FIN Ch.3

What are "retained earnings"?

"Retained earnings" represents a claim against assets, not assets per se. Stockholders allow management to retain earnings and reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account. Thus, retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else.

What explains the 70% intercorporate dividend exclusion.

(The intercorporate dividend exclusion = dividends are taxed more favorably: 70% of dividends received is excluded from taxable income, whereas the remaining 30% is taxed at the ordinary tax rate.) *ANSWER:* The rationale behind this exclusion is that when a corporation receives dividends and then pays out its own after-tax income as dividends to its stockholders, the dividends received are subjected to triple taxation: (1) The original corporation is taxed, (2) the second corporation is taxed on the dividends it receives, and (3) the individuals who receive the final dividends are taxed again.

____ is a noncash charge similar to depreciation except that it represents a decline in value of intangible assets. such as patents, copyrights, trademarks,and goodwill.

*Amortization* is a noncash charge similar to depreciation except that it represents a decline in value of intangible assets. such as patents, copyrights, trademarks,and goodwill.

____ consist of assets that should be converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory.

*Current assets* consist of assets that should be converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory.

____ consist of claims that must be paid off within one year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year.

*Current liabilities* consist of claims that must be paid off within one year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year.

____ liabilities consist of claims that must be paid off within one year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year.

*Current liabilities* consist of claims that must be paid off within one year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year.

____ assets consist of assets that should be converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory.

*Current* assets consist of assets that should be converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory.

____ is an annual charge against income that reflects the cost of the capital equipment and other tangible assets that were depleted in the production process

*Depreciation* is an annual charge against income that reflects the cost of the capital equipment and other tangible assets that were depleted in the production process Depreciation is not a cash outlay

____ is an estimate of a business's true economic profit for a given year, and it often differs sharply from accounting net income. The main reason for this difference is that although accounting income takes into account the cost of debt (the company's interest expense), it does not deduct for the cost of equity capital. By contrast, _____ takes into account the total dollar cost of all capital, which includes both the cost of debt and equity capital.

*Economic Value Added (EVA)* is an estimate of a business's true economic profit for a given year, and it often differs sharply from accounting net income. The main reason for this difference is that although accounting income takes into account the cost of debt (the company's interest expense), it does not deduct for the cost of equity capital. By contrast, *EVA* takes into account the total dollar cost of all capital, which includes both the cost of debt and equity capital.

_____ is the excess of NOPAT over capital costs

*Economic Value Added* is the excess of NOPAT over capital costs

____ assets are assets expected to be used for more than one year; they include plant and equipment in addition to intellectual property such as patents and copyrights.

*Fixed or Long-term assets* are assets expected to be used for more than one year; they include plant and equipment in addition to intellectual property such as patents and copyrights.

____ is the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flow

*Free Cash Flows (FCF)* is the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flow

The Statement of Cash Flows has 4 parts (operating activities, long-term investing activities, financing activities, and the summary). Describe each of the following entries and identify which of the 4 sections of the report they belong in: a. Additions to property, plant, and equipment b. Increase in bonds c. Net cash provided by financing activities d. Net income e. Cash and equivalents at the beginning of the year f. Net cash provided by (used in) operating activities g. Cash and equivalents at the end of the year h. Increase in accounts payable i. Net decrease in cash (Net sum of 1, II, and III) j. Increase in inventories k. Increase in notes payable l. Payment of dividends to stockholders m. Depreciation and amortization n. Increase in accrued wages and taxes o. Net cash used in investing activities p. Increase in accounts receivable

*I. OPERATING ACTIVITIES:* *a.* Net income - *b.* Depreciation and amortization *c.* Increase in inventories *d.* Increase in accounts receivable *e.* Increase in accounts payable *f.* Increase in accrued wages and taxes *g.* Net cash provided by (used in) operating activities *II. LONG-TERM INVESTING ACTIVITIES:* *h.* Additions to property, plant, and equipment *i.* Net cash used in investing activities *III. FINANCING ACTIVITIES:* *j.* Increase in notes payable *k.* Increase in bonds *l.* Payment of dividends to stockholders *m.* Net cash provided by financing activities *IV. SUMMARY:* *n.* Net decrease in cash (Net sum of 1, II, and III) *o.* Cash and equivalents at the beginning of the year *p.* Cash and equivalents at the end of the year See definitions in Word Document

____ can be deducted from operating income to obtain taxable income, but ____ cannot be deducted.

*Interest paid* can be deducted from operating income to obtain taxable income, but *dividends paid* cannot be deducted.

Define the terms market value added (MVA) and economic value added (EVA).

*Market Value Added (MVA)* is a performance measure that applies to the whole firm. MVA is the difference between the market value of a firm's equity and the book value as shown on the balance sheet. *Economic Value Added (EVA)*, sometimes called "economic profit", is a second performance measure that can be applied to individual departments as well as to the entire firm. Positive economic value is realized when a firm has an excess of NOPAT over capital costs. I.e., Companies realize positive EVA if the benefits of their investment exceed the cost of raising the necessary capital

____ is the excess of the market value of equity over its book value.

*Market Value Added (MVA)* is the excess of the market value of equity over its book value.

____ represents the amount of cash that the firm generates from its current operations.

*Net Operating Profit After Taxes (NOPAT)* represents the amount of cash that the firm generates from its current operations.

____ is the section of the Statement of Cash Flows deals with items that occur as part of normal ongoing operations

*Operating Activities* is the section of the Statement of Cash Flows deals with items that occur as part of normal ongoing operations

Differentiate between operating and non-operating income.

*Operating Income, or (EBIT) Earnings before Interest and Taxes,* is derived from the firm's regular core business and is calculated before deducting interest expenses and taxes, which are considered to be non-operating costs. If you want to compare two companies' operating performances, it is best to focus on their operating income. It is also focused on by analysts when they are estimate firms' long-run stock values.

____ represent the cumulative total of all earnings kept by the company during its life

*Retained Earnings* represent the cumulative total of all earnings kept by the company during its life

____ represents the amount that stockholders paid the company when shares were purchased and the amount of earnings the company has retained since its origination.

*Stockholders' Equity* represents the amount that stockholders paid the company when shares were purchased and the amount of earnings the company has retained since its origination.

____ represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock). The ____ of capital is total invested capital multiplied by the after-tax percentage cost of this capital.

*Total invested capital* represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock). The *annual dollar cost* of capital is total invested capital multiplied by the after-tax percentage cost of this capital.

The annual report is the most important report that corporations issue to stockholders, and it contains what two types of information?

1. a verbal section, often presented as a letter from the chairperson, which describes the firm's operating results during the past year and discusses new developments that will affect future operations. 2. the report provides these four basic financial statements: (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of stockholders' equity

What four financial statements are typically included in the annual report? (Hint: think BISS)

1. balance sheet 2. income statement 3. statement of cash flows 4. statement of stockholders' equities

What (4) statements are related to one another and, when taken together, provide an accounting picture of the firm's operations and financial position?

1. balance sheet 2. income statement 3. statement of cash flows 4. statement of stockholders' equity

On a balance sheet, assets are divided into what two major categories?

1. current assets 2. fixed, or long-term, assets

What are the two ways to think about stockholders' equity? What are two equations for stockholders' equity?

1. it is the amount that stockholders paid to the company when they bought shares the company sold to raise capital, in addition to all of the earnings the company has retained over the years: *Stockholders' equity = Paid-in capital + Retained earnings* 2. Stockholders' equity can also be thought of as residual: *Stockholders' equity = Total assets - Total liabilities*

Explain the difference between total debt and total liabilities.

A company's *Total Debt* includes both its short-term (notes payable) and long-term interest bearing liabilities. *Total Liabilities* equal total debt plus the company's "free" (non-interest bearing) liabilities i.e., the company's total debt plus their accounts payable and accruals

A company's ____ includes both its short-term and long-term interest-bearing liabilities.

A company's *total debt* includes both its short-term and long-term interest-bearing liabilities

A manager's primary goal is to maximize ____, which is based on the firm's future cash flows. a. profits b. cash flow c. shareholder value d. shareholder wealth

A manager's primary goal is to maximize *shareholder value*, which is based on the firm's future cash flows. c. shareholder value

A manager's primary goal is to maximize shareholder value, which is based on the firm's ____. a. past cash flows b. future cash flows c. profits d. growth

A manager's primary goal is to maximize shareholder value, which is based on the firm's *future cash flows.* b. future cash flows

What does a positive level of FCF indicate? What does a negative?

A positive level of FCF indicates that the firm is generating more than enough cash to finance current investments in fixed assets and working capital. By contrast, negative free cash flow means that the company does not have sufficient internal funds to finance investments in fixed assets and working capital, and that it will have to raise new money in the capital markets in order to pay for these investments.

What does a positive number in the retained earnings account indicate?

A positive number in the retained earnings account *indicates only that the firm has in the past earned income and has not paid it all out as dividends.* Even though a company reports record earnings and shows an increase in retained earnings, it still may be short of cash if it is using its available cash to purchase current and fixed assets to support growth. The same situation holds for individuals. You might own a new BMW (no loan), many clothes, and an expensive stereo (hence, have a high net worth); but if you had only $0.23 in your pocket plus $5.00 in your checking account, you would still be short of cash.

Although assets are reported in dollar terms, only the ____ and ___ account represents actual spendable money. ____ represent credit sales that have not yet been collected. ____ show the cost of raw materials, work in process, and finished goods. ____ represent the cost of the buildings and equipment used in operations minus the depreciation that has been taken on these assets.

Although assets are reported in dollar terms, only the *cash and equivalents account* represents actual spendable money. *Accounts receivable* represent credit sales that have not yet been collected. *Inventories* show the cost of raw materials, work in process, and finished goods. *Net fixed assets* represent the cost of the buildings and equipment used in operations minus the depreciation that has been taken on these assets.

A ____ is a report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management's analysis of the firm's past operations and future prospects.

Annual report

Assets must equal ___ on a balance sheet

Assets must equal *liabilities and equity* on a balance sheet

Assets on the balance sheet are listed by:

Assets on the balance sheet are listed by *the length of time before they will be converted to cash (inventories and accounts receivable) or used by the firm (fixed assets).*

Assets such as stocks, bonds, and real estate are defined as ____.

Assets such as stocks, bonds, and real estate are defined as *capital assets.*

What motivated Congress to tax dividends at a lower rate than the rate on ordinary income?

Because corporations pay dividends out of earnings that have already been taxed, there is double taxation of corporate income— income is first taxed at the corporate rate; and when what is left is paid out as dividends, it is taxed again. This double taxation motivated Congress to tax dividends at a lower rate than the rate on ordinary income.

If a company has raised $1 million in capital, and the current cost of capital is 10%, the annual dollar cost of capital would be ____

Capital = $1,000,000 Cost of Capital = 0.1 Annual Cost of Capital = $1,000,000(0.10) = $100,000

Changes in stockholders' equity during the accounting period are reported in the ____

Changes in stockholders' equity during the accounting period are reported in the *statement of stockholders' equity.*

Claims on a balance sheet are listed in the order:

Claims on a balance sheet are listed in the order *in which they must be paid*: Accounts payable must generally be paid within a few days, accruals must also be paid promptly, notes payable to banks must be paid within one year, and so forth, down to the stockholders' equity accounts, which represent ownership and need never be "paid off."

Companies create value (and realize positive EVA) if the benefits of their investments exceed:

Companies create value (and realize positive EVA) if the benefits of their investments *exceed the cost of raising the necessary capital.* Total invested capital represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock).

When do companies create value and realize Economic Value Added (EVA)?

Companies create value (and realize positive EVA) if the benefits of their investments *exceed the cost of raising the necessary capital.* Total invested capital represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock).

Which of the following are Current Assets? a. Cash and equivalents b. Net plant and equipment c. Accounts receivable d. Inventory e. Other long-term assets

Current Assets include: a. Cash and equivalents c. Accounts receivable d. Inventory

Which of the following are Current Liabilities? a. Accrued wages and taxes b. Accounts payable c. Common stock d. Notes payable e. Long-term debt

Current Liabilities include: a. Accrued wages and taxes b. Accounts payable d. Notes payable

Current assets are often called ____ because these assets "turn over"; that is, they are used and then replaced throughout the year.

Current assets are often called *working capital* because these assets "turn over"; that is, they are used and then replaced throughout the year.

Current assets consist of assets that should be converted to cash within one year, and they include:

Current assets consist of assets that should be converted to cash within one year, and they include: 1. cash and cash equivalents 2. accounts receivable 3. inventory.

Current liabilities consist of claims that must be paid off within one year, including:

Current liabilities consist of claims that must be paid off within one year, including: 1. accounts payable 2. accruals (total of accrued wages and accrued taxes) 3. notes payable to banks and other short-term lenders that are due within one year.

Current liabilities include ____, ____, and ____

Current liabilities include *accounts payable, accruals, and notes payable to the bank.*

Depreciation and amortization are noncash expenses that reduce ____ but DO NOT reduce ____

Depreciation and amortization are noncash expenses that reduce *EBIT* but DO NOT reduce *the amount of cash the company has available to pay its investors.*

What is EBITDA?

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization Even though depreciation and amortization are reported as costs on the income statements, they are not cash expenses—cash was spent in the past, when the assets being written off were acquired, but no cash is paid out to cover depreciation and amortization. Therefore, managers, security analysts, and bank loan officers who are concerned with the amount of cash a company is generating often calculate EBITDA,

What is economic value added (EVA) an estimate of and how/why does it frequently differ from accounting net income?

EVA is *an estimate of a business's true economic profit for a given year. The EVA often differs from accounting net income mainly due to the fact that *accounting net income does not deduct for the cost of equity capital,* although it does take the cost of debt (the company's interest expense) into account. By contrast, EVA takes into account the total dollar cost of capital, which includes both the cost of debt and equity capital.

Why is earnings per share called "the bottom line"? What is EBIT, or operating income?

Earnings per share (EPS) is often called "the bottom line," denoting that of all items on the income statement, EPS is the one that is most important to stockholders.

*T/F* Suppose two companies have identical sales, operating costs, and assets. However, one company uses some debt, and the other uses only common equity. Despite their identical operating performances, the company with no debt (and therefore no interest expense) would report a lower net income .

FALSE Different firms have different amounts of debt, different tax carry-backs and carry-forwards, and different amounts of non-operating assets such as marketable securities. These differences can cause two companies with identical operations to report significantly different net incomes. For example, suppose two companies have identical sales, operating costs, and assets. However, one company uses some debt, and the other uses only common equity. Despite their identical operating performances, the company with no debt (and therefore no interest expense) would report a *higher* net income because no interest was deducted from its operating income. Consequently, if you want to compare two companies' operating performances, it is best to focus on their operating income.

*T/F* Dividends paid can be deducted from operating income to obtain taxable income, but interest paid cannot be deducted.

FALSE *Interest paid* can be deducted from operating income to obtain taxable income, but *dividends paid* cannot be deducted.

*T/F* A long-term capital gain is taxed at the same rate as ordinary income. However, short-term capital gains are taxed differently.

FALSE A *short-term* capital gain is taxed at the same rate as ordinary income. However, *long-term* capital gains are taxed differently. For most taxpayers, the rate on long-term capital gains is only 15%. Thus, if in 2014, you were in the 35% tax bracket, any short-term capital gains you earned would be taxed just like ordinary income; but your long-term capital gains would only be taxed at 15%. However, the maximum tax rate on long-term capital gains is 20% for taxpayers in the 39.6% tax bracket. But even for individuals at these top tax brackets, the tax rate on long-term capital gains still remains considerably lower than the tax rate on ordinary income

*T/F* Changes in interest rates and inflation affect both the market value of the company's assets and liabilities and the corresponding book values shown in the financial statements.

FALSE Changes in interest rates and inflation affect the market value of the company's assets and liabilities but often have no effect on the corresponding book values shown in the financial statements.

*T/F* Net income equals cash from operations.

FALSE If all sales were for cash, if all costs required immediate cash payments, and if the firm were in a static situation, net income would equal cash from operations. However, these conditions don't hold, so *net income is NOT equal to cash from operations*. In the Statement of Cash Flows, *the first operating activity* is net income, which is the first source of cash. However, *because Net Income does NOT equal cash from operations, adjustments must be made in the remainder of the Statement of Cash Flows.*

*T/F* If the value of a firm's bonds fell below their purchase price, the true value of the firm's assets would decline, but the amount of its liabilities would remain unchanged and the value of common equity would also remain unchanged.

FALSE If the value of a firm's bonds fell below their purchase price: 1. The true value of the firm's assets would decline 2. The amount of the firm's liabilities would remain unchanged 3. *The reported value of retained earning, and thus common equity, would decline* because: Stockholders' Equity = Total Assets - Total Liabilities

*T/F* The corporate tax system favors equity financing over debt financing.

FALSE It is generally not possible to finance exclusively with debt; and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed—*The corporate tax system favors debt financing over equity financing.*

*T/F* Notes payable are "free" sources of short-term credit

FALSE Notes payable are funds obtained from the bank that bear interest and are therefore not free. Funds that are received from a firm's suppliers are known as accounts payable. These loans are typically are "free" in the sense that they do not bear interest. Accruals are also considered "free".

*T/F* The information contained in the annual report not a very reliable or useful tool to help forecast future earnings and dividends.

FALSE The information contained in the annual report *can be used* to help forecast future earnings and dividends.

*T/F* If you want to compare two companies' operating performances, it is best to focus on their net income.

FALSE if you want to compare two companies' operating performances, it is best to focus on their *operating income.*

A company has EBIT of $30 million, depreciation of $5 million, and a 40% tax rate. It needs to spend $10 million on new fixed assets and $15 million to increase its current assets. It expects its accounts payable to increase by $2 million, its accruals to increase by $3 million, and its notes payable to increase by $8 million. The firm's current liabilities consist of only accounts payable, accruals, and notes payable. What is its free cash flow? p. 77

FCF = [EBIT (1-T)] + Depreciation & Amortization] - [Capital Expenditures + ΔNOWC] *I: SOLVE FOR NOPAT* NOPAT = EBIT(1-T) EBIT = $30 Tax = 0.4 *NOPAT = $30(0.6) = $18* *II: DETERMINE DEPRECIATION & AMORTIZATION* Depreciation = $5 *III: DETERMINE CAPITAL EXPENDITURES* Capital Expenditures = $10 spent on new fixed assets *IV: SOLVE FOR ΔNOWC* ΔNOWC = ΔCurrent Assets - (ΔCurrent Liabilities - ΔNotes Payable) *IV-a: Solve for ΔCurrent Liabilities* ΔCurrent Liabilities = ΔAccruals + ΔAccounts Payable + ΔNotes Payable Accruals = $3 Accounts Payable = $2 Notes Payable = $8 ΔCurrent Liabilities = $3 + $2 + $8 = $13 *IV-b: Solve for ΔNOWC* ΔCurrent Assets = $15 ΔNOWC = $15 - ($13 - $8) = $10 *V: SOLVE FOR FCF* FCF = ($18 + $5) - (10 + 10) = $23 - $20 = $3 *ΔNOWC =$3*

What is the difference between net working capital and net operating working capital (NOWC)?

Financial analysts often make an important distinction between the "free" liabilities (accruals and accounts payable) and interest-bearing notes payable (which incur interest expense that is included as a financing cost on the firm's income statement). With this distinction in mind, analysts often focus on net operating working capital (NOWC) *which differs from net working capital because interest-bearing notes payable are subtracted from current liabilities.*

How does net operating working capital (NOWC) differ from net working capital?

Financial analysts often make an important distinction between the "free" liabilities (accruals and accounts payable) and interest-bearing notes payable (which incur interest expense that is included as a financing cost on the firm's income statement). With this distinction in mind, analysts often focus on net operating working capital (NOWC) which differs from net working capital because *interest-bearing notes payable are subtracted from current liabilities.*

What is free cash flow (FCF) and why is it an important determinant of a firm's value? p. 78

Free Cash Flow (FCF) is the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows, which is an important determinant of a firm's health and value.

If Allied had invested surplus funds in bonds backed by subprime mortgages and the bonds' value fell below their purchase price, the true value of the firm's assets would have declined. The amount of its liabilities would not have changed—the firm would still owe the amount it had promised to pay its creditors. Therefore, the reported value of the common equity must decline. The accountants would make a series of entries, and the result would be a reduction in retained earnings—and thus in common equity. In the end, assets would equal liabilities and equity, and the balance sheet would balance. This example shows why:

If Allied had invested surplus funds in bonds backed by subprime mortgages and the bonds' value fell below their purchase price, the true value of the firm's assets would have declined. The amount of its liabilities would not have changed—the firm would still owe the amount it had promised to pay its creditors. Therefore, the reported value of the common equity must decline. The accountants would make a series of entries, and the result would be a reduction in retained earnings—and thus in common equity. In the end, assets would equal liabilities and equity, and the balance sheet would balance. *This example shows why common stock is more risky than bonds—any mistake that management makes has a big impact on the stock- holders. Of course, gains from good decisions also go to the stockholders; so with risk come possible rewards.*

A firm like Allied can finance its operations with either debt or stock. What is a firm expected to pay if it uses debt? What will it pay if it uses stock?

If a firm uses debt to finance its operations, it is expected to pay *interest* If it uses stock, it is expected to use *dividends*

If we subtract current liabilities from current assets, the difference is called ____

If we subtract current liabilities from current assets, the difference is called *net working capital*. *Net working capital = Current assets - Current liabilities*

What is interest income received by a corporation taxed as? What rate is interest income taxed at? Which is taxed more favorably: interest income or dividends?

Interest income received by a corporation is *taxed as ordinary income at regular corporate tax rates*. However, dividends are taxed more favorably: 70% of dividends received is excluded from taxable income, whereas the remaining 30% is taxed at the ordinary tax rate.

Why is the annual report of great interest to investors?

It is of great interest to investors because the information contained in the annual report can be used to help forecast future earnings and dividends.

Which of the following are Long-Term (Fixed) Assets? a. Cash and equivalents b. Net plant and equipment c. Accounts receivable d. Inventory e. Other long-term assets

Long-Term (Fixed) Assets include: b. Net plant and equipment e. Other long-term assets

Long-term assets are assets expected to be used for more than one year; they include:

Long-term assets are assets expected to be used for more than one year; they include: 1. plant and equipment 2. intellectual property such as patents and copyrights

NOPAT is the amount of money that investments in ____ and ____ have generated for the company's investors after paying for operating costs and taxes In this regard it represents the benefits of ____

NOPAT is the amount of money that investments in *net fixed assets* and *net operating working capital* have generated for the company's investors after paying for operating costs and taxes In this regard it represents the benefits of *capital investments*.

On the income statement, what is subtracted from net sales in order to determine the net income available to common shareholders?

Net sales are shown at the top of the statement; then operating costs, interest, and taxes are subtracted to obtain the net income available to common shareholders.

Note that whereas ____ value added applies to the entire firm, ____ value added can be determined for divisions as well as for the company as a whole, so it is useful as a guide to "reasonable" compensation for divisional as well as top corporate managers.

Note that whereas *Market Value Added (MVA)* applies to the entire firm, *Economic Value Added (EVA)* can be determined for divisions as well as for the company as a whole, so it is useful as a guide to "reasonable" compensation for divisional as well as top corporate managers.

On a balance sheet, ____ includes bonds that mature in more than a year.

On a balance sheet, *long-term debt* includes bonds that mature in more than a year.

On a balance sheet, bank loans are shown as ____. Funds from a bank often bear interest that a firm must pay.

On a balance sheet, bank loans are shown as *notes payable*. Funds from a bank often bear interest that a firm must pay.

On a balance sheet, plant and equipment is generally reported ____

On a balance sheet, plant and equipment is generally reported *net of accumulated depreciation.*

Plant and equipment is generally reported net of accumulated depreciation. In the example (p. 60) Allied's long-term assets consist entirely of net plant and equipment, and we often refer to them as ____

Plant and equipment is generally reported net of accumulated depreciation. In the example (p. 60) Allied's long-term assets consist entirely of net plant and equipment, and we often refer to them as "net fixed assets"

Suppose a firm has excess cash that it does not need for operations, and it plans to invest this cash in marketable securities. The tax factor ____, rather than bonds.

Suppose a firm has excess cash that it does not need for operations, and it plans to invest this cash in marketable securities. *The tax factor favors stocks, which pay dividends, rather than bonds, which pay interest.* For example, suppose Allied had $100,000 to invest, and it could buy bonds that paid 8% interest, or $8,000 per year, or stock that paid 7% in dividends, or $7,000. Allied is in the 40% federal-plus-state tax bracket. Therefore, if Allied bought bonds and received interest, its tax on the $8,000 of interest would be (0.4)$8,000 = $3,200 and its after-tax income would be $4,800. If it bought stock, its tax would be $7,000(0.12) = $840 and its after-tax income would be $6,160. Other factors might lead Allied to invest in bonds, but when the investor is a corporation, the tax factor favors stock investments.

Suppose a firm with $10 million of assets, sales of $5 million, and $1.5 million of earnings before interest and taxes (EBIT). If the firm were financed entirely by bonds and if it made interest payments of $1.5 million: a. what would its taxable income be? b. Taxes would be what? c. How much would its investors receive? If the firm had no debt and was therefore financed entirely by stock: a. what would its taxable income be? b. Taxes would be what? c.How much would its investors receive? The rate of return to investors on their $10 million investment when higher when the firm uses which option? Why is this the better option?

Suppose a firm with $10 million of assets, sales of $5 million, and $1.5 million of earnings before interest and taxes (EBIT). If the firm were financed entirely by bonds and if it made interest payments of $1.5 million: a. the firm's taxable income would be *zero* b. that taxes would be *zero* c. the firm's investors would receive the entire $1.5 million If the firm had no debt and was therefore financed entirely by stock: a. all of the $1.5 million of EBIT would be taxable income to the corporation b. the tax would be $1,500,000(0.40) = $600,000; c. investors would receive only receive $0.9 million versus $1.5 million under debt financing. Therefore, the rate of return to investors on their $10 million investment is much higher when debt is used. This is *because dividends paid to bondholders/stockholders is taxable whereas interest paid can be deducted from operating income to obtain taxable income, but dividends paid cannot be deducted* Of course, it is generally not possible to finance exclusively with debt; and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed—the corporate tax system favors debt financing over equity financing.

*T/F* Financial analysts often make an important distinction between the "free" liabilities (accruals and accounts payable) and interest-bearing notes payable (which incur interest expense that is included as a financing cost on the firm's income statement).

TRUE

*T/F* "Retained earnings" represents a claim against assets, not assets per se.

TRUE "retained earnings" represents a claim against assets, not assets per se. Stockholders allow management to retain earnings and reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account. Thus, retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else.

*T/F* Retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else.

TRUE "Retained earnings" represents a claim against assets, not assets per se. Stockholders allow management to retain earnings and reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account. *Thus, retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else.*

*T/F* Interest paid can be deducted from operating income to obtain taxable income, but dividends paid cannot be deducted.

TRUE Interest paid can be deducted from operating income to obtain taxable income, but dividends paid cannot be deducted.

*T/F* The corporate tax system favors debt financing over equity financing.

TRUE It is generally not possible to finance exclusively with debt; and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed—*The corporate tax system favors debt financing over equity financing.*

*T/F* Items reported on the financial statements reflect historical, in-the-past, values, not current market values, and there are often substantial differences between the two.

TRUE Items reported on the financial statements reflect historical, in-the-past, values, not current market values, and there are often substantial differences between the two. Changes in interest rates and inflation affect the market value of the company's assets and liabilities but often have no effect on the corresponding book values shown in the financial statements. Perhaps, more importantly, the market's assessment of value takes into account its ongoing assessment of current operations as well as future opportunities. For example, it cost Microsoft very little to develop its first operating system, but that system turned out to be worth many billions that were not shown on its balance sheet. For a given level of debt, these increases in asset value also lead to a corresponding increase in the market value of equity

*T/F* Net income as reported on the income statement is not cash

TRUE The *statement of cash flows* is the accounting report that shows how much cash the firm is generating.

*T/F* A short-term capital gain is taxed at the same rate as ordinary income. However, long-term capital gains are taxed differently.

TRUE A short-term capital gain is taxed at the same rate as ordinary income. However, long-term capital gains are taxed differently. For most taxpayers, the rate on long-term capital gains is only 15%. Thus, if in 2014, you were in the 35% tax bracket, any short-term capital gains you earned would be taxed just like ordinary income; but your long-term capital gains would only be taxed at 15%. However, the maximum tax rate on long-term capital gains is 20% for taxpayers in the 39.6% tax bracket. But even for individuals at these top tax brackets, the tax rate on long-term capital gains still remains considerably lower than the tax rate on ordinary income

____ reports on operations over a period of time

The *Income Statement* reports on operations over a period of time

The ____ is a report that shows how items that affect the balance sheet and income statement affect the firm's cash flows.

The *Statement of Cash Flows* is a report that shows how items that affect the balance sheet and income statement affect the firm's cash flows.

The ____ is the accounting report that shows how much cash the firm is generating.

The *statement of cash flows* is the accounting report that shows how much cash the firm is generating.

The claims against assets are of what two basic types?

The claims against assets are of two basic types—*liabilities* (or money the company owes to others) and *stockholders' equity.*

The claims against assets on a balance sheet are of what two basic types?

The claims against assets on balance sheets are of two basic types—*liabilities* (or money the company owes to others) and *stockholders' equity.*

The firm's ____ report *what has actually happened* to its assets, earnings, and dividends over the past few years, whereas ____ attempt to explain why things turned out the way they did and what might happen in the future.

The firm's *financial statements* report what has actually happened to its assets, earnings, and dividends over the past few years, whereas *management's verbal statements* attempt to explain why things turned out the way they did and what might happen in the future.

How are the income statement and the balance sheet interrelated?

The income statement is tied to the balance sheet through the retained earnings account on the balance sheet. Net income as reported on the income statement less dividends paid is the retained earnings for the year (e.g., 2015). Those retained earnings are added to the cumulative retained earnings from prior years to obtain the year-end 2015 balance for retained earnings. The retained earnings for the year are also reported in the statement of stockholders' equity.

What is displayed on the left side of a balance sheet statement?

The left side of a balance sheet statement shows *the assets that the firm owns*

The left side of the balance sheet statement shows the ____, and the right side shows the firm's liabilities and stockholders' equity, which are claims against the firm's assets.

The left side of the balance sheet statement shows *the assets that the company owns*, and the right side shows the firm's liabilities and stockholders' equity, which are claims against the firm's assets.

The left side of the balance sheet statement shows the assets that the company owns, and the right side shows the firm's ____

The left side of the balance sheet statement shows the assets that the company owns, and the right side shows the firm's *liabilities and stockholders' equity*, which are claims against the firm's assets.

What is displayed on the right side of a balance sheet statement?

The right side of a balance sheet statement shows *the firm's liabilities and stockholders' equity*, which are claims against the firms assets

The total of ____, ____, and ____ represent current liabilities on its balance sheet.

The total of *accounts payable, accruals, and notes payable* represent current liabilities on its balance sheet.

The total of what three accounts represent current liabilities on a firm's balance sheet?

The total of *accounts payable, accruals, and notes payable* represent current liabilities on its balance sheet.

The total of accounts payable, accruals, and notes payable represent ____ on its balance sheet.

The total of accounts payable, accruals, and notes payable represent *current liabilities* on its balance sheet.

How do managers decide which actions are most likely to increase cash flows, and how do investors estimate future cash flows?

Through a study of financial statements that publicly traded firms must provide to investors.

Total Assets = a. Current Assets - Current Liabilities b. [Current Assets + Long-Term (Fixed) Assets] - Long-Term Debt c. [Current Assets + Long-Term (Fixed) Assets] - [Current Liabilities + Long-Term Debt] d. Current Assets + Long-Term (Fixed) Assets

Total Assets = d. Current Assets + Long-Term (Fixed) Assets

Refer to Allied's balance sheets shown in Table 3.1 on p. 62. What was Allied's total debt on December 31, 2014?

Total Debt(2014) = Short-term debt + Long-term debt *Short-term debt = notes payable NOT accruals & accounts payable)* Total debt(2014) = $60 + $580 = $640

Total Liabilities and Equity = a. Current Liabilities + Stockholders' Equity b. Stockholders' Equity + Long-Term Debt c. Stockholders' Equity + [Current Assets - Current Liabilities] d. Current Liabilities + Long-Term Debt + Stockholders' Equity e. c. Stockholders' Equity + [Total Assets - Current Liabilities]

Total Liabilities and Equity = d. Current Liabilities + Long-Term Debt + Stockholders' Equity

When Allied buys inventory items on credit, its suppliers, in effect, lend it the money used to finance the inventory items. Allied could have borrowed from its bank or sold stock to obtain the money, but it received the funds from its suppliers. These loans are shown as ____, and they typically are "free" in the sense that they do not bear interest. Similarly, Allied pays its workers every two weeks and pays taxes quarterly; so Allied's labor force and taxing authorities provide it with loans equal to its accrued wages and taxes. In addition to these "free" sources of short-term credit, Allied borrows from its bank on a short-term basis. These bank loans are shown as ____. Although accounts payable and accruals do not bear interest, Allied pays interest on funds obtained from the bank.

When Allied buys inventory items on credit, its suppliers, in effect, lend it the money used to finance the inventory items. Allied could have borrowed from its bank or sold stock to obtain the money, but it received the funds from its suppliers. These loans are shown as *accounts payable*, and they typically are "free" in the sense that they do not bear interest. Similarly, Allied pays its workers every two weeks and pays taxes quarterly; so Allied's labor force and taxing authorities provide it with loans equal to its accrued wages and taxes. In addition to these "free" sources of short-term credit, Allied borrows from its bank on a short-term basis. These bank loans are shown as *notes payable*. Although accounts payable and accruals do not bear interest, Allied pays interest on funds obtained from the bank.

When analyzing a Statement of Cash Flows, what are "healthy" or desireable cash flows in each section of the report?

When analyzing a Statement of Cash Flows, you want to see the follow cash flows in each section: *Section I - Operating Activities:* In the long-run, Section I needs to show *positive operating cash flows* *Section II - Longer-Term Investing Activities:* We would expect Section II to show expenditures on fixed assets that are about equal to: a. its depreciation charges (to replace worn out fixed assets), along with b. some additional expenditures to provide for growth *Section III - Financing Activities:* Section III would normally show some net borrowing in addition to a 'reasonable" amount of dividends *Section IV - Summary:* Section IV should show a reasonably stable year-to-cash year balance

When the investor is a corporation, the tax factor favors ____ investments.

When the investor is a corporation, the tax factor favors *stock* investments.

With Stockholders' Equity: *a.* [Common Stock - Retained Earnings] = [Total Assets + Total Liabilities] *b.* [Common Stock + Retained Earnings] = [Total Assets - Total Liabilities] *c.* [Common Stock - Retained Earnings] = [Total Assets - Total Liabilities] *d.* Retained Earnings = [Total Assets - Total Liabilities] *e.* Retained Earnings = [Total Assets + Total Liabilities]

With Stockholders' Equity: *b.* [Common Stock + Retained Earnings] = [Total Assets - Total Liabilities] Common Stock + Retained Earnings *must equal* Total Assets - Total Liabilities

A ____ is a statement of a firm's financial position at a specific point in time. a. balance sheet b. income statement c. statement of cash flows d. statement of stockholders' equities

a. balance sheet A *balance sheet* is a statement of a firm's financial position at a specific point in time.

The ____ shows what assets the company owns and who has claims on those assets as of a given date—for example, December 31, 2015. a. balance sheet b. income statement c. statement of cash flows d. statement of stockholders' equity

a. balance sheet The *balance sheet* shows what assets the company owns and who has claims on those assets as of a given date—for example, December 31, 2015.

The ____ shows the firm's sales and costs (and thus profits) during some past period—for example, 2015. a. balance sheet b. income statement c. statement of cash flows d. statement of stockholders' equity

b. income statement The *income statement* shows the firm's sales and costs (and thus profits) during some past period—for example, 2015.

The ____ shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash. a. balance sheet b. income statement c. statement of cash flows d. statement of stockholders' equity

c. statement of cash flows The *statement of cash flows* shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash.

The ____ shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year. a. balance sheet b. income statement c. statement of cash flows d. statement of stockholders' equity

d. statement of stockholders' equity The *statement of stockholders' equity* shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year.

What is the formula for net operating working capital (NOWC)?

net operating working capital (NOWC) = Current assets - (Current liabilities - Notes payable)