Chapter 3 Questions/HW

You have just been hired as a financial analyst for Basel Industries. Unfortunately, company headquarters (where all records are kept) has burned down. You need to recreate the cash flow statement for the year just ended. The firm had $1,000,000 in the bank at the end of the prior year and its working capital accounts except cash remained constant during the year. It earned $5 million in net income during the year but paid $75,000 in dividends to common shareholders. Throughout the year, the firm purchased $5.5 million of machinery. The annual depreciation expense for the year is $450,000, but the purchase price for the machinery represents addition to property, plant, and equipment before depreciation. Finally, you find a long term debt of $1 million at a 6% interest rate. What is the firm's end of year cash balance? Recreate the firm's cash flow statement to arrive at your answer.

$300,000

What are some of the basic users of financial statements and how do they use them?

3-2 Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or in which to invest, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way.

IF a "typical" fit reports $20 million of retained earnings on its balance sheets, could its directors declare a $20 million cash dividend without having any qualms about what they were doing?

3-3 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 over its life. Consequently, the $20 million would be an investment in all of the firm's assets.

Explain: Although the balance sheet can be thought of as a snapshot of a firms financial position at a point in time, the income state meant reports on operations over a period of time

3-4 The balance sheet shows the firm's financial position on a specific date, for example, December 31, 2012. 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, 2012. 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, 2012, would represent the firm's sales over the period from January 1, 2012, through December 31, 2012, not just sales for December 31, 2012.

Can a company have neg. cash flow and still be highly valued bit investors?

3-8 Yes. Negative free cash flow is not necessarily bad. Most rapidly growing companies have negative free cash flows because the fixed assets and working capital needed to support rapid growth generally exceed cash flows from existing operations. This is not bad, provided the new investments will eventually be profitable and they contribute to free cash flow.

How are managements actions incorporated iN EVA and MVA? How are EVA and MVA related?

3-9 MVA, the difference between book and market value, measures management's ability to maximize shareholder value. EVA accounts for the true economic profit of a firm, including the firm's cost of equity capital. When management invests in projects that return excess profit over the cost of debt and equity capital, EVA is positive. A positive EVA increases shareholder value and contributes to keeping MVA positive.

Over the years, McLaughlin Corporation's shareholders have provided $35,000,000 of capital, when they purchased new issues of stock and allowed management to retain some of the firm's earnings. The firm now has 2,000,000 shares of common stock outstanding, and the shares sell at a price of $30 per share. How much value has McLaughlin's management added to stockholder wealth over the years, i.e., what is their MVA?

Book value of equity = $35,000,000. Price per share (P0) = $30.00. Common shares outstanding = 2,000,000 shares. Market value of equity= P0 × Common shares outstanding = $30 × 2,000,000 = $60,000,000. MVA = Market value of equity - Book value of equity = $60,000,000 - $35,000,000 = $25,000,000.

What is free cash flow? Why might you be more interested in free cash flow than net income?

Free cash flow is the amount of cash that could be withdrawn from the firm without harming its ability to operate and to produce future cash flows. It is calculated as after-tax operating income plus depreciation less capital expenditures and the change in net operating working capital. It is more important than net income because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company's operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.

Financial stamens are based on GAAP and are audited by CPS firms. Do investors need to worry about validity of these statements?

Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legitimate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting practices.

Pearson Brothers recently reported an EBITDA of 7.5 million and net income of 1.8 million. It had $2.0 million of interest expense, and its corporate tax rate was 40%. What was its charge for depreciation and amortization?

Step 1: (EBITDA - Depreciation)= NI / (1 - Tax Rate)= 1.8 / (1 - .4)= 3 Step 2: (EBITDA- Depreciation)= EBITDA - Depreciation - Interest 3= 7.5- D - 2 D= $2.5 million

In its most recent financial statements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends were paid to shareholders during the year?

Step 1: 810-780=30 Step 2: 50-30=20 $20 million in dividends

Little Books Inc. recently reported $3 million of net income. Its EBIT was $6 million, and its tax rate was 40%. What was its interest expense?

Step 1: EBT= (Net income / .6), 3/.6=5 Step 2: EBT= EBIT- Interest 5= 6- I I= $1 million interest expense

Britton Industries has operating income for the year of $3,000,000 and a 40% tax rate. Its total invested capital is $20,000,000 and its after-tax percentage cost of capital is 8%. What is the firm's EVA?

Step 1: Economic Value Added (EVA)= Operating Income (1-Tax Rate) - Invested Capital x After Tax Percentage Cost of Capital Step 2: EVA= $3,000,000 (1-.40) - $20,000,000 x .08 Step 3: $1,456,000

Computer World Inc. paid out $22.5 million in total common dividends and reported $278.9 million of retained earnings at year-end. The prior year's retained earnings were $212.3 million. What was the net income? Assume that all dividends declared were actually paid.

Step 1: Ending R/E = Beg. R/E + Net income - Dividends Step 2: $278,900,000 = $212,300,000 + Net income -$22,500,000 Step 3: $278,900,000 = $189,800,000 + Net income Step 4: Net income = $89,100,000

Henderson Industries has $500 million of common equity on its balance sheet; its stock price is $60 per share, and its Market Value Added (MVA) is $130 million. How many common shares are currently outstanding?

Step 1: MVA= P0* # common of shares - BV of equity Step 2: 130= 60x - 500 Step 3: x= 10500 common shares

For 2014, Everyday Electronics reported $22.5 million of sales and $18 million of operating costs (including depreciation). The company has $15 million of total invested capital. Its after tax cost of capital is 9% and its federal-plus-state income tax rate was 35%. What was the firm's Economic Value Added (EVA)? That is, how much value did management add to stockholder's wealth during 2014?

Step 1: Tax rate is 35%, WACC is 9%, Investor-supplied operating capital is $15,000,000 Step 2: (Sales) $22,500,000 - $18,000,000 (Operating costs including depreciation) = EBIT of $4,500,000 Step 3: EVA= (EBIT)(1 - T) − (Operating Capital)(WACC) = $4,500,000(0.65) - ($15,000,000)(0.09) = $2,925,000 − $1,350,000 = $1,575,000

Which of the following actions are most likely to directly increase cash as shown on a firm's balance sheet? Explain. a) It issues $2 million of new common stock b) It buys new plant and equipment at a cost of $3 million c) It reports a large loss for the year d) It increases the dividends paid on its common stock

a) Increase b) Decrease c) Decrease, but a possible increase if the firm receives a tax refund for the prior year d) Decrease

W.C. Cycling had $55,000 in cash at year-end 2013 and $25,000 in cash at year-end 2014. The firm invested in property, plant, and equipment totaling $250,000. Cash flow from financing activities totaled +$170,000. a) What was the cash flow from operating activities? b) If accruals increased by $25,000, receivables and inventories increased by $100,000, and depreciation and amortization totaled $10,000, what is the firm's net income?

a) Step 1: 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 of -$30,000 Step 2: 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 = change in cash CF from operations + $250,000 + $170,000 = -$30,000 CF from operations = $50,000.

What four financial statements are contained in most annual reports?

he four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows.