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Solutions for chapter 2

By Lester Murray,2014-07-02 13:36
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Solutions for chapter 2

    Solutions for chapter 2

    E24

    2004

    2004 Ending Retained Earnings 2004 Beginning Retained Earnings

     or = + Revenues for 2004

    2005 Beginning Retained Earnings Expenses for 2004

     Dividends for 2004

     ($523) = ($499) + $1,383 X $0

     X = $1,407

Expenses for 2004 are $1,407.

2005

     ($758) = ($523) + $1,522 $1,608 X

     X = $149

Dividends declared for 2005 are $149.

2006

     ($596) = ($758) + X $1,550 $5

     X = $1,717

Revenue for 2006 is $1,717.

     2004 2005 2006

    Sales growth (%) .................................................... N/A 10.0% 12.8% Profits ...................................................................... ($24) ($86) $ 167 Profits as a percentage of sales ............................. (1.7%) (5.7%) 9.7% Dividends................................................................. $ 0 $ 149 $ 5 Dividends as a percentage of net income .............. N/A N/A 3.0%

    The advertising agency had modest sales growth from 2004 to 2006. However, from 2005 to 2006, the Company was able to go from losses to a profit. Even though the Company had a loss in 2005 the Company paid a healthy dividend. Then in 2006, when the Company showed a profit, it virtually

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eliminated the dividend. There is reason to be optimistic going forward. In 2006 the Company

    was able to show a nice growth in its sales while at the same time showing a reduction in its

    expenses.

    E211

    George’s Business

    Income Statement

     For the Year Ended

    Lease revenue ........................................................................................ $3,000

     Expenses ................................................................................................ 2,500

     Net income .............................................................................................. $ 500

    George’s Business

    Statement of Stockholders’ Equity

     For the Year Ended

     Contributed Retained

     Capital Earnings

    Beginning Balance $ 0 $ 0

    Stock Issue 6,000

    Net Income 500

    Cash Dividends _____ (800)

    Ending Balance $6,000 $ (300)

    George’s Business

    Balance Sheet

     As of

    Assets

    Cash ....................................................................................................... $ 2,700

     Land ....................................................................................................... 8,000

     Total assets ............................................................................................ $ 10,700

     Liabilities & Stockholders’ Equity

     Note payable........................................................................................... $ 5,000

     Contributed capital .................................................................................. 6,000

     Retained earnings .................................................................................. (300)

     Total liabilities & stockholders’ equity ..................................................... $ 10,700

2

    George’s Business

    Statement of Cash Flows

     For the Year Ended

    Cash flows from operating activities:

     Cash collections from customers .......................................... $ 3,000

     Cash payments for expenses ............................................... (2,500)

     Net cash flow from operating activities ............................ $ 500

     Cash flows from investing activities:

     Purchase of land ................................................................... $ (8,000)

     Net cash flow from investing activities ............................. (8,000)

     Cash flows from financing activities:

     Proceeds from equity investor .............................................. $ 6,000

     Proceeds from borrowing ...................................................... 5,000

     Cash payments for dividends ............................................... (800)

     Net cash flow from financing activities ............................. 10,200

     Increase in cash ........................................................................ $ 2,700

     Beginning cash balance ............................................................ 0

     Ending cash balance ................................................................. $ 2,700

    Upon examining George’s financial statements the bank would certainly be concerned because George paid out more in dividends than the net income he realized during the year. George’s

    statement of retained earnings shows a negative balance, which means that the payment to equity investors which was disguised as return on capital was in fact a return of capital. Generally, dividend

    payments cannot exceed the Retained Earnings balance.

P23

    2005

    Contributed Capital:

     Total assets = Total liabilities + Total stockholders' equity

     ($300 + $200 + $500 + $100 + $700) = ($200 + $500) + (Contributed cap. + $400)

     Contributed capital = $700

Net Income:

     Net income = Sales Expenses

     = $1,000 $400

     = $600

    Dividends:

    3

     Ending retained earnings = Beginning retained earnings + Net income Dividends

     $400 = $0 + $600 Dividends

     Dividends = $200

2006

    Inventory:

     Total assets = Total liabilities + Total stockholders' equity

     ($300 + $300 + Inventory + $200 + $600) = ($300 + $600) + ($400 + $800)

     Inventory = $700

Expenses:

     Net income = Sales Expenses

     $400 = $1,100 Expenses

     Expenses = $700

Dividends:

     Ending retained earnings = Beginning retained earnings + Net income Dividends

     $800 = $400 + $400 Dividends

     Dividends = $0

2007

    Accounts Receivable:

     Total assets = Total liab. + Total stockholders' equity

     ($200 + Accts. rec. + $400 + $400 + $700) = ($500 + $800) + ($600 + $300)

     Accounts receivable = $500

Expenses:

     Net income = Sales Expenses

     ($100) = $700 Expenses

     Expenses = $800

Dividends:

     Ending retained earnings = Beginning retained earnings + Net income Dividends

     $300 = $800 + ($100) Dividends

     Dividends = $400

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2008

    Accounts Payable:

     Total assets = Total liabilities + Total stockholders' equity

     ($500 + $700 + $400 + $400 + $800) = (Accts. pay. + $700) + ($600 + $600)

     Accounts payable = $900

Net income:

     Ending retained earnings = Beginning retained earnings + Net income Dividends

     $600 = $300 + Net income $200

     Net income = $500

Sales:

     Net income = Sales Expenses

     $500 = Sales $600

     Sales = $1,100

    In order to assess the financial performance of this company, we need to calculate the measures of solvency and earning power. Respective measures are computed as follows:

     Measures of Solvency 2005 2006 2007 2008

     Current Ratio: 5 4.33 2.20 1.78

     Working Capital: $800 $1,000 $600 $700

     Debt/Equity Ratio: .64 .75 1.44 1.33

    The only measure of earning power that we can compute for this company is Return on Equity. The other measures, such as EPS and P/E Ratio, cannot be computed since the relevant information is not available.

     Measures of Earning Power 2005 2006 2007 2008

     Return on Equity: .55 .33 * .42

     *No return on stockholder’s equity during 2007 since the company suffered a loss of $100.

    Overall, looking at the measures of solvency and earning power, one can safely conclude that the financial performance and position of the company has deteriorated since its inception in 2005.

    The current ratio has continued to decline and working capital has also gone down. While the company has taken more debt, it has been unable to leverage against the interest of the stockholders, since the return on equity has declined considerably. In one year, 2007, the company even suffered a loss.

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The company paid dividends even during the year of loss, indicating a poorly devised dividend policy.

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