Chapter One

Telluride Mining's equity has a market value of $25 million with 800,000 shares outstanding. The book value of its equity is $15 million. The company decides to raise money by selling an additional 10%. If there are no taxes or transaction costs, and investors do not change their perception of the firm, what should the market value of the firm be after this stock issuance? Its price per share?

In essence the sale raises company cash by $2,500,000, increasing the value of the firm by just this amount. The new market value should be $27,500,000. The price per share should remain $31.25 ($27,500,000/880,000 shares).

Telluride Mining's equity has a market value of $25 million with 800,000 shares outstanding. The book value of its equity is $15 million. If the company repurchases 20% of its shares in the stock market at their current price, how will this affect the book value of equity if all else remains the same?

Telluride Mining will pay $31.25 per share for the 160,000 shares it repurchases. This reduces the book value of equity by $5,000,000. Assuming all else remains the same, the new book value will be $10,000,000.

You are responsible for labor relations in your company. During heated labor negotiations, the General Secretary of your largest union exclaims, "Look, this company has $15 billion in assets, $7.5 billion in equity, and made a profit last year of $300 million—due largely, I might add, to the effort of union employees. So don't tell me you can't afford our wage demands." How would you reply?

The General Secretary has confused accounting profits with economic profits. Earning $300 million on a $7.5 billion equity investment is a return of only 4 percent. This is poor performance and is too low for the company to continue attracting new investment necessary for growth. The company is certainly not covering its cost of equity.

Why do you suppose financial statements are constructed on an accrual basis rather than a cash basis?

Because the accountant's primary goal is to measure earnings, not cash generated. She sees earnings as a fundamental indicator of viability, not cash generation. A more balanced perspective is that over the long run successful companies must be both profitable and solvent; that is, they must be profitable and have cash in the bank to pay their bills when due. This means that you should pay attention to both earnings and cash flows.

What does it mean when cash flow from operations on a company's cash flow statement is negative? Is this bad news? Is it dangerous?

Operating losses - operating expenses exceed operating income, these losses are dangerous Rising receivables and inventories are growing in step with sales, and provided the company is able to finance the cash shortfalls.

What does it mean when cash flow from investing activities on a company's cash flow statement is negative? Is this bad news? Is it dangerous?

A. The company purchased more property, plant, equipment than it disposed of during the year. B. Positive cash flows from investing activities can signal problems, suggesting the firm has no attractive investment opportunities or that it might be liquidating productive assets due to financial difficulties.

During 2013, Acadia, Inc. earned net income of $500,000. increased its accounts receivable by $150,000. The book value of assets declined equal to the year's depreciation of $130,000, and market value assets increased by $25,000. Based only on this information, how much cash did Acadia generate during the year?

Accounting income: $500,000 Accounts Receivable: ( + ) $150,000 Depreciation: ( - ) $130,000 is a non-cash charge. The $25,000 increase in market value of assets adds to the market value of the business, but is nota cash flow. Acadia, Inc. generated $480,000

T/F - If a company gets into financial difficulty, it can use some of its shareholders' equity to pay its bills for a time.

False. - Shareholders' equity is on the liabilities side of the balance sheet. It represents owners' claims on company assets. The money contributed by owners and supplemented by retained profits has already been spent to acquire company assets.

T/F - It is impossible for a firm to have a negative book value of equity without the firm going into bankruptcy.

False. A negative book value of equity just means that the book value of liabilities exceeded the book value of assets. It is not an indicator of bankruptcy.

T/F - If a company increases its dividend, its net income will decrease.

False. Earnings are allocated to either dividends or retained earnings after net income is calculated. Increasing the dividend will reduce retained earnings, but will not affect net income.

T/F - The "goodwill" account on the balance sheet is an attempt by accountants to measure the benefits that result from a company's public relations efforts in the community.

False. Goodwill arises when one firm acquires another at a price above its book value. For example, if one firm acquires another for $10 million in cash but the target has a book value of only $8 million, the accountants record a $10 million reduction in the acquirer's cash, an $8 million increase in assets, and a $2 million increase in goodwill to balance the accounts.

What does it mean when cash flow from operations on a company's cash flow statement is negative? Is this bad news? Is it dangerous?

It means the company's op activities consumed cash. Operating losses - operating expenses exceed operating income, these losses are dangerous Rising receivables and inventories are growing in step with sales, and provided the company is able to finance the cash shortfalls.

What does it mean when cash flow from financing activities on a company's cash flow statement is negative? Is this bad news? Is it dangerous?

Negative cash flows from financing activities means that the firm is paying out more money to investors (in the form of debt principal repayment, interest payments, dividends and share repurchases) than it is raising from investors. Usually, negative cash flows from financing activities are associated with mature companies generating more than enough cash from operations to fund future activities. It is not necessarily bad news. Conversely, early-stage firms, rapidly growing firms, and those in financial distress typically have positive cash flows from financing activities.

Telluride Mining's equity has a market value of $25 million with 800,000 shares outstanding. The book value of its equity is $15 million. The company decides to raise money by selling an additional 10% of its shares on the market. If it can issue these additional shares at the current market price, how will this affect the book value of equity if all else remains the same?

Shares outstanding increase 10 percent, or 80,000 shares. At $31.25 per share, Telluride would raise $2,500,000

Telluride Mining's equity has a market value of $25 million with 800,000 shares outstanding. Telluride Mining will pay $31.25 per share for the 160,000 shares it repurchases. This reduces the book value of equity by $5,000,000. If there are no taxes or transaction costs, and investors do not change their perceptions of the firm, what should the market value of the firm be after the repurchase?

Since nothing else has changed, investors do not change their perceptions of the firm, and there are no taxes or transaction costs, the market value should fall by exactly the amount of the cash paid in the transaction. The new market value should be $20,000,000.

T/F - A reduction in an liability account is a use of cash, while a reduction in a asset account is a source of cash.

True. An asset account decreases, cash is made available for other uses. Thus, decreases in assets are sources of cash. In order to decrease a liability account, the firm must use cash to lower the liability. Thus, decreases in liability accounts are uses of cash.

T/F - You can construct a sources and uses statement for 2014 if you have a company's balance sheets for year-end 2013 and 2014.

True. By comparing a balance sheet from the beginning of 2014 (year-end 2013) with a balance sheet from the end of 2014, it is possible to construct a sources and uses statement for 2014.