Chapter 2 Concepts Review and Critical Thinking Questions 4. The major difference is the treatment of interest expense.

The accounting statement of cash flows treats interest as an operating cash flow, while the financial cash flows treat interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears on the income statement, which shows the operations for the period, it is an operating cash flow. Interest is a financing expense, which results from the companys choice of debt and equity. We will have more to say about this in a later chapter. Market values can never be negative. Imagine a share of stock selling for $20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest and principal, its cash flow to creditors will be negative.

5.

9.

10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives. Problems 1. CA NFA TA Balance Sheet CL LTD OE $31,300 TL & OE $ 5,300 26,000 $ 3,900 14,200 ?? $31,300

OE = $31,300 14,200 3,900 = $13,200 NWC = CA CL = $5,300 3,900 = $1,400 2. Sales Costs Depreciation EBIT Interest EBT Taxes Net income Income Statement $493,000 210,000 35,000 $248,000 19,000 $229,000 80,150 $148,850

Addition to retained earnings = Net income Dividends Addition to retained earnings = $148,850 50,000 = $98,850

3. 4.

Book value assets = $7,900,000

Market value assets = $9,100,000

Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($246K 100K) Taxes = $79,190 Average tax rate = $79,190 / $246,000 = 32.19% Marginal tax rate = 39%. Income Statement Sales Costs Depreciation EBIT Interest Taxable income Taxes Net income $14,900 5,800 1,300 $7,800 780 $7,020 2,808 $4,212

5.

OCF = EBIT + Depreciation Taxes OCF = $7,800 + 1,300 2,808 OCF = $6,292 6. 7. Net capital spending = NFAend NFAbeg + Depreciation Net capital spending = $1,730,000 1,650,000 + 284,000 = $364,000 Long-term debt account will increase by $10 million. The company sold 10 million new shares of stock with a $1 par value, the common stock account will increase by $10 million. The capital surplus account will increase by $33 million. Net income = $9 million; paid $2 million in dividends, addition to retained earnings = $7 million, The new long-term debt and stockholders equity portion of the balance sheet will be: Long-term debt Total long-term debt Shareholders equity Preferred stock Common stock ($1 par value) Accumulated retained earnings Capital surplus Total equity Total Liabilities & Equity 8. 9. $ 82,000,000 $ 82,000,000

$ 9,000,000 30,000,000 104,000,000 76,000,000 $ 219,000,000 $ 301,000,000

Cash flow to creditors = Interest paid Net new borrowing Cash flow to creditors = $118,000 ($1,390,000 1,340,000) = $68,000 Cash flow to stockholders = Dividends paid Net new equity Cash flow to stockholders = $385,000 [($450,000 + 3,050,000) ($430,000 + 2,600,000)] Cash flow to stockholders = $385,000 ($3,500,000 3,030,000) = $85,000

10. Cash flow from assets Cash flow from assets $17,000 Operating cash flow 11.

= Cash flow to creditors + Cash flow to stockholders = $68,000 85,000 = $17,000 = $17,000 = OCF Change in NWC Net capital spending = OCF ($69,000) 875,000 = $17,000 69,000 + 875,000 = $789,000 Statement of cash flows

Operations Net income Depreciation Changes in other current assets Accounts payable Total cash flow from operations Investing activities Acquisition of fixed assets Total cash flow from investing activities Financing activities Proceeds of long-term debt Dividends Total cash flow from financing activities Change in cash (on balance sheet) b. c.

$105 90 (55) (10) $170

$(140) $(140)

$30 (45) ($15) $15

Change in NWC = NWCend NWCbeg = [($50 + 155) 85] [($35 + 140) 95) = $40 Operating cash flow Net income Depreciation Operating cash flow Capital spending Ending fixed assets Beginning fixed assets Depreciation Capital spending Cash flow from assets Operating cash flow Capital spending Change in NWC Cash flow from assets

$105 90 $195

$340 (290) 90 $140

$195 (140) (40) $ 15

12 . Cash flows from the firm Capital spending Additions to NWC Cash flows from the firm Cash flows to investors of the firm Sale of long-term debt Sale of common stock Dividends paid Cash flows to investors of the firm 13. Income Statement Sales Cost of goods sold Selling costs Depreciation EBIT Interest Taxable income Taxes Net income b. 14. $1,200,000 450,000 225,000 110,000 $415,000 81,000 $334,000 116,900 $217,100

$(15,000) (1,500) $(16,500)

(19,000) (3,000) 19,500 $(2,500)

OCF = EBIT + Depreciation Taxes = $415,000 + 110,000 116,900 = $408,100 Income Statement Sales Costs Depreciation Other expenses EBIT Interest Taxable income Taxes Net income Dividends Additions to RE $167,000 91,000 8,000 5,400 $62,600 11,000 $51,600 18,060 $33,540 $9,500 $24,040

a. OCF = EBIT + Depreciation Taxes = $62,600 + 8,000 18,060 = $52,540 b. CFC = Interest Net new LTD = $11,000 ($7,100) = $18,100 c. CFS = Dividends Net new equity = $9,500 7,250 = $2,250 d. CFA = CFC + CFS = $18,100 + 2,250 = $20,350 CFA is also equal to OCF Net capital spending Change in NWC. Net capital spending = Increase in NFA + Depreciation = $22,400 + 8,000 = $30,400 CFA = OCF Net capital spending Change in NWC $20,350 = $52,540 30,400 Change in NWC. Change in NWC = $1,790.

18. a. b. 21. a.

Taxes Growth = 0.15($50K) + 0.25($25K) + 0.34($3K) = $14,770 Taxes Income = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($235K) + 0.34($7.465M) = $2,652,000 Each firm has a marginal tax rate of 34% on the next $10,000 of taxable income. The income statement is: Income Statement Sales Cost of good sold Depreciation EBIT Interest Taxable income Taxes Net income $15,300 10,900 2,100 $ 2,300 520 $ 1,780 712 $1,068

b.

OCF = EBIT + Depreciation Taxes OCF = $2,300 + 2,100 712 = $3,688

c. Change in NWC == (CAend CLend) (CAbeg CLbeg) = ($3,950 1,950) ($3,400 1,900) = $2,000 1,500 = $500 Net capital spending = NFAend NFAbeg + Depreciation = $12,900 11,800 + 2,100 = $3,200 CFA = OCF Change in NWC Net capital spending = $3,688 500 3,200 = $12 The cash flow from assets can be positive or negative, since it represents whether the firm raised funds or distributed funds on a net basis.. d. Cash flow to creditors = Interest Net new LTD = $520 0 = $520 Cash flow to stockholders = Cash flow from assets Cash flow to creditors = $12 520 = $532 OR Cash flow to stockholders = Dividends Net new equity Net new equity = $500 (532) = $1,032 The firm had positive earnings and positive cash flow from operations. The firm invested $500 in new net working capital and $3,200 in new fixed assets. Therefore, had to raise $12: $1,032 in new equity (after paying out $500 dividends to shareholders and $520 interest to creditors).

22. a.

Total assets 2009 Total liabilities 2009 Owners equity 2009 Total assets 2010 Total liabilities 2010 Owners equity 2010

= $780 + 3,480 = $4,260; = $318 + 1,800 = $2,118 = $4,260 2,118 = $2,142 = $846 + 4,080 = $4,926 = $348 + 2,064 = $2,412 = $4,926 2,412 = $2,514 = NWC10 NWC09 = $498 462 = $36

b. c.

Change in NWC

Net capital spending = $4,080 3,480 + 960 = $1,560 Net capital spending = Fixed assets bought Fixed assets sold $1,560 = $1,800 Fixed assets sold Fixed assets sold = $1,800 1,560 = $240 EBIT = Sales Costs Depreciation = $10,320 4,980 960 = $4,380 EBT = EBIT Interest = $4,380 259 = $4,121 Taxes = $4,121 .35 = $1,442 OCF = EBIT + Depreciation Taxes = $4,380 + 960 1,442 = $3,898 Cash flow from assets = OCF Change in NWC Net capital spending. Cash flow from assets = $3,898 36 1,560 = $2,302

d.

Net new borrowing = LTD10 LTD09 = $2,064 1,800 = $264 Cash flow to creditors = Interest Net new LTD = $259 264 = $5 Net new borrowing = $264 = Debt issued Debt retired Debt retired = $360 264 = $96 Cash flow from assets = OCF Change in NWC Net capital spending Cash flow from assets = $2,510.62 819 1,299 = $396.62 Cash flow to creditors = Interest Net new LTD Cash flow to creditors = $402 ($10,702 9,173) = $1,127 Net new equity = Common stockend Common stockbeg Common stock + Retained earnings = Total owners equity Net new equity = OEend OEbeg + REbeg (REbeg + Additions to RE) = $23,041 23,203 656.62 = $818.62 Cash flow to stockholders = Dividends Net new equity Cash flow to stockholders = $701 ($818.62) = $1,519.62 As a check, cash flow from assets is $396.62. Cash flow from assets = Cash flow from creditors + Cash flow to stockholders Cash flow from assets = $1,127 + 1,519.62 = $392.62