Chapter 3, Problem 20IC

a.

Summary Introduction

To determine: The effect of expansion of the after-tax operating income, sales, net income and net operating working capital.

Operating Income:

The operating income refers to that income which is the net income of a business, excluding the financial effects and taxes.

Net Operating Working Capital:

It is a fiscal tool to measure the working liquidity of the business. It is calculated by subtracting the operating current assets which do not include interest from the operating liabilities which also not include interest.

Net Income:

It is the total earnings of the business which is derived from deducting all the interest and taxes from the income.

Explanation of Solution

Calculation of the effect on net income:

The formula to calculate the effect on net income is as follows:

$\left(\text{Effect}\text{on}\text{net}\text{income}\right)=\left[\left(\text{Net}\text{income}\text{of}\text{2018}\right)-\left(\text{Net}\text{income}\text{of}\text{2017}\right)\right]$

Substitute ($160,176) for net income of 2018 and $87,960 for net income of 2017 in the above formula.

$\begin{array}{c}\left(\text{Effect}\text{on}\text{net}\text{income}\right)=\left[\left(-\$160,176\right)-\$87,960\right]\\ =-\$248,136\end{array}$

The net income decreases by $248,136.

Calculation of after-tax operating income of 2018,

$\begin{array}{c}\text{After-tax}\text{operating}\text{income}=\text{EBIT}\left(1-\text{Tax}\text{rate}\right)\\ =-\$130,948\left(1-0.4\right)\\ =-\$78,569\end{array}$

The after-tax operating income of 2018 is ($78,569).

Calculation of after-tax operating income of 2017,

$\begin{array}{c}\text{After-tax}\text{operating}\text{income}=\text{EBIT}\left(1-\text{Tax}\text{rate}\right)\\ =\$190,248\left(1-0.4\right)\\ =\$114,149\end{array}$

The after-tax operating income for2017 is $114,149.

Calculation of net-operating working capital of 2018,

$\begin{array}{c}\left(\begin{array}{l}\text{Net-operating}\\ \text{working}\text{capital}\end{array}\right)=\left[\left(\text{Current}\text{assets}-\text{Excess cash}\right)-\left(\begin{array}{l}\text{Current}\text{liabilities}\\ -\text{Notes}\text{payable}\end{array}\right)\right]\\ =\left(\$1,926,802-\$7,282\right)-\left(\$1,650,568-\$636,808\right)\\ =\$1,919,520-1,013,760\\ =\$905,760\end{array}$

The net operating working capital of 2018 is $905,760.

Calculation of net-operating working capital of 2017,

$\begin{array}{c}\left(\begin{array}{l}\text{Net-operating}\\ \text{working}\text{capital}\end{array}\right)=\left[\left(\text{Current}\text{assets}-\text{Excess cash}\right)-\left(\begin{array}{l}\text{Current}\text{liabilities}\\ -\text{Notes}\text{payable}\end{array}\right)\right]\\ =\left(\$1,124,000-\$57,600\right)-\left(\$481,600-\$200,000\right)\\ =\$1,066,400-\$281,600\\ =\$784,800\end{array}$

The net operating working capital of 2017 is $784,800.

Conclusion:

Hence, the net operating working capital increases by $120,960 and the net income decreases by $248,136.

b.

Summary Introduction

To determine: The effect of the expansion on the free cash flow.

Free Cash Flow:

It refers to that cash, which a company can produce after expansion. This is a degree of financial performance of a firm.

Explanation of Solution

Calculation of the effect on the free cash flow:

The formula to calculate the effect on free cash flow of 2016 is as follows:

$\text{Free}\text{cash}\text{flow}=\left[\begin{array}{l}\text{After-tax}\text{operating}\text{income}\\ +\text{Depreciation}\end{array}\right]-\left[\begin{array}{l}\text{Capital}\text{expenditures}\\ +\left(\begin{array}{l}\text{Difference}\text{in}\text{net-operating}\\ \text{working}\text{capital}\end{array}\right)\end{array}\right]$

Substitute ($78,569) for after-tax operating income, $116,960 for depreciation, $711,950 for the capital expenditures and $70,642 for the difference in the net operating working capital in the above formula.

$\begin{array}{c}\text{Free}\text{cash}\text{flow}=\left[-\$78,569+\$116,960\right]-\left[\$711,950+\$120,960\right]\\ =\$38,391-\$832910\\ =-\$794,519\end{array}$

The free cash flow in 2018 is ($794,519).

Conclusion

Hence, the expansion showsnegative cash flow of ($794,519) which means that the shareholder wealth has been destroyed.

c.

Summary Introduction

To explain: Whether the suppliers were paid on time or not and if not the reasons for the late.

Answer to Problem 20IC

The suppliers were not paid on time and the reasons for this are as follows:

• The accounts payable balance has raised by 260% from the last year.
• The sales balance has raised by only 76%.
• These records of the company demonstrates that the suppliers were not paid on time.

Explanation of Solution

• The suppliers of any company are needed to be paid on time.
• The increased accounts payable and not a high percentage of sales is not a good record for a company.
• If suppliers do not pay on time, the relationship gets strained with them.
• If it exists to be late in paying the suppliers, the suppliers will sue the company and make it as bankrupt.

Conclusion

Thus, the company fails to pay the suppliers on time and the reasons are as mentioned above.

d.

Summary Introduction

To explain: Whether the sales price increases the costs per unit sold and if that affects the cash balance.

Answer to Problem 20IC

From the income statements, the following conclusions are made:

• It does not look like the sales price exceeds the costs per unit sold.
• As the company is spending much cash than it is earning, the balance in the cash account has reduced.

Explanation of Solution

• The income statement shows the costs at which each unit is sold and also the sales price.
• Any effect on the cash balance and the costs can be known by the income statement.

Conclusion

Hence, the sales price increases the costs per unit sold and the cash account balance has reduced.

e.

Summary Introduction

To explain: The effect on the cash account and the effect on cash account if the credit policy is changed.

Answer to Problem 20IC

The effect on the cash account in the given situation is as follows:

• By extending the credit terms of the sale, it will take more time to get the money.
• The cash account will reduce and the accounts receivable will increase.
• The inventory and the fixed assets, both can build up.
• The accounts receivable would increase, then the cash will decline.
• When the collections will increase, then the cash would rise.
• In this situation, the company needs to borrow or sell the stock to provide fund for the expansion.

Explanation of Solution

• If the credit policy changes for any company, it surely affects the cash balance.
• If the credit terms are extended, the time for receiving the money also increases.
• The accounts receivable balance rises when the credit term is extended and so the cash balance reduces.

Conclusion

Thus, the cash balance will decrease when the credit policy is changed.

f.

Summary Introduction

To explain: The imagination of a situation in which the price of sales increases the production cost and selling output.

Answer to Problem 20IC

The situation, where the sales price increases the costs of producing and selling a unit of output, the vast increase in sales volume leads the cash balance to decrease. This situation has the following effects:

• The inventory would build up in this case and so the fixed assets will also increase much before the sales could be raised.
• The accounts receivable will arise in this situation and the cash would decline.
• When the collections will start, then the cash balance will increase.
• To finance the expansion, the company needs to borrow or sell the stock.

Explanation of Solution

• A situation in which the price of the sales is more than the costs of producing and selling the output and the vast increase in the sales volume leads the cash balance to reduce.
• In this situation, it is dramatic that despite high selling price the sales volume has increased.
• The company if has to do the expansion, has to sell or lend the stocks.

Conclusion

Hence,in the given situation the effects are as mentioned above.

g.

Summary Introduction

To explain: The way in which the expansion program is financed and the way it affects the financial strength of the company.

Answer to Problem 20IC

• The company is financed with external capital instead of internally generated funds.
• The company issued long-term debt rather than the common stock that reduces the financial strength and the flexibility of the company.

Explanation of Solution

• When a company expands, it needs some financing; this financing is done with the external capital instead of internally generated funds.
• When the company finances with the external capital, the company has to bear the interests also.
• But when this financing is done with funds generated internally, the company has not to bear any interests.

Conclusion

Hence, the company is financed with the external capital and it reduces the financial strength of the company.

h.

Summary Introduction

To explain: The effect of the asset expansion and whether this requires a raise in the external capital.

Answer to Problem 20IC

The effects of the asset expansion are as follows:

• The company has broken in 2018 this means that the sales revenue has equaled the total operating costs and the interest charges.
• In this situation, the firm needs to finance an increase in the assets.

Explanation of Solution

• The asset expansion means that the company is trying to acquire new assets, for this the company needs some way for the financing.
• The expansion of the assets causes the company to experience the shortage of cash, which in turn requires it to raise the external capital.

Conclusion

Hence, in the given situation, the company would have to finance an increase in the assets.

i.

Summary Introduction

To explain: The effects on the (1) physical stock of assets, (2) the balance sheet account for fixed assets, (3) the company’s reported net income and (4) the cash position of the company.

Answer to Problem 20IC

If the fixed assets are depreciated over 7 years rather than 10 years the effects are as follows:

1. (1) The physical stock of assets- There will not be any effect on the physical stock of assets.
2. (2) The balance sheet accounts for fixed assets- The balance sheet account for the fixed assets would reduce because the accumulated depreciation will raise as the assets are depreciating for 7 years over 10 years.
3. (3) The company’s reported net income- As the depreciation expense will raise, the net income would decrease.
4. (4) The cash position of the company- The cash position of the firm will increase, as the tax payments would be reduced.

Explanation of Solution

• If the depreciation year of the assets is reduced, this results in a reduction of the accumulated depreciation.
• When there is less accumulated depreciation, the balance in the depreciation account would reduce.
• This would also result in a declinein net income.
• But, as it will reduce the tax payments, the cash position is improved.

Conclusion

Hence, (1) the physical stock of the assets would have no effect, (2) the balance sheet account would decline, (3) the reported net income would decrease and (4) the cash position will improve.

j.

Summary Introduction

To explain: The meaning and calculations of the earnings per share, dividends per share and the book value per share and the reason for the market price per share not equal to the book value per share.

Answer to Problem 20IC

The meaning and calculations of the given terms are as follows:

• Earnings per share: The earnings per share refer to that part of the profit of the company which is divided into each of the outstanding shares of the stock of a company. It is computed by dividing the net income by the number of outstanding shares.
• Dividends per share: The dividends per share refer to that sum of declared dividends that is issued by a company for each of the shares which is outstanding. This is the amount of dividend which is received by the shareholders for each number of shares. It is calculated by dividing the amount of dividend from the shares outstanding.
• Book value per share: The book value per share refers to that part of common equity, which is given to each of the shareholders. It is computed by dividing the common equity by the outstanding number of shares.

The market price per share is not equivalent to the book value per share. The market value of a share reflects the profitability that can be earned by the share in the future while book value per share denotes the historic cost of the share.

Explanation of Solution

• The dividends per share, earnings per share and the book value per share are the profitability ratios.
• These ratios help to determine the capacity of a company and help the investor and the user understand the financial status of the company.
• The market price per share is different than the book value per share as both reflect a different value.

Conclusion

Thus, the meaning and calculation of the given terms are as explained above and the market price for one share is not equal to book value per share.

k.

Summary Introduction

To explain: The tax treatment of (1) the payment of interest and dividends, (2) dividends received and interest earned, (3) capital gains and (4) tax loss carry-backs and carry-forwards and the effect of these items on the taxes.

Answer to Problem 20IC

The tax treatment for the given items is as follows:

• (1) Interest and dividends paid: The payment of interest is considered as an expense and is paid out of pre-tax income. So, the payment of interest is tax deductible for a business. The payment of interest is generally not tax-deductible for the individuals, but the exception is limited to home mortgage. The payment of dividends by a business are paid out of after-tax income.
• (2) Interest earned and dividends received: The interest received either by a individual or business is taxable income and is subject to taxes of standard income, except for the local and state government debt interest. The dividends gained are taxed at the rate of capital gains for the individuals. But this sometimes faces double taxation also. The portion of dividends, which is received by corporations is not included in the tax.
• (3) Capital gains: The capital gains for individuals are taxed as ordinary income if it exceeds one year, and is taxed at the capital gains rate if it is held for more than one year. The capital gains for corporations are taxed as ordinary income.
• (4) Tax-loss carry backs and carry forwards: The tax-loss carrybacks and carry forward provisions lets the businesses to utilize a loss in the present year to compensate the profits in the prior years and if losses have not been fully set by previous profits they can be carried forward to compensate the profits in future.

Explanation of Solution

• The tax treatment is different for different kinds of heads.
• The interest paid is not taxed to the individual.
• The interest earned is taxable as per the subject to taxes.
• The dividends are paid after the tax treatment.
• The dividends received are capital gains and are subject to taxes.

Conclusion

Thus, the tax treatment for the given items is as mentioned above.