Chapter 3, Problem 14P

a.

Summary Introduction

To compute: The net operating working capital of Company B.

Financial Statements: A part of annual report that is attributed to the financials of the company for an accounting period is called financial statements. These include income statement, statement of retained earnings, balance sheet and cash flow statement.

Net Operating Working Capital: The difference of current assets and current liabilities is called working capital. When only accounts payable and accruals are considered instead of total current liabilities, the difference is called net operating working capital.

Answer to Problem 14P

The Company B has net operating working capital of $53,725 and $44,000 in 2015 and 2014, respectively

Explanation of Solution

Solution:

Given (for 2015),

Accounts payable are $10,800.

Accruals are $7,600.

Current assets are $72,125.

Formula to compute net operating working capital,

$\text{Net Operating Working Capital}=\left[\begin{array}{l}\text{Current Assets}-\text{Accounts Payable}\\ -\text{Accruals}\end{array}\right]$

Substitute $10,800 for accounts payable, $7,600 for accruals and $72,125 for current assets.

$\begin{array}{c}\text{Net Operating Working Capital}=\$72,125-\$10,800-\$7,600\\ =\$53,725\end{array}$

Given (for 2014),

Accounts payable are $9,000.

Accruals are $6,000.

Current assets are $59,000.

Formula to compute net operating working capital,

$\text{Net Operating Working Capital}=\left[\begin{array}{l}\text{Current Assets}-\text{Accounts Payable}\\ -\text{Accruals}\end{array}\right]$

Substitute $9,000 for accounts payable, $6,000 for accruals and $59,000 for current assets.

$\begin{array}{c}\text{Net Operating Working Capital}=\$59,000-\$9,000-\$6,000\\ =\$44,000\end{array}$

Conclusion

Therefore the Company B has net operating working capital of $53,725 and $44,000 in 2015 and 2014, respectively.

b.

Summary Introduction

To compute: The free cash flow in 2015 for Company B.

Free Cash Flow: The cash generated over and above required by business operations and capital expenditure is called free cash flow. Statement of cash flow reports the cash flow generated or consumed by the business.

Answer to Problem 14P

The free cash flow in 2015 for Company B is $11,175.

Explanation of Solution

Determine the capital expenditure

$\begin{array}{c}CapitalExpenditure=\left[ChangeinFixedAsset+Depreciation\right]\\ =\left[\left(\$50,000-\$47,000\right)+\$5,000\right]\\ =\left[\$3,000+\$5,000\right]\\ =\$8,000\end{array}$

Therefore the capital expenditure is $8,000

Determine the free cash flow for 2015

$\begin{array}{c}FreeCashFlo{w}_{2015}=\left[\begin{array}{l}\left(\left(EBIT\times \left(1-Tax\right)\right)+Depreciation\right)-\\ \left(\begin{array}{l}IncreaseinNetOperatingWorkingCapital+\\ CapitalExpenditure\end{array}\right)\end{array}\right]\\ =\left[\left(\left(\$39,000\times \left(1-40\%\right)\right)+\$5,000\right)-\left(\begin{array}{l}\left(\$53,275-\$44,000\right)+\\ \$8,000\end{array}\right)\right]\\ =\left[\$23,400+\$5,000-\$\text{17,275}\right]\\ =\$\text{11,125}\end{array}$

Therefore the free cash flow in 2015 for Company B is $11,175.

c.

Summary Introduction

To prepare: The statement of stockholders’ equity of Company B for 2015.

Statement of Stockholders’ Equity: Statement of stockholders’ equity shows the opening and closing balance of stockholder’s equity with the changes occurred during the accounting period.

Answer to Problem 14P

Company B has stockholders’ equity of $82,025 at the end of year 2015.

Explanation of Solution

Statement of stockholders’ equity:

	Shares	Amount	Retained Earnings	Total Stockholders’ Equity
Balances, December 31, 2014	5,000	50,000	20,850	70,850
Net income, 2015			22,350
Cash dividends			(11,175)
Additional to retained earnings				11,175
Balances, December 31, 2015				82,025

d.

Summary Introduction

To compute: The economic value added for Company B.

Economic Value Added (EVA): It is a measure along with market value added, to evaluate management’s performance. It considers the opportunity costs of capital invested in the business and the net operating profit generated by the business.

Answer to Problem 14P

The economic value added for Company B is $13,027.50.

Explanation of Solution

Given,

Net operating income is $39,000.

Income tax rate is 40%.

Total invested capital $103,725.

After tax percentage cost of capital is 10%.

Formula to compute economic value added,

$\text{Economic Value Added}=\left[\begin{array}{l}\text{Operating Income}\left(1-\text{Tax Rate}\right)-\text{Invested Capital}\\ \times \text{After Tax Percentage Cost of Capital}\end{array}\right]$

Substitute $39,000 for operating income, 40% for tax rate, $97,025 for invested capital and 10% for after tax percentage cost of capital.

$\begin{array}{c}\text{Economic Value Added}=\left[\$39,000\left(1-0.40\right)-\$103,725\times 0.10\right]\\ =\$23,400-\$10,372.50\\ =\$13,027.50\end{array}$

Therefore the economic value added for Company B is $13,027.50.

Working note:

Calculation of total invested capital,

$\begin{array}{c}\text{Total Invested Capital}=\text{Equity}+\text{Debt}+\text{Notes}Payable\\ =\$82,025+\$15,000+\$6,700\\ =\$103,725\end{array}$

e.

Summary Introduction

To compute: The market value added for Company B in 2015.

Market Value Added: The measure to evaluate management’s performance in a company’s operations and growth, market value added considers the market value of company’s outstanding shares. It reports the market value over and above the book value of those outstanding shares.

Answer to Problem 14P

The market value added for Company B in 2015 is $17,975.

Explanation of Solution

Given,

Book value of common equity is $50,000.

Stock price is $20 per share.

Number of shares outstanding are 5,000.

Formula to compute market value added,

$\text{Market Value Added}=\left[\begin{array}{l}\left(\text{Number of Outstanding Shares}\times \text{Stock Price}\right)\\ -\text{Book Value of Equity}\end{array}\right]$

Substitute $50,000 for common book value of equity, $20 for stock price and 5,000 for number of shares outstanding.

$\begin{array}{c}{\text{Market Value Added}}_{2015}=\left(5,000\times \$20\right)-\$82,025\\ =\left[\$100,000-\$82,025\right]\\ =\$\text{17,975}\end{array}$

Therefore the market value added for Company B in 2015 is $17,975.