Chapter 2: ANSWERS TO END-OF-CHAPTER QUESTIONS
2-1 The four financial statements contained in most annual reports are the
balance sheet, income statement, statement of retained earnings, and statement of cash flows.
2-2 No, because the $20 million of retained earnings would probably not be
held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the firm’s assets.
2-3 The balance sheet shows the firm’s financial position on a specific date,
for example, December 31, 2002. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2002. The income statement, on the other hand, reports on the firm’s operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2002, would represent the firm’s sales over the period from January 1, 2002, through December 31, 2002, not just sales for December 31, 2002.
2-4 The emphasis in accounting is on the determination of accounting income,
or net income, while the emphasis in finance is on net cash flow. Net cash flow is the actual net cash that a firm generates during some specified period. The value of an asset (or firm) is determined by the cash flows generated. Cash is necessary to purchase assets to continue operations and to pay dividends. Thus, financial managers should strive to maximize cash flows available to investors over the long run.
Although companies with relatively high accounting profits generally
have a relatively high cash flow, the relationship is not precise. A business’s net cash flow generally differs from net income because some of the expenses and revenues listed on the income statement are not paid out or received in cash during the year. The relationship between net cash flow and net income can be expressed as:
Net cash flow = Net income + Non-cash charges - Non-cash revenues.
The primary examples of non-cash charges are depreciation and amorti-zation. These items reduce net income but are not paid out in cash, so we add them back to net income when calculating net cash flow. Likewise, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash flow. Typically, depreciation and amortization represent the largest non-cash items, and in many cases the other non-cash items roughly net to zero. For this reason, many analysts assume that net cash flow equals net income plus depreciation and amortization.
Dryden Press Answers and Solutions: 2 - 1
2-5 Operating cash flow arises from normal, ongoing operations, whereas net
cash flow reflects both operating and financing decisions. Thus,
operating cash flow is defined as the difference between sales revenues
and operating expenses paid, after taxes on operating income. Operating
cash flow can be calculated as follows:
Operating cash flow = EBIT (1 - T) + Depreciation and amortization
= NOPAT + Depreciation and amortization.
Note that net cash flow can be calculated as follows:
Net cash flow = Net income + Depreciation and amortization.
Thus, the difference between the two equations is that net cash flow
includes after-tax interest expense.
2-6 Accountants translate physical quantities into numbers when they
construct the financial statements. The numbers shown on balance sheets
generally represent historical costs. When examining a set of financial
statements, one should keep in mind the physical reality that lies behind
the numbers, and the fact that the translation from physical assets to
numbers is far from precise.
2-7 Investors (both debt and equity investors) use financial statements to
make intelligent decisions about what firms to invest in, managers need
financial statements to operate their businesses, and taxing authorities
need them to assess taxes.
2-8 Operating capital is the amount of investor-supplied capital (interest
bearing debt, preferred stock, and common equity) used to acquire the
company’s net operating assets. Without this capital a firm cannot exist,
as there is no source of funds with which to finance operations.
2-9 NOPAT is the amount of net income a company would generate if it had no
debt and held no non-operating assets. NOPAT is a better measure of the
performance of a company’s operations because debt lowers income. In
order to get a true reflection of a company’s operating performance, one
would want to take out debt to get a clearer picture of the situation.
2-10 Free cash flow is the cash flow actually available for distribution to
investors after the company has made all the investments in fixed assets,
new products, and operating working capital necessary to sustain ongoing
operations. It is defined as net operating profit after taxes (NOPAT)
minus the amount of net investment in operating working capital and fixed
assets necessary to sustain the business. It is the most important
measure of cash flows because it shows the exact amount available to all
2-11 Double taxation refers to the fact that corporate income is subject to an
income tax, and then stockholders are subject to a further personal tax
on dividends received.
Answers and Solutions: 2 - 2
2-12 Because interest paid is tax deductible but dividend payments are not,
the after-tax cost of debt is lower than the after-tax cost of equity.
This encourages the use of debt rather than equity. This point is
discussed in detail in the chapters titled, “The Cost of Capital” and
“Capital Structure and Leverage.”
2-13 Accounting net income includes only the cost for debt capital, not the
cost of equity capital. Consequently, the cost of equity capital could
be so large as to produce a negative EVA.
Answers and Solutions: 2 - 3
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
2-1 NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ?
Need to set up an income statement and work from the bottom up.
$3,000,000$3,000,000Interest 1,000,000 ?EBT $5,000,000 EBT = (1?T)0.6Taxes (40%) 2,000,000
Interest = EBIT - EBT = $6,000,000 - $5,000,000 = $1,000,000.
2-2 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?
NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.
2-3 EBIT = $170,000; Operating capital = $800,000; k = 11.625%; T = 40%; A-T
EVA = ?
EVA = EBIT(1 - T) - AT dollar cost of capital
= $170,000(1 - 0.4) – ($800,000 ? 0.11625)
= $102,000 - $93,000
2-4 NI = $50,000,000; R/E = $810,000,000; R/E = $780,000,000; Dividends = ? Y/EB/Y
R/E + NI – Div = R/E B/YY/E
$780,000,000 + $50,000,000 – Div = $810,000,000
$830,000,000 – Div = $810,000,000
$20,000,000 = Div.
2-5 EBITDA = $7,500,000; NI = $1,800,000; Int = $2,000,000; T = 40%; DA = ?
DA 2,500,000 EBITDA – DA = EBIT; DA = EBITDA – EBIT
EBIT $5,000,000 EBIT = EBT + Int = $3,000,000 + $2,000,000
Int 2,000,000 (Given) $1,800,000$1,800,000 ?EBT $3,000,000 (1?T)0.6Taxes (40%) 1,200,000
NI $1,800,000 (Given)
Answers and Solutions: 2 - 4
2-6 EBIT = $750,000; DEP = $200,000; AMORT = 0; 100% Equity; T = 40%; NI = ?;
NCF = ?; OCF = ?
First, determine net income by setting up an income statement:
Taxes (40%) 300,000
NCF = NI + DEP and AMORT = $450,000 + $200,000 = $650,000.
OCF = EBIT(1 - T) + DEP and AMORT = $750,000(0.6) + $200,000 = $650,000.
Note that NCF = OCF because the firm is 100 percent equity financed.
2-7 Statements b, c, and d will all decrease the amount of cash on a
company’s balance sheet, while Statement a will increase cash through the
sale of common stock. This is a source of cash through financing
2-8 a. NOPAT = EBIT(1 – T)
b. NCF = NI + DEP and AMORT
= $1,500,000,000 + $3,000,000,000
c. OCF = NOPAT + DEP and AMORT
= $2,400,000,000 + $3,000,000,000
d. FCF = NOPAT – Net Investment in Operating Capital
= $2,400,000,000 - $1,300,000,000
?Total Investor-Supplied?A-T Cost???? e. EVA = NOPAT – ??????of CapitalOperating Capital??????
= $2,400,000,000 – [($20,000,000,000)(0.10)]
2-9 MVA = (P ? Number of common shares) ? BV of equity 0
$130,000,000 = $60X ? $500,000,000
$630,000,000 = $60X
X = 10,500,000 common shares.
Answers and Solutions: 2 - 5
2-10 First, determine the firm’s total operating capital: Total operating capital = Net operating working capital ? Net fixed
= $5,000,000 ? $37,000,000
Now, you can calculate the firm’s EVA:
EVA = EBIT (1 ? T) ? (WACC)(Total operating capital)
= $6,375,000 (1 ? 0.40) ? (0.085)($42,000,000)
= $3,825,000 ? $3,570,000
2-11 Ending R/E = Beg. R/E ? Net income ? Dividends
$278,900,000 = $212,300,000 ? Net income ? $22,500,000 $278,900,000 = $189,800,000 ? Net income
Net income = $89,100,000.
2-12 a. From the statement of cash flows the change in cash must equal cash
flow from operating activities plus long-term investing activities
plus financing activities. First, we must identify the change in cash
Cash at the end of the year $25,000
Cash at the beginning of the year ?55,000
Change in cash -$30,000
The sum of cash flows generated from operations, investment, and
financing must equal a negative $30,000. Therefore, we can calculate
the cash flow from operations as follows:
CF from operations ? CF from investing ? CF from financing = ? in cash
CF from operations ? $250,000 ? $170,000 = -$30,000
CF from operations = $50,000.
b. To determine the firm’s net income for the current year, you must
realize that cash flow from operations is determined by adding sources of
cash (such as depreciation and amortization and increases in accrued
liabilities) and subtracting uses of cash (such as increases in
accounts receivable and inventories) from net income. Since we
determined that the firm’s cash flow from operations totaled $50,000
in part a of this problem, we can now calculate the firm’s net income
Increase inIncrease inCF fromDepreciationNI ? ? ? = accruedA/R andandamortizationoperationsliabilitiesinventory
NI + $10,000 + $25,000 - $100,000 = $50,000
NI - $65,000 = $50,000
NI = $115,000.
Answers and Solutions: 2 - 6
2-13 Working up the income statement you can calculate the new sales level
would be $12,681,482.
Sales $12,681,482 $5,706,667/(1 ? 0.55) Operating costs (excl. D&A) 6,974,815 $12,681,482 ? 0.55 EBITDA $ 5,706,667 $4,826,667 + $880,000
Depr. & amort. 880,000 $800,000 ? 1.10 EBIT $ 4,826,667 $4,166,667 + $660,000
Interest 660,000 $600,000 ? 1.10 EBT $ 4,166,667 $2,500,000/(1 ? 0.4) Taxes (40%) 1,666,667 $4,166,667 ? 0.40 Net income $ 2,500,000
2-14 a. Because we’re interested in net cash flow available to common
stockholders, we exclude common dividends paid.
= NI available to common stockholders + Depreciation and 02CFamortization
= $364 + $220 = $584 million.
The net cash flow number is larger than net income by the current
year’s depreciation and amortization expense, which is a noncash
b. Balance of RE, December 31, 2001 $1,302
Add: NI, 2002 364
Less: Div. paid to common stockholders (146)
Balance of RE, December 31, 2002 $1,520
The RE balance on December 31, 2002 is $1,520 million.
c. $1,520 million.
d. Cash + Marketable securities = $15 million.
e. Total current liabilities = $620 million.
2-15 a. Income Statement
Sales revenues $12,000,000
Costs except deprec. and amort. (75%) 9,000,000
EBITDA $ 3,000,000
Depreciation and amortization 1,500,000
EBT $ 1,500,000
Taxes (40%) 600,000
Net income $ 900,000
Add back deprec. and amort. 1,500,000
Net cash flow $ 2,400,000
b. If depreciation and amortization doubled, taxable income would fall to
zero and taxes would be zero. Thus, net income would decrease to zero,
Answers and Solutions: 2 - 7
but net cash flow would rise to $3,000,000. Menendez would save
$600,000 in taxes, thus increasing its cash flow:
?CF = T(?Depreciation and amortization) = 0.4($1,500,000) = $600,000.
c. If depreciation and amortization were halved, taxable income would
rise to $2,250,000 and taxes to $900,000. Therefore, net income would
rise to $1,350,000, but net cash flow would fall to $2,100,000.
d. You should prefer to have higher depreciation and amortization charges
and higher cash flows. Net cash flows are the funds that are
available to the owners to withdraw from the firm and, therefore, cash
flows should be more important to them than net income.
e. In the situation where depreciation and amortization doubled, net
income fell by 100 percent. Since many of the measures banks and
investors use to appraise a firm’s performance depend on net income, a
decline in net income could certainly hurt both the firm’s stock price
and its ability to borrow. For example, earnings per share is a
common number looked at by banks and investors, and it would have
declined by 100 percent, even though the firm’s ability to pay
dividends and to repay loans would have improved.
2-16 This involves setting up the income statement and working from the bottom
Sales Revenue* $2,500,000
Cost of Goods Sold (60%) 1,500,000 2,500,000 ? 0.6
EBITDA $1,000,000 EBITDA = EBIT + DEP and
Deprec. and amort. 500,000 (Given)
EBIT $ 500,000 EBIT = EBT + Interest
Interest 100,000 (Given) $240,000$240,000EBT $ 400,000 EBT = ?(1?T)0.6Taxes (40%) 160,000
$240,000$240,000NI $ 240,000 (Given) ? (1?T)0.6* Sales Revenue - COGS = EBITDA
Revenue - 0.6(Revenue) = $1,000,000
0.4 Revenue = $1,000,000
Revenue = $2,500,000.
2-17 a. NOPAT = EBIT(1 - T)
Net operatingNon-interest charging b. = Current assets - working capitalcurrent liabilities01
= $360,000,000 - ($90,000,000 + $60,000,000)
Answers and Solutions: 2 - 8
Net operating = $372,000,000 - $180,000,000 = $192,000,000. working capital02
Net plantNet operatingc. Operating capital = ?01and equipmentworking capital
= $250,000,000 + $210,000,000
Operating capital = $300,000,000 + $192,000,000 02
d. FCF = NOPAT - Net investment in operating capital
= $90,000,000 - ($492,000,000 - $460,000,000)
e. The large increase in dividends for 2002 can most likely be attributed
to a large increase in free cash flow from 2001 to 2002, since FCF
represents the amount of cash available to be paid out to stockholders
after the company has made all investments in fixed assets, new
products, and operating working capital necessary to sustain the
Answers and Solutions: 2 - 9
Answers and Solutions: 2 - 10