Chapter 3 Q&A

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1. What four financial statements are contained in most annual reports? A: Cash flow, balance sheet, income statement, and stockholders equity 2. Who are some of the basic users of financial statements, and how do they use them? A: -Bankers and investors use the financial statements to make informed decisions about what firms to invest in. -Managers need financial statements to operate their business efficiently -Tax authorities need them to assess taxes 3. If a “typical” firm reports $20 million of retained earnings on its balance sheet, could its directors declare a $20 million cash dividend without having any qualms about what they were doing? Explain your answer. A: -No, retained earnings would not be held in cash most likely -Retained earnings represent reinvestment of earnings by the firm over its life -It would be an investment in all of the firm assets 4. Explain the following statement: Although the balance sheet can be thought of as a snapshot of a firm’s financial position at a point in time, the income statement reports on operations over a period of time. A: -The balance sheet shows the firm financial position on a specific date. For example, the cash account shown on the balance sheet would represent the cahs the firm had on hand for that point in time -The income statement, on the other hand, reports on the firm’s operations over a period of time. For example, revenues that were incurred over a particular time period. It represents the

firm’s revenue for the entire period. Revenue gained at the beginning and end of the period is included 5. Financial statements are based on generally accepted accounting principles (GAAP) and are audited by CPA firms. Do investors need to worry about the validity of those statements? Explain your answer. A: -Yes, even though GAAP is required managers still have a lot of discretion in deciding how and when to report certain transactions. -Even if two firms have the same operating situation it may report financial statements that show differences. Some may be legitimate differences of opinion about the correct way to record transactions. In other cases, managers may report numbers in a way that helps them present either higher earnings or more stable earnings over time -There have been cases where managers report fraudulent statements 7. What is free cash flow? If you were an investor, why might you be more interested in free cash flow than net income? A: -Free cash flow is the amount of cash that could be withdrawn without harming the firm’s ability to operate and produce future cash flow -It is calculated as after-tax operating income + depreciation minus capital expenditures and the change (new minus old) in net operating working capital (Current assets - Current liabilities) -Free cash flow is more important than net income because it shows the exact amount available to all investors (stockholders and debtholders). -The value of a company’s operations depends on expected future free cash flows. Managers make their companies more valuable by increasing their free cash flow -Net income on the other hand shows accounting profit but not cash flow

8. Would it be possible for a company to report negative free cash flow and still be highly valued by investors; that is, could a negative free cash flow ever be viewed optimistically by investors? Explain your answer. A: -Yes. Negative free cash flows are not necessarily bad. Most rapidly growing companies have negative free cash flow because the fixed assets and working capital are expanding Hopefully these investments in assets will be profitable 9. How are management’s actions incorporated in EVA and MVA? How are EVA and MVA interconnected? -MVA is the difference between a firm’s market value and the book value of its equity. The higher a firm’s MVA the better the job management is doing for the firm’s shareholders. -EVA is the difference between a firm’s after-tax net operating profit and the annual dollar cost of capital. -Companies (via their managers) create value and realize positive EVA if the benefits of their investments exceed the cost of raising the necessary capital. If EVA is positive , then aftertax operating income exceeds the cost of the capital needed to produce that income and management’s actions are adding value for stockholders -Positive EVA on an annual basis will help ensure that MVA is also positive 10. Explain the following statement: Our tax rates are progressive. Higher-income means a higher percentage paid in taxes 11. Could income ever be subject to triple taxation? Explain your answer. A: -Yes if, the original corporation is first taxed

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-The second corporation is then taxed on the dividends it received from the first tax -The individuals who receive the final dividends are taxed again -This is why corporations that receive dividend income can exclude some of the dividends from its taxable income to minimize triple taxation 12. How does the deductibility of interest and dividends by the paying corporation affect the choice of financing (i.e., the use of debt versus equity)? A: -Interest paid is tax deductible but dividends payments are not . Therefore, the after-tax cost of debt is lower than the after-tax cost of equity -This encourages the use of debt rather than equity PROBLEMS 1. BALANCE SHEET The assets of Dallas & Associates consist entirely of current assets and net plant and equipment . The firm has total assets of $ 2 . 5 million and net plant and equipment equals $ 2 million. It has notes payable of $150,000, long-term debt of $750,000, and total common equity of $1.5 million. The firm does have accounts payable and accruals on its balance sheet. The firm only finances with debt and common equity, so it has no preferred stock on its balance sheet. What is the company’s total debt? 150,000 + 750,000 = 900,000 What is the amount of total liabilities and equity that appears on the firm’s balance sheet? 2.5 million What is the balance of current assets on the firm’s balance sheet? 500,000 What is the balance of current liabilities on the firm’s balance sheet? 2.5 - 1.5 = 1 million - 750,000 = 250,000 What is the amount of accounts payable and accruals on its balance sheet? (Hint: Consider this as a single line item on the firm’s balance sheet.) 250,000 - 150,000 = 100,000

What is the firm’s net working capital? 500,000 - 250,000 = 250,000 What is the firm’s net operating working capital? = Current Asset - (Current Liabilities - Interset baring Current Liablities) 500 - (250 - 100) = 500 - 100 = 400 What is the explanation for the difference in your answers to parts f and g? NOWC - NWC 400 - 250 = 150,00 which equals the notes payable 2. INCOME STATEMENT Byron Books Inc. recently reported $13 million of net income. Its EBIT was $20.8 million, and its tax rate was 35%. What was its interest expense? (Hint: Write out the headings for an income statement, and fill in the known values. Then divide $13 million of net income by (1-T)=0.65 to find the pretax income. The difference between EBIT and taxable income must be interest expense. Use this same procedure to complete similar problems.) A: EBIT = 20.8 TR = .35 NI = 13 EBT = NI / (1 - TR) EBT = 13/ .65 = 20 Interest = EBIT - EBT = 20.8 - 20 = .8 million 5. MVA Harper Industries has $900 million of common equity on its balance sheet; its stock price is $80 per share; and its market value added (MVA) is $50 million. How many common shares are currently outstanding? Common equity = 900 million Price per share = 80 Market value added = 50 million

MVA = (P * number of outstanding shares) - BV common equity 950,000,000 / 80 = 11,875,000 9. BALANCE SHEET Which of the following actions are most likely to directly increase cash as shown on a firm’s balance sheet? Explain and state the assumptions that underlie your answer. It issues $4 million of new common stock. This would increase cash through the sale of new stock It buys new plants and equipment at a cost of $3 million. This would decrease cash It reports a large loss for the year. This might increase cash if the tax refund is high enough It increases the dividends paid on its common stock This would decrease cash 10. STATEMENT OF STOCKHOLDERS’ EQUITY Electronics World Inc. paid out $22.4 million in total common dividends and reported $144.7 million of retained earnings at year-end. The prior year’s retained earnings were $95.5 million. What was the net income? Assume that all dividends declared were actually paid. Dividends = 22.4 mill Retained earnings 144.7 mill current

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Retained earnings = 95.5 prior = Dividends + Retained earnings at end (current) - Retained earnings at beg. 22.4 + 144.7 - 95.5 = 71.6 11. EVA For 2016, Gourmet Kitchen Products reported $22 million of sales and $19 million of operating costs (including depreciation). The company has $15 million of total invested capital. Its after-tax cost of capital is 10%, and its federal-plus-state income tax rate was 36%. What was the firm’s economic value added (EVA), that is, how much value did management add to stockholders’ wealth during 2016? Sales = 22 million Operating Costs = 19 million Total invested capital = 15 m After-tax cost of capital = .1 Tax rate = .36 EBIT = Sales - Operating costs =22 - 19 = 3 =EBIT (1-TR) - (TIC)(ATCC %) = 3 (.64) - (15)(0.1) = 420,000 12 STATEMENT OF CASH FLOWS Hampton Industries had $39,000 in cash at year-end 2015 and $11,000 in cash at year-end 2016. The firm invested in property, plant, and equipment totaling $210,000. Cash flow from financing activities totaled +$120,000. Cash end 2015 = 39 Cash at 2016 = 11 Investment 210 =Financing = 120

What was the cash flow from operating activities? -28 = CFO - 210 + 120 CFO = 62 If accruals increased by $15,000, receivables and inventories increased by $50,000, and depreciation and amortization totaled $25,000, what was the firm’s net income? 62 = NI + 15 - 50 + 25 62 = NI - 10 NI = 72 13 STATEMENT OF CASH FLOWS First job will be to recreate the firm’s cash flow statement for the year just ended. The firm had $100,000 in the bank at the end of the prior year, and its working capital accounts except cash remained constant during the year. It earned $5 million in net income during the year but paid $800,000 in dividends to common shareholders. Throughout the year, the firm purchased $5.5 million of machinery that was needed for a new project. You have just spoken to the firm’s accountants and learned that annual depreciation expense for the year is $450,000; however, the purchase price for the machinery represents additions to property, plant, and equipment before depreciation. Finally, you have determined that the only financing done by the firm was to issue long-term debt of $1 million at a 6% interest rate. What was the firm’s end-of-year cash balance? Recreate the firm’s cash flow statement to arrive at your answer. Cash in prior year = 100,000 Net Income = 5,000,000 Dividends = 800,000 Purchase FA = 5,500,000 Depreciation 450,000 Financing 1 million at 0.06 No interest paid yet I. Operating Activities Net Income 5,000,000 Depreciation 450,000 Net Cash Provided by CFO 5,450,000 II. Long-Term Investing Activities Additions to PPE (5,500,000)

Net Cash used in investing activities (5,500,000) III. Financing Activities LT debt 1,000,000 Dividends (800,000) Net Cash Provided by CFA 200,000 IV. Summary Net Cash (I, II, & III) 150,000 Cash and equivalence at beg. 100,000 Cash and equivalence at end 250,000 14. Balance Sheets as of December 31

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Income Statement for Year Ending December 31, 2016 What was net operating working capital for 2015 and 2016? NOWC = Current Asset - (Current Liabilities - Iinterset baring) 83,320 - (25,100 - 7,000) = 65,220 (2016) 71,000 - (20,050 - 5,050) = 56,000 (2015) B. What was Arlington’s 2016 free cash flow? = EBIT(1 - Tax Rate) + Depreciation - (capital expenditure + ∆ Net Operating Working Capital) =32,400 - 17,220 = 15,180

EBIT = 44,000 Depreciation = 6,000 Capital Expenditure = ∆ Fixed Assets + Depreciation (if not added) =2,000 + 6,000 Net Operating Working Capital = ∆ Net Operating Working Capital =9,220 3. Construct Arlington’s 2016 statement of stockholders’ equity. Common Stock Retained Earnings Total SE Balance 12/31/15 4,000 $40,000 36,950 76,950 Net Income 2016 23,190 Cash Dividends (13,920) Add Net income - Dividends 9,270 Balance 12/31/16 4,000 $40,000 46,220 86,220 4.What was Arlington’s 2016 EVA? Assume that its after-tax cost of capital is 10%. EBIT = 44,000 Tax Rate = 0.4 Total Invested Capital = Financing Liability + Total Equity Or = Total Assets - (Non-interest bearing Current Liabilities) Or = Total Debt + Total Equity Example = Notes payable + Long term debt + Total equity =7,000 + 20,000 + 86,220 = 113,220 Economic Value Added (Annual cost of capital) = NOPAT - (Total Invested Capital) * (After-tax cost of capital %) Or = EBIT * (1 - Tax Rate) - (Total Invested Capital) * (After Tax =44,000(0.6) - (113,220) *(.1) = 15,078

15. INCOME STATEMENT Edmonds Industries is forecasting the following income statement: The CEO would like to see higher sales and a forecasted net income of $2,100,000. Assume that operating costs (excluding depreciation and amortization) are 55% of sales and that depreciation and amortization and interest expenses will increase by 6%. The tax rate, which is 40%, will remain the same. (Note that while the tax rate remains constant, the taxes paid will change.) What level of sales would generate $2,100,000 in net income? Before After NI 1,680,00 Operating costs 5,500,00 Depreciation and amortization = 1,200,000 TR =.4 Interest Expense = 500,00 NI = 2,100,00 Operating costs same D&A = 1272000 TR = .4 Interest Expense = 530,00 NI = 2,100,000 Operating costs = .55 of sales Depreciation & Amortization inc. 6% TR = .4 EBT = Net Income / (1-taxes rate) 2100000 / (1-0.4) = 3500000 EBIT = EBT + Interest 4030000 EBIT EBITDA = EBIT + Depreciation and Amortization = 5,302,000.00 Sales * .45 = EBITDA = 11,782,222.22

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16. FINANCIAL STATEMENTS The Davidson Corporation’s balance sheet and income statement are provided here. Davidson Corporation: Balance Sheet as of December 31, 2016 (Millions of Dollars) Davidson Corporation: Income Statement for Year Ending December 31, 2016 (Millions of Dollars) Construct the statement of stockholders’ equity for December 31, 2016. N o common stock was issued during 2016. Example

EPS = Net Income / Common Shares Outstanding 3.72 = 372 / x = 100 Shares (stock issued) Amount Look at balance sheet Retained Earnings Total Stockholders’ Equity Balance 2015 100,000,000 $260,000,00 1,374,000,00 2016 Net income 372,000,000 Cash dividends (146,000,00) Additions to retained earnings Balance 2016 1,600,000,000 1,600,000,00 = x - 146,000,000 + 372,00,00 =1,374,000,00