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Chapter 2 ANSWERS TO END-OF-CHAPTER QUESTIONS

By Alfred West,2014-06-27 23:00
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Chapter 2 ANSWERS TO END-OF-CHAPTER QUESTIONS ...

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

    investors.

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.

    EBIT $6,000,000

    $3,000,000$3,000,000Interest 1,000,000 ?EBT $5,000,000 EBT = (1?T)0.6Taxes (40%) 2,000,000

    NI $3,000,000

    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

     = $9,000.

    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 = ?

    EBITDA $7,500,000

    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:

    EBIT $750,000

    Interest 0

    EBT $750,000

    Taxes (40%) 300,000

    NI $450,000

    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

    activities.

    2-8 a. NOPAT = EBIT(1 T)

     = $4,000,000,000(0.6)

     = $2,400,000,000.

     b. NCF = NI + DEP and AMORT

     = $1,500,000,000 + $3,000,000,000

     = $4,500,000,000.

     c. OCF = NOPAT + DEP and AMORT

     = $2,400,000,000 + $3,000,000,000

     = $5,400,000,000.

     d. FCF = NOPAT Net Investment in Operating Capital

     = $2,400,000,000 - $1,300,000,000

     = $1,100,000,000.

    ?Total Investor-Supplied?A-T Cost???? e. EVA = NOPAT ??????of CapitalOperating Capital??????

     = $2,400,000,000 [($20,000,000,000)(0.10)]

     = $400,000,000.

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

    assets

     = $5,000,000 ? $37,000,000

     = $42,000,000.

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

     = $255,000.

    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

    as follows:

    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

    as follows:

    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

    charge.

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

    up.

    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

    AMORT

    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)

    = $150,000,000(0.6)

    = $90,000,000.

    Net operatingNon-interest charging b. = Current assets - working capitalcurrent liabilities01

     = $360,000,000 - ($90,000,000 + $60,000,000)

     = $210,000,000.

     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

    = $460,000,000.

    Operating capital = $300,000,000 + $192,000,000 02

    = $492,000,000.

    d. FCF = NOPAT - Net investment in operating capital

     = $90,000,000 - ($492,000,000 - $460,000,000)

     = $58,000,000.

    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

    business.

     Answers and Solutions: 2 - 9

Answers and Solutions: 2 - 10

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