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Solution Manual For Finance: Applications and Theory, 5th Edition

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    Chapter 2 - Reviewing Financial Statements CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS q uestions LG 2 - 1 1 . List and describe the four major financial statements. The four basic financial statements are: 1. The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time. 2. The income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time — generally one year. 3. The statement of cash flows shows the firm’s cash flows over a given period of time. This statement reports the amounts of cash the firm generated and distributed during a particular time period. The bottom line on the statement of cash flows―the difference between cash sources and uses―equals the change in cash and marketable securities on the firm’s balance sheet from the previous year’s balance. 4. The statement of retained earnings provides additional details about changes in retained earnings during a reporting period. This financial statement reconciles net income earned during a given period minus any cash dividends paid within that period to the change in retained earnings between the beginning and ending of the period . LG 2 - 1 2 . On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items? a. earnings before taxes - income statement b. net plant and equipment - balance sheet c. increase in fixed assets - statement of cash flows d. gross profits - income statement e. balance of retained earnings, December 31, 20xx - statement of retained earnings and balance sheet f. common stock and paid - in surplus - balance sheet g. net cash flow from investing activities - statement of cash flows h. accrued wages and taxes – balance sheet i. increase in inventory - statement of cash flows LG 2 - 1 3 . What is the difference between current liabilities and long - term debt? Current liabilities constitute the firm’s obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long - term debt includes long - term loans and bonds with maturities of more than one year. LG 2 - 1 4 . How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet? Firm managers can choose the accounting method they use to record depreciation against their fixed assets. Two choices include the straight - line method and the modified accelerated cost recovery system (MACRS). Companies often calculate depreciation using MACRS when they figure the firm’s taxes and the straight - line method when reporting income to the firm’s

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    Chapter 2 - Reviewing Financial Statements stockholders. The MACRS method accelerates deprecation, which results in higher depreciation expenses, lower taxable income, and lower taxes in the early years of a project’s life. The straight - line method results in lower depreciation expenses, but also results in higher taxes in the early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will favor the MACRS depreciation method. LG 2 - 1 5. What is bonus depreciation? How did the Tax Cuts and Jobs Act of 2017 temporarily extend and modify bonus depreciation? Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition cost of qualifying assets as "bonus depreciation." This additional depreciation deduction was allowed to encourage business investment. However, bonus depreciation was a temporary provision; the rate would have been 50 percent in 2017, 40 percent in 2018, and 30 percent in 2019, before phasing out in 2020. The Tax Cuts and Jobs Act of 2017 extended and modified bonus depreciation, allowing businesses to immediately deduct 100 percent of the cost of eligible property in the year it is placed in service, through 2022. The amount of allowable bonus depreciation will then be phased down over four years: 80 percent will be allowed for property placed in service in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026. MACRS or straight - line depreciation is applied to any costs that do not qualify for bonus depreciation. LG2 - 1 6. What are the costs and benefits of holding liquid securities on a firm’s balance sheet? The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate little or no profits for a firm. For example, cash is the most liquid of all assets, but it earns little, if any, return for the firm. In contrast , fixed assets are illiquid, but provide the means to generate revenue. Thus, managers must consider the trade - off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than generating profits. LG 2 - 2 7 . Why can the book value and market value of a firm differ? A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what assets might be worth today if the firm were to sell them. Inflation and market forces make many assets worth more now than they were when the firm bought them. So in most cases, book values differ widely from the market values for the same assets — the amount that the assets would fetch if the firm actually sold them. For the firm’s current assets — those that mature within a year―the book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short - term assets into cash fairly quickly, so the book value of these assets is generally close to their market value. LG 2 - 2 8 . From a firm manager’s or investor’s point of view, which is more important―the book value of a firm or the market value of the firm?

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    Chapter 2 - Reviewing Financial Statements Balance sheet assets are listed at historical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firm’s assets. Similarly, the stockowners’ equity listed on the balance sheet generally differs from the true market value of the equity — in this case, the market value may be higher or lower than the value listed on the firm’s accounting books. So , financial managers and investors often find that balance sheet values are not always the most relevant numbers. LG 2 - 3 9 . How did the Tax Cuts and Jobs Act of 2017 change corporate tax laws? The Tax Cuts and Jobs Act (TCJA) of 2017 is the most recent revision of corporate tax laws and represents one of the most significant changes in more than 30 years. The Act permanently lowers corporate taxes from a progressive schedule that saw tax rates as high as 35 percent to a flat 21 percent starting in 2018. LG 2 - 3 10 . What i s the difference between an average tax rate and a marginal tax rate? A firm can figure the average tax rate as the percentage of each dollar of taxable income that the firm pays in taxes. From your economics classes, you can probably guess that the firm’s marginal tax rate is the amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns. LG2 - 3 11 . How did the Tax Cuts and Jobs Act of 2017 change the tax deductibility of corporate interest in debt ? The Tax Cuts and Jobs Act of 2017 c ontains a new limitation on the deductibility of net interest expense (interest expense minus interest income) that exceeds 30 percent of a firm’s “adjusted taxable income” starting in 2018. For tax years beginning before January 1, 2022, “adjusted taxable income” is measured as a business’ EBITDA. For subsequent tax years, “adjusted taxable income” is measured as EBIT, no longer including an add - back for depreciation and amortization. Thus, beginning in 2022, the new limitation will become more severe. Prior corporate tax laws generally allowed full deduction of interest paid or accrued by businesses. LG 2 - 3 1 2 . How does the payment of interest on debt affect the amount of taxes the firm must pay? Corporate interest payments appear on the balance sheet as an expense item, so we deduct the allowable portion of interest payments from operating income when the firm calculates taxable income. But, any dividends paid by corporations to their shareholders are not tax deductible. This is one factor that encourages managers to finance projects with debt financing rather than to sell more stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses mainly equity financing. The equity - financed firm will have very little interest expense to deduct for tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt - financed firm. The debt - financed firm will pay fewer taxes and be able to pay more of its operating income to asset funders, i.e., its bondholders and stockholders . So , as long as interest on debt is under the 30 percent allowable cap for tax deduction, even stockholders prefer that firms finance assets primarily with debt rather than with stock.

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    Chapter 2 - Reviewing Financial Statements LG 2 - 4 1 3 . The income statement is prepared using GAAP. How does this affect the reported revenue and expense measures listed on the balance sheet? Company accountants must prepare firm income statem ents following GAAP principles. GAAP procedures require that the firm recognize revenue at the time of sale, but sometimes the company receives the cash before or after the time of sale. Likewise, GAAP counsels the firm to show production and other expenses on the balance sheet as the sales of those goods take place. So production and other expenses associated with a particular product’s sale only appear on the income statement (for example, cost of goods sold and depreciation) when that product sells. Of course, just as with the revenue recognition, actual cash outflows incurred with production may occur at a very different point in time — usually much earlier than GAAP principles allow the firm to formally recognize the expenses. Further, income statements contain several non - cash entries , the largest of which is depreciation. Depreciation attempts to capture the non - cash expense incurred as fixed assets deteriorate from the time of purchase to the point when those assets must be replaced. Let’s illustrate the effect of depreciation: Suppose a firm purchases a machine for $100,000. The machine has an expected life of five years and at the end of those five years, the machine will have no expected salvage value. The firm lays out a $100,000 cash outflow at the time of purchase. But the entire $100,000 does not appear on the income statement in the year that the firm purchases the machine — in accounting terms, the machine is not expensed in the year of purchase. Rather, if the firm’s accounting department uses the straight - line depreciation method, it deducts only $100,000/5 , or $20,000 , each year as an expense. This $20,000 equipment expense is not a cash outflow for the firm. The person in charge of buying the machine knows that the cash flow occurred at the time of purchase — and it totaled $100,000 rather than $20,000. So, figures shown on an income statement may not represent the actual cash inflows and outflows for a firm during a particular period. LG 2 - 4 1 4 . Why do financial managers and investors find cash flow s to be more important than accounting profit? Financial managers and investors are far more interested in actual cash flows than they are in the somewhat artificial, backward - looking accounting profit listed on the income statement. This is a very important distinction between the accounting point of view and the finance point of view. Finance professionals know that the firm needs cash, not accounting profit, to pay the firm’s obligations as they come due, to fund the firm’s operations and growth, and to compensate the firm’s ultimate owners: its shareholders. Thus, the statement of cash flows is a financial statement that shows the firm’s cash flows over a given period of time. This statement reports the amounts of cash that the firm generated and distributed during a particular time period. LG 2 - 5 1 5 . Which of the following activities result in an increase (decrease) in a firm’s cash? a. D ecrease fixed assets – increase in cash b. D ecrease accounts payable – decrease in cash c. P ay dividends – decrease in cash d. S ell common stock – increase in cash e. D ecrease accounts receivable – increase in cash

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    Chapter 2 - Reviewing Financial Statements f. I ncrease notes payable – increase in cash LG 2 - 5 1 6 . What is the difference between cash flow s from operating activities, cash flow s from investing activities, and cash flow s from financing activities? Cash flows from operations are those cash inflows and outflows that result directly from producing and selling the firm’s products. These cash flows include: net income, depreciation, and working capital accounts other than cash and operations - related short - term debt. Cash flows from investing activities are cash flows associated with buying or selling of fixed or other long - term assets. This section of the statement of cash flows shows cash inflows and outflows from long - term investing activities — most significantly the firm’s investment in fixed assets. Cash flows from financing activities are cash flows that result from debt and equity financing transactions. These include raising cash by: i ssuing short - term debt, issuing long - ter m debt, issuing stock, using cash to pay dividends, using cash to pay off debt, and using cash to buy back stock. LG 2 - 5 1 7 . What are free cash flows for a firm? What does it mean when a firm’s free cash flow is negative? Free cash flows are the cash flows available to pay the firm’s stockholders and debtholders after the firm has made the necessary working capital investments, fixed asset investments, and developed the necessary new products to sustain the firm’s ongoing operations. If free cash flow is negative, the firm's operations produce no cash flows available for investors. LG 2 - 6 1 8 . What is earnings management? Managers and financial analysts have recognized for years that firms use considerable latitude in using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed, within the GAAP framework, firms can “smooth” earnings. That is, firms often take steps to over - or understate earnings at various times. Managers may choose to smooth earnings to show investors that firm assets are growing steadily. Similarly, one firm may be using straight - line depreciation for its fixed assets, while another is using a modified accelerated cost recovery method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS accounting methods, its managers write fixed asset values down quickly; assets will thus have lower book value than if the firm used straight line depreciation methods. This process of controlling a firm’s earnings is called earnings management. LG 2 - 6 1 9 . What does the Sarbanes - Oxley Act require of firm managers? The Sarbanes - Oxley Act, passed in June 2002, requires public companies to ensure that their corporate boards’ audit committees have considerable experience applying generally accepted accounting principles (GAAP) for financial statements. The Act also requires that any firm’s senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm’s financial condition during the period covered. If a firm’s board of directors or senior managers fails to comply with Sarbanes - Oxley (SOX), the firm may be delisted from stock exchanges.

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    Chapter 2 - Reviewing Financial Statements p roblems b asic 2 - 1 Balance Sheet You are evaluating the balance sheet for Goodman’s Bees Corporation. p roblems From the balance sheet you find the following balances: cash and marketable securities = LG 2 - 1 $400,000, a ccounts receivable = $1,200,000, i nventory = $2,100,000, a ccrued wages and taxes = $500,000, a ccounts payable = $800,000, and n otes payable = $600,000. Calculate Goodman Bee s’ net working capital. N et working capital = C urrent assets - C urrent liabilities. Goodman’s Bees ’ current assets = Cash and marketable securities = $400,000 Accounts receivable = 1,200,000 Inventory = 2,100,000 Total current assets $3,700,000 and current liabilities = Accrued wages and taxes = $500,000 Accounts payable = 800,000 Notes payable = 600,000 Total current liabilities $1,900,000 So the firm’s net working capital was $1,800,000 ($3,700,000 - $1,900,000). LG 2 - 1 2 - 2 Balance Sheet Casello Mowing & Landscaping’s year - end 20 21 balance sheet lists current assets of $435 , 2 00, fixed assets of $ 550 , 800, current liabilities of $416 , 6 00, and long - term debt of $ 314 , 5 00. Calculate Casello ’s total stockholders’ equity. Recall the balance sheet identity in Equation 2 - 1: Assets = Liabilities + Equity. Rearranging this equation: Equity = Assets – Liabilities. Thus, the balance sheets would appear as follows: Book value Book value Assets Liabilities and Equity Current assets $ 435,200 Current liabilities $ 416,600 Fixed assets 550,800 Long - term debt 314,500 Stockholders’ equity 2 54,900 Total $ 986,000 Total $ 986,000 LG 2 - 1 2 - 3 Income Statement The Fitness Studio , Inc.’s 20 21 income statement lists the following income and expenses: EBIT DA = $ 650 ,000, EBIT = $538,000, i nterest expense = $63,000, and n et income = $435,000. Calculate the 20 2 1 t axes reported on the income statement. With $650, 000 of EBITDA, The Fitness Studio is allowed to deduct $195,000 ($650,000 x 30 percent) in net interest expense. The recorded interest expense of $63,000 is under this limit and is thus all tax deductible. EBIT $538,000 Interest expense - 63,000 EBT $ 475,000

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    Chapter 2 - Reviewing Financial Statements Taxes - 40,000 Net income $435,000 LG 2 - 1 2 - 4 Income Statement The Fitness Studio , Inc.’s 20 2 1 income statement lists the following income and expenses: EBIT DA = $ 923 ,000, EBIT = $ 773 , 5 00, i nterest expense = $ 100 ,000, and t axes = $ 2 3 4 , 5 00. The firm has no preferred stock outstanding and 100,000 shares of common stock outstanding. Calculate the 20 1 8 earnings per share. With $ 923 , 000 of EBITDA, The Fitness Studio is allowed to deduct $ 276 , 9 00 ($ 923 ,000 x 30 percent) in net interest expense. The recorded interest expense of $100,000 is under this limit and is thus all tax deductible. EBIT $773,500 Interest expense - 100,000 EBT $ 673,500 Taxes - 234,500 Net income $439,000 Thus, $439,000 Earnings per share (EPS) = — —— ——— = $4.39 per share 100,000 shares LG 2 - 1 2 - 5 Income Statement Consider a firm with an EBIT of $850,000. The firm finances its assets with $2,500,000 debt (costing 7.5 percent and is all tax deductible ) and 400,000 shares of stock selling at $5.00 per share. To reduce firm’s risk associated with this financial leverage, the firm is considering reducing its debt by $1, 0 00,000 by selling an additional 200,000 shares of stock. The firm’s tax rate is 21 percent . The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $850,000. Calculate the change in the firm’s EPS from this change in capital structure. The EPS before and after this change in capital structure is illustrated below: Before capital structure change After capital structure change EBIT $850,000 $850,000 Less: Interest ($2,500,000 x 0.075) 187,500 ($1, 5 00,000 x 0.0 7 5) 112 , 5 00 EBT 662,500 7 3 7 , 5 00 Less: Taxes (21 %) 139 , 125 154 , 875 Net income $ 523 , 37 5 $ 582 , 625 Divide by # of shares 400,000 600,000 EPS $ 1.3084 $0. 9710 The change in capital structure would decrease the stockholders EPS by $0. 3374 . LG 2 - 1 2 - 6 Income Statement Consider a firm with an EBIT of $550,000. The firm finances its assets with $1,000,000 debt (costing 5.5 percent and is all tax deductible ) and 200,000 shares of stock selling at $12.00 per share. The firm is considering increasing its debt by $900,000, using the proceeds to buy back 75,000 shares of stock. The firm’s tax rate is 21 percent . The change in capital structure will have no effect on the operations of the firm. Th us, EBIT will remain at $5 50,000. Calculate the change in the firm’s EPS from this change in capital structure.

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    Chapter 2 - Reviewing Financial Statements The EPS before and after this change in capital structure is illustrated below: Before capital structure change After capital structure change EBIT $550,000 $550,000 Less: Interest ($1,000,000 x 0.055) 55,000 ($1,900,000 x 0.055) 104,500 EBT 495,000 445,500 Less: Taxes ( 21 %) 103 , 95 0 93 , 555 Net income $391,05 0 $ 351 , 945 Divide by # of shares 200,000 125,000 EPS $1. 9552 $2. 8156 The change in capital structure increases the stockholders EPS by $0. 8604 . LG 2 - 3 2 - 7 Corporate Taxes Oakdale Fashions, Inc., 2021 Income Statement is reported below. 2021 Net sales (all credit) $5 65,000 Less: Cost of goods sold 2 1 5 ,000 Gross profits 3 5 0 ,000 Less: Other operating expenses 9 0 ,000 Earnings before interest, taxes, depreciation, and amortization (EBITDA) 2 60,000 Less: Depreciation and amortization 1 5,000 Earnings before interest and taxes (EBIT) 245,000 Less: Interest 8 0,000 Earnings before taxes (EBT) 165,000 Less: Taxes Net income $ Determine the firm’s 2021 tax liability, net income, average tax rate, and marginal tax rate. (LG2 - 3) With $2 6 0,000 of EBITDA, Oakdale Fashions is allowed to deduct only $ 78 ,000 ($2 6 0,000 x 30 percent) of its $8 0 ,000 in net interest expense. Thus, Taxable income = EBIT – Allowable interest deduction = $245,000 - $78,000 = $167,000 Tax liability = 0.21x Taxable income = 0.21($167,000) = $35,070 The 30 percent cap on the allowable interest deduction results in an increase in Oakdale Fashions ’ tax liability of $420 (0.21($80,000 - $78,000)). Net income = EBT – Tax liability = $165,000 - $35,070 = $129,930 The average tax rate for Oakdale Fashions Inc. comes to: $ 35 , 07 0 Average tax rate = ———— = 2 1 . 00 % $167 ,000

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    Chapter 2 - Reviewing Financial Statements If Oakdale Fashions , Inc. earned $1 more of taxable income, it would pay 21 cents (its tax rate of 21 percent) more in taxes. Thus, th e firm’s marginal tax rate is 21 percent. LG 2 - 3 2 - 8 Corporate Taxes Everybody’s Fitness 2021 Income Statement is reported below (in millions of dollars). 2021 Net sales (all credit) $ 88 5 Less: Cost of goods sold 4 4 0 Gross profits 445 Less: Other operating expenses 2 1 5 Earnings before interest, taxes, depreciation, and amortization (EBITDA) 2 3 0 Less: Depreciation and amortization 5 2 Earnings before interest and taxes (EBIT) 1 7 8 Less: Interest 75 Earnings before taxes (EBT) 1 03 Less: Taxes Net income $ Determine the firm’s 2021 tax liability, net income, average tax rate, and marginal tax rate. (LG2 - 3) With $2 3 0 ,000 ,000 of EBITDA, Everybody’s Fitness is allowed to deduct only $ 69,000 ,000 ($2 3 0 ,000 ,000 x 30 percent) of its $ 75,000 ,000 in net interest expense. Thus, Taxable income = EBIT – Allowable interest deduction = $ 178,000 ,000 - $ 69,000 ,000 = $ 109,000 ,000 Tax liability = 0.21x Taxable income = 0.21($ 109,000 ,000) = $ 22 , 890,000 The 30 percent cap on the allowable interest deduction results in an increase in Everybody’s Fitness’ tax liability of $ 1, 2 60,00 0 (0.21($ 75,000 ,000 - $ 69,000 ,000)). Net income = EBT – Tax liability = $103,000,000 - $22,890,000 = $80,110,000 The average tax rate for Everybody’s Fitness comes to: $22,890,000 Average tax rate = —— —— —— = 2 1 . 00 % $109,000,000 If Oakdale Fashions , Inc. earned $1 more of taxable income, it would pay 21 cents (its tax rate of 21 percent) more in taxes. Thus, th e firm’s marginal tax rate is 21 percent. LG 2 - 3 2 - 9 Corporate Taxes Hunt Taxidermy, Inc. , is concerned about the taxes paid by the company in 20 21 . In addition to $ 42 . 4 million of taxa ble income, the firm received $2 , 9 75,000 of interest

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    Chapter 2 - Reviewing Financial Statements on state - issued bonds and $ 1,0 00,000 of dividends on common stock it owns in Oakdale Fashions, Inc. Calculate Hunt Taxidermy’s tax liability, average tax rate, and marginal tax rate. In this case, interest on the state - issued bonds is not taxable and should not be included in taxable income. Further, the first 50 percent of the dividends received from Oakdale Fashions is not taxable. Thus, only 50 percent of the dividends received are taxed, so: Taxable income = $42,400,000 + ( 0 . 5 )$1,000,000 = $42, 9 00,000 Now Hunt Taxidermy’s tax liability will be: Tax liability = 0 . 21 ($42, 9 00,000 ) = $ 9 , 00 9 , 000 The $1,000,000 of dividend income increased Hunt Taxidermy’s tax liability by $105,000 ( 0 . 5 x $1,000,000 x 0 . 21 ). Hunt Taxidermy’s resulting average tax rate is: Average tax rage = $ 9 , 00 9 , 000/$42, 9 00,000 = 21 .00% Finally, if Hunt Taxidermy earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21 percent) more in taxes. Thus, the firm’s marginal tax rate is 21 percent. LG2 - 3 2 - 10 Corporate Taxes Chapman & Power Inc., is concerned about the taxes paid by the company in 20 21 . In addition to $ 135,000,000 of taxa ble income, the firm received $15 ,5 00 ,000 of interest on state - issued bonds and $ 12,0 00,000 of dividends on common stock it owns in Hunt Taxidermy . Calculate Chapman & Power ’s tax liability, average tax rate, and marginal tax rate. In this case, interest on the state - issued bonds is not taxable and should not be included in taxable income. Further, the first 50 percent of the dividends received from Hunt Taxidermy is not taxable. Thus, only 50 percent of the dividends received are taxed, so: Taxable income = $ 135 , 0 00,000 + ( 0 . 5 )$1 2 ,000,000 = $ 1 4 1 , 0 00,000 Now Hunt Taxidermy’s tax liability will be: Tax liability = 0 . 21 ($ 1 4 1 , 0 00,000 ) = $ 29 , 610, 000 The $1 2 ,000,000 of dividend income increased Chapman & Power’s tax liability by $1 ,260 ,000 ( 0 . 5 x $1 2 ,000,000 x 0 . 21 ). Hunt Taxidermy’s resulting average tax rate is: Average tax rage = $ 29 , 610, 000/$ 1 4 1 , 0 00,000 = 21 .00% Finally, if Chapman & Power earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21 percent) more in taxes. Thus, the firm’s marginal tax rate is 21 percent. LG 2 - 4 2 - 11 Statement of Cash Flows Ramakrishnan Inc. reported 20 2 1 net income of $15 million and depreciation of $2,650,000. The top part of Ramakrishnan, Inc.’s 20 2 1 and 20 20 balance sheets is listed below (in millions of dollars). Current assets: 20 2 1 20 20 Current liabilities: 20 2 1 20 20 Cash and marketable Accrued wages and securities $ 20 $ 15 taxes $ 19 $ 18 Accounts receivable 84 75 Accounts payable 51 45 Inventory 121 110 Notes payable 45 40

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    Chapter 2 - Reviewing Financial Statements Total $225 $200 Total $115 $103 Calculate the 20 2 1 net cash flow from operating activitie s for Ramakrishnan, Inc. Cash Flows from Operating Activities Net income $15,000,000 Additions (sources of cash): Depreciation 2,650,000 Increase in accrued wages and taxes 1,000,000 Increase in accounts payable 6,000,000 Subtractions (uses of cash): Increase in accounts receivable - 9,000,000 Increase in inventory - 1 1,000,000 Net cash flow from operating activities: $4,650,000 LG 2 - 4 2 - 1 2 Statement of Cash Flows In 20 2 1 , Usher Sports Shop had cash flows from investing activities of - $ 4 , 364 ,000 and cash flows from financing activities of - $ 5 , 880 ,000. The balance in the firm’s cash account was $ 1,615 ,000 at the beginning of 20 2 1 and $1, 74 2,000 at the end of the year. Calculate Usher Sports Shop’s ca sh flow from operations for 20 2 1 . Net change in cash and marketable securities = $1,742,000 - $1,615,000 = $127,000 Cash f lows from o perating a ctivities = $10,371,000 Cash f lows from i nvesting a ctivities = - 4,364,000 Cash f lows from f inancing a ctivities = - 5,880,000 Net c hange in c ash and m arketable s ecurities = $127,000 LG 2 - 5 2 - 1 3 Free Cash Flow You are considering an investment in Fields and Struthers, Inc. , and want to evaluate the firm’s free cash flow. From the income statement, you see that Fields and Struthers earned an EBIT of $62 million, had a tax rate of 30 percent , and its depreciation expense was $5 million. Fields and Struthers’ gross fixed assets increased by $32 million from 20 20 to 20 20 . The firm’s current assets increased by $20 million and spontaneous current liabilities increased by $12 million. Calculate Fields and Struthers’ NOPAT, operating cash flow, investment in operating capital , and free cash flow for 20 21 . Fields and Struthers’ NOPAT was: NOPAT = EBIT(1 – Tax rate) = $62m.(1 – 0. 21 ) = $4 8.98 m. O perating cash flow for 20 21 was: OCF = NOPAT + Depreciation = $ 48.98 m. + $5m . = $ 53.98 m . Investment in operating capital for 20 21 was: IOC = ΔGross fixed assets + ΔNet operating working capital = $32m. + ($20m. - $12m.) = $40 m. Accordingly, Fields and Struthers’ free cash flow for 20 21 was: FCF = Operating cash flow – Investment in operating capital = $ 53.98 m. - $40m. = $ 13.98 m.

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    Chapter 2 - Reviewing Financial Statements In other words, in 20 21 , Fields and Struthers had cash flows of $ 13.98 million available to pay its stockholders and debtholders. LG 2 - 5 2 - 1 4 Free Cash Flow Tater and Pepper Corp. reported free cash flows for 20 21 of $3 9.1 million and investment in operating capital of $ 22.1 million. Tater and Pepper i ncurr ed $ 13.6 million in depreciation expense and paid $ 28.9 million in taxes on EBIT i n 20 21 . Calculate Tater and Pepper’s 20 21 EBIT. Tater and Pepper’s free cash flow for 20 21 was: FCF = Operating cash flow – Investment in operating capital $39.1m. = Operating cash flow - $22.1m. So, operating cash flow = $39.1m. + $22.1m. = $61.2m. Tater and Pepper’s operating cash flow was: OCF = EBIT(1 – Tax rate) + Depreciation = EBIT – Taxes on EBIT + Depreciation $61.2m. = EBIT – $28.9m. + $13.6m. So, EBIT = $61.2m. + $28.9m. - $13.6m. = $76.5m. LG 2 - 1 2 - 1 5 Statement of Retained Earnings Mr. Husker’s Tuxedos, Corp. began the year 20 21 with $256 million in retained earnings. The firm earned n et income of $33 million in 20 21 and paid dividends of $5 million to its preferred stockholders and $10 million to its common stockholders. What is the year - end 20 21 balance in retained earnings for Mr. Husker’s Tuxedos? The statement of retained earnings for 20 21 is as follows: Balance of retained earnings, December 31, 20 20 $256m. Plus: Net income for 20 21 33m. Less: Cash dividends paid Preferred stock $5m. Common stock 10m. Total cash dividends paid 15m. Balance of retained earnings, December 31, 20 21 $27 4 m. LG 2 - 1 2 - 1 6 Statement of Retained Earnings Use the following information to find dividends paid to common stockholders during 20 21 . Balance of r etained e arnings, December 31, 20 20 $462m. Plus: Net i ncome for 20 21 15m. Less: Cash d ividends p aid Preferred s tock $1m. Common s tock _6m. Total c ash d ividends p aid 7m. Balance of r etained e arnings, December 31, 20 21 $470m. Total c ash d ividends p aid = $ 470 m. - $ 1 5m. - $ 462 m. = - $ 7 m. Thus, common stock dividends paid = $ 7 m. - $ 1 m = $ 6 m. i ntermediate 2 - 1 7 Balance Sheet Mikey’s Bar and Grill has total assets of $15 million of which $5 million

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    Chapter 2 - Reviewing Financial Statements p roblems are current assets. Cash makes up 10 percent of the current assets and accounts receivable makes up another 40 percent of current assets. Mikey’s gross plant and equipment has a book value of $11.5 million and other long - term assets have a book value of $500,000. Using this information, what is the LG 2 - 1 balance of inventory and the balance of depreciation on Mikey’s Bar and Grill’s balance sheet? Current assets: (in millions) Cash and marketable securities $ 0.5 ( 0 .1 x $5) Accounts receivable 2.0 ( 0 .4 x $5) Inventory step 1. 2.5 ($5 - $0.5 - $2.0) Total $5.0 Fixed assets: Gross plant and equipment $11.5 Less: Depreciation step 4. 2.0 ($11.5 - $9.5) Net plant and equipment step 3. $9.5 ($10.0 - $0.5) Other long - term assets 0.5 Total step 2. $1 0.0 ($15.0 - $5.0) Total assets $ 1 5 . 0 LG 2 - 1 2 - 1 8 Balance Sheet Sophie ’s Tobacco Shop has total assets of $ 91.8 million. Fifty percent of these assets are financed with debt of which $ 28.9 million is current liabilities. The firm has no preferred stock , but the balance in common stock and paid - in surplus is $ 2 0.4 million. Using this information what is the balance for long - term debt and retained earnings on Sophie ’s Tobacco Shop’s balance sheet? (in millions) Total current liabilities $28.9 Long - term debt: step 3. 1 7.0 (= $ 45.9 - $ 28.9 ) Total debt: step 2. $ 45.9 (= 0 .5 x $ 91.8 ) Stockholders’ equity: Preferred stock $ 0.0 Common stock and paid - in surplus 20.4 (20 million shares) Retained earnings step 5. 2 5 .5 (= $ 45.9 - $2 0.4 ) Total step 4 $ 45.9 (= $ 91.8 - $ 45.9 ) Total liabilities and equity step 1. $ 91.8 (= Total Assets) LG 2 - 2 2 - 1 9 Market Value versus Book Value Muffin’s Masonry, Inc ’s balance sheet lists net fixed asset as $14 million. The fixed assets could currently be sold for $19 million. Muffin’s current balance sheet shows current liabilities of $5.5 million and net working capital of $4.5 million. If all the current accounts were liquidated today, the company would receive $7.25 million cash after paying the $5.5 million in current liabilities. What is the book value of Muffin’s Masonry’s assets today? What is the market value of these assets?

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    Chapter 2 - Reviewing Financial Statements BOOK MARKET VALUE VALUE Assets Current assets Step 1. $10m. Step 3. $12.75m. Fixed assets 14 m. 19.00 m. Total Step 2. $24m. Step 4. $ 31.75 m. Step 1. Net working capital (book value) = Current assets (book value) – Current liabilities (book value) = $4.5m. = Current assets (book value) - $5.5m. => Current assets (book value) = $4.5m. + $5.5m. = $10m. Step 2. Total assets (book value) = $10m. + $14m. = $24m. Step 3. Net working capital (market value) = Current assets (market value) – Current liabilities (market value) = $7.25m. = Current assets (market value) - $5.5m. => Current assets (market value) = $7.25m. + $5.5m. = $1 2.75 m. Step 4. Total assets (market value) = $12.75m. + $19m. = $ 31.75 m. LG 2 - 2 2 - 20 Market Value versus Book Value Ava’s SpinBall Corp. lists fixed assets of $12 million on its balance sheet. The firm’s fixed assets have recently been appraised at $16 million. Ava’s SpinBall Corp.’s balance sheet also lists current assets at $5 million. Current assets were appraised at $6 million. Current liabilities’ book and market values stand at $3 million and the firm’s book and market values of long - term debt are $7 million. Calculate the book and market values of the firm’s stockholders’ equity. Construct the book value and market value balance sheets for Ava’s SpinBall Corp. (LG2) Recall the balance sheet identity in Equation 2 - 1: Assets = Liabilities + Equity. Rearranging this equation: Equity = Assets – Liabilities. Thus, the balance sheets would appear as follows: BOOK MARKET BOOK MARKET VALUE VALUE VALUE VALUE Assets Liabilities and Equity Current assets $ 5m. $ 6m. Current liabilities $ 3m. $ 3m. Fixed assets 1 2m. 16 m. Long - term debt 7m. 7m. Stockholders’ equity 7 m . 1 2m. Total $17m. $22m. Total $17m. $22m. LG 2 - 1 2 - 21 Debt versus Equity Financing You are considering a stock investment in one of two firms ( NoEquity , Inc. , and NoDebt , Inc.), both of which operate in the same industry and have identical EBITDA of $37.7 million and operating income of $ 32 .5 million. NoEquity , Inc. , finances its $ 6 5 million in assets with $ 6 4 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $6 5 million in assets with no debt and $ 6 5 million in equity. Both firms pay a tax rate of 21 percent on their taxable income. Calculate the net income and return on asset - funders’ investment for the two firms. With $37.7 million of EBITDA AllDebt Inc., may deduct up to $11.31 million ($37.7 x 30 percent) of interest expense for tax purposes. Thus, AllDebt Inc., is allowed to deduct all of its interest expense. NoEquity NoDebt Operating income $32.500m $32.50 0 m Less: Interest ($64m. x 0 .1) 6 . 40 0 m 0 . 00 0 m Taxable income $26.10 0 m $32.50 0 m Less: Taxes ( 21 %) 5.481 m 6 . 825 m Net income $ 20 . 619 m $ 2 5 . 675 m

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    Chapter 2 - Reviewing Financial Statements Income available for asset funders $10.379m $25.675m (= Operating income - Taxes) Return on asset - funders’ investment $ 27.019 m/$65m = 41.57 % $2 5 . 6 75m/$65m = 3 9.5 0% LG 2 - 1 2 - 2 2 Debt versus Equity Financing You are considering a stock investment in one of two firms (AllDebt, Inc. , and AllEquity, Inc.), both of which operate in the same industry and have identical EBITDA of $ 14.7 million and operating income of $12.5 million. AllDebt, Inc. , finances its $25 million in assets with $24 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc. , finances its $25 million in assets with no debt and $25 million in equity. Both firms pay a tax rate of 21 percent on their taxable income. Calculate the income available to pay the asset funders (the debt holders and stockholders) and resulting return on asset - funders’ investment for the two firms. With $14.7 million of EBITDA AllDebt Inc., may deduct up to $4.41 million ($14.7 x 30 percent) of interest expense for tax purposes. Thus, AllDebt Inc., is allowed to deduct all of its interest expense. AllDebt AllEquity Operating income $12.50 0 m $12.50 0 m Less: Interest ($24m. x 0 .1) 2 . 40 0 m 0 . 0 0 0 m Taxable income $10.10 0 m $12.5 0 0m Less: Taxes ( 21 %) 2.121 m 2.625 m Net income $ 7 . 9 7 9 m $ 9 . 8 75 m Income available for asset funders $ 10.379m $9 . 8 75m (= Operating income - Taxes) Return on asset - funders’ investment $ 10.379 m./$25m. = 41.516 % $ 9.8 75m./$25m. = 3 9 . 5 0 0 % LG 2 - 1 2 - 2 3 Income Statement You have been given the following information for Corky’s Bedding Corp.: a. N et sales = $11,250,000 . b. Cost of goods sold = $7, 5 0 0,000. c. Othe r operating expenses = $250,000. d. A ddition to retained earnings = $1,000,000. e. D ividends paid to preferred and common stockholders = $495,000 . f. I nterest expense = $850,000 , all of which is tax deductible . The firm’s tax rate is 35 percent. Calculate the depreciation expense for Corky’s Bedding Corp. Net sales $11,250,000 Less: Cost of goods sold 7,500,000 Gross profits Step 4. $3, 7 50,000 Less: Other operating expenses 2 5 0,000 Earnings before interest, taxes, depreciation, and amortization (EBITDA) Step 5. $3 ,500,000 Less: Depreciation Step 6 . 350,000 Earnings before interest and taxes (EBIT) Step 3. $3 , 150 , 000 Less: Interest 850,000 Earnings before taxes (EBT) Step 2. $2, 3 00 , 000 Less: Taxes ( 21 %)

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    Chapter 2 - Reviewing Financial Statements Net income Step 1. $1, 817 ,000 Less: Common and preferred stock dividends $ 817 ,000 Addition to retained earnings $1,000,000 Step 1. Net income = Common and preferred stock dividends + Addition to retained earnings = $ 817 ,000 + $1,000,000 = $1, 817 ,000 Step 2. EBT (1 – Tax rate) = Net income => EBT = Net income/(1 – Tax rate) = $1, 817 ,000/(1 - 0 . 21 ) = $2, 3 00,000 Step 3. EBIT – Interest = EBT => EBIT = EBT + Interest = $2, 3 00 , 000 + $850,000 = $3 , 150 , 000 Step 4. Gross profits = Net sales – Cost of goods sold = $11,250,000 – 7,500,000 = $3, 7 50,000 Step 5. EBITDA = Gross profits – Other operating expenses = $3,750,000 – 250,000 = $3,5 0 0,000 Step 6 . EBITDA – Depreciation = EBIT => Depreciation = EBITDA – EBIT = $3,5 0 0,000 - $3 , 1 5 0 , 000 = $ 350 , 000 LG 2 - 1 2 - 2 4 Income Statement You have been given the following information for Moore’s HoneyBee Corp.: a. N et sales = $ 32 , 0 00,000 . b. G ross profit s = $ 18 , 7 00,000 . c. Other operating expenses = $2,500,000 . d. A ddition to retained earnings = $ 4 , 7 00,000 . e. D ividends paid to preferred and common stockholders = $ 2 , 9 00,000 . f. D epreciation expense = $ 2 , 8 00,000. The firm’s tax rate is 35 percent. The firm’s interest expense is all tax deductible. Calculate the cost of goods sold and the interest expense for Moore’s HoneyBee Corp. Net sales $32,000,000 Less: Cost of goods sold Step 1. 13 , 3 00,000 Gross profits $ 18 , 7 00,000 Less: Other operating expenses 2 , 5 0 0,000 Earnings before interest, taxes, depreciation, and amortization (EBITDA) Step 4 . $ 16 , 2 00,000 Less: Depreciation 2,800,000 Earnings before interest and taxes (EBIT) Step 5 . $ 13 , 400 , 000 Less: Interest Step 6 . 1 , 70 0 , 000 Earnings before taxes (EBT) Step 3. $ 11 , 700 , 000 Less: Taxes ( 21 %) Net income Step 2. $ 9 , 243 ,000 Less: Common and preferred stock dividends $ 2,900,000 Addition to retained earnings $ 6 , 343 ,000 Step 1. Net sales - Cost of goods sold = Gross profits => Cost of goods sold = Net sales – Gross Profits = $32,000,000 – $18,700,000 = $ 13 , 3 00,000 Step 2. Net income = Common and preferred stock dividends + Addition to retained earnings = $2,900,000 + $ 6 , 343 ,000 = $ 9 , 243 ,000 Step 3. EBT (1 – Tax rate) = Net income => EBT = Net income/(1 – Tax rate) = $ 9 , 243 ,000/(1 - 0 . 21 ) = $ 11 , 700 , 000 Step 4. EBITDA = Gross profits – Other operating expenses = $18,700,000 – 2,500,000 = $ 16 , 20 0,000 Step 5 . EBITDA – Depreciation = EBIT = $1 6 , 2 00,000 - $ 2 , 800 , 000 = $ 13 , 400 , 000 Step 6 . EBIT – Interest = EBT => Interest = EBIT - EBT = $ 13 , 400 , 000 - $11, 7000 , 000 = $ 1 , 70 0 , 000 LG 2 - 1 2 - 2 5 Income Statement Consider a firm with an EBITDA of $1,100,000 and an EBIT of $ 1, 00 0,000. The firm finances its assets with $ 4,5 00,000 debt (costing 8 percent , all of which is

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    Chapter 2 - Reviewing Financial Statements tax deductible ) and 200,000 shares of stock selling at $ 16 .00 per share. T o reduce risk associated with this financial leverage, t he firm is considering reducing its debt by $ 2,5 00,000 by selling additional shares of stock. The firm ’s tax rate is 21 percent . The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $ 1, 00 0,000. Calculate the change in the firm’s EPS from this change in capital structure. With $1,100,000 of EBITDA, the firm may deduct up to $330,000 ($1,100,000 x 30 percent) of interest expense for tax purposes. Thus, given the current capital structure, the firm may deduct only $330,000 of its $360,000 interest expense ($4,500,000 x 0.0 8 ) for tax purposes. Thus, Taxable income = EBIT – Allowable interest deduction = $1,000,000 - $330,000 = $670,000 Tax liability = 0.21x Taxable income = 0.21($670,000) = $140,700 With the proposed change in capital structure, the firm may deduct all of its $160,000 ($ 2 , 0 00,000 x 0.0 8 ) interest expense for tax purposes. Number of shares of stock that must be sold to raise $2,500,000: $2,500,000/$16 = 156,250 => number of shares of stock outstanding after refinancing = 200,000 + 156,250 = 356,250 The EPS before and after this change in capital structure is illustrated below: Before capital structure change After capital structure change EBIT $ 1,00 0,000 $ 1,00 0,000 Less: Interest ($ 4 , 5 00,000 x 0.0 8 ) 36 0,000 ( $ 2,0 00,000 x 0.0 8) 16 0,000 EBT 64 0,000 84 0,000 Less: Taxes ( 21 %) 14 0 , 7 00 176 , 4 00 Net income $ 499 , 3 00 $ 663 , 6 00 Divide by # of shares 200,000 3 56 , 25 0 EPS $ 2 . 4965 $1. 86 27 The change in capital structure will result in a decrease in the stockholders EPS by $0. 6 338 . LG 2 - 1 2 - 2 6 Income Statement Consider a firm with an EBITDA of $13,00,000 and an EBIT of $ 1 0 ,50 0,000. The firm finances its assets with $ 5 0 , 0 00,000 debt (costing 6.5 percent ) and 10 ,0 00,000 shares of stock selling at $ 10 .00 per share. The firm is considering increasing its debt by $ 25,0 00,000, using the proceeds to buy back shares of stock. The firm ’s tax rate is 21 percent . The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $ 1 0 ,500 ,000. Calculate the change in the firm’s EPS from this ch ange in capital structure. With $13 ,0 00,000 of EBITDA, the firm may deduct up to $3,900,000 ($13,000,000 x 30 percent) of interest expense for tax purposes. Thus, given the current capital structure, the firm may deduct the full $3,250,000 ($ 50 , 0 00,000 x 0.065) of its interest expense for tax purposes. With the proposed change in capital structure, the firm may deduct only $3,900,000 of its $4,875,000 interest expense ($ 75 , 0 00,000 x 0.065) for tax purposes. Thus, Taxable income = EBIT – Allowable interest deduction = $10,500,000 - $3,900,000 = $6,600,000

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    Chapter 2 - Reviewing Financial Statements Tax liability = 0.21x Taxable income = 0.21($6,600,000) = $1,386,000 Number of shares of stock that can be repurchased with $ 2 5,000,000: $25,000,000/$10 = 2,500,000 => number of shares of stock outstanding after refinancing = 10,000,000 – 2,500,000 = 7,500,000 The EPS before and after this change in capital structure is illustrated below: Before capital structure change After capital structure change EBIT $ 10,50 0,000 $ 10, 5 0 0,000 Less: Interest ($ 50 , 0 00,000 x 0.0 65) 3,25 0,000 ($ 75,0 00,000 x 0.0 65) 4 ,875 ,000 EBT 7,25 0,000 5,625 ,000 Less: Taxes ( 21 %) 1 , 522 , 5 00 1 , 386 ,000 Net income $ 5 , 727 , 5 00 $ 4 , 239 ,000 Divide by # of shares 10,0 00,000 7,50 0,000 EPS $ 0 . 57275 $ 0.5 6520 The change in capital structure de creases the stockholders EPS by $0. 0 0755 . While interest on debt is tax deductible up to 30 percent of EBITDA, in this case the change in the capital structure causes the firm to hit the tax deductible cap. The tax benefits of additional debt do not apply once the firm hits the cap, causing debt to no longer be an attractive option from stockholders viewpoint. LG 2 - 3 2 - 2 7 Corporate Taxes The Dakota Corporation had a 20 21 taxable income of $33,365,000 from operations after all operating costs but before ( 1) interest charges of $8,500,000 , all of which is tax deductible ; ( 2) dividends received of $750,000 ; ( 3) dividends paid of $5,250,000 ; and ( 4) income taxes. The firm ’s EBITDA is $tax rate is 21 percent . a. C alculate Dakota ’ s income tax liability. The first 5 0 percent of the dividends received is not taxable. Thus, only 5 0 percent of the dividends received are taxed, so: Taxable income = $33,365,000 - $8,500,000 + ( 0 . 5 )$750,000 = $25, 24 0,000 Now Dakota Corp.’s tax liability will be: Tax liability = 0 . 21 ($25, 24 0,000 ) = $ 5,300 , 4 00 b. What are Dakota’s average and marginal tax rates on taxable income? Dakota Corp.’s average tax rate is: Average tax ra t e = $ 5 , 300 , 4 00 /$25, 24 0,000 = 21 .00% Finally, if Dakota Corp earned $1 more of taxable income, it would pay 21 cents (based on its tax rate of 21 percent) more in taxes. Thus, the marginal tax rate is 21 percent. LG 2 - 3 2 - 2 6 Corporate Taxes Suppose that in addition to $1 7 . 8 5 million of taxable income, Texas Taco, Inc. , received $ 1,10 5,000 of interest on state - issued bonds and $ 76 0,000 of dividends on common stock it owns in ArizonaTaco, Inc . a. C alculate Texas Taco ’ s income tax liability.

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    Chapter 2 - Reviewing Financial Statements Interest on the state - issued bonds is not taxable and should not be included in taxable income. Further, the first 5 0 percent of the dividends received from Arizona Taco is not taxable. Thus, only 5 0 percent of the dividends received are taxed, so: Taxable income = $17,850,000 + ( 0 . 5 )$760,000 = $18, 230 ,000 Texas Taco’s tax liability will be: Tax liability = 0 . 21 ($18, 23 0,000) = $ 3 , 828 , 30 0 b. What are Texas Taco’s average and marginal tax rates on taxable income? Texas Taco’s resulting average tax rate is: Average tax ra t e = $ 3 , 828 , 30 0 /$18, 230 ,000= 21.00 % Finally, if Texas Taco earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21 percent) more in taxes. Thus, the marginal tax rate is 21 percent. LG 2 - 5 2 - 2 9 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Clancy’s Dog Biscuit Corp oration . Clancy ’ s Dog Biscuit Corporation Balance Sheet as of December 31, 20 21 and 20 20 (in millions of dollars) 20 21 20 20 20 21 20 20 Assets Liabilities and Equity Current assets: Current liabilities : Cash and marketable Accrued wages and securities $ 5 $ 5 taxes $ 10 $ 6 Accounts receivable 20 19 Accounts payable 16 15 Inventory 36 29 Notes payable 14 13 Total $ 61 $ 53 Total $ 40 $ 34 Fixed assets: Long - term debt: $ 57 $ 53 Gross plant and equipment $106 $ 88 Less: Accumulated Stockholders’ equity: de preciation 15 11 Preferred stock (2 million shares) $ 2 $ 2 Net plant and Common stock and equipment $ 91 $ 77 paid - in surplus 11 11 Other long - term (5 million shares) assets 15 15 Retained earnings 57 45 Total $106 $ 92 Total $ 70 $ 58 Total assets $ 167 $145 Total liabilities and equity $ 167 $145 Clancy ’ s Dog Biscuit Corporation Income Statement for Years Ending December 31, 20 21 and 20 20 (in millions of dollars) 20 21 20 20 Net sales $ 76 $ 80 Less: Cost of goods sold 3 8 3 5 Gross profits $ 38 $ 4 5 Less: Other operating expenses 6 5 Earnings before interest, taxes, depreciation, and

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    Chapter 2 - Reviewing Financial Statements tization (EBITDA) $ 32 $ 40 Less: Depreciation 4 4 Earnings before interest and taxes (EBIT) $ 28 $ 36 Less: Interest 5 5 Earnings before taxes (EBT) $ 23 $ 31 Less: Taxes 5 7 Net income $18 $24 Less: Preferred stock dividends $ 1 $ 1 Net income available to common stockholders $17 $23 Less: Common stock dividends 5 5 Addition to retained earnings $12 $18 Per (common) share data: Earnings per share (EPS) $3.00 $4.20 Dividends per share (DPS) $ 1.00 $ 1.00 Book value per share (BVPS) $13.60 $11.20 Market value (price) per share (MVPS) $14.25 $14.60 SOLUTION: Statement of Cash Flows for Year Ending December 31, 20 21 (in millions of dollars) 20 21 A. Cash f lows from o perating a ctivities Net income $1 8 Additions (sources of cash): Depreciation 4 Increase accrued wages and taxes 4 Increase in accounts payable 1 Subtractions (uses of cash): Increase in accounts receivable - 1 Increase in inventory - 7 Net cash flow from operating activities: $1 9 B. Cash f lows from i nvesting a ctivities Subtractions: Increase fixed assets - $18 Increase in other long - term assets 0 Net cash flow from investing activities: - $18 C. Cash f lows from f inancing a ctivities Additions: Increase in notes payable $ 1 Increase in long - term debt 4 Increase in common and preferred stock 0 Subtractions: Preferred stock dividends - 1 Common stock dividends - 5 Net cash flow from financing activities: - $1 D. Net c hange in c ash and m arketable s ecurities - $ 0

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    Chapter 2 - Reviewing Financial Statements LG 2 - 5 2 - 30 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Valium’s Medical Supply Corp oration . Valium ’ s Medical Supply Corporation Balance Sheet as of December 31, 20 21 and 20 20 (in thousands of dollars) 20 21 20 20 20 21 20 20 Assets Liabilities and Equity Current assets: Current liabilities : Cash and marketable Accrued wages and securities $ 74 $ 73 taxes $ 58 $ 45 Accounts receivable 199 189 Accounts payable 159 145 Inventory 322 291 Notes payable 131 131 Total $ 595 $ 553 Total $ 348 $ 321 Fixed assets: Long - term debt: $ 565 $549 Gross plant and equipment $1,084 $ 886 Less: Accumulated Stockholders’ equity: d epreciation 153 116 Preferred stock (6 thousand shares) $ 6 $ 6 Net plant and Common stock and equipment $ 931 $ 770 paid - in surplus 120 120 Other long - term (100 thousand shares) assets 130 130 Retained earnings 617 457 Total $1,061 $ 900 Total $ 743 $ 583 Total assets $1,656 $ 1,453 Total liabilities and equity $1,656 $1,453 Valium ’ s Medical Supply Corporation Income Statement for Years Ending December 31, 20 21 and 20 20 (in thousands of dollars) 20 21 20 20 Net sales $ 888 $ 798 Less: Cost of goods sold 387 350 Gross profits $ 501 $ 448 Less: Other operating expenses 48 42 Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 4 53 $ 406 Less: Depreciation and amortization 37 35 Earnings before interest and taxes (EBIT) $ 416 $ 371 Less: Interest 46 40 Earnings before taxes (EBT) $ 370 $ 331 Less: Taxes 78 70 Net income $ 2 92 $ 2 6 1 Less: Preferred stock dividends $ 6 $ 6 Net income available to common stockholders $ 2 86 $ 2 55 Less: Common stock dividends 126 126 Addition to retained earnings $ 160 $ 1 29 Per (common) share data:

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    Chapter 2 - Reviewing Financial Statements Earnings per share (EPS) $2. 86 $2. 55 Dividends per share (DPS) $ 1 . 26 $ 1 . 26 Book value per share (BVPS) $7.37 $5.77 Market value (price) per share (MVPS) $8.40 $6.25 SOLUTION: Statement of Cash Flows for Year Ending December 31, 20 21 (in thousands of dollars) A. Cash f lows from o perating a ctivities Net income $2 92 Additions (sources of cash): Depreciation and amortization 37 Increase in accrued wages and taxes 13 Increase in accounts payable 14 Subtractions (uses of cash): Increase in accounts receivable - 10 Increase in inventory - 31 Net cash flow from operating activities: $ 315 B. Cash f lows from i nvesting a ctivities Subtractions: Increase in fixed assets - $198 Increase in other long - term assets 0 Net cash flow from investing activities: - $198 C. Cash f lows from f inancing a ctivities Additions: Increase in notes payable $ 0 Increase in long - term debt 16 Increase in common and preferred stock 0 Subtractions: Preferred stock dividends - 6 Common stock dividends - 126 Net cash flow from financing activities: - $ 116 D. Net c hange in c ash and m arketable s ecurities $ 1 LG 2 - 5 2 - 31 Statement of Cash Flows Chris ’ Outdoor Furniture, Inc. , has net cash flows from operating activities for the last year of $340 million. The income statement shows that net income is $315 million and depreciation expense is $46 million. During the year, the change in inventory on the balance sheet was $38 million, change in accrued wages and taxes was $15 million and change in accounts payable was $20 million. At the beginning of the year the balance of accounts receivable was $50 mil lion. Calculate the end - of - year balance for accounts receivable. A. Cash f lows from o perating a ctivities (in millions) Net income $315 Additions (sources of cash): Depreciation 46

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    Chapter 2 - Reviewing Financial Statements Increase accrued wages and taxes 15 Increase in accounts payable 20 Subtractions (uses of cash): Increase in accounts receivable - 18 (= $ 340 - $ 315 - $ 46 - $ 15 - $ 20 + $ 38) Increase in inventory - 38 Net cash flow from operating activities: $340 End - of - year balance for accounts receivable = $50m. + $18m. = $68m. LG 2 - 5 2 - 3 2 Statement of Cash Flows Dogs 4 U Corporation has net cash flow from financing activities for the last year of $ 34 million. The company paid $1 78 million in dividends last year. During the year, the change in notes payable on the balance sheet was $ 39 million, and change in common and preferred stock was $0. The end - of - year balance for long - term debt was $ 3 1 5 million. Calculate the beginning - of - year balance for long - term debt. C. Cash f lows from f inancing a ctivities (in millions) Additions: Increase in notes payable $ 39 Increase in long - term debt 1 73 (=$ 34 + $1 78 - $3 9 ) Increase in common and preferred stock 0 Subtractions: Stock dividends - 178 Net cash flow from financing activities: $34 B eginning - of - year balance for long - term debt = $31 5 m. - $1 73 m = $ 142 m. LG 2 - 5 2 - 31 Free Cash Flow The 20 21 income statement for Duffy’s Pest Control shows that depreciation expense was $197 million, EBIT was $ 440 million, and the tax rate was 21 percent. At the beginning of the year, the balance of gross fixed assets was $1,562 million and net operating working capital was $417 million. At the end of the year , gross fixed assets was $1,803 million. Duffy’s free cash flow for the year was $424 million. Calculate the end - of - year balance for net operating working capital. Duffy’s Pest Control’s operating cash flow was: OCF = EBIT(1 – Tax rate) + Depreciation = ($4 4 0 m. (1 - 0. 21 ) + $197m.) = $5 44 . 6 m. Duffy’s Pest Control’s free cash flow for 2021 was: FCF = Operating cash flow – Investment in operating capital $424m. = $5 44 . 6 m. - Investment in operating capital => Investment in operating capital = $54 4 . 6 m. - $424m. = $ 120 . 6 m. Accordingly, investment in operating capital for 20 2 1 was: IOC = ΔGross fixed assets + ΔNet operating working capital $1 20 . 6 m. = ($1,803m. - $1,562m.) + (Ending net operating working capital - $417m.) => Ending net operating working capital = $ 120.6 m. - ($1,803m. - $1,562m.) + $417m. = $29 6 . 6 m. LG 2 - 5 2 - 3 4 Free Cash Flow The 20 21 income statement for Egyptian Noise Blasters shows that depreciation expense is $ 85 million, NOPAT is $246 million. At the end of the year, the balance

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    Chapter 2 - Reviewing Financial Statements gross fixed assets was $655 million. The change in net operating working capital during the year was $7 3 million. Egyptian’s free cash flow for the year was $1 90 million. Calculate the beginning-of-year balance for gross fixed assets. Egyptian Noise Blasters’ operating cash flow was: OCF = NOPAT + Depreciation = = ($246 m . + $85m . ) = $331m. Egyptian Noise Blasters’ free cash flow for 20 21 was: FCF = Operating cash flow – Investment in operating capital $190m. = $331m. - Investment in operating capital = > Investment in operating capital = $331m. - $190m. = $141m. Accordingly, investment in operating capital for 20 21 was: IOC = ΔGross fixed assets + ΔNet operating working capital $141m. = ($655m. – Beginning of year gross fixed assets) + $73m. => Beginning of year gross fixed assets = $655m. - $141m. + $73m. = $587m. LG2-1 2-35 Statement of Retained Earnings Thelma and Louie, Inc., started the year with a balance of retained earnings of $543 million and ended the year with retained earnings of $589 million. The company paid dividends of $35 million to the preferred stockholders and $88 million to common stock holders. Calculate Thelma and Louie’s net income for the year. Statement of Retained Earnings as of December 31, 20 21 (in millions of dollars) Balance of retained earnings, December 31, 20 20 $543 Plus: Net income for 20 21 169 (= $589 + $123 - $543) Less: Cash dividends paid Preferred stock $35 Common stock 88 Total cash dividends paid 12 3 Balance of retained earnings, December 31, 20 21 $ 589 LG 2 - 1 2 - 3 6 Statement of Retained Earnings Jamaica Tours, Inc. , started the year with a balance of retained earnings of $1, 780 million. The company reported net income for the year of $ 284 million and paid dividends of $1 7 million to the preferred stock holders and $5 9 million to common stock holders. Cal culate Jamaica Tour’s end - of - year balance in retained earnings. Statement of Retained Earnings as of December 31, 201 8 (in millions of dollars) Balance of retained earnings, December 31, 201 7 $1,780 Plus: Net income for 201 8 284 Less: Cash dividends paid Preferred stock $17 Common stock 59 Total cash dividends paid 76 Balance of retained earnings, December 31, 201 8 $ 1,988

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    Chapter 2 - Reviewing Financial Statements a dvanced 2 - 3 7 Income Statement Listed below is the 20 21 income statement for Tom and Sue Travels , Inc. p roblems LG 2 - 1 Tom and Sue Travels, Inc. Income Statement for Year Ending December 31, 20 21 (in millions of dollars) Net sales $16.500 Less: Cost of goods sold 7.100 Gross profits 9.400 Less: Other operating expenses 3.200 Earnings before interest, taxes, depreciation, and amortization (EBITDA) 6.200 Less: Depreciation 2.900 Earnings before interest and taxes (EBIT) 3.300 Less: Interest 0.950 Earnings before taxes (EBT) 2.350 Less: Taxes 0. 495 Net income $ 1. 85 5 The CEO of Tom and Sue’s wants the company to earn a net income of $2.250 million in 20 22 . Cost of goods sold is expected to be 60 percent of net sales, depreciation and other operating expenses are not expected to change, interest expense is expected to increase to $1. 416 million , and the firm’s tax rate will be 21 percent. Calculate the net sales needed to produce net income of $2.250 million. Tom and Sue Travels, Inc. Income Statement for Year Ending December 31, 20 22 (in millions of dollars) Net sales Step 5 . $ 25 .910 L ess: Cost of goods sold Step 6 . 1 5 . 546 Gross profits Step 4 . 10 . 3 6 4 Less: Other operating expenses 3.200 Earnings before interest, taxes, depreciation, and amortization (EBITDA) Step 3. 7.164 Less: Depreciation 2.900 Earnings before interest and taxes (EBIT) Step 2. 4.264 Less: Interest 1. 416 Earnings before taxes (EBT) Step 1. 3.214 Less: Taxes Net income $ 2.250 Step 1. EBT (1 - t) = Net income = $2.250m = EBT (1 - 0 . 21 ) => EBT = $2.250m./(1 - 0 . 21 ) = $ 2.848 m. Step 2. EBIT = EBT + Interest = $ 2.848 m. + $1. 416 m. = $4.264m. Step 3. EBITDA = EBIT + Depreciation = $4.264m. + $2.900m. = $ 7 . 1 64m Step 4 . Gross profits = EBIT DA + Other operating expenses = $ 7 . 1 64m. + $3.200m. = $ 10 . 3 64m Step 4. Net sales = Gross profits/(1 - Cost of goods sold percent) = $ 10 . 364m./(1 - 0 .6) = $ 25 . 91 0m.

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    Chapter 2 - Reviewing Financial Statements Step 5. Cost of goods sold = Net sales – Gross profits = $ 25 .910m. - $ 10 . 3 64 = $1 5 . 5 46m. LG 2 - 1 2 - 3 8 Income Statement You have been given the following information for PattyCake ’s Athletic Wear Corp. for the year 20 21 : a. N et sales = $ 38 , 250,000. b. C ost of goods sold = $ 22 , 070,000. c. Other operating expenses = $5,300,000. d. A ddition to retained earnings = $ 2 , 195 , 500. e. D ividends paid to preferred and common stockholders = $1, 912,000. f. Interest expense = $1,78 5,000. g. The firm’s tax rate is 21 percent. In 20 22 : h. net sales are expected to increase by $ 9.75 million. i. C ost of goods sold is expected t o be 60 percent of net sales. j. D epreciation and other operating expenses are expected to be the same as in 20 21 . k. I nter est expense is expected to be $2 ,00 4 , 367 . l. T he tax rate is e xpected to be 21 percent of EBT. m. D ividends paid to preferred and common stockholders will not change. Calculate the addition to retained earnings expected in 20 22 . Income Statement for Year Ending December 31, 20 21 (in millions of dollars) Net sales $38,250,000 Less: Cost of goods sold 22,07 0 ,000 Gross profits 16,180,000 Less: Other operating expenses 5,300,000 Earnings before interest, taxes, depreciation, and amortization (EBITDA) 10,880,0 00 Less: Depreciation $1 0 , 8 80,000 - $6, 984 , 3 6 7 3 , 89 5, 633 Earnings before interest and taxes (EBIT) $ 5 , 19 9, 367 + $1,785,000 6, 984 , 367 Less: Interest 1,78 5,000 Earnings before taxes (EBT) $ 4 ,107,500 / (1 - 0 . 21 ) 5 , 199,367 Less: Taxes Net income $ 4 ,107,500 Less: Preferred and common stock dividends $1, 9 12,000 Addition to retained earnings $ 2 ,195,500 Income Statement for Year Ending December 31, 20 22 (in millions of dollars) Net sales (all credit) $38,250,000 + $9,750,000 $48,000,000 Less: Cost of goods sold 0 .6 x $48,000,000 28,80 0 ,000 Gross profits 19,200,000 Less: Other operating expenses 5,300,000

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    Chapter 2 - Reviewing Financial Statements Earnings before interest, taxes, depreciation, and amortization (EBITDA) 13,900,000 Less: Depreciation 3 , 895 , 633 Earnings before interest and taxes (EBIT) 10 , 00 4, 367 Less: Interest 2 ,00 4 , 367 Earnings before taxes (EBT) 8 , 00 0,000 Less: Taxes ( 21 %) 1 , 680 ,000 Net income $ 6,320 ,000 Less: Preferred and common stock dividends $1, 9 12,000 Addition to retained earnings $ 4 , 408 ,000 LG 2 - 5 2 - 3 9 Free Cash Flow Rebecky ’s Flowers 4U, Inc. , had free cash flow s during 20 21 of $43 million, NOPA T of $85 million, and depreciation of $14 million. Using this information, fill in the blanks on Rebecky ’s balance sheet below. Rebecky ’s operating cash flow for 20 21 was: OCF = NOPAT + Depreciation = ($ 8 5m. + $14m.) = $99m. Rebecky ’s free cash flow was: FCF = Operating cash flow – Investment in operating capital $43m. = $99m. - Investment in operating capital So, Investment in operating capital = $99m. - $43m. = $56m. IOC = ΔGross fixed assets + ΔNet operating working capital $56m. = ($333m. - $300m.) + ΔNet operating working capital => ΔNet operating working capital = $56m. - ($333m. - $300m.) = $23m. ΔNet operating working capital = $23m. = ∆ Current assets - ∆ Current liabilities $23m. = ($221m. - $190m.) - ∆ Current liabilities => ∆ Current liabilities = ($221m. - $190m.) - $23m. = $8m. => 2021 Current liabilities = $110m. + $8m. = $118m. and 20 2 1 Current liabilities = Accrued wages and taxes + Accounts payable + Notes payable $118m. = $17m. + Accounts payable + $45m. => Accounts payable = $118m. - $17m. - $45m. = $56m. => Long - term debt = $ 550 m. - $ 118 m. - $ 237 m. = $ 19 5m. Rebecky ’ s Flowers 4U, Inc. Balance Sheet as of December 31, 20 21 and 20 20 (in millions of dollars) 20 2 1 20 20 20 2 1 20 20 Assets Liabilities and Equity Current assets: Current liabilities : Cash and marketable Accrued wages and securities $ 28 $ 25 taxes $ 17 $ 15 Accounts receivable 75 65 Accounts payable 56 50 Inventory 118 100 Notes payable 45 45 Total $221 $190 Total $118 $110 Fixed assets: Long - term debt: $195 $190 Gross plant and equipment $333 $300

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    Chapter 2 - Reviewing Financial Statements Less: Accumulated Stockholders’ equity: d epreciation 54 40 Preferred stock (5 million shares) $ 5 $ 5 Net plant and Common stock and equipment $279 $260 paid - in surplus 40 40 Other long - term (20 million shares) assets 50 50 Retained earnings 192 155 Total $329 $310 Total $237 $200 Total assets $5 5 0 $50 0 Total liabilities and equity $5 5 0 $50 0 LG 2 - 5 2 - 3 8 Free Cash Flow Vin ny’s Overhead Construction had free cash flow during 20 2 1 of $2 5.4 million. The change in gross fixed assets on Vinny ’s balance sheet during 20 2 1 was $ 7. 0 million and the change in net operating working capital was $8.4 million. Using this information, fill in the blanks on Vin ny’s income statement below. IOC = ΔGross fixed assets + ΔNet operating working capital => IOC = $7.0m. + $ 8.4 m. = $ 15.4 m. FCF = Operating cash flow – Investment in operating capital => $2 5 .4m. = OCF – $15.4m. => OCF = $ 25 . 4 m. + $ 15 .4m. = $ 4 0. 8 m. OCF = EBIT (1 – 0.21 ) + Depreciation Using the numbers below: $40.8m. = EBIT (1 – 0.21) + $10.2 m. => EBIT = ( $ 4 0 . 8 m. - $10.2m.)/(1 – 0.21) = $38.73m Vinny ’ s Overhead Construction, Corp. Income Statement for Year Ending December 31, 20 2 1 (in millions of dollars) Net sales $ 1 82 .1 0 Step 1. (= $66.00 + $116.10) Less: Cost of goods sold 116.10 Gross profits $ 66.00 Less: Other operating expenses 1 7 .0 7 Step 7. (= $66.00 - $48.93) Earnings before interest, taxes, depreciation, and amortization (EBITDA) 48.93 Step 6. (= $38.73 + $10.20) Less: Depreciation 10.20 Earnings before interest and taxes (EBIT) $ 38.73 Step 2. (from above) Less: Interest 3 . 73 Step 5 . (= $3 8 . 73 - $3 5 . 0 0) Earnings before taxes (EBT) $ 3 5 . 00 Step 3 . (= $27.6 5 / (1 – 0.2 1 ) Less: Taxes ( 21 % from above) 7 . 3 5 Step 4 . (= $3 5 . 0 0 - $27.6 5 ) Net income $27.6 5 research i t! Reviewing Financial Statements Go the web site of Wal - Mart Stores, Inc. at www.walmartstores.com and get the latest financial statements from the annual report using the following steps.

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    Chapter 2 - Reviewing Financial Statements Go to Wal - Mart Stores, Inc.’s Web site at www.walmartstores.com. Click on Investors, then select Annual Reports ; next choose Annual Reports & Proxies . This will bring the file onto your computer that contains the relevant data. Locate the total assets, total equity, net sales, net income, dividends paid, cash flows from operating activities, and cash flows from investing activities for the last two years. How have these items changed over the last two years? SOLUTION: The solution will vary with the year annual report is accessed. However, the annual report for each year summarizes the financial information necessary to evaluate key information used by firm managers, who make financial decisions, and by investors, who decide whether or not to invest in the firm.

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    Chapter 2 - Reviewing Financial Statements i ntegrated mini - c ase: Working with Financial Statements Shown below are partial financial statements for Garners’ Platoon Mental Health Care, Inc. Fill in the blanks on the four financial statements. Garners ’ Platoon Mental Health Care, Inc. Balance Sheet as of December 31, 20 21 and 20 20 (in millions of dollars) 20 21 20 20 20 21 20 20 Assets Liabilities and Equity Current assets: Current liabilities : Cash and marketable Accrued wages and securities $ 421 $ ____ taxes $ 316 $ 242 Accounts receivable ____ 1 ,020 Accounts payable 867 7 91 Inventory 1, 760 1, 581 Notes payable ____ 714 Total $3,290 $ ____ Total $2,055 $1,747 Fixed assets: Long - term debt: $3,090 $ ____ Gross plant and equipment $ ____ $ 4,743 Less: Accumulated Stockholders’ equity: d epreciation 8 40 6 40 Preferred stock ( 30 million shares) $ 60 $ 60 Net plant and Common stock and equipment $4,972 $ ____ paid - in surplus 637 ___ Other long - term assets ____ 790 (200 million shares) Total $5,864 $4,893 Retained earnings 3,312 2,440 Total $4,009 $3,137 Total assets $ ____ $7,889 Total liabilities and equity $9,154 $7,889 Garners ’ Platoon Mental Health Care, Inc. Income Statement for Years Ending December 31, 20 21 and 20 20 (in millions of dollars) 20 21 20 20 Net sales $4,980 $ Less: Cost of goods sold 2,0 35 Gross profits $ 2, 734 $ 2, 313 Less: Other operating expenses 125 100 Earnings before interest, taxes, depreciation, and amortization (EBITDA) 2,609 2,213 Less: Depreciation 200 191 Earnings before interest and taxes (EBIT) $ 2,409 $ Less: Interest (21 percent) 285 Earnings before taxes (EBT) $2,094 $1,737 Less: Taxes _____ Net income $1, 654 $1, 372

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