695 Long-term debt 350 350

Stockholders’ equity 720 321

Total liabilities and

Total assets $1,565 $1,214 stockholders’ equity $1,565 $1,214

3.3 Depreciation and amortization expenses are:

a. Part of current assets on the balance sheet.

b. After-tax expenses that reduce a firm’s cash flows.

c. Long-term liabilities that reduce a firm’s net worth.

d. Noncash expenses that cause a firm’s after-tax cash flows to exceed its net

income.

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Solution: d

Depreciation and amortization expenses are (d) noncash expenses that cause a

firm’s after-tax cash flows to exceed its net income.

3.4 You are given the following information about Clarkesville Plumbing Company.
Revenues last year totaled $896, depreciation expenses $75, costs of goods sold $365,
and interest expenses $54. At the end of the year, current assets were $121 and current
liabilities were $107. The company has an average tax rate of 34 percent. Calculate its net
income by setting up an income statement.

Solution: Clarkesville’s income statement and net income are as follows:

Clarkesville Plumbing Company
Income Statement as of December 31, 2011

Amount

Revenues $896.00

COGS 365.00

EBITDA $531.00

Depreciation 75.00

EBIT $456.00

Interest 54.00

EBT $402.00

Taxes (34%) 136.68

Net income $265.32

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3.5 The Huntington Rain Gear Company had $633,125 in taxable income in the year ending

September 30, 2010. Calculate the company’s tax using the tax schedule in Exhibit 3.6.

Solution: Huntington’s tax bill is calculated as follows:

Tax rate Income Tax

15% $50,000 $ 7,500

25 (75,000–50,000) 6,250

34 (100,000–75,000) 8,500

39 (335,000–100,000) 91,650

34 (633,125–335,000) 101,363

Total taxes payable 207763

Critical Thinking Questions

3.1 What is a major reason for the accounting scandals in recent years? How do firms attempt

to meet Wall Street analysts’ projection of earnings?

Most people believe that managers’ short-term focus is driven by Wall Street’s demand

that companies meet or beat the earnings forecasted by stock analysts. Rather than report

the actual earnings of the firm, managers try to meet the market’s expectations by starting

with the bottom-line number and backing into a sales figure. Thus, the sales may be

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 consistent with the reported earnings figure, but do not represent the true revenue

generated by the firm.

3.2 Why are taxes and the tax code important for managerial decision making?

Understanding the tax code is critical to finance managers, since most decisions are made

on an after-tax basis. Furthermore, taxes affect any valuation analysis and also determine

the bottom-line figure that is of concern to shareholders and managers.

3.3 Identify the five fundamental principles of GAAP and explain briefly their importance.

The assumption of arm’s length transaction assumes that all business transactions

between two parties are made rationally from an economic perspective and both parties

will make the deal that provides them the best value. The cost principle calls for the

recognition of all accounting transactions at historic cost, or the amount paid or received

when the transaction was concluded at arm’s length. The realization principle implies

that revenue should be recognized only at the time of the sale. The matching principle

dictates that revenue is first recognized and then is matched with the costs incurred in

producing the revenue. Finally, the going concern assumption implies that the firm will

continue to operate and that all assets should be recorded at their cost rather than at their

liquidation value.

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3.4 Explain why firms prefer to use accelerated depreciation methods over the straight-line

method for tax purposes.

When a firm uses accelerated depreciation, the depreciation expense is higher than with

the straight-line method. This reduces the taxable income and the amount of tax paid by

the firm. As a result of this higher noncash expense, the firm’s cash flow is higher.

3.5 What is treasury stock? Why do firms have treasury stock?

Any shares repurchased by the company in the open market are recorded as treasury

stock in the shareholders’ equity account in the balance sheet. The most common reason

for firms doing this is to reduce the number of shares outstanding in the market when the

management believes that its firm’s stock is undervalued. This reduction in the number of

shares outstanding is expected to boost the share price.

3.6 Define book-value accounting and market- value accounting.

Book-value accounting implies that all assets and liabilities are recorded and reported at

the historical cost when they were acquired. Market-value accounting requires that all

assets and liabilities are reported at their current market value.

3.7 Compare and contrast depreciation expense and amortization expense.

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 Depreciation expense is the amount by which a firm’s fixed assets are written down in a

period during which the assets are utilized for generating cash flows. Amortization is the

amount by which intangible assets like goodwill, patents, license, copyrights, and

trademarks are written down in any period that they are utilized by the firm to generate

benefits. Both depreciation and amortization are noncash expenses that will serve to

boost the firm’s after-tax cash flows.

3.8 Why are retained earnings not considered an asset of the firm?

Retained earnings are part of shareholders’ equity that has already been utilized by the

company. It is a liability of the company and corresponds to a claim by the firm’s

shareholders. The retained earnings reported on the balance sheet have already been

allocated by the company among various assets and hence are not available for current or

future uses. New retained earnings have to be generated to provide for new uses!

3.9 How does a firm’s cash flow from operating activity used in the calculation of the cash

flow to investors differ from net income, and why?

Net income is an accounting figure that includes both cash and noncash expenses. In

addition, revenues are recognized before they are collected and expenses are recognized

before they are paid. Cash flow from operating activity recognizes that certain revenues

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 and expenses, while recognized for accounting purposes, do not actually involve a cash

flow and ignores the effects of these non-cash items on the income statement.

3.10 What is the statement of cash flows, and what is its role?

This financial statement records both the cash inflows and cash outflows for a period of

time. Thus, it reports the changes in the cash position of a firm between successive

accounting periods.

Questions and Problems

BASIC

3.1 Balance sheet: Given the following information about the Elkridge Sporting Goods, Inc.,

construct a balance sheet for the period ending June 30, 2011. On that date the firm had

cash and marketable securities of $25,135, accounts receivables of $43,758, inventory of

$167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts

payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and

common stock of $150,000. How much retained earnings does the firm have?

LO 2

Solution:

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 Assets Book Value Liabilities Book Value

Cash $ 25,135 Accounts payables $ 67,855

Accounts receivable 43,758 Notes payables 36,454

Inventories 167,112

Total current assets $236,005 Total current liabilities $104,309

Net fixed assets 325,422 Long-term debt 223,125

Other assets 13,125 Common stock 150,000

Retained earnings 97,118

Total liabilities and

Total assets $574,552 stockholders’ equity $574,552

3.2 Inventory accounting: Differentiate between FIFO and LIFO.

LO 2

Solution: FIFO (first in, first out) refers to the practice of firms, when making sales, assuming

that the inventory that came in first (at a lower price) is being sold first. LIFO (last in,

last out) implies that a firm is selling the higher cost, newer inventory first, leaving

the lower cost, older inventory on the balance sheet.

3.3 Inventory accounting: Explain how the choice of FIFO versus LIFO can affect a firm’s

balance sheet and income statement.

LO 2

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Solution: FIFO makes sense during times of rising prices because it allows the firm to eliminate

the lower priced inventory first, resulting in higher profit margin. This allows the firm

to leave higher valued inventory on the balance sheet. During inflationary times, a

firm using LIFO would see a lower profit margin and lower values of inventory on

the balance sheet. It is important that anyone who is analyzing firms using different

accounting methods on inventory recognize the impact on the bottom line (profit

margin and net income) and on current assets.

3.4 Market-value accounting: How does the use of market-value accounting help

managers?

LO 3

Solution: Market-value accounting of both assets and liabilities allows managers to have a truer

picture of their company’s financial condition and to do a better job of estimating

cash flows that the assets would generate. However, marking-to-market is not as easy

as it sounds because of the difficulties involved in coming up with the correct market

value of current assets and liabilities.

3.5 Working capital: Laurel Electronics reported the following information at its annual

meetings. The company had cash and marketable securities worth $1,235,455, accounts

payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121,

notes payable worth $1,151,663, and other current assets of $121,455. What is the

company’s net working capital?

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 LO 2

Solution:

Total current assets = $1,235,455 + $3,488,121 + $7,121, 599 + 121,455

= $11,966,630

Total current liabilities = $4,159,357 + $1,151,663

= $5,311,020

Net working capital = $11,966,630 - $5,311,020 = $6,655,610

3.6 Working capital: The financial information for Laurel Electronics referred to in Problem

3.5 is all at book value. Suppose marking-to-market reveals that the market value of the

firm’s inventory is 20 percent below its book value, its receivables are 25 percent below

its book value, and the market value of its current liabilities is identical to the book value.

What is the firm’s net working capital using market values? What is the percent change

in net working capital?

LO 2

Solution:

Market value of inventory = $7,121,599 × 0.80 = $5,697,279

Market value of receivables = $3,488,121 × 0.75 = $2,616,091

Total current assets = $1,235,455 + $2,616,091 + $5,697,279 + 121,455

= $9,670,280

Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020

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 Net working capital = $9,670,280 - $5,311,020 = $4,359,260

3.7 Income statement: The Oakland Mills Company has disclosed the following financial

information in its annual reports for the period ending March 31, 2011; sales of $1.45

million, cost of goods sold of $812,500, depreciation expenses of $175,000, and interest

expenses of $89,575. Assume that the firm has a tax rate of 35 percent. What is the

company’s net income? Set up an income statement to answer the question.

LO 4

Solution:

Amount

Revenues $1,450.000.00

COGS 812,500.00

EBITDA $ 637,500.00

Depreciation 175,000.00

EBIT $ 462,500.00

Interest 89,575.00

EBT $ 372,925.00

Taxes (35%) 130,523.75

Net income $ 242,401.25

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3.8 Cash flow: Describe the organization of the statement of cash flows.

LO 5

Solution: The statement of cash flows identifies the cash inflows and cash outflows of the firms

for a specified period. This allows one to estimate the net cash flows from operations.

This financial statement is organized to report the cash flows resulting from the three

basic activities in any firm—operating, investing, and financing. See Exhibit 3.4 for

an example. The cash flows from operations are the results of netting all revenues

and expenses that result from the operating activities of the firm. Buying and selling a

firm’s assets lead to cash flows from investing activities. Cash flows from financing

activities arise from the firm borrowing from its investors and/or making payments to

its lenders and shareholders.

3.9 Cash flows: During 2011, Towson Recording Company increased its investment in

marketable securities by $36,845, funded fixed assets acquisitions of $109,455, and had

marketable securities of $14,215 mature. What is the net cash used in investing activities?

LO 5

Solution:

Long-Term Investing Activities

Net property, equipment, and other assets $(109,455.00)

Net acquisitions and dispositions 0.00

Investments in marketable securities (22,630.00) = 36,845-14,215

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 Net cash used in investing activities $(132,085.00)

3.10 Cash flows: Caustic Chemicals management identified the following cash flows as

significant in their year end meeting with analysts. During the year, Caustic had repaid

existing debt of $312,080 and raised additional debt capital of $650,000. It also

repurchased stock in the open market for a total of $45,250. What is the net cash provided

by financing activities?

LO 5

Solution:

Financing Activities

Loan repayment $(312,080)

Increase in long-term debt 650,000

Purchase of treasury stock (45,250)

Net cash provided by financing activities $ 292,670

3.11 Cash flow: Identify and explain the noncash expenses that a firm may incur.

LO 5

Solution: A firm may have several items on its income statement that did not result in any cash

outflow to the firm. The two largest are depreciation expenses and amortization

expenses. Other noncash expenses include deferred taxes, wages, and depletion

charges, which is similar to depreciation and used for natural resource assets. Prepaid

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 expenses also fit into this category as they represent expenses to the firm that are yet

to be paid out.

3.12 Cash flows: Given the data for Oakland Mills Company in problem 3.7 above, compute

the cash flows to investors from operating activity.

LO 7

Solution:

CFOA = EBIT – current taxes + Noncash expenses

= $462,500.00 - $130,523.75 – $0.00 + $175,000 = $506,976.25

3.13 Cash flows: Hillman Corporation reported current assets of $3,495,055 for the year ending

December 31, 2011 and current assets of $3,103,839 for the year ending December 31,

2010. Current liabilities for the firm were $2,867,225 and $2,760,124 at the end of 2011

and 2010 respectively. Compute the cash flow invested in net working capital at Hillman

Corporation during 2011.

LO 5

Solution:

CFNWC = ($3,495,055 - $2,867,225) – ($3,103,83993 - $2,760,124) = $284,061

= $284,115

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3.14 Cash flows: Del Bridge Construction had long- term assets before depreciation of

$990,560 on December 31, 2010 and $1,211,105 on December 31, 2011. How much

cash flow was invested in long-term assets for Del Bridge in 2011?

LO 5

Solution:

CFLTA = $1,211,105 - $990,560 = $220,545.

3.15 Tax: Define average tax rate and marginal tax rate.

LO 8

Solution: The average tax rate is defined as the total taxes paid divided by taxable income.

The marginal tax rate, meanwhile, represents the tax rate that is paid on the last

dollar of income earned, or the rate that will be paid on the next dollar earned.

3.16 Tax: What is the relevant tax rate to use when making financial decisions? Explain why.

LO 8

Solution: Managers need to use the marginal tax rate for making financial decisions. This is

because any additional cash flows that result from a firm’s new projects will be taxed

at the marginal tax rate. Thus, this is the appropriate rate to use.

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3.17 Tax: Manz Property Management Company announced that in the year ended June 30,

2011, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit

3.6.

LO 8

Solution:

Earnings before tax = $1,478,936

Tax rate Income Tax

15% $0 to $50,000 $ 7,500.00

25 50,001  75,000 6,250.00

34 75,001  100,000 8,500.00

39 100,001  335,000 91,650.00

34 335,001  10,000,000 388,938.24

35 10,000,001  15,000,000

38 15,000,001  18,333,333

35 More than $18,333,333

$502,838.2

Total taxes payable 4

INTERMEDIATE

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3.18 Balance sheet: Tim Dye, the CFO of Blackwell Automotive, Inc., is putting together this

year’s financial statements. He has gathered the following information. The firm had a

cash balance of $23,015, accounts payable of $163,257, common stock of $313,299,

retained earnings of $512,159, inventory of $212,444, goodwill and other assets equal to

$78,656, net plant and equipment of $711,256, and short-term notes payable of $21,115.

It also has accounts receivables of $141,258 and other current assets of $11,223. How

much long-term debt does Blackwell Automotive have?

LO 2

Solution:

Liabilities and Stockholders’

Assets Equity

Cash and marketable $ 23,015 Accounts payable and accruals $ 163,257

securities

Accounts receivable 141,258 Notes payable 21,115

Inventories 212,444

Other current assets 11,223

Total current assets $ 387,940 Total current liabilities $ 184,372

Net plant and equipment 711,256 Long-term debt 168,022

Goodwill and other assets 78,656 Total liabilities $ 352,394

Common stock 313,299

Retained earnings 512,159

Total common equity $ 825,458

Total liabilities and

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 Total assets $1,177,852 stockholders’ equity $1,177,852

3.19 Working capital: Mukhopadhya Network Associates has a current ratio of 1.60, where

the current ratio is defined as follows: current ratio = current assets/current liabilities. The

firm’s current assets are equal to $1,233,265, its accounts payables are $419,357, and its

notes payables are $351,663. Its inventory is currently at $721,599. The company plans

to raise funds in the short-term debt market and invest the entire amount in additional

inventory. How much can notes payable increase without the current ratio falling below

1.50?

LO 2

Solution:

Let x be the amount raised through notes payables.

New current liabilities = $419,357+ $351,663 + x
New current assets = $1,233,265 + x

Thus the firm can add up to $153,470 in inventory by raising money through notes
payable without changing the ratio of current assets to current liabilities to more than

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 1.50. (This ratio of current assets to current liabilities is known as the current ratio and
will be discussed in the next chapter.)

3.20 Market value: Reservoir Bottling Co. reported the following information at the end of

the year. Total current assets are worth $237,513 at book value and $219,344 at market

value. In addition, plant and equipment have a market value of $343,222, and a book

value of $362,145. The company’s total current liabilities are valued at market for

$134,889, and have a book value of $129,175. Both the book value and the market value

of its long-term debt is $144,000. If the company’s total assets are equal to a market

value of $562,566 and a book value of $599,658, what is the difference in the book value

and market value of its stockholders’ equity?

LO 3

Solution:

Book Market Book Value Market

Assets Value Value Liabilities Value

Total current assets $237,513 $219,344 Total current liabilities $129,175 $134,889

Net fixed assets 362,145 343,222 Long-term debt 144,000 144,000

Other assets 0 0 Common stock 326,483 283,677

Total assets $599,658 $562,566 Total liabilities and $599,658 $562,566

stockholders’ equity

Change in value of equity = $283,677 – $326,483 = $(42,806)

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3.21 Income statement: Nimitz Rental Company provided the following information to its

auditors. For the year ended March 31, 2011, the company had revenues of $878,412,

general and administrative expenses of $352,666, depreciation expenses of $131,455,

leasing expenses of $108,195, and interest expenses equal to $78,122. If the company’s

tax rate was 34 percent, what is its net income after taxes?

LO 4

Solution:

Nimitz Rental Company

Income Statement as of March 31, 2011(in $ 000s)

Amount

Net sales $878,412

Selling and administrative expenses 352,666

Leasing expenses 108,195

EBITDA $417,551

Depreciation 131,455

EBIT $286,096

Interest expense 78,122

EBT $207,974

Taxes (34%) 70,711

Net income $137,263

3.22 Income statement: Sosa Corporation recently reported an EBITDA of $31.3 million and

$9.7 million of net income. The company had $6.8 million in interest expense, and its

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 corporate tax rate was 35 percent. What was the company’s depreciation and amortization

expense?

LO 4

Solution:

Amount

EBITDA $31,300,000.00

Less: Depreciation and amortization 9,576,923.08

EBIT $21,723,076.92

Interest 6,800,000.00

EBT $14,923,076.92

Taxes (35%) 5,223,076.92

Net income $ 9,700,000.00

3.23 Income statement: Fraser Corporation has announced that its net income for the year

ended June 30, 2011, was $1,353,412. The company had EBITDA of $ 4,967,855, and its

depreciation and amortization expense was equal to $1,112,685. The company’s tax rate

is 34 percent. What was its interest expense?

LO 4

Solution:

Amount

EBITDA $4,967,855.00

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 Depreciation 1,112,685.00

EBIT $3,855,170.00

Interest 1,804,545.76

EBT $2,050,624.24

Taxes (34%) 697,212.24

Net income $1,353,412.00

3.24 Income Statement: For its most recent fiscal year, Carmichael Hobby Shop recorded an

EBITDA of $512,725.20, EBIT of $362,450.20, zero interest expense, and cash flow to

investors from operating activity of $348,461.25. Assuming there are no non-cash

revenues recorded on the income statement, what is the firm’s net income after taxes?

LO 4

Solution:

We know that:

Since interest expense = $0, we know that:

EBIT = EBT

Therefore,

Net income = EBIT - Current taxes

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 and so:

Current taxes = Net income - EBIT

Substituting into the equation for CFOA above (Equation 3.4) yields:

Since:

We can calculate net income as:

3.25 Retained earnings: Columbia Construction Company earned $451,888 during the year

ended June 30, 2011. After paying out $225,794 in dividends, the balance went into

retained earnings. If the firm’s total retained earnings were $846,972, what was the

retained earnings on its balance sheet on July 1, 2010?

LO 4

Solution:

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 Columbia Construction Company
Retained Earnings for 2011 (in $000s)

Balance of retained earnings, July 1, 2010 $ 620,878.00

Add: Net income, 2011 451,888.00

Less: Dividends to common stockholders (225,794.00)

Balance of retained earnings, June 30, 2011 $ 846,972.00

3.26 Cash flow: Refer to the information given in Problem 3.21. What is the cash flow for

Nimitz Rental?

LO 5

Solution:

Cash flow from operation = Net income + Depreciation

= $137,263 + $131,455

= $268,718

3.27 Tax: Mount Hebron Electrical Company’s financial statements indicated that the

company had earnings before interest and taxes of $718,323. The interest rate on its

$850,000 debt was 8.95 percent. Calculate the taxes the company is likely to owe. What

are the marginal and the average tax rates for this company?

LO 8

Solution:

EBIT $718,323.00

Interest 76,075.00

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 EBT $642,248.00

Tax rate Income Tax

15% $0 to $50,000 $ 7,500.00

25 50,001  75,000 6,250.00

34 75,001  100,000 8,500.00

39 100,001  335,000 91,650.00

34 335,001  10,000,000 104,464.32

35 10,000,001  15,000,000

38 15,000,001  18,333,333

35 More than $18,333,333

$218,364.3

Total taxes payable 2

Marginal tax rate = 34%

Average tax rate = Total taxes / Taxable income

= $218,364.22 / $642,248

= 34%

ADVANCED

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3.28 Income statement: The Centennial Chemical Corp. announced that, for the period

ending March 31, 2011, it had earned income after taxes worth $2,768,028.25 on

revenues of $13,144,680. The company’s costs (excluding depreciation and amortization)

amounted to 61 percent of sales and it had interest expenses of $392,168. What is the

firm’s depreciation and amortization expense if its tax rate was 34 percent?

LO 4

Solution:

Amount
Revenues $13,144,680.00
Costs $8,018,254.80
EBITDA $5,126,425.20
Depreciation and
$540,275.00
amortization
EBIT $4,586,150.20
Interest $392,168.00
EBT $4,193,982.20
Taxes (34%) $1,425,953.95
Net income $2,768,028.25

3.29 Retained earnings: Eau Claire Paper Mill, Inc., had, at the beginning of the fiscal year,

April 1, 2010, retained earnings of $323,325. During the year ended March 31, 2011, the

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 company produced net income after taxes of $713,445 and paid out 45 percent of its net

income as dividends. Construct a statement of retained earnings and compute the year-

end balance of retained earnings.

LO 4

Solution:

Balance of retained earnings, April 1, 2010 $ 323,325.00

Add: Net income, 2011 713,445.00

Less: Dividends to common stockholders (321,050.25)

Balance of retained earnings, March 31, 2011 $ 715,719.75

3.30 Taxes: Menomonie Casino Company earned $23,458,933 before interest and taxes for

the fiscal year ending March 31, 2011. If the casino had interest expenses of $1,645,123,

calculate its tax burden using Exhibit 3.6. What are the marginal and the average tax rates

for this company?

LO 8

Solution:

EBIT $23,458,933.00

Interest 1,645,123.00

EBT $21,813,810.00

Tax rate Income Tax

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 15% $0 to $50,000 $ 7,500.00

25 50,001  75,000 6,250.00

34 75,001  100,000 8,500.00

39 100,001  335,000 91,650.00

34 335,001  10,000,000 3,286,100.00

35 10,000,001  15,000,000 1,750,000.00

38 15,000,001  18,333,333 1,266,666.54

35 More than $18,333,333 1,218,166.95

$7,634,833.4
Total taxes payable
9

Marginal tax rate = 35%

Average tax rate = Total taxes / Taxable income

= $7,634,833.49 / $21,813,810

= 35%

3.31 Cash flows: Vanderheiden Hog Products Corp. provided the following financial

information for the quarter ending June 30, 2011:

Net income: $189,425

Depreciation and amortization: $63,114

Increase in receivables: $ 62,154

Increase in inventory: $57,338

Increase in accounts payables: $37,655

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 Decrease in other current assets: $27,450

What is this firm’s cash flow from operating activities during this quarter?

LO 5

Solution:

Operating Activities

Net income $189,425

Additions (sources of cash)

Depreciation and amortization 63,114

Increase in accounts payable 37,655

Decrease in other current assets 27,450

Increase in accrued income taxes 0

Subtractions (uses of cash)

Increase in accounts receivable (62,154)

Increase in inventories (57,338)

Net cash provided by operating activities $198,152

3.32 Cash flows: Analysts following the Tomkovick Golf Company were given the following

information for the years ended June 30, 2011 and June 30 2010:

2011 2010

Assets

Cash and marketable securities $ 33,411 $ 16,566

Accounts receivable 260,205 318,768

Inventory 423,819 352,740

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 Other current assets 41,251 29,912

Total current assets $ 758,686 $ 717,986

Plant and equipment 1,931,719 1,609,898

Less: Accumulated depreciation (419,044) (206,678)

Net plant and equipment $1,512,675 $1,403,220

Goodwill and other assets 382,145 412,565

Total assets $2,653,506 $2,533,771

Liabilities and Stockholders’ Equity 2011 2010

Accounts payable and accruals $ 378,236 $ 332,004

Notes payable 14,487 7,862

Accrued income taxes 21,125 16,815

Total current liabilities $ 413,848 $ 356,681

Long-term debt 679,981 793,515

Total liabilities $1,093,829 $1,150,196

Preferred stock __ __

Common stock (10,000 shares) 10,000 10,000

Additional paid-in capital 975,465 975,465

Retained earnings 587,546 398,110

Less: Treasury stock (13,334) __

Total common equity $1,559,677 $1,383,575

Total liabilities and stockholders’ equity $2,653,506 $2,533,771

In addition, it was reported that the company had a net income of $ 3,155,848 and that

depreciation expenses were equal to $212,366 during 2011.

a. Construct a 2011 cash flow statement for this firm.

b. Calculate the net cash provided by operating activities.

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 c. What is the net cash used in investing activities?

d. Compute the net cash provided by financing activities.

LO 5

Solution:

Tomkovick Golf Company

Year ended June 30, 2011

Operating Activities

Net income $ 3,155,848.00

Additions (sources of cash)

Depreciation and amortization 212,366.00

Increase in accounts payable 46,232.00

Decrease in accounts receivable 58,563.00

Increase in accrued income taxes 4,310.00

Subtractions (uses of cash)

Increase in other current assets (11,339.00)

Increase in inventories (71,079.00)

Net cash provided by operating activities $ 3,394,901.00

Long-Term Investing Activities

Increase in property equipment $ (321,821.00)

Decrease in goodwill and other assets 30,420.00

Net cash used in investing activities $ (291,401.00)

Financing Activities

Increase in notes payable $ 6,625.00

Decrease in long-term debt (113,534.00)

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 Payment of cash dividends (=NI (kỳ này) – Add. (2,966,412.00)

RE

Purchase of treasury stock (13,334.00)

Net cash provided by financing activities $(3,086.655.00)

Effect of exchange rates on cash $ 0.00

Net increase in cash and marketable securities 16,845.00

Cash and securities at beginning of year 16,566.00

Cash and securities at end of year $ 33,411.00

NOTE: CHECK TOTAL NCF – ADD. To Cash item (số cuối kỳ - số đầu kỳ)

3.33 Cash flows: Based on the financial statements for Tomkovick Golf Company above,

compute the cash flow invested in net working capital and the cash flow invested in long-

term assets for a calculation of the cash flows to investors in 2010.

LO 7

Solution:

CFNWC = ($758,686 – $413,848) – ($717,986 – $356,681) = -$16,467

CFLTA = ($1,931,719 – $1,609,898) + ($382,145 - $412,565) = $291,401

Sample Test Problems

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3.1 Drayton, Inc. has current assets of $256,312, and total assets of $861,889. It also has

current liabilities of $141,097, common equity of $200,000, and retained earnings of

$133,667. How much long-term debt does the firm have?

Solution:

Assets Liabilities and Equity

Total current $256,312.0 Total current liabilities $141,097.00

assets
0

Long-term debt $387,125.00

Common stock 200,000.00

Retained earnings 133,667.00

Total assets $861,889.0 Total liabilities and stockholders’ $861,889.00

equity
0

$861,889 – 141,097-200,000-133,667 = $387,125 (long-term debt)

3.2 Ellicott Testing Company produced revenues of $745,000 in 2011. It had expenses

(excluding depreciation) of $312,640, depreciation of $65,000, and interest expense of

$41,823. It pays a marginal tax rate of 34 percent. What was the firm’s net income after

taxes?

Solution:

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 Amount

Revenues $745,000.00

Costs 312,640.00

EBITDA $432,360.00

Depreciation 65,000.00

EBIT $367,360.00

Interest 41,823.00

EBT $325,537.00

Taxes (34%) 110,682.58

Net income $214,854.42

3.3 Tejada Enterprises reported a EBITDA of $7,300,125 and net income of $3,328,950 for

the fiscal year ended December 31, 2011. During the same period, the company had

$1,155,378 in interest expense, $1,023,285 in depreciation and amortization expense, and

an average corporate tax rate of 35 percent. What was the cash flow to investors from

operating activity during 2011?

Solution:

CFOA = $7,300,125 – 0.35 × ($7,300,125 - $1,023,285 - $1,155,378) + $1,023,285

= $5,507,613

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3.4 In the year ended June 30, 2011, Tri King Company increased its investment in

marketable securities by $234,375, made fixed assets acquisition totaling $1,324,766, and

sold $77,215 of long-term debt. In addition, the firm had a net inflow of $365,778 from

selling assets. What is the net cash used in investing activities?

Solution:

Long-Term Investing Activities

Net property, equipment and other assets $(1,324,766)

Net acquisitions and dispositions 365,778

Investments in marketable securities (234,375)

Net cash used in investing activities $((1,193,363)

3.5 Triumph Soccer Club has the following cash flows during this year. It repaid existing

debt of $875,430 while raising new debt capital of $1,213,455. It also repurchased stock

in the open markets for a total of $71,112. What is the net cash provided by financing

activities?

Solution:

Financing Activities

Loan repayment $(875,430)

Increase in long-term debt 1,213,455

Purchase of treasury stock (71,112)

Net cash provided by financing activities $ $266,913

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