Chapter 2, Problem 20QP

Calculating Cash Flows Cusic Industries had the following operating results for 2015: sales = $20,300; cost of goods sold= $14,500; depreciation expense= $2,900; interest expense = $690; dividends paid = $660. At the beginning of the year, net fixed assets were $15,470, current assets were $4,630, and current liabilities were $2,520. At the end of the year, net fixed assets were $17,120, current assets were $5,345, and current liabilities were $2,785. The tax rate for 2015 was 40 percent.

1. a. What is net income for 2015?
2. b. What is the operating cash flow for 2015?
3. c. What is the cash flow from assets for 2015? Is this possible? Explain.
4. d. If no new debt was issued during the year, what is the cash flow to creditors? What is the cash flow to stockholders? Explain and interpret the positive and negative signs of your answers in (a) through (d).

Summary Introduction

To calculate: The net income for 2015.

Answer to Problem 20QP

Solution: The net income of the company for the year 2015 is $1,326.

Explanation of Solution

Given information:

Company C has sales of $20,300, cost of goods sold of $14,500, depreciation of $2,900, interest expenses of $690, dividend of $660. Opening fixed assets are $15,470, current assets are $4,630, and current liabilities are $2,520.

Closing net fixed assets are $17,120, current assets are $5,345, and current liabilities are $2,785.

The taxes are at the rate of 40%.

Compute the net income of Company C:

Income statement
Particulars	Amount	Amount
Net sales		$20,300
Less:
Costs	$14,500
Depreciation	$2,900	$17,400
Earnings before interest and taxes		$2,900
Less: Interest paid		$690
Taxable income		$2,210
Less: Taxes ($2,210×40%)		$884
Net income		$1,326

Hence, the net income is $1,326.

Summary Introduction

To calculate: The operating cash flow for 2015.

Answer to Problem 20QP

The operating cash flow of Company C is$4,916.

Explanation of Solution

Given information:

The earnings before interest and taxes are $2,900, depreciation are $2,900, and taxes are $884.

(Refer to Part (a) for the solution).

Compute the operating cash flow:

Operating cash flow
Particulars	Amount
Earnings before interest and taxes	$2,900
Add: Depreciation	$2,900
	$5,800
Less: Taxes	$884
Operating cash flow	$4,916

Hence, the operating cash flow is $4,916.

Summary Introduction

To calculate: The cash flow from assets for 2015 and the possibility of having negative cash flow from assets.

Answer to Problem 20QP

The cash flow from assets is −$84.

Explanation of Solution

Given information:

Company C has sales of $20,300, cost of goods sold of $14,500, depreciation of $2,900, interest expenses of $690, dividend of $660. Opening fixed assets are $15,470, current assets are $4,630, and current liabilities are $2,520.

Closing net fixed assets are $17,120, current assets are $5,345, and current liabilities are $2,785.

The taxes are at the rate of 40%.

Formulae:

The formula to calculate the ending net working capital:

$\text{Ending net working capital}=\text{Ending current assets}-\text{Ending current liabilities}$

The formula to calculate the beginning net working capital:

$\text{Beginning net working capital}=\text{Beginning current assets}-\text{Beginning current liabilities}$

The formula to calculate the change in net working capital:

$\text{Change in net working capital}=\left(\begin{array}{l}\text{Ending net working capital}-\\ \text{Beginning net working capital}\end{array}\right)$

The formula to calculate the cash flow from assets:

$\text{Cash flow from assets}=\left(\begin{array}{l}\text{Operating}\\ \text{cash flow}\end{array}\right)-\left(\begin{array}{l}\text{Change in net}\\ \text{working capital}\end{array}\right)-\left(\begin{array}{l}\text{Net capital}\\ \text{spending}\end{array}\right)$

Note: The following calculations are required to compute the cash flow from assets.

Compute the ending net working capital:

$\begin{array}{c}\text{Ending net working capital}=\text{Ending current assets}-\text{Ending current liabilities}\\ =\text{\$5,345}-\text{\$2,785}\\ =\text{\$2,560}\end{array}$

Hence, the ending net working capital is $2,560.

Compute the beginning net working capital:

$\begin{array}{c}\text{Beginning net working capital}=\text{Beginning current assets}-\text{Beginning current liabilities}\\ =\text{\$4,630}-\text{\$2,520}\\ =\text{\$2,110}\end{array}$

Hence, the beginning net working capital is $2,110.

Compute the change in net working capital:

$\begin{array}{c}\text{Change in net working capital}=\left(\begin{array}{l}\text{Ending net working capital}-\\ \text{Beginning net working capital}\end{array}\right)\\ =\$2,560-\$2,110\\ =\$450\end{array}$

Hence, the change in net working capital is $450.

Compute the net capital spending:

Net capital spending
Particulars	Amount
Ending net fixed assets	$17,120
Less: Beginning net fixed assets	$15,470
	$1,650
Add: Depreciation	$2,900
Net capital spending	$4,550

Hence, the net capital spending is $4,550.

Compute the cash flow from assets:

The operating cash flow is $ $4,916. (Refer to Part (b) for the solution). The change in net working capital is −$450, the net capital spending is $4,550.

$\begin{array}{c}\text{Cash flow from assets}=\left(\begin{array}{l}\text{Operating}\\ \text{cash flow}\end{array}\right)-\left(\begin{array}{l}\text{Change in net}\\ \text{working capital}\end{array}\right)-\left(\begin{array}{l}\text{Net capital}\\ \text{spending}\end{array}\right)\\ =\$4,916-\$450-\$4,550\\ =-\$84\end{array}$

Hence, the cash flow from assets are −$84.

Determine whether the company can have negative cash flow from assets:

The cash flow from assets can be negative. A negative cash flow from assets means that the company borrowed funds to invest in fixed assets. In the given situation, the operating cash flow is positive. However, the cash flow from assets is negative because the company raised additional capital to invest in fixed assets.

Summary Introduction

To calculate: The cash flow to creditors and the cash flow to stockholders’

Answer to Problem 20QP

Solution:

The cash flow to creditors is $690 and the cash flow to stockholders’ is −$774.

Explanation of Solution

Given information:

Company C had to pay interest expenses of $690 and dividend of $660. There were no debt borrowings in the current year. The cash flow from assets is −$84. (Refer to the above solution).

Formulae:

The formula to calculate the cash flow to creditors:

$\text{Cash flow to creditors}=\text{Interest paid}-\text{Net new borrowing}$

The formula to calculate the cash flow to stockholders:

$\text{Cash flow to stockholders}=\text{Cash flow from assets}-\text{Cash flow to creditors}$

Or

$\text{Cash flow to stockholders'}=\text{Dividends paid}-\text{Net new equity raised}$

Compute the cash flow to creditors:

$\begin{array}{c}\text{Cash flow to creditors}=\text{Interest paid}-\text{Net new borrowing}\\ =\text{\$690}-\text{0}\\ =\text{\$690}\end{array}$

Hence, the cash flow to creditors is $690.

Compute the cash flow to stockholders:

$\begin{array}{c}\text{Cash flow to stockholders}=\text{Cash flow from assets}-\text{Cash flow to creditors}\\ =-\text{\$84}-\$690\\ =-\$774\end{array}$

Hence, the cash flow to stockholders is −$774.

Compute the new equity issued:

$\begin{array}{c}\text{Cash flow to stockholders'}=\text{Dividends paid}-\text{Net new equity raised}\\ -\text{\$774}=\text{\$660}-\text{Net new equity raised}\\ \text{Net new equity raised}=\$660+\$774\\ =\$1,434\end{array}$

Hence, the new equity raised is $1,434.

Final interpretation of the answers in all the parts of the solution:

The operating cash flow and the net income of the company for the year 2015 is positive. The company had to invest $450 in working capital. It also invested $4,550 for buying new fixed assets. To meet the investment needs, the company raised $1,434 in new equity and $84 from its shareholders. It paid $660 as dividends, and $690 as interest. After paying dividends and interest, the company had $84 to meet the investment needs.