Chapter 3, Problem 24QP

a)

Summary Introduction

To discuss: Free cash flow of Company Q in the year 2019.

Explanation of Solution

Generally free cash flow involves three elements they are as follows,

• Interest paid to the debt holders of the company.
• Cash available to the shareholders of the company.
• Finally, subtract cash necessary to pay for new investments.

$\begin{array}{c}\text{Net}\text{working}\text{capital}=\text{}\text{Net}\text{current}\text{assets}-\text{Net}\text{current}\text{liabilities}\\ =\left(\text{Accounts}\text{payables}\text{in}\text{2018- Accounts payables in 2019}\right)\\ -\left(\text{Receivables}\text{in}2019-\text{Receivables}\text{in}2018\right)\\ -\left(\text{Inventories}\text{in}\text{2019}-\text{inventories}\text{in}\text{2018}\right)\\ -\left(\text{Other}\text{current}\text{assets}\text{in}\text{2019}-\text{Other}\text{current}\text{assets}\text{in}\text{2018}\right)\\ =\left(\$3,403-\$3,143\right)-\left(\$1,375-\$1,335\right)\\ -\left(\$122-\$117\right)-\left(\$1,089-\$616\right)\\ =-\$258\end{array}$

Hence, net working capital is -$258.

$\begin{array}{c}\text{Cash}\text{flow}\text{from}\text{operations}=\text{}\text{Net}\text{income}+\text{Interest}+\text{Depreciation}\\ -\text{Additions}\text{to}\text{net}\text{working}\text{capital}\\ =\$5,465+\$517+\$1,402-\$258\\ =\$7,126\end{array}$

 Here, capital expenditure is $3,049. Therefore,

$\begin{array}{c}\text{Free}\text{cash}\text{flow}=\text{}\text{Cash}\text{flow}\text{from}\text{operations}-\text{Capital}\text{expenditure}\\ =\$7,126-\$3,049\\ =\$4,077\end{array}$

Hence, free cash flow is $4,077.

b)

Summary Introduction

To determine: Tax to be paid by Company Q if it is entirely financed by equity.

Explanation of Solution

From the income statement it is observed that, interest expense amounting to $517 has paid to debt fund holders. If company has entirely financed by equity there is no need of payment of interest. So that amount is also treated as income. On that income, Company has to pay 21% corporate tax to the government.

 $\begin{array}{c}\text{Tax}=\text{}\$517\times 0.21\\ =\$108.57\end{array}$

Therefore the amount of $108.57 has been additionally paid by company to government.

c)

Summary Introduction

To determine: Company’s free cash flow if the type of funding is through equity only.

Explanation of Solution

Free cash flow is calculated by deducting capital expenditures from the cash flow from operations.

$\begin{array}{c}\text{Net}\text{working}\text{capital}=\text{}\text{Net}\text{current}\text{assets}-\text{Net}\text{current}\text{liabilities}\\ =\left(\$3,403-\$3,143\right)-\left(\$1,375-\$1,335\right)\\ -\left(\$122-\$117\right)-\left(\$1,089-\$616\right)\\ =-\$258\end{array}$

$\begin{array}{c}\text{Cash}\text{flow}\text{from}\text{operations}=\text{}\text{Net}\text{income}+\text{Interest}+\text{Depreciation}\\ -\text{Additions}\text{to}\text{net}\text{working}\text{capital}\\ =\$5,465+0+\$1,402-\$258\\ =\$6,945\end{array}$

The amount of net income is given in the question as $5,465.

Here, capital expenditure is $3,049. Therefore,

$\begin{array}{c}\text{Free}\text{cash}\text{flow}=\text{}\text{Cash}\text{flow}\text{from}\text{operations}-\text{Capital}\text{expenditure}\\ =\$6,945-\$3,049\\ =\$3,896\end{array}$

$3,896 is the free cash flow of company if it was funded totally by equity.