Ch 2.2

Book Value of Equity

"Total stockholders' equity".

EBITDA calculation

-EBITDA = EBIT(income loss from operations,IS) + Depreciation & Amortization(CF) -

A firm has a substantial amount of excess cash invested in money market accounts. Which of the following events will not cause a firm's interest income to fall?

A maturing bond issue is refinanced at a higher interest rate. -If interest rates drop the invested cash will earn a lower return. If stock is repurchased the funds spent will no longer earn interest income. The same is true if the funds were spent on land. This would also lead to less interest income. The best answer to the question is the refinanced bond. A higher interest rate will result in a higher interest expense. It will not directly cause the firm's interest income to decrease.

prepaid expense

A prepaid expense refers to the payment for goods or services to be provided at a future date. The expense is recorded as a current asset initially then expensed as the benefit is received. Accrued expenses refer to expenses incurred, but not recognized as cash has not yet been paid. Amortization refers to the expensing of the value of intangible assets over time.

A bakery uses peanut butter as a raw ingredient to make peanut butter cookies. On its financial reports, it allocates peanut butter to the peanut butter cookie product line. For purposes of reporting on this line, peanut butter is considered what type of expense?

A variable expense is tied to the volume of goods produced. A fixed expense is incurred regardless of volume. Peanut butter is a variable expense. Since it is tracked to the cookie product line, peanut butter is a direct expense of this line. The more peanut butter cookies the bakery makes, the more peanut butter it will use.

Company A is growing faster than Company B II. Company A's EBITDA margin is increasing III. Company A would likely trade at a higher multiple than Company B (Ex 24)

Company A's sales growth rate from 2010 to 2011 is 25%, while Company B's sales growth rate from 2010 to 2011 is 12.5%. At the same time, Company A's EBITDA margin (EBITDA / Sales) is increasing from 25% in 2010 to 30% in 2011, while Company B's EBITDA margin is decreasing from 22.5% to 22.2% from 2010 to 2011. As Company A has a stronger growth and cash flow profile than Company B, it should trade at a higher multiple, despite Company B's larger size. Leverage is impossible to distinguish based on the sales and EBITDA information provided.

A company declares a dividend. Which of following occurs on the balance sheet:

Dividends Payable increases Retained Earnings decreases

EBITDA

EBITDA is a non-GAAP financial metric. -firm's financial structure does not influence the calculation of its EBITDA. -EBITDA measures performance by adding back to Net Income, interest expense, tax expense, amortization expense and depreciation expense. -is used by many as a proxy for cash flow it misses out on capturing the changes in the net working capital accounts such as accounts receivable, inventory and accounts payable.

Interest coverage

EBITDA/Interest Expense (from IS)

In times of rising inflation in inventory costs, which of the following methods of valuing inventory will result in the largest reported gross profit?

FIFO means "first-in-first-out" so the oldest inventory is considered to be sold first. This inventory will have the lowest cost basis in inflationary times. Therefore, the firm will report (and pay tax on) higher gross profit due to lower cost of goods sold. LIFO (last-in-first-out) assumes the most recent inventory (highest cost) is sold first.

ABC Corp. is acquiring 100% of NCE Corp., paying $100,000. NCE Corp.'s balance sheet on the date of acquisition includes $50,000 of assets and $21,000 of liabilities. NCE's assets and liabilities on the balance sheet are fairly valued except for the real estate which is worth $40,000 more than what is listed on the balance sheet. How much goodwill should be placed on the acquirer's balance sheet?

Fair market value of Net Assets purchased is the $29,000 of book value plus the $40,000 additional value in the real estate = $69,000. Goodwill is the purchase price of $100,000 less the $69,000 fair value of net assets = $31,000.

SpencerCo purchases TargetCo for $500 million at the end of 2009. Assuming TargetCo has no debt, what is SpencerCo's new goodwill amount after completing the acquisition? 750M

Goodwill is created from the excess amount paid for a target over its existing book value. Hence, if the acquirer pays $500 million for a target's equity and that target has a book value of $250 million (as indicated by TargetCo's shareholders' equity), then the goodwill created is $250 million. Added to the acquirer's existing goodwill, this nets to total pro forma goodwill of $750 million.

Use the information in Exhibit 33 to answer the following question. Over the last twelve months Company B had cost of goods sold of $2.5 billion while Company D had cost of goods sold of $1.1 billion. Which of the following is true regarding the gross margin for the two companies?Company B's is higher than Company D's

Gross margin represents the profit remaining after cost of goods sold is subtracted from sales. To determine sales, the enterprise values for the two companies is divided by the EV/LTM Sales multiples, yielding $4.881 billion in sales and $2.091 billion in sales for companies B & D, respectively. Therefore, the gross profit for each company and gross margins are: Company B Gross Profit = $4.881 billion - $2.5 billion = $2.381 billion Gross Margin = $2.381 billion / $4.881 billion = 48.8% Company D Gross Profit = $2.091 billion - $1.1. billion = $990.91 million Gross Margin = $990.91 million / $2.091 billion = 47.4%

RTY Corp. owns a corporate headquarters which they acquired five years earlier. RTY sells this building on December 31, 2018, and receives a substantial amount of cash. Simultaneously RTY signs a thirty-year lease with the new buyer so they may utilize the building. What will be the impact of this sale leaseback on key financial measures in the year 2019?

II. RTY's depreciation expense will be lower in 2019 compared to 2018. III. RTY's EBITDA will be lower in 2019 compared to 2018. -If a company sells their asset and engages in a sale leaseback, future rent expense will be higher. Since rent expense is part of SGA, the EBITDA number will be lower. Because the company no longer owns the asset they will no longer record a depreciation expense.

Which statement is true about income statement margins

If COGS decreases in absolute dollars by more than operating expenses increase in absolute dollars, the company's operating margin should increase. -If sales increase the possibility exists that gross profit will increase and that EBIT will also increase, but there is no evidence that the gross profit margin or that the EBIT margin will increase. If sales decrease earnings could actually rise if enough expenses are eliminated. For example, if a company disposed of a losing division, sales would drop but earnings could actually increase. However, if COGS decreased by $3 and operating expenses increased by $1, EBIT would be $2 higher leading to a higher operating margin (EBIT/Sales).

On a day when AHJ Corp. stock is trading at $100 per share, the company executes a block trade, buying back 100,000 of their shares at $103. Assume the par value of the stock is $1 per share. AHJ repurchases the stock reserving the right to reissue the shares in the future. What would be the impact of this transaction on AHJ's balance sheet?

If a company repurchases their stock, it should be recorded at whatever price was paid, not what the fair market value of the stock might be. In this case, it would be $10,300,000. If the stock repurchased was going to be permanently retired, the par value (common stock line) would be reduced by $100,000 ($1 par x 100,000 shares) and the capital surplus line (APIC) would be reduced by $10,200,000 adding up to $10,300,000. Since the shares might be reissued one day, a negative equity account called "treasury stock" will be created for the $10,300,000.

If a company's taxable income is higher than its book- reported income what impact will it have on the company's financial statements? Deferred Tax asset

If a company's taxable income is higher than its book-reported income that will result in a deferred tax asset. This is because the company has the right to receive a future tax benefit. They will pay less taxes in the future. If the opposite were true and a company's book-reported income is higher than its taxable income, the company will be saving taxes. Conservative accounting principles forces the recording of a deferred tax liability signifying the taxes saved today will have to be paid to the government in future years.

While a company's operating profit margin has held steady at 15%, its net profit margin has declined from 8% to 3%. What factors possibly account for this pattern?

Increased taxes and interest costs -Operating margin = operating income/net sales. Operating income is the difference between operating revenues and operating expenses, and it can also be expressed as earnings before interest and taxes (EBIT). Net profit margin = net profit (after interest and taxes)/net sales. Operating margin and net profit margin both have the same denominator, net sales. The main differences in their numerators are interest and taxes, as cost of goods sold would impact both.

A company takes a $10 million goodwill impairment in one of its reporting units. This means that the value of goodwill previously carried on the books of the unit was

More than its fair value Goodwill impairments are required at the reporting unit level when the value carried on the books exceeds the fair value of the goodwill. Impairments must be charged off against net income and reported earnings.

GAAP financial metric on a company's income statement

Net income -Net income is a GAAP financial metric that represents the residual profit after all of a company's expenses have been netted out. Net income can also be viewed as the earnings available to equity holders once all of the company's obligations have been satisfied (e.g., to suppliers, vendors, service providers, employees, utilities, lessors, lenders, state and local treasuries). EBITDA (earnings before interest, taxes, depreciation and amortization) is an important measure of profitability. As EBITDA is a non-GAAP financial measure and typically not reported by public filers, it is generally calculated by taking EBIT (or operating income/profit as often reported on the income statement) and adding back the depreciation and amortization (D&A) as sourced from the cash flow statement. EBITDA is a widely used proxy for operating cash flow as it reflects the company's total cash operating costs for producing its products and services.

Which balance sheet accounts would be impacted when a corporation issues new stock to the public.

Par Value II. Additional paid in capital -When stock is issued, cash increases in the asset of the balance sheet. In order to balance the balance sheet the common stock line and the APIC line must also increase

ABC Corporation, a profitable company, uses the LIFO method to account for its inventory. During the current year inventory price levels have declined. This will serve to:

Raise ABC Corporation's gross profit this year. -This question is somewhat atypical. We expect a rising cost environment for a company using LIFO. This year prices are decreasing making the outcome the opposite of what we expect. This will cause the LIFO company to report higher profits and pay higher taxes. This causes a higher ending inventory which will serve to lower the cost of goods sold.

Z Corporation, a profitable company has a marginal tax rate of 40% and a current ratio of 1.2 During an inflationary period for inventory costs it switches its inventory method from FIFO to LIFO. The switch takes place on January 1, 2017. All else being equal, which statement is most probably true?

Reported Net Income for 2017 will be lower as a result of this switch -Switching to LIFO during an inflationary period will cause ending inventory values to be lower on the balance sheet. This will cause Cost of Goods Sold to be higher, causing Gross Profit to be lower. Despite saving taxes and lowering tax expense, the reported Net Income will also decrease. Since inventory will be lower on the balance sheet the reported current ratio will decrease. Since Net Income will now be less, so will EPS.

A company has 10 million common shares outstanding. It announces that it plans to increase its annual dividend payout by 50 cents per share. What will be the impact of this change on retained earnings over the next two years, compared to the former dividend payout rate?

Retained earnings will decrease by $10 million -Dividends paid out to shareholders reduce retained earnings dollar for dollar. So an increase in dividend payout of 50 cents per share x 10 million shares will reduce retained earnings by $5 million per year. The impact is cumulative, so retained earnings will be $10 million lower over two years, compared to keeping the former dividend rate.

Z Corporation, a profitable company, has a marginal tax rate of 40% and a current ratio of 1.2 During an inflationary period (related to inventory costs), it switches its inventory method from LIFO to FIFO. The switch takes place on January 1, 2017. All else being equal, which statement is most probably true?

Since a switch to FIFO is being made, inventory will once again be fairly valued at current costs rather than being shown at older lower costs. Cosmetically this will make the current assets higher which will push the current ratio higher. Switching back to FIFO will result in a tax cost during inflation, not a tax savings. It also will result in higher profit margins and higher net income.

A drone manufacturing company expects revenues to double in each of the next three years. Its gross revenue this year (year zero) is $10 million. Its fixed expenses are $5 million and its gross profit margin is 25%. Assuming fixed expenses stay constant, what will EBIT be in year 3?

Starting at $10 million in year zero, gross revenue will double three times, to $20 million in year 1, $40 million in year 2, and $80 million in year 3. Gross profit margin is 25% of $80 million = $20 million in year 3. Subtract fixed expenses of $5 million from $20 million = $15 million EBIT in year 3.

DFG Corp. sells a factory on December 1, 2017 and leases it back from its new owner. DFG then paid the entire proceeds of the sale to its shareholders as a dividend on December 31, 2017. How would DFG's debt to equity ratio be impacted by this series of events?

The debt to equity ratio would be negatively impacted. This is because the dividend would reduce both the asset and equity of the balance sheet. With less equity DFG's debt to equity ratio would deteriorate. Furthermore, once the lease is signed it would be capitalized adding additional debt to the balance sheet. In summary - more leverage and less equity will both have a negative impact on this ratio.

Which company would likely have the lowest Operating Leverage?

The pharmaceutical and software companies would have high R&D expenses and hence high fixed costs. Similarly, launching satellites is an expensive fixed cost. On the other hand, producing artisanal mayonnaise is likely to be labor intensive and therefore would have high variable costs. High operating leverage means high fixed costs.

Good Builders, Inc. buys a new dump truck for $50,000. The dump truck has a useful life of 10 years and a salvage value of $8,000. For accounting purposes, Good Builders, Inc. depreciates the dump truck on a straight line basis. For tax purposes, it uses a form of accelerated depreciation and books $21,000 of depreciation expense at the end of the fiscal year. Good Builders, Inc. has a marginal tax rate of 42% and an effective tax rate of 38%. Which of the following is true regarding the effect of these transactions as of the end of the fiscal year

Under straight-line depreciation, the annual depreciation = (purchase price - salvage value)/useful life = ($50,000 - $8,000)/10 years = $4,200. Since the company declares a greater depreciation expense for tax purposes, this will lead to lower declared income and lower taxes paid than it actually reports. As a result, this creates a deferred tax liability - the company will need the pay the difference at some point in the future. The amount of the deferred tax liability = (tax depreciation - accounting depreciation) x marginal tax rate = ($21,000 - $4,200) x 42% = $7,056. The effective tax rate is a blended rate that is not generally used when adjusting financial statements.

Earned surplus

cumulative earnings after dividends have been paid from net income

TYU Corp. manufacturers and sells handmade leather wallets. VBN Corp. develops and sells software used in on-line internet applications. Which statement is true about these two company's cost structures and the impact on profitability?

VBN has a high level of operating leverage. Accordingly, a spike in sales will lead to sign significantly higher net profit margins. -High levels of operating leverage exist when a firm's cost structure is primarily made up of fixed costs with low corresponding variable costs. VBN has high operating leverage. This means that for a $1 increase in sales, the net income of the firm will rise substantially because there is little variable cost (cost of goods sold) to reduce their profitability. TYU has low operating leverage, because a much higher portion of their costs consist of the labor and leather (cost of goods sold) each time a wallet is produced and sold.

straight line depreciation

assumes a uniform depreciation expense over the estimated useful life of an asset? -Depreciation expenses are typically scheduled over several years corresponding to the useful life of each of the company's respective asset classes. The straight-line depreciation method assumes a uniform depreciation expense over the estimated useful life of an asset. For example, an asset purchased for $100 million that is determined to have a ten-year useful life with no salvage value would be assumed to have an annual depreciation expense of $10 million per year for ten years. Most other depreciation methods fall under the category of accelerated depreciation, which assumes that an asset loses most of its value in the early years of its life (i.e., the asset is depreciated on an accelerated schedule allowing for greater deductions earlier on). The modified accelerated cost recovery system (MACRS) and double declining methods are both forms of accelerated depreciation.

Which one of these items is not added back to earnings to obtain EBITDA?

cash on the balance sheet -EBITDA is earnings before interest, taxes, depreciation and amortization. Two sub-components of interest expense are long-term debt cost and financing costs. Cash on the balance sheet does not impact EBITDA, which is derived from the income statement (not the balance sheet).

BS

displays a company's financial position at a point in time. It lists the assets, liabilities, and shareholders' equity balances as of the fiscal quarter or year end. The values for debt and equity reflected on the balance sheet are shown on a book value basis, as opposed to market value.

An increase in retained earnings would be reflected in which of the following balance sheet line-items?

shareholders' equity -Retained earnings are increased by net income less dividend distributions. They are a component of shareholders' equity. Noncontrolling interest refers to minority interest exerting no influence of the decisions or operations of a company. Current assets refer to assets that can be sold or can be reasonably expected to be sold within one year.