Chapter 2, Problem 21QP

a)

Summary Introduction

To calculate: The net income for 2016.

Introduction:

Cash flow refers to the difference between the cash that comes into the business and the cash that goes out of the business. The following are the different types of cash flows in a corporation:

• Cash flow from assets:

  It refers to difference between the revenues from the sale of assets and the money invested in purchasing the assets.

• Cash flow to creditors:

  It refers to the interest paid to the creditors minus the net fresh debt borrowed by the company.

• Cash flow to stockholders:

  It refers to the dividend paid to the shareholders of the company minus the fresh equity raised by the company.

• Operating cash flow:

  It refers to the cash flow from operating activities of the firm.

Answer to Problem 21QP

The net income of the company for 2016 is $2,661.

Explanation of Solution

Given information:

Company T had sales of $28,476. The costs of goods sold were $20,136. The company charged $3,408 as depreciation. It had to pay interest expenses amounting to $497. The tax rate applicable to Company T was 40 percent.

Compute the net income of Company T:

Company T
Income statement
Particulars	Amount	Amount
Net sales		$28,476
Less:
Costs	$20,136
Depreciation	$3,408	$23,544
Earnings before interest and taxes		$4,932
Less: Interest paid		$497
Taxable income		$4,435
Less: Taxes ($4,435×40%)		$1,774
Net income		$2,661

Hence, the net income is $2,661.

b)

Summary Introduction

To calculate: The operating cash flow for 2016.

Introduction:

Cash flow refers to the difference between the cash that comes into the business and the cash that goes out of the business. The following are the different types of cash flows in a corporation:

• Cash flow from assets:

  It refers to difference between the revenues from the sale of assets and the money invested in purchasing the assets.

• Cash flow to creditors:

  It refers to the interest paid to the creditors minus the net fresh debt borrowed by the company.

• Cash flow to stockholders:

  It refers to the dividend paid to the shareholders of the company minus the fresh equity raised by the company.

• Operating cash flow:

  It refers to the cash flow from operating activities of the firm.

Answer to Problem 21QP

The operating cash flow of Company T is $6,566.

Explanation of Solution

Given information:

The earnings before interest and taxes is $4,932, the depreciation is $3,408, and the taxes are $1,774 (Refer to Part (a) of the solution).

Compute the operating cash flow:

Company T
Operating cash flow
Particulars	Amount
Earnings before interest and taxes	$4,932
Add: Depreciation	$3,408
	$8,340
Less: Taxes	$1,774
Operating cash flow	$6,566

Hence, the operating cash flow is $6,566.

c)

Summary Introduction

To calculate: The cash flow from assets for 2016 and the possibility of having negative cash flow from assets.

Introduction:

Cash flow refers to the difference between the cash that comes into the business and the cash that goes out of the business. The following are the different types of cash flows in a corporation:

• Cash flow from assets:

  It refers to difference between the revenues from the sale of assets and the money invested in purchasing the assets.

• Cash flow to creditors:

  It refers to the interest paid to the creditors minus the net fresh debt borrowed by the company.

• Cash flow to stockholders:

  It refers to the dividend paid to the shareholders of the company minus the fresh equity raised by the company.

• Operating cash flow:

  It refers to the cash flow from operating activities of the firm.

Answer to Problem 21QP

The cash flow from assets is ($413).

Explanation of Solution

Given information:

The current assets and current liabilities of Company T at the beginning of the year were $3,528 and $3,110 respectively. Its current assets and current liabilities at the end of the year were $4,234 and $2,981 respectively.

The net fixed assets of Company T at the beginning of the year amounted to $19,872, and the net fixed assets at the end of the year were $22,608. It charged $3,408 as depreciation in 2016.

Formulae:

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

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

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

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

Compute the ending net working capital:

$\begin{array}{c}\text{Ending net working capital}=\text{Ending current assets}-\text{Ending current liabilities}\\ =\$4,234-\$2,981\\ =\$1,253\end{array}$

Hence, the ending net working capital is $1,253.

Compute the beginning net working capital:

$\begin{array}{c}\text{Beginning net working capital}=\text{Beginning current assets}-\text{Beginning current liabilities}\\ =\$3,528-\$3,110\\ =\$418\end{array}$

Hence, the beginning net working capital is $418.

Compute the change in net working capital:

$\begin{array}{c}\text{Change in net working capital}=\left(\begin{array}{l}\text{Ending net working capital}-\\ \text{Beginning net working capital}\end{array}\right)\\ =\$1,253-\$418\\ =\$835\end{array}$

Hence, the change in net working capital is $835.

Compute the net capital spending:

Company T
Net capital spending
Particulars	Amount
Ending net fixed assets	$22,608
Less: Beginning net fixed assets	$19,872
	$2,736
Add: Depreciation	$3,408
Net capital spending	$6,144

Hence, the net capital spending is $6,144.

Compute the cash flow from assets:

The operating cash flow is $6,566 (Refer to Part (b) of the solution). The change in net working capital is $835, and the net capital spending is $6,144.

$\begin{array}{c}\text{Cash flow from assets}=\left(\begin{array}{l}\text{Operating}\\ \text{cash flow}\end{array}\right)-\left(\begin{array}{l}\text{Change in net}\\ \text{working capital}\end{array}\right)-\left(\begin{array}{l}\text{Net capital}\\ \text{spending}\end{array}\right)\\ =\$6,566–\$835–\$6,144\\ =\left(\$413\right)\end{array}$

Hence, the cash flow from assets is ($413).

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.

d)

Summary Introduction

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

Introduction:

Cash flow refers to the difference between the cash that comes into the business and the cash that goes out of the business. The following are the different types of cash flows in a corporation:

• Cash flow from assets:

  It refers to difference between the revenues from the sale of assets and the money invested in purchasing the assets.

• Cash flow to creditors:

  It refers to the interest paid to the creditors minus the net fresh debt borrowed by the company.

• Cash flow to stockholders:

  It refers to the dividend paid to the shareholders of the company minus the fresh equity raised by the company.

• Operating cash flow:

  It refers to the cash flow from operating activities of the firm.

Answer to Problem 21QP

The cash flow to creditors is $497, and the cash flow to stockholders’ is ($910).

Explanation of Solution

Given information:

Company T had to pay interest expenses amounting to $497. There were no debt borrowings in the current year. The cash flow from assets is ($413).

Formulae:

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

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

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

Compute the cash flow to creditors:

$\begin{array}{c}\text{Cash flow to creditors}=\text{Interest paid}-\text{Net new borrowing}\\ =\$497-\$0\\ =\$497\end{array}$

Hence, the cash flow to creditors is $497.

Compute the cash flow to stockholders:

$\begin{array}{c}\text{Cash flow to stockholders}=\text{Cash flow from assets}-\text{Cash flow to creditors}\\ =\left(\$413\right)-\$497\\ =\left(\$910\right)\end{array}$

Hence, the cash flow to stockholders is ($910).

Compute the new equity issued:

$\begin{array}{c}\text{Cash flow to stockholders'}=\text{Dividends paid}-\text{Net new equity raised}\\ \left(\$910\right)=\$739-\text{Net new equity raised}\\ \text{Net new equity raised}=\$910+\$739\\ =\$1,649\end{array}$

Hence, the new equity raised is $1,649.

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 2016 is positive. The company had to invest $835 in working capital. It also invested $6,144 for buying new fixed assets. To meet the investment needs, the company raised $1,649 in new equity and $413 from its shareholders. It paid $739 as dividends, and $497 as interest. After paying dividends and interest, the company had $413 to meet the investment needs.