Chapter 3 Financial Statemen ts, Cash Flow, and Taxes

Answers to End- of- Chapter Questions

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The four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders equity, and statement of cash flows. Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or in which to invest, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way. No, because the !" million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. #onsequently, the !" million would be an investment in all of the firms assets. The balance sheet shows the firms financial position on a specific date, for example, $ecember %&, !""'. (t shows each account balance at that particular point in time. )or example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on $ecember %&, !""'. The income statement, on the other hand, reports on the firms operations over a period of time, for example, over the last &! months. (t reports revenues and expenses that the firm has incurred over that particular time period. )or example, the sales figures reported on the income statement for the period ending $ecember %&, !""', would represent the firms sales over the period from *anuary &, !""', through $ecember %&, !""', not +ust sales for $ecember %&, !""'. (nvestors need to be cautious when they review financial statements. ,hile companies are required to follow -../, managers still have quite a lot of discretion in deciding how and when to report certain transactions. #onsequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. 0ome variations may stem from legitimate differences of opinion about the correct way to record transactions. (n other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. .s long as they follow -../, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. 1nfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. (ndeed, a number of high2 profile executives have faced criminal charges because of their misleading accounting practices. )ree cash flow is the amount of cash that could be withdrawn from the firm without harming its ability to operate and to produce future cash flows. (t is calculated as after2 tax operating income plus depreciation less capital expenditures and the 1

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Chapter 3# Financial State me n ts, Cash Flow, and Taxes Answers and Solutions

change in net working capital. (t is more important than net income because it shows the exact amount available to all investors 3stockholders and debtholders4. The value of a companys operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit. 3- $ 5es. Negative free cash flow is not necessarily bad. 6ost rapidly growing companies have negative free cash flows because the fixed assets and working capital needed to support rapid growth generally exceed cash flows from existing operations. This is not bad, provided the new investments will eventually be profitable and they contribute to free cash flow. This statement means that the higher ones income, the larger the percentage paid in taxes. $ouble taxation refers to the fact that corporate income is sub+ect to an income tax, and then stockholders are sub+ect to a further personal tax on dividends received. (n fact, because of double taxation #ongress was motivated to reduce the tax rate on dividends to the same rate 3&784 as long2 term capital gains 3at least through !"&"4. (ncome could even be sub+ect to triple taxation. Triple taxation occurs when 3&4 the original corporation is first taxed, 3!4 the second corporation is then taxed on the dividends it received, and 3%4 the individuals who receive the final dividends are taxed again. Therefore, corporations that receive dividend income can exclude some of the dividends from its taxable income. This provision in the Tax #ode minimi9es the amount of triple taxation that would otherwise occur. Because interest paid is tax deductible but dividend payments are not, the after2 tax cost of debt is lower than the after2 tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in :The #ost of #apital; and :#apital 0tructure and <everage ; chapters.

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Answers and Solutions Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Solutions to End- of- Chapter (ro)lems

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N( = %,""","""> ?B(T = @,""","""> T = A"8> (nterest = B Need to set up an income statement and work from the bottom up. ?B(T (nterest ?BT Taxes 3A"84 N( @,""",""" &,""",""" 7,""",""" !,""",""" %,""","""

%,""",""" %,""",""" = ?BT = 3& T4 ".@

(nterest = ?B(T C ?BT = 3- 2

@,""",""" C 7,""",""" =

&,""",""". &!,7"","""> N( =

0ales = !",""","""> Dperating costs 3excl. deprec.4 = &,'"","""> (nt = !,""","""> T = A"8> $eprec. = B 0ales !",""",""" Dp. costs 3ex. deprec.4 &!,7"",""" $eprec. !,7"",""" ?B(T 7,""",""" (nterest !,""",""" ?BT %,""",""" Taxes 3A"84 &,!"",""" N( &,'"","""

0ales C Dp. costs C $eprec. = ?B(T ?B(T = ?BT E (nt = %,""",""" E !,""",""" 3-iven4 &,'"",""" &,'"",""" = 3& T4 ".@ 3-iven4 H'",""","""> $ividends = B

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N( =

7",""","""> FG?5G? =

'&",""","""> FG? BG5 =

FG?BG5 E N( C $iv = FG?5G? H'",""",""" E 7",""",""" C $iv = '&",""",""" '%",""",""" C $iv = '&",""",""" !",""",""" = $iv. 30tatements b and d will decrease the amount of cash on a companys balance sheet. 0tatement a will increase cash through the sale of common stock. 0elling stock provides cash through financing activities. Dn one hand, 0tatement c would decrease cash> however, it is also possible that 0tatement c would increase cash, if the firm receives a tax refund. ?nding FG? !H',I"",""" !H',I"",""" Net income = Beg. FG? + Net income $ividends = !&!,%"",""" + Net income !!,7"",""" = &'I,'"",""" + Net income = 'I,&"",""".

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Chapter 3# Financial State me n ts, Cash Flow, and Taxes Answers and Solutions

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a* )rom the statement of cash flows the change in cash must equal cash flow from operating activities plus long2 term investing activities plus financing activities. )irst, we must identify the change in cash as followsJ #ash at the end of the year C #ash at the beginning of the year #hange in cash !7,""" C 77,""" 2 %","""

The sum of cash flows generated from operations, investment, and financing must equal a negative %",""". Therefore, we can calculate the cash flow from operations as followsJ #) from operations + #) from investing + #) from financing = in cash #) from operations !7",""" + &H",""" = 2 %",""" #) from operations = 7",""". )* 0ince we determined that the firms cash flow from operations totaled 7",""" in /art a of this problem, we can now calculate the firms net income as followsJ N( + $epreciation + N( E

(ncrease in (ncrease in #) from accrued .GF and = operations liabilitie s inventory

!7,""" C &"",""" = N( C @7,""" = N( = 7",""" 7",""" &&7,""".

&",""" E

3- $

a* N,#!""H = Total #. C 3.G/ E .ccruals4 = 7I,""" C 3 I,""" E @,"""4 = AA,""". N,#!""' = = H!,&!7 C 3 &",'"" E 7%,H!7. H,@""4

)* )#) = ?B(T 3& C T4 E $eprec. C #apital expenditures C KN,# = %I,""" 3& C ".A4 E 7,""" C ',""" C I,H!7 = &",@H7. NoteJ To arrive at capital expenditures you add depreciation to the change in net )., so #apital expenditures = 7,""" E %,""" = ',""". c* 0tatement of 0tockholders ?quity, !""' #ommon 0tock 0hares .mount Balances, &!G%&G"H !""' Net (ncome #ash $ividends .ddition 30ubtraction4 to retained earnings Balances, &!G%&G"' 7,""" 7",""" Fetained Total 0tockholders ?arnings ?quity !",'7" !!,%7" 3&&,&H7 4 &&,&H7 %!,"!7 H",'7"

7,"""

7","""

&&,&H7 '!,"!7

Answers and Solutions Chapter 3# Financial State me n ts, Cash Flow, and Taxes

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,orking up the income statement you can calculate the new sales level would be &!,@'&,A'!. 0ales Dperating costs 3excl. $eprec.4 $epreciation ?B(T (nterest ?BT Taxes 3A"84 Net income &!,@'&,A'! @,IHA,'&7 ''",""" A,'!@,@@H @@",""" A,&@@,@@H &,@@@,@@H !,7"",""" 0 C ".A70 C $eprec. = ?B(T &!,@'&,A'! ".77 '"",""" &.&" A,&@@,@@H E @@",""" @"",""" &.&" !,7"","""G3& ".A4 A,&@@,@@H ".A"

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a* Balance of F?, $ecember %&, !""H &,%HA .ddJ N(, !""' %H! <essJ $iv. paid to common stockholders 3&A@ 4 Balance of F?, $ecember %&, !""' &,@"" The F? balance on $ecember %&, !""' is &,@"" million. To arrive at this statement, you must work up the statement because you havent been given the &!G%&G"H F? balance. )* &,@"" million. &7 million. @!" million.

c* #ash E ?quivalents =

d* Total current liabilities =

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a*

Net working capital "H

= =

= #urrent assets C 3.G/ E .ccruals4 %@",""",""" C 3 I",""",""" E !&",""",""". = @",""","""4

Net working capital "'

%H!,""",""" C &'",""",""" =

&I!,""",""".

)* )#)"' = ?B(T 3& C T4 E $eprec. C #ap. expend. 2 KN,# = &7",""",""" 3".@4 E %",""",""" C '",""",""" C 32 &',""","""4 = I",""",""" E %",""",""" 2 '",""",""" E &',""",""" = 7',""",""". Note that depreciation must be added to KNet /L? to arrive at capital expenditures. c* The large increase in dividends for !""' can most likely be attributed to a large increase in free cash flow from !""H to !""', since )#) represents the amount of cash available to be paid out to stockholders after the company has made all

Chapter 3# Financial State me n ts, Cash Flow, and Taxes Answers and Solutions

investments in fixed assets, new products, and working capital necessary to sustain the business.

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Answers and Solutions Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Comprehensi+e,Spreadsheet (ro)lem

Note to Instructors: The solution to this pro)lem is not pro+ided to students at the )ac- of their text* .nstructors can access the Excel file on the text)oo-/s we) site or the .nstructor/s 0esource C1* 3- 11 a* KEY INPUT DATA: Laiho Industries Sales E!ITDA as a "er#enta$e o% sales De"r' as a & o% %i(ed assets Ta( rate Interest e("ense Di+idend "a,out ratio Laiho Industries In#o-e State-ent .in thousands o% dollars/ Sales E("enses e(#ludin$ de"re#iation and a-orti1ation E!ITDA De"re#iation and a-orti1ation E!IT Interest e("ense E!T Ta(es .4 &/ Net In#o-e 6o--on di+idends Addition to retained earnin$s )* State-ent o% Sto#7holders8 E9uit, .in thousands o% dollars/ !alan#e o% :etained Earnin$s, De#e-;er 21, 0 Add: Net In#o-e, 0 ) Less: 6o--on di+idends "aid, 0 ) !alan#e o% :etained Earnin$s, De#e-;er 21, 0 * $2),**4 $21,2)3 .10,554/ $5*,3 5 0 ) $455,15 2)3,)*) $3),0*2 *,2)) $3 ,))4 ),5*5 $50,2 5 0 ,504 $21,2)3 $10,554 $1),)21 $455,15 15& 11& 4 & $),5*5 4 &

4ound a%ter %indin$ E!ITDA 4ound this %irst

Chapter 3# Financial Statements, Cash Flow, and Taxes Comprehensive/Spreadsheet Problem $

State-ent o% 6ash 4lo<s .in thousands o% dollars/ ="eratin$ A#ti+ities Net In#o-e De"re#iation and a-orti1ation In#rease in a##ounts "a,a;le In#rease in a##ruals In#rease in a##ounts re#ei+a;le In#rease in in+entories Net #ash "ro+ided ;, o"eratin$ a#ti+ities In+estin$ A#ti+ities Additions to "ro"ert,, "lant, and e9ui"-ent Net #ash used in in+estin$ a#ti+ities 4inan#in$ A#ti+ities In#rease in notes "a,a;le In#rease in lon$>terde;t In#rease in #o--on sto#7 Pa,-ent o% #o--on di+idends Net #ash "ro+ided ;, %inan#in$ a#ti+ities Su--ar, Net in#rease?de#rease in #ash 6ash ;alan#e at the ;e$innin$ o% the ,ear 6ash ;alan#e at the end o% the ,ear

$21,2)3 *,2)) *,350 *,)01 .1*,)2)/ .2,430/ $20,54*

.$20,11*/ .$20,11*/

$0,5 10,25 1 , .10,554/ $10,055

$12,105 )5,*05 $1 0,)5

c* Net @or7in$ 6a"ital .-ust ;e %inan#ed ;, e(ternal sour#es/ N@6 * A #urrent assets > .A?P and a##ruals/ N@6 * A $01 ,024 > $45,*35 N@6 * A $134,435 N@6 ) A N@6 ) A N@6 ) A #urrent assets $044,355 $1)2,401 > > .A?P and a##ruals/ $31,02)

% Comprehensive/Spreadsheet Problem Chapter 3# Financial Statements, Cash Flow, and Taxes

d* .n increase in the firmMs dividend payout ratio would have no effect on its corporate taxes paid because dividends are paid with after2 tax dollars. Nowever, the companyMs shareholders would pay additional taxes on the additional dividends they would receive. .s of &"G"', dividends are generally taxed at a maximum rate of &78.

Chapter 3# Financial Statements, Cash Flow, and Taxes Comprehensive/Spreadsheet Problem &

.nte2rated Case

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1/3eon .nc*, (art . Financial Statements and Taxes

1onna 4amison, a 2''3 2raduate of the 5ni+ersit6 of Florida with 6ears of )an-in2 experience, was recentl6 )rou2ht in as assistant to the chairperson of the )oard of 1/3eon .nc*, a small food producer that operates in north Florida and whose specialt6 is hi2h- 7ualit6 pecan and other nut products sold in the snac- foods mar-et* 1/3eon/s president, Al 8at-ins, decided in 2''$ to underta-e a ma9or expansion and to :2o national; in competition with Frito- 3a6, Ea2le, and other ma9or snac- foods companies* 8at-ins )elie+ed that 1/3eon/s products were of hi2her 7ualit6 than the competition/s< that this 7ualit6 differential would ena)le it to char2e a premium price< and that the end result would )e 2reatl6 increased sales, profits, and stoc- price* The compan6 dou)led its plant capacit6, opened new sales offices outside its home territor6, and launched an expensi+e ad+ertisin2 campai2n* 1/3eon/s results were not satisfactor6, to put it mildl6* .ts )oard of directors, which consisted of its president, +ice president, and plus ma9or stoc-holders =who were all local )usinesspeople>, was most upset when directors learned how the expansion was 2oin2* 5nhapp6 suppliers were )ein2 paid late< and the )an- was complainin2 a)out the deterioratin2 situation, threate nin2 to cut off credit* As a result, 8at-ins was informed that chan2es would ha+e to )e made?and 7uic-l6< otherwise he would )e fired* Also, at the )oard/s insistence, 1onna 4amison was )rou2ht in and 2i+en the 9o) of assistant to Fred Campo, a retired )an-er who was 1/3eon/s

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Inte ra te d Case

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

chairperson and lar2est stoc-holder* Campo a2reed to 2i+e up a few of his 2olfin2 da6s and help nurse the compan6 )ac- to health, with 4amison/s help* 4amison )e2an )6 2atherin2 the financial statem en ts and other data 2i+en in Ta)les .C 3- 1, .C 3- 2, .C 3- 3, and .C 3- * Assume that 6ou are 4amison/s assistant* @ou must help her answer the followin2 7uestions for Campo* =Aote# 8e will continue with this case in Chapter , and 6ou will feel more comforta)le with the anal6sis there* * But answerin2 these 7uestions will help prepare 6ou for Chapter (ro+ide clear explanations*> Ta)le .C 3- 1* Balance Sheets 2''% Assets Cash C Accounts recei+a)le .n+entories Total current assets 1,12 ,' ' ' Eross fixed assets 3ess accumulated depreciation Aet fixed assets Total assets !iabilities and E"uit# Accounts pa6a)le Aotes pa6a)le Accruals Total current lia)ilities 3on2- term de)t Common stoc- =1'',' ' ' shares> 0etained earnin2s Total e7uit6 Total lia)ilities and e7uit6 $,2%2 C "32,1 " ' D 1,2%$,3 " ' C 1,&2",% ' 2 1,2'2,& ! ' 2"3,1 " ' C &3&,$ & ' C 2,%"",! & 2 1, "%,% ' ' 2''$ !$,"' ' 3!1,2 ' ' $1!,2 ' ' C &1,' ' ' 1 ",2 ' ' C 3 ,% ' ' C

C !2 ,1 " ' "3",% ' % %&," ' ' C 1,"!',! " % $23, 3 2 "',' ' ' 32,!& 2 C &2,! & 2 C 2,%" " , ! & 2 1, " % , % ' '

C 1 !," ' ' 2'',' ' ' 13",' ' ' C %1," ' ' 323, 3 2 "',' ' ' 2'3,$ " % C ""3,$ " % C

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Inte ra te d Case

11

Ta)le .C 3- 2* .ncome State m e n ts Sales Cost of 2oods sold Fther expenses Total operatin2 costs excludin2 depreciation and amortiGa tion 3,22 2 , " $ 2 1epreciation and amortiGation EB.T .nterest expense EBT Taxes = 'H> Aet income E(S 1(S Boo- +alue per share Stoc- price Shares outstandin2 Tax rate 3ease pa6ments Sin-in2 fund pa6ments 2''% C ",'3 ,' ' ' 3, 32,' ' ' !,!2%,' ' ' !1&,& % % C ",' $ , & % % 11",& " ' =C 13',& % > 13",' 1 2 =C 2"",&" ' > =1'",$ % > a = C 1"',1 $ " > =C C C C 1*"'2 > '*11' *&2" 2*2! 1'',' ' ' '*''H ','' ' ' 2''$ C 2,%" ,' ' ' 3!%," $ 2 C 1%,&' ' C 1&', 2 % 3,%2 % C 1 "," ' ' !%," ' C %$,&" ' C C C C '*%%' '*22' "*"3% %*!' 1'',' ' ' '*''H ','' ' '

Aote# a The firm had sufficient taxa)le income in 2''" and 2''$ to o)tain its full tax refund in 2''%*

TAB3E .C3- 3* State m e n t of Stoc-holders/ E7uit6, 2''% Total Common Stoc0etained Stoc-holders/ Shares Amount Earnin2s E7uit6 1'',' ' ' C "',' ' ' C2'3,$ " % C""3,$ " % =1"',1 $ " > =11,'' ' > =1$1,1 $ " > =1$1,1 $ " >

Balances, 12,31,' $ 2''% Aet .ncome Cash 1i+idends Addition =Su)traction> to 0etained Earnin2s
12 Inte ra te d Case

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Balances, 12,31,' %

1'',' ' '

C "',' ' '

C 32,!& 2

C &2,! & 2

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Inte ra te d Case

13

Ta)le .C 3- * Stateme nt of Cash Flows, 2''% Fperatin2 Acti+ities Aet income 1"',1$ " > 1epreciation and amortiGation .ncrease in accounts pa6a)le .ncrease in accruals .ncrease in accounts recei+a)le .ncrease in in+entories Aet cash pro+ided )6 operatin2 acti+ities 3on2- Term .n+estin2 Acti+ities Additions to propert6, plant, and e7uipment Aet cash used in in+estin2 acti+ities =C$11,& ! ' > Financin2 Acti+ities .ncrease in notes pa6a)le .ncrease in lon2- term de)t (a6ment of cash di+idends Aet cash pro+ided )6 financin2 acti+ities Summar6 Aet decrease in cash Cash at )e2innin2 of 6ear Cash at end of 6ear A* =C 11",& " ' 3$%,! " ' 3!3," ' ' =2%',& " ' > =!$2,1 " ' > =C 1" ,1$ " >

=C $11,&! ' >

C 3",% ' % '',' ' ' =11,'' ' > C %2!,% ' %

=C !',31 % > !$,"' ' C $,2%2

8hat effect did the expansion ha+e on sales, after- tax operatin2 income, net wor-in2 capital =A8C>, and net incomeI

Answer# JS3- 1 throu2h S3- & pro+ide )ac-2round informa tion* Then show S3 -1' throu2h S3- 13 here*K Sales increased )6 C2,"' 2 , ' ' ' * AT operatin2 income '% L EB.T=1 M Tax rate>
1 Inte ra te d Case Chapter 3# Financial State me n ts, Cash Flow, and Taxes

L -C13', & % = 1 M '* > L -C13', & % = ' * " > L -C$%,! " & * AT operatin2 income '$ L C11 ,2 ! $ *

Accounts Accounts A8C '% L Cash N recei+a)le N .n+entorie s M pa6a)le N Accruals L =C$,2% 2 N C"32,1 " ' N C1,2%$,3 " ' > M =C!2 ,1" ' N
C %&,"' ' > L C&13,' 2* A8C '$ L =C!$,"' ' N C3!1,2' ' N C$1!,2' ' > M =C1 !," ' ' N C13",'' ' > L C% 2, ' '* A8C L C&13,' 2 M C% 2, ' ' L C$'," 2* Aet wor-in2 capital increased )6 C$'," 2* A. '% M A. '$ L =C1" ' , 1 $ " > M C%$,& " ' L =C2 % , 1 3 " > * There was a )i2 drop, -C2 %,1 3 " , in net income durin2 2''%* B* 8hat effect did the compan6/s expansion ha+e on its free cash flowI Answer# JShow S3- 1 here*K

FCF '% L EB.T=1 M T> M Aet in+estm e n t in operatin2 capital L =- C$%,! " & > M =C1,% ! 2 , % 3 2 M C1,1% $ , 2 ' ' > L =- C$%,! " & > M C""!," 3 2 L =C$ , 2 ' 1 > * Free cash flow was -C$ C* ,2 ' 1 in 2''%*

1/3eon purchases materials on 3'- da6 terms, meanin2 that it is supposed to pa6 for purchases within 3' da6s of

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Inte ra te d Case

1!

receipt* 4ud2in2 from its 2''% )alance sheet, do 6ou thinthat 1/3eon pa6s suppliers on timeI Explain, includin2 what pro)lems mi2ht occur if suppliers are not paid in a timel6 manner* Answer# JShow S3- 1! here*K 1/3eon pro)a)l6 does not pa6 its suppliers on time 9ud2in2 from the fact that its accounts pa6a)les )alance increased )6 2"'H from the past 6ear, while sales increased )6 onl6 $"H* Compan6 records would show if the6 paid suppliers on time* B6 not pa6in2 suppliers on time, 1/3eon is strainin2 its relationship with them* .f 1/3eon continues to )e late, e+entuall6 suppliers will cut the compan6 off and put it into )an-ruptc6* 1* 1/3eon spends mone6 for la)or, materials, and fixed assets =deprecia tion> to ma-e products?and spends still more mone6 to sell those products* Then the firm ma-es sales that result in recei+a)les, which e+entuall6 result in cash inflows* 1oes it appear that 1/3eon/s sales price exceeds its costs per unit soldI Oow does this affect the cash )alanceI Answer# JShow S3- 1" here*K .t does not appear the 1/3eon/s sales price exceeds its costs per unit sold as indicated in the income state m e n t * The compan6 is spendin2 more cash than it is ta-in2 in and, as a result, the cash account )alance has decreased* E* Suppose 1/3eon/s sales mana2e r told the sales staff to start offerin2 "'- da6 credit terms rather than the 3'- da6 terms now )ein2 offered* 1/3eon/s competitors react )6
1" Inte ra te d Case Chapter 3# Financial State me n ts, Cash Flow, and Taxes

offerin2 similar terms, so sales remain constant* 8hat effect would this ha+e on the cash accountI Oow would the cash account )e affected if sales dou)led as a result of the credit polic6 chan2eI Answer# JShow S3- 1$ here*K B6 extendin2 the sales credit terms, it would ta-e lon2er for 1/3eon to recei+e its mone6?its cash account would decrease and its accounts recei+a)le would )uild up* Because collections would slow, accounts pa6a)le would )uild up too* .n+entor 6 would ha+e to )e )uilt up and possi)l6 fixed assets too )efore sales could )e increased* Accounts recei+a)le would rise and cash would decline* Puch later, when collections increased cash would rise* 1/3eon would pro)a)l6 need to )orrow or sell stoc- to finance the expansion* F* Can 6ou ima2ine a situation in which the sales price exceeds the cost of producin2 and sellin2 a unit of output, 6et a drama tic increase in sales +olume causes the cash )alance to declineI Explain* Answer# This situation is li-el6 to occur as su22ested in the second part of the answer to Question F* E* 1id 1/3eon finance its expansion pro2ra m with internall6 2enera t e d funds =additions to retained earnin2s plus depreciation> or with external capitalI Oow does the choice of financin2 affect the compan6/s financial stren2thI

Chapter 3# Financial State me n ts, Cash Flow, and Taxes

Inte ra te d Case

1$

Answer# JShow S3- 1% here*K 1/3eon financed its expansion with external capital rather than internall6 2enera t e d funds* .n particular, 1/3eon issued lon2- term de)t rather than common stoc-, which reduced its financial stren2th and flexi)ilit6* O* 0efer to Ta)les .C 3- 2 and .C 3- * Suppose 1/3eon )ro-e e+en in 2''% in the sense that sales re+enues e7ualed total operatin2 costs plus interest char2es* 8ould the asset expansion ha+e caused the compan6 to experience a cash shorta2e that re7uired it to raise external capitalI Answer# JShow S3- 1& here*K E+en if 1/3eon had )ro-en e+en in 2''%, the firm would ha+e had to finance an increase in assets* .* .f 1/3eon starts depreciatin2 fixed assets o+er $ 6ears rather than 1' 6ears, would that affect =1> the ph6sical stoc- of assets, =2> the )alance sheet account for fixed assets, =3> the compan6/s reporte d net income, and = > the compan6/s cash positionI Assume the same depreciation method is used for stoc-holder reportin2 and for tax calculations and that the accountin2 chan2e has no effect on assets/ ph6sical li+es* Answer# JShow S3- 2' here*K This would ha+e no effect on the ph6sical stoc- of the assets< howe+er, the )alance sheet account for net fixed assets would decline )ecause accumula te d depreciation would increase due to depreciatin2 assets o+er $ 6ears +ersus 1' 6ears* Because
1% Inte ra te d Case Chapter 3# Financial State me n ts, Cash Flow, and Taxes

depreciation expense would increase, net income would decline* Finall6, the firm/s cash position would increase, )ecause its tax pa6ments would )e reduced* 4* Explain how earnin2s per share, di+idends per share, and )oo- +alue per share are calculate d, and what the6 mean* 8h6 does the mar-e t price per share not e7ual the )oo+alue per shareI Answer# Aet income di+ided )6 shares outstandin2 e7uals earnin2s per share* 1i+idends di+ided )6 shares outstandin2 e7uals di+idends per share, while )oo- +alue per share is calculate d as total common e7uit6 di+ided )6 shares outstandin2* Par-e t price per share does not e7ual )oo- +alue per share* The mar-e t +alue of a stoc- reflects future profita)ilit6, while )oo- +alue per share represents historical cost* Q* Explain )riefl6 the tax trea tm e n t of =1> interest and di+idends paid, =2> interest earned and di+idends recei+ed, =3> capital 2ains, and = > tax loss carr6- )ac- and carr6forward* Oow mi2ht each of these items affect 1/3eon/s taxesI Answer# JShow S3- 21 throu2h S3- 2" here*K For a )usiness, interest paid is considered an expense and is paid out of pre- tax income* Therefore, interest paid is tax deducti)le for )usinesses* For indi+iduals, interest paid is 2enerall6 not tax deducti)le, with the nota)le exception )ein2 limited tax deducti)ilit6 on home mort2a2e interest* 1i+idends paid )6
Chapter 3# Financial State me n ts, Cash Flow, and Taxes Inte ra te d Case 1&

a )usiness are paid out of after- tax income* .nterest earned, whether )6 a )usiness or indi+idual, is taxa)le income and su)9ect to standard income taxes, except for some state and local 2o+ernm e n t de)t interest* 1i+idends recei+ed are taxed at the capital 2ains rate for indi+iduals, creatin2 a :dou)le taxation; of di+idends =althou2h )6 not as much as it could )e if di+idends were taxed as ordinar6 income>* A portion of di+idends recei+ed )6 corpora tions is tax excluda)le, in order to a+oid :triple taxation* ; Capital 2ains are defined as the profits from the sale of an asset not used in the normal course of )usiness* For indi+iduals, capital 2ains on assets are taxed as ordinar6 income if held for less than a 6ear, and at the capital 2ains rate if held for more than a 6ear* Corporations face somew ha t differen t rules* Capital 2ains for corpora tions are taxed as ordinar6 income* Tax loss carr6- )ac- and carr6- forw ard pro+isions allow )usinesses to use a loss in the current 6ear to offset profits in prior 6ears =2 6ears>, and if losses ha+en/t )een completel6 offset )6 past profits the6 can )e carried forward to offset profits in the future =2' 6ears>* 1/3eon paid interest expense of C13",' 1 2 which was used to furthe r lower its tax lia)ilit6 resultin2 in a tax credit of C1'" ,$ % for a net loss of -C1"',1 $ " * Oowe+er, )ecause of the tax loss carr6- )ac- and carr6- forw ard pro+ision 1/3eon was a)le to o)tain its full tax refund in 2''% =as the firm had sufficient taxa)le income in 2''" and 2''$ >*

2'

Inte ra te d Case

Chapter 3# Financial State me n ts, Cash Flow, and Taxes