MBA 620, Financial Management (Chapter #1 Review)

During 2016, Acadia Inc. earned net income of $500,000. The firm increased its accounts receivable during the year by $150,000. The book value of its assets declined by an amount equal to the year's depreciation charge, or $130,000, and the market value of its assets increased by $25,000. Based only on this information, how much cash did Acadia generate during the year?

Acadia Inc. generated $480,000 of cash during 2016. The $500,000 net income ignores the fact that accounts receivable rose $150,000, a use of cash. It also treats $130,000 depreciation as an expense, whereas it is a noncash charge. The $25,000 increase in market value of assets adds to the market value of the business, but is not a cash flow. The final calculation is: $500,000 (accounting income) + $130,000 (depreciation) -$150,000 (increase in accounts receivables) = $480,000 (cash generated)

Briefly explain how the following transaction would affect a company's balance sheet. Sale of merchandise for $120,000 on credit

Accounts receivable rise $120,000; inventory falls; accrued taxes, owners' equity, and possibly other cost categories rise such that the algebraic sum equals $120,000

Why are financial statements constructed on an accrual basis rather than a cash basis when cash accounting is so much easier to understand?

An accountant's primary goal is to measure earnings and not cash generated. Earnings are viewed as a fundamental indicator of viability, not cash generation. Over the long term, successful companies must be both profitable and solvent. In addition to maintaining financial gains via sales, they need cash in the bank to pay their bills when due. This necessitates evaluation of earnings and cash flows.

Starbucks Corporation recently had a market value of equity of $90 billion and 1.5 billion shares outstanding. The book value of its equity is $6 billion. 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 issuance of 25 million shares of common stock? What would its price per share be?

At $60 per share, Starbucks would raise $1.5 billion. Thus, the market value should rise by $1.5 billion. The sale increases company cash by $1.5 billion and raises the value of the firm by the same amount. The new market value should be $91.5 billion. The price per share would remain $60 ($91.5 billion/1.525 billion shares). However, such equity sales often cause investors to be less optimistic about the firm's future performance and thus generate negative price effects at the time of announcement.

Briefly explain how the following transaction would affect a company's balance sheet. A firm's repurchase of 10,000 shares of its own stock at a price of $24 per share

Cash falls $240,000; owners' equity falls by $240,000 (via an increase in treasury stock)

Briefly explain how the following transaction would affect a company's balance sheet. A $40,000 payment to trade creditors

Cash falls $40,000; accounts payable falls $40,000

Briefly explain how the following transaction would affect a company's balance sheet. A dividend payment to shareholders for $50,000

Cash falls $50,000; owners' equity falls by $50,000 (via retained earnings)

Briefly explain how the following transaction would affect a company's balance sheet. Sale of used equipment with a book value of $300,000 for $500,000 cash

Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000

Briefly explain how the following transaction would affect a company's balance sheet. Sale of merchandise for $80,000 in cash

Cash rises $80,000; inventory falls; accrued taxes, owners' equity, and possibly other cost categories rise such that the algebraic sum equals $80,000

True or false: It is impossible for a firm to have a negative book value of equity without the firm going into bankruptcy.

False Book value of equity is simply the "plug" number that makes the book value of assets equal to the sum of the book value of liabilities and the book value of equity. If the book value of liabilities is greater than the book value of assets, then book value of equity must be negative. This does not necessarily determine bankruptcy, as it occurs when a firm cannot pay its bills in a timely manner and creditors force it to seek, or it voluntarily seeks, court protection.

True or false: 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.

True or false: 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, 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.

True or false: 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.

True or false: A reduction is an asset account is a use of cash, while a reduction in a liability account is a source of cash.

False The opposite of this statement is true. As 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. Therefore, decreases in liability accounts are uses of cash.

True or false: A company's market value of equity must always be higher than its book value of equity.

False This is typical, but it is not always the case. For example, if a company's business strategy is outdated and its assets are obsolete, it may have a market value of equity below book value.

Braintree Corporation has $5 billion in assets, $4 billion in equity, and earned a profit of $100 million last year as the economy boomed. Senior management proposes paying themselves a large cash bonus in recognition of their performance. As a member of Braintree's board of directors, how would you respond to this proposal?

Management is either dumb or thinks its board is. Earning $100 million on a $4 billion equity investment is a return of 2.5 percent, a figure well below any reasonable cost of equity. As a board member, I would vote to cut management's compensation, not raise it. I would also criticize them sharply for apparently attempting to deceive the board.

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. Conversely, early-stage firms, rapidly growing firms, and those in financial distress typically have positive cash flows from financing activities.

Briefly explain how the following transaction would affect a company's balance sheet. Purchase of a new building for $60 million cash

Net plant and equipment rises $60 million; cash falls $60 million

Briefly explain how the following transaction would affect a company's balance sheet. Purchase of a new $80 million building, financed 40% with cash and 60% with a bank loan

Net plant and equipment rises $80 million; cash falls $32 million; bank debt rises $48 million

Starbucks Corporation recently had a market value of equity of $90 billion and 1.5 billion shares outstanding. The book value of its equity is $6 billion. 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 of 25 million shares?

Stock price per share = $90 billion/1.5 billion shares = $60 per share 25,000,000 shares x $60 per share = $1,500,000,000 Investors do not change their perceptions of the firm because nothing else has changed. Additionally, since there are no taxes or transaction costs, the market value should fall by exactly the amount of cash paid in the transaction. The new market value should be $88.5 billion. The repurchase of shares will reduce cash by $1.5 billion or increase liabilities by the same amount if they finance the repurchase with debt. Either way, the firm is worth $1.5 billion less to owners after repurchase, or $88.5 billion. With 1.475 billion shares outstanding after repurchase, the price per share remains $60 ($88.5 billion/1.475 billion shares). However, share repurchases often have a positive price effect at the time of announcement.

Starbucks Corporation recently had a market value of equity of $90 billion and 1.5 billion shares outstanding. The book value of its equity is $6 billion. If the company repurchases 25 million shares in the stock market at their current price, how will this affect the book value of equity if all else remains the same?

Stock price per share = $90 billion/1.5 billion shares = $60 per share 25,000,000 shares x $60 per share = $1,500,000,000 Starbucks would pay $60 per share for the 25 million shares it repurchases. This reduces the book value of equity by $1.5 billion. Assuming all else remains the same, the new book value would be $4.5 billion.

Starbucks Corporation recently had a market value of equity of $90 billion and 1.5 billion shares outstanding. The book value of its equity is $6 billion. What is Starbucks' stock price per share? What is its book value per share?

Stock price per share = $90 billion/1.5 billion shares = $60 per share Book value per share = $6 billion/1.5 billion shares = $4 per share

Starbucks Corporation recently had a market value of equity of $90 billion and 1.5 billion shares outstanding. The book value of its equity is $6 billion. Instead of a share repurchase, the company decides to raise money by selling an additional 25 million 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?

Stock price per share = $90 billion/1.5 billion shares = $60 per share Shares outstanding would increase by 25 million shares. At $60 per share, Starbucks would raise $1.5 billion. Assuming all else remains the same, the new book value of equity will be $7.5 billion ($6 billion + $1.5 billion).

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 efforts of union employees. 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%. This is poor performance and it is too low for the company to continue attracting new investment necessary for growth. The company is certainly not covering its cost of equity.

Jonathan is currently a brew master for Acme Brewery. He really enjoys his job, but is intrigued by the prospect of quitting and starting his own brewery. He currently makes $62,000 at Acme Brewery. Jonathan anticipates that his new brewery will have annual revenues of $230,000 and total annual expenses for operating the brewery, outside of any payments to Jonathan, will be $190,000. Jonathan comes to you with his idea. He believes that he would be equally happy with either option, but that starting his own brewery is the right decision in light of its profitability. Do you agree with him? Why or why not?

The accounting profits from Jonathan's brewery are expected to be $40,000. These accounting profits do not include the implicit cost of the entrepreneur's time. Jonathan's time is worth at least $62,000, the current income he will have to forego to manage the brewery. When these implicit opportunity costs are included net income falls to: $230,000 - $190,000 - $62,000 = -$22,000 This new venture will reduce Jonathan's income, not increase it.

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

This means that the company's investing activities consumed cash, that the company purchased more property, plant, equipment, or marketable securities than it disposed of during the year. For most growing, stable companies, cash flows from investing activities are negative as firms build production capacity and replace used equipment. 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.

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?

This means that the company's operating activities consumed cash. A combination of two things can cause this: operating losses, and increases in accounts receivables and inventories. Operating losses can obviously be dangerous. Rising receivables and inventories are not dangerous if they increase simultaneously with sales and the company is able to finance cash shortfalls. Rising receivables and inventories relative to sales suggest slackening management control of important operating assets which is potentially dangerous.

After returning from a property management seminar, an employee for a real estate investment company recommends that the firm adopt an end-of-year policy of always selling properties that have risen in value since purchase and retaining properties that have fallen in value. The employee explains that with this policy the company will never show a loss on its real estate investment activities. Do you agree with this employee? Why or why not?

Too many companies have tried this. If the market value of a piece of land falls, the owner loses whether he sells or not. The market price of land falls because people think the future income stream to the owners is worth less. Continuing to hold the property forces the owner to accept the lower income. Whether the loss is recognized or not might affect accounting earnings, but has nothing to do with reality. Importantly, accounting income is the value of parcels sold, less their original purchase price, while economic income is the increase in market value of land, whether sold or not, over the period.

True or false: It is possible to construct a sources and uses statement for 2017 if you have a company's balance sheet for year-end 2016 and 2017.

True By comparing a balance sheet from the beginning of 2017 (year-end 2016) with a balance sheet from the end of 2017, it is possible to construct a sources and uses statement for 2017.