Chapter 3, Problem 14P

FREE CASH FLOW Arlington Corporation's financial statements (dollars and shares are in millions) are provided here.

Balance Sheets as of December 31

	2018	2017
Assets
Cash and equivalents	$ 15,000	$ 14,000
Accounts receivable	35,000	30,000
Inventories	33,320	27,000
Total current assets	$83,320	$71,000
Net plant and equipment	48,000	46,000
Total assets	$131,320	$117,000
Liabilities and Equity
Accounts payable	$ 10,100	$ 9,000
Accruals	8,000	6,000
Notes payable	7,000	5,050
Total current liabilities	$ 25,100	$ 20,050
Long term bonds	20,000	$20,000
Total liabilities	$45,100	$ 40,050
Common stock(4,000 shares)	40,000	40,000
Retained earnings	46,220	36,950
Common equity	$ 86,220	$ 76,950
Total liabilities and equity	$ 131,320	$ 117,000

Income Statement for Year Ending December 31, 2018

Sales	$ 210,000
Operating cost excluding depreciation and amortization	160,00
EBITDA	$ 50,000
Depreciation and amortization	6000
EBIT	$ 44,000
interest	5,350
EBT	5,38,650
Taxes (40%)	15,460
Net income	$ 23,190
Dividends paid	$13,920

1. a. What was net operating working capital for 2017 and 2018? Assume that all cash is excess cash; i.e., this cash is not needed for operating purposes.
2. b. What was .Arlington’s 2018 free cash flow?
3. c. Construct Arlington’s 2018 statement of stockholders’ equity.
4. d. What was Arlington’s 2018 EVA? Assume that its after tax cost of capital is 10%.
5. e. What was Arlington’s MVA at year-end 2018? Assume that its stock price at December 31, 2018? Was $25.

Summary Introduction

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

Financial Statements:

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

Net Operating Working Capital:

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

Explanation of Solution

Given information (for 2017)

Cash and equivalents is $14,000.

Note payable is $5,050.

Current assets are $71,000.

Current liabilities is $20,050.

Formula to compute operating current assets is as follows:

$\text{operating current assets}=\text{Total current assets}-\text{Cash and equivalents}$

Compute operating current assets is as follows:

$\begin{array}{c}\text{operating current assets}=\text{Total current assets}-\text{Cash and equivalents}\\ =\$71,000-\$14,000\\ =\$57,000\end{array}$

Hence, the operating current asset is $57,000.

Formula to compute operating current liabilities is as follows:

$\text{operating current liabilities}=\text{Total current libilities}-\text{Notes payable}$

Compute operating current liabilities is as follows:

$\begin{array}{c}\text{operating current liabilities}=\text{Total current libilities}-\text{Notes payable}\\ =\$20,050-\$5,050\\ =\$15,000\end{array}$

Hence, the operating current liabilities is $15,000.

Formula to compute net operating working capital is as follows:

${\text{Net operating working capital}}_{\left(2017\right)}=\text{Operating current assets}-\text{Operting current liabilities}$

Compute net operating working capital is as follows:

$\begin{array}{c}{\text{Net operating working capital}}_{\left(2017\right)}=\text{Operating current assets}-\text{Operting current liabilities}\\ =\$57,000-\$15,000\\ =\$42,000\end{array}$

Hence, the net operating working capital for 2017 is $42,000.

Given information (for 2018)

Cash and equivalents is $15,000.

Note payable is $7,000.

Current liabilities is $25,100.

Current assets are $83,320.

Formula to compute operating current assets:

$\text{operating current assets}=\text{Total current assets}-\text{Cash and equivalents}$

Compute operating current assets:

$\begin{array}{c}\text{operating current assets}=\text{Total current assets}-\text{Cash and equivalents}\\ =\$83,320-\$15,000\\ =\$68,320\end{array}$

Hence, the operating current asset is $68,320.

Formula to compute operating current liabilities:

$\text{operating current liabilities}=\text{Total current libilities}-\text{Notes payable}$

Compute operating current liabilities:

$\begin{array}{c}\text{operating current liabilities}=\text{Total current libilities}-\text{Notes payable}\\ =\$25,100-\$7,000\\ =\$18,100\end{array}$

Hence, the operating current liabilities is $18,100.

Formula to compute net operating working capital is as follows:

${\text{Net operating working capital}}_{\left(2018\right)}=\text{Operating current assets}-\text{Operting current liabilities}$

Compute net operating working capital is as follows:

$\begin{array}{c}{\text{Net operating working capital}}_{\left(2018\right)}=\text{Operating current assets}-\text{Operting current liabilities}\\ =\$68,320-\$18,100\\ =\$50,220\end{array}$

Hence, the net operating working capital for 2018 is $50,220.

Conclusion

Therefore, Company A has net operating working capital of $42,000 and $50,220 in 2017 and 2018, respectively.

Summary Introduction

To compute: The free cash flow in 2018 for Company A.

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

Explanation of Solution

Given information:

EBIT is $44,000.

Depreciation is $6,000.

Capital expenditure is $8,000.

Tax rate is 40%.

Change in net operating working capital is $8,220$\left(\$42,000-\$50,220\right)$.

Formula to compute free cash flow is as follows:

$\text{Free cash flow}=\left[\begin{array}{l}\text{EBIT}\left(1-\text{Tax}\right)\\ +\text{Depreciation}\end{array}\right]-\left[\left(\begin{array}{l}\text{Capital expenditure}\\ \text{+Change in net operating working capital}\end{array}\right)\right]$

Compute free cash flow is as follows:

Substitute $44,000 for EBIT, 40% for tax rate, $6,000 for depreciation, $8,000 for capital expenditure and $9,220 for change in net operating working capital.

$\begin{array}{c}\text{Free cash flow}=\left[\$44,000\left(1-0.40\right)+\$6,000\right]-\left(\$8,000+\$8,220\right)\\ =\$26,400+\$6,000-\$16,220\\ =\$16,180\end{array}$

Hence, the free cash flow is $16,180.

Conclusion

Therefore, Company A’s free cash flow for 2016 is $16,180.

Summary Introduction

To prepare: The statement of stockholders’ equity of Company A for 2018.

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.

Explanation of Solution

Statement of stockholders’ equity:

	Shares	Amount	Retained Earnings	Total Stockholders’ Equity
Balances, December 31, 2017	4,000	40,000	36,950	76,950
2018 Net income			23,190
Cash dividends			(13,920)
Additional to retained earnings				9,270
Balances, December 31, 2018	4,000	40,000	46,220	86,220

Conclusion

Therefore, Company A has stockholders’ equity of $86,220 at the end of year 2018.

Summary Introduction

To compute: The economic value added for Company A for 2018.

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

Explanation of Solution

Given information:

EBIT is $44,000.

Tax rate is 40%.

Total invested capital $113,220 (working note).

After tax percentage cost of capital is 10%.

Formula to compute economic value added is as follows:

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

Substitute $44,000 for EBIT, 40% for tax rate, $113,220 for invested capital and 10% for after tax percentage cost of capital.

Compute economic value added is as follows:

$\begin{array}{c}\text{Economic value added}=\left[\$44,000\left(1-0.40\right)-\$113,220\times 0.10\right]\\ =\$26,400-\$11,322\\ =\$15,078\end{array}$

Hence, the economic value added is $15,078.

Working note:

Calculation of total invested capital is as follows:

$\begin{array}{c}\text{Total invested capital}=\text{Note payable}+\text{Long term debt}+\text{Common equity}\\ =\$7,000+\$20,000+\$86,2200\\ =\$113,220\end{array}$

Hence, the total invested capital is $113,220.

Conclusion

Therefore, the economic value added of Company A for the year 2018 is $15,078.

Summary Introduction

To compute: The market value added for Company A for the year 2018.

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.

Explanation of Solution

Given information:

Book value of common equity is $86,220.

Stock price is $25 per share.

Number of shares outstanding are 4,000.

Formula to compute market value added is as follows:

$\text{Market value added}=\left[\begin{array}{l}\left(\text{Number of outstanding shares}\times \text{Stock price}\right)\\ -\text{Book value of equity}\end{array}\right]$

Substitute $86,220 for book value of common equity, $25 for stock price and 4,000 for number of shares outstanding.

Compute market value added is as follows:

$\begin{array}{c}\text{Market Value Added}=\left(4,000\times \$25\right)-\$86,220\\ =\$13,780\end{array}$

Hence, the market value is $13,780.

Conclusion

Therefore, the market value added for Company A for the year 2018 is $13,780.