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Chapter 3

Financial Statements, Cash Flows, and Taxes

Learning Objectives

1. Discuss generally accepted accounting principles (GAAP) and their importance to the
economy.
2. Know the balance sheet identity, and explain why a balance sheet must balance.
3. Describe how market-value balance sheets differ from book-value balance sheets.
4. Identify the basic equation for the income statement and the information it provides.
5. Explain the difference between cash flows and accounting income.
6. Explain how the four major financial statements discussed in this chapter are related.
7. Discuss the difference between average and marginal tax rates.

I.

Chapter Outline

3.1

Financial Statements and Accounting Principles


A.

Annual Reports

The annual report is a vehicle by which management communicates with the


firms shareholders and members of the public.

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The annual report has three sectionsa financial summary related to the past
years performance; information about the company, its products, and its
activities; and audited financial statements, including historical financial data.

B.

Generally Accepted Accounting Principles (GAAP)

These are accounting rules and standards that companies need to adhere to
when they prepare financial statements and reports.

GAAP is prepared by the Financial Accounting Standards Board (FASB) and


is authorized by the SEC.

C.

Fundamental Accounting Principles

The Assumption of Arms-Length TransactionTwo parties involved in an


economic transaction arrive at a decision independently and rationally.

The Cost PrincipleTransactions are recorded at the cost at which they


occurred.

The Realization PrincipleRevenue is recognized when transaction is


completed, while cash may not be collected until a later time.

The Matching PrincipleExpenses related to generating any revenue are


matched.

The Going Concern AssumptionIt is assumed that a company will continue


to operate for the predictable future.

D.

International GAAP

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The International Accounting Standards Board promotes uniform accounting


rules and procedures.

All European Union firms are expected to comply with International


Accounting Standards (IAS), since 2007.

The SEC does not recognize IAS and requires foreign firms listed on U.S.
stock exchanges to use U.S. GAAP.

3.2

The Balance Sheet


A.

This financial statement identifies all the assets and liabilities of a firm at a point
in time.

The left-hand side of the balance shows all the assets that the firm owns and
uses to generate revenues.

The right-hand side represents the liabilities of the firmthat is, the money
that the firm has borrowed from both creditors and shareholders.

In addition to the amount borrowed from suppliers and other creditors, the
balance sheet also lists the capital raised from its shareholders.

While assets are listed in their order of their liquidity, the liabilities are listed
in the order in which they must be paid.

Shareholders of the firms common equity are listed last as they will be paid
with whatever remains after paying all other suppliers of funds.

B.

Current Assets and Liabilities

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All assets that are likely to be converted to cash within a year are considered
to be current assets. These include cash and marketable securities, accounts
receivables, and inventory.

All liabilities that have to be paid within a year are listed as part of the current
liabilities. Thus, bank loans and other borrowings with less than a years
maturity, accounts payables, accrued wages, and taxes are included here.

The difference between the amount of current assets and current liabilities is
called net working capital.

C.

Net Working Capital

Net working capital is a measure of the liquidity of a firm, which is the ability
of the firm to meet its obligations as they come due.

As expressed in Equation 3.2, net working capital is the difference between


total current assets and total current liabilities.

D.

Accounting for Inventory

Inventory, the least liquid of current assets, is reported in one of two different
ways on the balance sheet.

First in, first out, or FIFO, refers to the practice of recognizing a sale as being
made up of inventory that was purchased earlier and having the lowest cost.

Last in, last out, or LIFO, calls for the firm to attribute any sale made to the
most recently acquired and most expensive inventory.

FIFO reporting leads to higher current asset value and higher net income.

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Firms may switch from one to another only under extraordinary circumstances
and not frequently.

E.

Long-Term Assets

These are the real assets that the firm acquires to produce its products and
generate cash flows. These include land, buildings, plant, and equipment.

Intangible assets, such as goodwill, patents, and copyrights, are also listed
here.

All long-term real assets are depreciated, while intangible assets are
amortized. Depreciating assets allows a firm to lower taxable income and
reduce taxes.

Firms are allowed to depreciate assets using the straight-line method or an


accelerated depreciation method that is allowed by the IRS.

F.

Long-Term Liabilities

These consist of the long-term debt of the company.

They include bank loans, mortgages, and bonds that have a maturity of one
year or longer.

G.

Equity

There are two sources of equity fundscommon equity and preferred equity.

Common equity represents the true ownership of the firm.

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Multiple accounts identify the various sources of equity fundspar value,


additional paid-in capital, retained earnings, and treasury stock.

Par value and paid-in capital represent the outside equity capital raised by the
firm by issuing shares.

Retained earnings result from the funds that the firm has reinvested in the firm
from its earnings. These funds are not cash since they already have been put to
work.

The treasury stock account reflects the value of the shares that the firm
repurchased from investors.

The other source of equity capital is preferred stock. It has features that make
it a combination of a fixed income security and an equity security.

3.3

Market Value versus Book Value


Traditionally, all assets are reported at their historical cost.

The balance sheet does not reflect the current market value of the assets, only
their acquired cost.

Adopting a marking to market approachthat is, reporting assets at their


current market valueprovides better information to management and
investors.

Downside is the difficulty in estimating market values of assets.

When both the liabilities and assets of a firm are reported at their current
market value, their difference represents the true market value of
shareholders equity.

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3.4

The Income Statement and the Statement of Retained Earnings


A.

The Income Statement

The profitability of a firm for any reporting period is measured in the financial
statement. The basic identity is shown in Equation 3.3.

Revenues represent the value of the products and services sold by the firm,
and they include both cash and credit sales.

Expenses range from the cost of producing goods for sale and asset utilization
costs such as depreciation or amortization.

B.

Net income is the difference between the firms revenues and expenses.

Depreciation, Amortization, and Other Income Statement Accounts

Depreciation is the writing off of the cost of any physical asset like plant or
machinery over its lifetime. This is a noncash expense.

Depreciation expense reduces a firms taxable income as well as the firms


taxes, while increasing the cash flow available to shareholders.

Firms can use one of two methods of depreciating an asset: the straight-line
method and the accelerated depreciation method. Firms are allowed to use one
approach for internal purposes and another for tax purposes.

Firms prefer the accelerated depreciation method for tax purposes because it
allows the firm to write off larger amounts of the cost of an asset over a
shorter period.

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Amortization expenses are related to the writing off of the value of intangible
assets like goodwill, patents, and licenses. It is also a noncash expense like
depreciation.

Nonrecurring expenses are associated with the closing down of unprofitable


operations or the restructuring of a firms operations.

Extraordinary items refer to income or expenses associated with events that


are not expected to happen on a regular basis.

C.

Bottom-Line Accounts

The first bottom-line income figure that would be of interest to shareholders


and creditors is earnings before interest, taxes, depreciation, and
amortization (EBITDA), which is the earnings generated from operations
prior to the recognition of expenses not directly connected to the production of
the products.

After netting out the expenses related to depreciation and amortization, we


arrive at earnings before interest and taxes (EBIT).

The next important income line is earnings before taxes (EBT) and
represents the taxable income for the period.

Finally, subtracting taxes from EBT yields net income, or net income after
taxes. This amount tells us the amount available to management to pay
dividends, pay off debt, or reinvest in the firm.

D.

The Statement of Retained Earnings

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This financial statement shows the changes in this account from one period to
the next.

This account will show changes whenever a firm reports a loss or profit and
when a cash dividend is declared.

3.5

Cash Flows
A.

Net Income versus Cash Flows

While accountants focus on net income, shareholders are more interested in


net cash flows.

Net income and cash flows are not the same because of the presence of
noncash revenues and expenses.

Equation 3.4 shows how we can derive the net cash flows from operating
activities (NCFOA) from net income. A simplified version of Equation 3.4 is
used when the only significant non cash items are depreciation and
amortization. Equation 3.5 shows this.

B.

The Statement of Cash Flows

This financial statement helps to measure the cash outflows and the cash
inflows generated during any period.

The statement is broken down into three parts to identify the cash flows
resulting from operating activities, investing activities, and financing
activities.

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Operating activities: Cash flows result from producing and selling goods and
services. Cash inflows result from selling the products and services from the
firm. Cash outflows are tied to the purchase of raw materials, inventory,
salaries and wages, utilities, rent, interest and other related expenses.

Investing activities: Cash inflows and outflows arise out of the acquisition and
sale of real assets necessary to operate the business. It can also result from the
buying and selling of financial assets such as bonds and stocks, making and
collecting loans, and selling and settling insurance contracts.

Financing activities: When a firm issues debt or equity securities and borrows
money from banks or other lenders, it produces cash inflows. If the firm pays
interest or dividends on the investors funds, or pays off debt or purchases
treasury stock, the firm has cash outflows.

The sum of the cash flows from these three activities measures the net cash
flows of the firm during a given period and is the bottom line of this financial
statement.

3.6

Tying the Financial Statements Together


The role of the balance sheet includes the following:

The balance sheet brings all the financial statements together, summarizing
the financing and investment activities of the firm at a point in time.

It recognizes the changes in the companys financial position since the last
reporting period that result from new activities or discontinued activities.

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It identifies to shareholders the impact on the owners equity account of all the
transactions that the firm was involved in since the last reporting period and
recognized in the income statement and statement of retained earnings.

3.7

Federal Income Tax


A.

Corporate Income Tax Rates

The federal income tax schedule for the year 2007 is shown in Exhibit 3.6.

It is a progressive tax schedule with rates ranging from 15 to 39 percent. This


means the higher a firms taxable income, the higher the tax liability.

B.

Average versus Marginal Tax Rates

The average tax rate is the total taxes paid divided by taxable income for the
period.

The marginal tax rate is the tax rate that is paid on the last dollar earned or the
next dollar earned.

C.

Tax Treatment of Dividends and Interest Payments

The current tax code in the United States allows interest payments on debt
issued by firms to be tax deductible.

Dividends paid on the firms preferred stock or common stock is not


deductible for tax purposes and is paid from after-tax income.

The result is a lower cost of debt financing relative to the cost of equity
financing.

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II.

Suggested and Alternative Approaches to the Material

This chapter focuses on the four important financial statements that every firm uses to provide
information about the financial condition of the company to both management and investors. In
addition, there are discussions on the generally accepted accounting principles (GAAP) and
International GAAP. The chapter also overviews market value accounting.
Many instructors may choose to cover this chapter in detail. This allows the students to
better understand the reporting of accounting information before moving on to the analysis of
financial statements in Chapter 4. This material becomes even more critical when the majority of
students taking the required first course in Finance are not Finance or Accounting majors.
Other instructors may choose to skim through the topics in this chapter if they feel that
their students are adequately prepared to tackle the topics in the next couple of chapters. Or they
can choose to skip this chapter altogether if their students have a strong enough accounting
background. This alternative will be especially helpful if this is a second Finance course, and it
will allow the instructor to cover other material.

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III. Summary of Learning Objectives


1.

Discuss generally accepted accounting principles (GAAP) and their importance to


the economy.
GAAP are a set of authoritative guidelines that define accounting practices at a particular
point in time. Thus, GAAP principles determine the rules for how a company maintains
its accounting system and how it prepares financial statements. Accounting standards are
important because without them, each firm could develop its own unique accounting
practices, which would make it difficult for stakeholders to monitor the firms true
performance or compare the performance of different firms. The result would be a loss of
confidence in the accounting system and the financial reports it produces.

2.

Know the balance sheet identity, and explain why a balance sheet must balance.
A balance sheet provides a summary of a firms financial position at a particular point in
time. The balance sheet identifies the productive resources (assets) that a firm uses to
generate income, as well as the sources of funding from creditors (liabilities) and owners
(shareholders equity) that were used to buy the assets. The balance sheet identity is: Total
assets = Total liabilities + Total stockholders equity. Total stockholders equity represents
ownership in the firm and is the residual claim of the owners after all other obligations to
creditors, employees, and vendors have been paid. The balance sheet must always
balance because the owners get what is left over after all creditors have been paidthat
is, Total stockholders equity = Total assets Total liabilities.

3.

Describe how market-value balance sheets differ from book-value balance sheets.

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Book value is the amount a firm paid for its assets at the time of purchase. The current
market value of an asset is the amount that a firm would receive for the asset if it were
sold on the open market (not in a forced liquidation). Most managers and investors are
more concerned about what a firms assets can earn in the future than about what the
assets cost in the past. Thus, balance sheets marked to market are more helpful in
showing a companys true financial condition than balance sheets based on historical
costs. Of course, the problem with marked-to-market balance sheets is that it is difficult
to estimate market values for some assets and liabilities. In addition, there are fears that
the management of some firms may be tempted to manipulate the estimates of market
value to favorably distort their firms true financial picture.

4.

Identify the basic equation for the income statement and the information it provides.
An income statement is a snapshot that provides a picture of the firms profit or loss for a
period of time, usually a month, quarter, or year. The income statement identifies the
major sources of revenues generated by the firm and the corresponding expenses that
were needed to generate those revenues. The equation for the income statement is: Net
income = Revenues - Expenses. If revenues exceed expenses, the firm generates a net
profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit
or income is the most comprehensive accounting measure of a firms performance.

5.

Explain the difference between cash flows and accounting income.


Cash flows represent the movement of cash within the firm. Cash flows are important in
finance because the value of any assetstocks, bonds, or a businessis determined by

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the future cash flows generated by the asset. Accounting profits, in contrast, are
calculated according to GAAP in order to determine taxes and to report to stakeholders in
a consistent manner. Accounting profits include noncash revenues (such as prepaid rent)
and noncash expenses (such depreciation), whereas cash flows do not include these items.

6.

Explain how the four major financial statements discussed in this chapter are
related.
The four financial statements discussed in the chapter are the balance sheet, the income
statement, the statement of cash flows, and the statement of retained earnings. The key
financial statement that ties the other three statements together is the statement of cash
flows, which summarizes changes in the balance sheet from the beginning of the year to
the end. These changes reflect information in the income statement and in the statement
of retained earnings.

7.

Discuss the difference between the average and marginal tax rates.
The average tax rate is total taxes divided by taxable income. It takes into account the
taxes paid at all levels of income, and therefore it will be lower than the marginal tax rate,
which is the rate that is paid on the last dollar of income earned. However, for very high
income earners, these two rates will be close to equal. When companies are making
financial decisions, they use the marginal tax rate, because new projects are expected to
generate additional cash flows, which will be taxed at the firms marginal tax rate.

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IV. Summary of Key Equations

Equation

Description

Formula

Balance sheet
3.1
3.2
3.3

3.4

3.5

Total assets = Total liabilities + Total stockholders equity


identity
Net working capital Net working capital = Total current assets Total current liabilities
Income statement
Net income = Revenues - Expenses
identity
Net cash flow from
NCFOA = Net income Noncash revenues + Noncash expenses
operating activities
Net cash flow from
NCFOA = Net income + Depreciation and amortization
operating activities

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V.

Before You Go On Questions and Answers

Section 3.1
1.

What types of information does a firms annual report contain?

A firms annual report is typically divided into three sections: financial tables with an
accompanying verbal explanation of the firms performance over the past year; a
corporate public relations section discussing the firms operations, and the audited
financial statements (balance sheet, income statement, statement of cash flows, and
statement of retained earnings).

2.

What is the realization principle, and why may it lead to a difference in the timing of
when revenues are recognized on the books and cash is collected?

According to the realization principle, revenue should only be recognized when the
earning process is completed and the exchange of goods or services can be determined by
an arms length transaction. Although this principle works in theory, it still does not
specify whether this is the point when the goods are ordered, when they are shipped, or
when the payment is actually received from the customer. Also, not many purchases are
paid for in cash any more. Therefore, even if the transaction is recognized at the point at
which the customer receives the goods, the actual cash flow might not occur until days
later (depending what the terms are).

Section 3.2

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1.

What is net working capital? Why might a low value for this number be considered
undesirable?

Net working capital is the difference between total current assets and total current
liabilities. A low value for this number is undesirable, for it indicates that the company
may not have enough cash on hand to cover its immediate expenses.

2.

Explain the accounting concept behind depreciation.

Depreciation in accounting is a noncash expense that helps to allocate the cost of an item
over its expected life. It reflects the estimated decrease in the value of an asset due to
wear and tear and obsolescence.

3.

What is treasury stock?

Treasury stock is the stock that the company purchased back from its investors. These
shares do not pay dividends, have no voting rights, and should not be included in sharesoutstanding calculations.

Section 3.3
1.

What is the difference between book value and market value?

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Book value is the price you paid for a particular asset. This price does not change as long
as you own the asset. On the other hand, market value is the price at which you can sell
an asset today, as it takes into account how much it can earn in the future.

2.

What are some objections to the preparation of marked-to-market balance sheets?

Marked-to-market balance sheets list the firms assets and liabilities at their current
market prices. Even though a balance sheet constructed with actual market values might
paint a more accurate picture of the companys financial situation, current values are
difficult to estimate, and a lot of the complicated models are potentially open to abuse.
Therefore, as of the present, the norm is to use book values.

Section 3.4
1.

How do you compute net income?

Net income is calculated as revenues minus expenses. It is the most comprehensive


accounting measure of a companys performance because it reflects the firms
accomplishments (revenues) relative to its efforts (expenses) during a time period.

2.

What is EBITDA, and what does it measure?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBIT
is defined as earnings before taxes and interest. The main difference between these two

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figures is that EBITDA shows the income earned purely from operations and reflects how
efficiently a firm can manufacture and sell its products without taking into account the
cost of the productive asset base.

3.

What accounting events trigger changes to the retained earnings account?

Two events will trigger changes to the retained earnings account: (1) a firms report of a
net income or loss and (2) the board of directors declaration of a cash dividend.

Section 3.5
1.

What is the difference between accounting profits and net cash flows?

Accounting profits and net cash flows are not the same because as accountants prepare
the financial statements, they do not simply count the cash coming in and cash going out.
The accounting profits are calculated based on the matching principle and other
accounting rules that adhere to GAAP, but are not necessarily based on cash transactions.

2.

Should a firm only consider depreciation and amortization expenses when calculating the
net cash flow? Explain.

Depreciation and amortization are taken into account when calculating both the net cash
flows and the net income. Both depreciation and amortization get treated as expenses on
the income statement, and they are subtracted from revenues to derive net income. When

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calculating net cash flows, depreciation and amortization are added to net income, as both
of these are noncash expenses.

3.

Explain the difference between financing and investing activities.

Investing activities refer to the buying and selling of long-term assets, whereas financing
activities refer to those activities where cash is obtained from, or repaid to, creditors or
owners (shareholders).

Section 3.6
1.

Explain how the four financial statements are related.

The four financial statements are linked together as follows: the ending cash balance
from the statement of cash flows is used as the cash balance on the balance sheet, and the
net income reported in the income statement is transferred to retained earnings on the
balance sheet. So as you can see, the balance sheet is the one financial statement that ties
all four statements together.

Section 3.7
1.

Why is it important to consider the consequences of taxes when financing a new project?

When financing a new project, it is important to consider the consequences of taxes


because ultimately they have a significant impact on companys income.

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2.

Which type of tax rate, marginal or average, should be used in analyzing the expansion of
a product line, and why?

When analyzing the expansion of a product line, the marginal tax rate should be the type
to consider because it is the amount paid on an additional dollar of income earned. Since
expansion of a product line is expected to generate new cash flows, the company will be
taxed based on the additional earnings. Average tax rate is not as relevant when making
financing decisions because it is simply the total taxes paid divided by taxable income.

3.

What are the tax implications of a decision to finance a project using debt rather than new
equity?

The difference between debt financing and financing through new equity is in the tax
treatment of interest and dividends. While interest payments on debt are tax-deductible
business expenses, dividends paid to common or preferred stockholders are not
deductible.

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VI. Self-Study Problems

3.1

The going -concern assumption of GAAP implies that the firm:


a.

is going under and needs to be liquidated at historical cost.

b.

will continue to operate and its assets should be recorded at historical cost.

c.

will continue to operate and that all assets should be recorded at their cost rather
than at their liquidation value.

d.

Solution:

is going under and needs to be liquidated at liquidation value.

c
One of the key assumptions under GAAP is the going concern assumption, which
states that the firm (c) will continue to operate and that all assets should be
recorded at their cost rather than at their liquidation value.

3.2

The Ellicott City Ice Cream Company management has just completed an assessment of
its assets and liabilities and has come up with the following information. It has total
current assets worth $625,000 at book value and $519,000 at market value. In addition,
its long-term assets include plant and equipment valued at market for $695,000, while
their book value was $940,000. The companys total current liabilities are valued at
market for $543,000, while their book value is $495,000. Both the book value and the
market value of its long-term debt is $350,000. If the companys total assets are equal to a

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market value of $1,214,000 (book value of $1,565,000), what are the book value and
market value of its shareholders equity?

Solution:

The book value and market value are as follow (in thousands of dollars):
Book

Market

Assets
Total current assets
Fixed assets

Value
$ 625
940

Value
$ 519
695

Total assetsS

$1,565

$1,214

Book

Market

Liabilities
Total current liabilities
Long-term debt
Stockholders equity

Value
$ 495
350
720

Value
$ 543
350
321

Total liabilities and stockholders

$1,565

$1,214

equity

3.3

Depreciation and amortization expenses are:


a.

part of current assets on the balance sheet.

b.

after-tax expenses that reduce a firms cash flows.

c.

long-term liabilities that reduce a firms net worth.

d.

noncash expenses that cause a firms after-tax cash flows to exceed its net income.

Solution:

d
Depreciation and amortization expenses are (d) noncash expenses that cause a
firms after-tax cash flows to exceed its net income.

3.4

You are given the following information about Clarkesville Plumbing Company.
The companys annual report on December 31, 2008, showed that during the year
its revenues totaled $896, current assets $121, current liabilities $107,
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depreciation expenses $75, costs of goods sold $365, and interest expenses $54.
The company is in the 34 percent tax bracket. Calculate its net income by setting
up an income statement.

Solution:

Clarkesvilles income statement and net income are as follows:


Clarkesville Plumbing Company
Income Statement as of December 31, 2008
Amount
$896.00
365.00
$531.00
75.00
$456.00
54.00
$402.00
136.68
$265.32

Revenues
Costs
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income

3.5

The Huntington Rain Gear Company had $633,125 in taxable income in the year ending
September 30, 2008. Calculate the companys tax using the tax schedule in Exhibit 3.6.

Solution:

Huntingtons tax bill is calculated as follows:

Tax rate
15%
25
34
39
34

Income
$50,000
(75,00050,000)
(100,00075,000)
(335,000100,000)
(633,125335,000)
Total taxes payable

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Tax
$ 7,500
6,250
8,500
91,650
101,363
$215,263

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VII. Critical Thinking Questions


3.1

What is a major reason for the accounting scandals in recent years? How do firms attempt
to meet Wall Street analysts projection of earnings?

Most people believe that managers short-term focus is driven by Wall Streets demand
that companies meet or beat the earnings forecasted by stock analysts. Rather than report
the actual earnings of the firm, managers try to meet the markets expectations by starting
with the bottom-line number and backing into a sales figure. Thus, the sales may be
consistent with the reported earnings figure, but do not represent the true revenue
generated by the firm.

3.2

Why are taxes and the tax code important for managerial decision making?

Understanding the tax code is critical to finance managers, since most decisions are made
on an after-tax basis. Furthermore, taxes affect any valuation analysis and also determine
the bottom-line figure that is of concern to shareholders and managers.

3.3

Identify the five fundamental principles of GAAP and explain briefly their importance.

The assumption of arms length transaction assumes that all business transactions
between two parties are made rationally from an economic perspective and both parties
will make the deal that provides them the best value. The cost principle calls for the
recognition of all accounting transactions at historic cost, or the amount paid or received

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when the transaction was concluded at arms length. The realization principle implies
that revenue should be recognized only at the time of the sale. The matching principle
dictates that revenue is first recognized and then is matched with the costs incurred in
producing the revenue. Finally, the going concern assumption implies that the firm will
continue to operate and that all assets should be recorded at their cost rather than at their
liquidation value.

3.4

Explain why firms prefer to use accelerated depreciation methods over the straight-line
method for tax purposes.

When a firm uses accelerated depreciation, the depreciation expense is higher than with
the straight-line method. This reduces the taxable income and the amount of tax paid by
the firm. As a result of this higher noncash expense, the firms cash flow is higher.

3.5

What is treasury stock? Why do firms have treasury stock?

Any shares repurchased by the company in the open market are recorded as treasury
stock in the shareholders equity account in the balance sheet. The most common reason
for firms doing this is to reduce the number of shares outstanding in the market when the
management believes that its firms stock is undervalued. This reduction in the number of
shares outstanding is expected to boost the share price.

3.6

Define book-value accounting and market- value accounting.

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Book-value accounting implies that all assets and liabilities are recorded and reported at
the historical cost when they were acquired. Market-value accounting requires that all
assets and liabilities are reported at their current market value.

3.7

Compare and contrast depreciation expense and amortization expense.

Depreciation expense is the amount by which a firms fixed assets are written down in a
period during which the assets are utilized for generating cash flows. Amortization is the
amount by which intangible assets like goodwill, patents, license, copyrights, and
trademarks are written down in any period that they are utilized by the firm to generate
benefits. Both depreciation and amortization are noncash expenses that will serve to
boost the firms after-tax cash flows.

3.8

Why are retained earnings not considered an asset of the firm?

Retained earnings are part of shareholders equity that has already been utilized by the
company. It is a liability of the company and corresponds to a claim by the firms
shareholders. The retained earnings reported on the balance sheet have already been
allocated by the company among various assets and hence are not available for current or
future uses. New retained earnings have to be generated to provide for new uses!

3.9

How does net cash flow differ from net income and why?

Page 30 of 54

Net income or profit after taxes is an accounting figure that includes both cash and
noncash expenses. In addition, revenues are recognized before they are collected and
expenses are recognized before they are paid. Net cash flow, on the other hand, only
recognizes cash inflows and cash outflows that have occurred. Accrual-based accounting
causes a time lag between the point when revenues and expenses are recorded and the
point when the cash flows actually occur.

3.10

What is the statement of cash flows, and what is its role?

This financial statement records both the cash inflows and cash outflows for a period of
time. Thus, it reports the changes in the cash position of a firm between successive
accounting periods.

Page 31 of 54

VIII.

Questions and Problems

BASIC

3.1

Balance sheet: Given the following information about the Elkridge Sporting Goods, Inc.,
construct a balance sheet for the period ending June 30, 2008. The firm had cash and
marketable securities of $25,135, accounts receivables of $43,758, inventory of
$167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts
payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and
common stock of $150,000. How much retained earnings does the firm have?

Solution:
Assets
Cash
Accounts receivable
Inventories
Total current assets
Net fixed assets
Other assets
Total assets

Book Value
$ 25,135
43,758
167,112
$236,005
325,422
13,125
$574,552

Liabilities
Accounts payables
Notes payables
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and

Book Value
$ 67,855
36,454
$104,309
223,125
150,000
97,118
$574,552

stockholders equity
3.2

Inventory accounting: Differentiate between FIFO and LIFO.

Solution: FIFO (first in, first out) refers to the practice of firms, when making sales, assuming
that the inventory that came in first (at a lower price) is being sold first. LIFO (last in,

Page 32 of 54

last out) implies that a firm is selling the higher cost, newer inventory first, leaving
the lower cost, older inventory on the balance sheet.

3.3

Inventory accounting: Explain how the choice of FIFO versus LIFO can affect a firms
balance sheet and income statement.

Solution: FIFO makes sense during times of rising prices because it allows the firm to eliminate
the lower priced inventory first, resulting in higher profit margin. This allows the firm
to leave higher valued inventory on the balance sheet. During inflationary times, a
firm using LIFO would see a lower profit margin and lower values of inventory on
the balance sheet. It is important that anyone who is analyzing firms using different
accounting methods on inventory recognize the impact on the bottom line (profit
margin and net income) and on current assets.

3.4

Market-value accounting: How does the use of market-value accounting help


managers?

Solution: Market-value accounting of both assets and liabilities allows managers to have a truer
picture of their companys financial condition and to do a better job of estimating
cash flows that the assets would generate. However, marking-to-market is not as easy
as it sounds because of the difficulties involved in coming up with the correct market
value of current assets and liabilities.

Page 33 of 54

3.5

Working capital: Laurel Electronics reported the following information at its annual
meetings. The company had cash and marketable securities worth $1,235,455, accounts
payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121,
notes payable worth $1,151,663, and other current assets of $121,455. What is the
companys net working capital?

Solution:
Total current assets

= $1,235,455 + $3,488,121 + $7,121, 599 + 121,455


= $11,966,630

Total current liabilities = $4,159,357 + $1,151,663


= $5,311,020
Net working capital

3.6

= $11,966,630 - $5,311,020 = $6,655,610

Working capital: The financial information for Laurel Electronics referred to in Problem
3.5 is all book value. Suppose marking-to-market reveals that the market value of the
firms inventory is 20 percent below its book value and its receivables are 25 percent
below its book value. The market value of its current liabilities is identical to the book
value. What is the firms net working capital using market values? What is the percent
change in net working capital?

Solution:
Market value of inventory = $7,121,599 * 0.80 = $5,697,279
Market value of receivables = $3,488,121 * 0.75 = $2,616,091

Page 34 of 54

Total current assets = $1,235,455 + $2,616,091 + $5,697,279 + 121,455


= $9,670,280
Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020
Net working capital = $9,670,280 - $5,311,020 = $4,359,260
$4,359,260 $6,656,610
$6,656,610
34.5%

Percent Change

3.7

Income statement: The Oakland Mills Company has disclosed the following financial
information in its annual reports for the period ending March 31, 2008. It produced sales
of $1.45 million, had cost of goods sold to the tune of $812,500, depreciation expenses of
$175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35
percent. What is the companys net income? Set up an income statement to answer the
question.

Solution:
Amount
$1,450.000.00
812,500.00
$ 637,500.00
175,000.00
$ 462,500.00
89,575.00
$ 372,925.00
130,523.75
$ 242,401.25

Revenues
Costs
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (35%)
Net income
3.8

Cash flow: Describe the organization of the statement of cash flows.

Page 35 of 54

Solution: The statement of cash flows identifies the cash inflows and cash outflows of the firms
for a specified period. This allows one to estimate the net cash flows from operations.
This financial statement is organized to report the cash flows resulting from the three
basic activities in any firmoperating, investing, and financing. See Exhibit 3.4 for
an example. The cash flows from operations are the results of netting all revenues
and expenses that result from the operating activities of the firm. Buying and selling a
firms assets lead to cash flows from investing activities. Cash flows from financing
activities arise from the firm borrowing from its investors and/or making payments to
its lenders and shareholders.

3.9

Cash flows: During 2008, Towson Recording Company increased its investment in
marketable securities by $36,845, funded fixed assets acquisitions of $109,455, and had
marketable securities of $14,215 mature. What is the net cash used in investing activities?

Solution:
Long-Term Investing Activities
Net property, equipment, and other assets
Net acquisitions and dispositions
Investments in marketable securities
Net cash used in investing activities
3.10

$(109,455.00)
0.00
(22,630.00)
$(132,085.00)

Cash flows: Caustic Chemicals identified the following cash flows as significant in its
meeting with analysts. During the year, it had repaid existing debt of $312,080 and raised
additional debt capital of $650,000. It also repurchased stock in the open market for a
total of $45,250. What is the net cash provided by financing activities?

Page 36 of 54

Solution:
Financing Activities
Loan repayment
Increase in long-term debt
Purchase of treasury stock
Net cash provided by financing activities
3.11

$(312,080)
650,000
(45,250)
$ 292,670

Cash flow: Identify and explain the noncash expenses that a firm may incur.

Solution: A firm may have several items on its income statement that did not result in any cash
outflow to the firm. The two largest are depreciation expenses and amortization
expenses. Other noncash expenses include deferred taxes, wages, and depletion
charges, which is similar to depreciation and used for natural resource assets. Prepaid
expenses also fit into this category as they represent expenses to the firm that are yet
to be paid out.

3.12

Tax: Define average tax rate and marginal tax rate.

Solution: The average tax rate is defined as the total taxes paid divided by taxable income.
The marginal tax rate, meanwhile, represents the tax rate that is paid on the last
dollar of income earned, or the rate that will be paid on the next dollar earned.

3.13

Tax: What is the relevant tax rate to use when making financial decisions? Explain why.

Page 37 of 54

Solution: Managers need to use the marginal tax rate for making financial decisions. This is
because any additional cash flows that result from a firms new projects will be taxed
at the marginal tax rate. Thus, this is the appropriate rate to use.

3.14

Tax: Manz Property Management Company announced that in the year ended June 30,
2008, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit
3.6.

Solution:
Earnings before tax = $1,478,936
Tax
Tax rate
15%
25
34
39
34
35
38
35

Income
$0 to $50,000
50,001 75,000
75,001 100,000
100,001 335,000
335,001 10,000,000
10,000,001 15,000,000
15,000,001 18,333,333
More than $18,333,333

$ 7,500.00
6,250.00
8,500.00
91,650.00
388,938.24

$502,838.2
Total taxes payable

INTERMEDIATE

Page 38 of 54

3.15

Balance sheet: Tim Dye, the chief financial officer of Blackwell Automotive, Inc., is
putting together this years financial statements. He has gathered the following
information. The firm had a cash balance of $23,015, accounts payable of $163,257,
common stock of $313,299, retained earnings of $512,159, inventory of $212,444,
goodwill and other assets equal to $78,656, net plant and equipment of $711,256, and
short-term notes payable of $21,115. It also has accounts receivables of $141,228 and
other current assets of $11,223. What amount of long-term debt does Blackwell
Automotive have?

Solution:
Liabilities and Stockholders
Assets
Cash and marketable

securities
Accounts receivable
Inventories
Other current assets
Total current assets
Net plant and equipment
Goodwill and other assets

141,258
212,444
11,223
$ 387,940
711,256
78,656

Total assets

23,015

$1,177,852

Equity
Accounts payable and accruals

$ 163,257

Notes payable
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and stockholders

21,115
$ 184,372
168,022
$ 352,394
313,299
512,159
$ 825,458
$1,177,852

equity

3.16

Balance sheet: Refer to the information for Blackwell Automotive in Problem 3.15.
What level of working capital does Blackwell Automotive have?

Solution:
Net working capital

Total current assets Total current liabilities

Page 39 of 54

3.17

$387,940 $184,372 = $203,568

Working capital: Mukhopadhya Network Associates has a current ratio of 1.60. Its
current assets are equal to $1,233,265, its accounts payables are $419,357, and its notes
payables are $351,663. Its inventory is currently at $721,599. The company plans to raise
funds in the short-term debt market and invest the entire amount in additional inventory.
How much can their notes payable increase without lowering their ratio of current assets
to current liabilities to below 1.50?

Solution:
Let x be the amount raised through notes payables.
New current liabilities = $184,372 + x
New current assets = $387,940 + x
Current assets
$387,940 x
1 .5
Current liabilitie s
$184,372 x
1.5 * ($184,372 x ) $387,940 x
1.5x x $387,940 $276,558
0.5x $111,382
x $111,382 0.5
$222,764
Thus the firm can add up to $222,764 in inventory by raising money through notes
payable without changing the ratio of current assets to current liabilities to more than
1.50. (This ratio of current assets to current liabilities is known as the current ratio and
will be discussed in the next chapter.)

Page 40 of 54

3.18

Market value: Reservoir Bottling Co. reported to shareholders the following


information. It has total current assets worth $237,513 at book value and $219,344 at
market value. In addition, its long-term assets include plant and equipment valued at
market for $343,222, while their book value is $362,145. The companys total current
liabilities are valued at market for $134,889, while their book value is $129,175. Both the
book value and the market value of its long-term debt is $144,000. If the companys total
assets are equal to a market value of $562,566 (book value of $599,658), what is the
difference in the book value and market value of its stockholders equity?

Solution:
Book
Assets
Total current assets
Net fixed assets
Other assets
Total assets

Value
$237,513
362,145
0
$599,658

Market
Value
$219,344
343,222
0
$562,566

Liabilities
Total current liabilities
Long-term debt
Common stock
Total liabilities and stockholders

Book

Market

Value
$129,175
144,000
326,483
$599,658

Value
$134,889
144,000
283,677
$562,566

equity

Change in value of equity = $283,677 $326,483 = $(42,806)

3.19

Income statement: Nimitz Rental Company provided the following information to its
auditors. For the year ended March 31, 2008, the company had revenues of $878,412,
general and administrative expenses of $352,666, depreciation expenses of $131,455,
leasing expenses of $108,195, and interest expenses equal to $78,122. If the companys
tax rate was 34 percent, what is its net income after taxes?

Page 41 of 54

Solution:
Nimitz Rental Company
Income Statement as of March 31, 2008 (in $ 000s)
Net sales
Selling and administrative expenses
Leasing expenses
EBITDA
Depreciation
EBIT
Interest expense
EBT
Taxes (34%)
Net income
3.20

Amount
$878,412
352,666
108,195
$417,551
131,455
$286,096
78,122
$207,974
70,711
$137,263

Income statement: Sosa Corporation recently reported an EBITDA of $31.3 million and
$9.7 million of net income. The company has $6.8 million interest expense, and the
corporate tax rate is 35 percent. What was the companys depreciation and amortization
expense?

Solution:
EBITDA

Amount
$31,300,000.0

Less: Depreciation and amortization


EBIT

0
9,576,923.08
$21,723,076.9

Interest
EBT

2
6,800,000.00
$14,923,076.9

Taxes (35%)
Net income

2
5,223,076.92
$ 9,700,000.00

Page 42 of 54

3.21

Income statement: Fraser Corporation has announced that its net income for the year
ended June 30, 2008, is $1,353,412. The company had an EBITDA of $ 4,967,855, and
its depreciation and amortization expense was equal to $1,112,685. The companys tax
rate is 34 percent. What is the amount of interest expense for Fraser Corporation?

Solution:
Amount
$4,967,855.00
1,112,685.00
$3,855,170.00
1,804,545.76
$2,050,624.24
697,212.24
$1,353,412.00

EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income
3.22

Income statement: Carmichael Hobby Shop has an EBITDA of $512,725.20, an EBIT of

$362,450.20, and a cash flow of $348,461.25. What is the net income after taxes for this
firm?

Solution:
Amount
$1,314,680.00
801,954.80
$512,725.20
150,275.00
$362,450.20
62,168.00
$300,282.20
102,095.95
$198,186.25

Revenues
Costs
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income

Page 43 of 54

3.23

Retained earnings: Columbia Construction Company earned $451,888 during the year
ended June 30, 2008. After paying out $225,794 in dividends, the balance went into
retained earnings. If the firms total retained earnings were $846,972, what was the level
of retained earnings on its balance sheet on July 1, 2007?

Solution:
Columbia Construction Company
Retained Earnings for 2008 (in $000s)
Balance of retained earnings, July 1, 2007
Add: Net income, 2008
Less: Dividends to common stockholders
Balance of retained earnings, June 30, 2008
3.24

$ 621,178.00
451,588.00
(225,794.00)
$ 846,972.00

Cash flow: Refer to the information given in Problem 3.19. What is the cash flow for
Nimitz Rental?

Solution:
Cash flow from operation

3.25

Net income + Depreciation

$137,263 + $131,455

$268,718

Tax: Mount Hebron Electrical Companys financial statements indicated that the
company had an EBIT of $718,323. Its interest rate on debt of $850,000 was 8.95
percent. Calculate the amount of taxes the company is likely to owe. What are the
marginal and the average tax rates for this company?

Page 44 of 54

Solution:
EBIT
Interest
EBT

$718,323.00
76,075.00
$642,248.00
Tax

Tax rate
15%
25
34
39
34
35
38
35

Income
$0 to $50,000
50,001 75,000
75,001 100,000
100,001 335,000
335,001 10,000,000
10,000,001 15,000,000
15,000,001 18,333,333
More than $18,333,333

$ 7,500.00
6,250.00
8,500.00
91,650.00
104,464.32

$218,364.3
Total taxes payable
Marginal tax rate

34%

Average tax rate

Total taxes / Taxable income

$218,364.22 / $642,248

34%

ADVANCED

3.26

Income statement: The Centennial Chemical Corp. announced that for the period ending
March 31, 2008, it had earned income after taxes worth $5,330,275 on revenues of
$13,144,680. The companys costs (excluding depreciation and amortization) amounted

Page 45 of 54

to 61 percent of sales, and it had interest expenses of $392,168. What is the firms
depreciation and amortization expense if its tax rate was 34 percent?

Solution:

3.27

Revenues

Amount
$13,144,680.0

Costs
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income

0
8,018,254.80
$ 5,126,425.20
540,275.00
$ 4,586,150.20
392,168.00
$ 4,193,982.20
1,425,953.95
$ 5,330,275.00

Retained earnings: Eau Claire Paper Mill, Inc., had, at the beginning of the fiscal year,
April 1, 2007, retained earnings of $323,325. During the year ended March 31, 2008, the
company produced net income after taxes of $713,445 and paid out 45 percent of its net
income as dividends. Construct a statement of retained earnings and compute the yearend balance of retained earnings.

Solution:
Balance of retained earnings, April 1, 2007
Add: Net income, 2008
Less: Dividends to common stockholders
Balance of retained earnings, March 31, 2008
3.28

$ 323,325.00
713,445.00
(321,050.25)
$ 715,719.75

Taxes: Menomonie Casino Company earned $23,458,933 before interest and taxes for the
fiscal year ending March 31, 2008. If the casino had interest expenses of $1,645,123,

Page 46 of 54

calculate its tax burden using Exhibit 3.6. What are the marginal and the average tax rates
for this company?

Page 47 of 54

Solution:
EBIT
Interest
EBT

$23,458,933.00
1,645,123.00
$21,813,810.00
Tax

Tax rate
15%
25
34
39
34
35
38
35

Income
$0 to $50,000
50,001 75,000
75,001 100,000
100,001 335,000
335,001 10,000,000
10,000,001 15,000,000
15,000,001 18,333,333
More than $18,333,333
Total taxes payable

Marginal tax rate

35%

Average tax rate

Total taxes / Taxable income

$7,634,833.49 / $21,813,810

35%

3.29

7,500.00
6,250.00
8,500.00
91,650.00
3,286,100.00
1,750,000.00
1,266,666.54
1,218,166.95
$7,634,833.4
9

Cash flows: Vanderheiden Hog Products Corp. provided the following financial
information for the quarter ending June 30, 2008:

Net income: $189,425


Depreciation and amortization: $63,114
Increase in receivables: $ 62,154

Page 48 of 54

Increase in inventory: $57,338


Increase in accounts payables: $37,655
Decrease in other current assets: $27,450

What is this firms cash flow from operating activities during this quarter?

Page 49 of 54

Solution:
Operating Activities
Net income
Additions (sources of cash)
Depreciation and amortization
Increase in accounts payable
Decrease in other current assets
Increase in accrued income taxes
Subtractions (uses of cash)
Increase in accounts receivable
Increase in inventories
Net cash provided by operating activities
3.30

$189,425
63,114
37,655
27,450
0
(62,154)
(57,338)
$198,152

Cash flows: Analysts following the Tomkovick Golf Company were given the following
information for the year ended June 30, 2008:

Assets
Cash and marketable securities
Accounts receivable
Inventory
Other current assets
Total current assets
Plant and equipment
Less: Accumulated depreciation
Net plant and equipment
Goodwill and other assets
Total assets
Liabilities and Stockholders Equity
Accounts payable and accruals
Notes payable
Accrued income taxes
Total current liabilities
Long-term debt
Total liabilities
Preferred stock
Common stock (10,000 shares)
Additional paid-in capital
Retained earnings
Less: Treasury stock
Total common equity
Total liabilities and stockholders equity

Page 50 of 54

2008

2007

33,411
260,205
423,819
41,251
$ 758,686
1,931,719
(419,044)
$1,512,675
382,145
$2,653,506

16,566
318,768
352,740
29,912
$ 717,986
1,609,898
(260,678)
$1,403,220
412,565
$2,533,771

2008
$ 378,236
14,487
21,125
$ 413,848
679,981
$1,093,829
__
10,000
975,465
587,546
13,334
$1,559,677
$2,653,506

2007
$ 332,004
7,862
16,815
$ 356,681
793,515
$1,150,196
__
10,000
975,465
398,110
__
$1,383,575
$2,533,771

In addition, it was reported that the company had a net income of $ 3,155,848 and that
depreciation expenses were equal to $212,366.
a. Construct a cash flow statement for this firm.
b. Calculate the net cash provided by operating activities.
c. What is the net cash used in investing activities?
d. Compute the net cash provided by financing activities.

Solution:
Tomkovick Golf Company
Year ended June 30, 2008
Operating Activities
Net income
Additions (sources of cash)
Depreciation and amortization
Increase in accounts payable
Decrease in accounts receivable
Increase in accrued income taxes
Subtractions (uses of cash)
Increase in other current assets
Increase in inventories
Net cash provided by operating activities
Long-Term Investing Activities
Increase in property equipment
Decrease in goodwill and other assets
Net cash used in investing activities
Financing Activities
Increase in notes payable
Decrease in long-term debt
Payment of cash dividends
Purchase of treasury stock
Net cash provided by financing activities
Effect of exchange rates on cash
Net increase in cash and marketable securities
Cash and securities at beginning of year
Cash and securities at end of year

Page 51 of 54

$ 3,155,848.00
212,366.00
46,232.00
58,563.00
4,310.00
(11,339.00)
(71,079.00)
$ 3,394,901.00
$ (321,821.00)
30,420.00
$ (291,401.00)
$

6,625.00
(113,534.00)
(2,966,412.00)
(13,334.00)
$(3,086.655.00)
$
$

0.00
16,845.00
16,566.00
33,411.00

Sample Test Problems

3.1

Drayton, Inc., has current assets of $256,312, and total assets of $861,889. It also has
current liabilities of $141,097, common equity of $200,000, and retained earnings of
$133,667. How much long-term debt does the firm have?

Solution:
Assets
Cash
Accounts receivable
Inventories
Total current assets

Book Value
$ 32,322.00
47,758.00
176,232.00
$256,312.00

Liabilities and Stockholders Equity


Accounts payables
Notes payables

Net fixed assets


Other assets

$579,452.00
26,125.00

Long-term debt
Common stock
Retained earnings
Total liabilities and stockholders equity

Total assets

3.2

$861,889.00

Total current liabilities

Book Value
$ 86,755.00
54,342.00
$141,097.00
$387,125.00
200,000.00
133,667.00
$861,889.00

Ellicott Testing Company produced revenues of $745,000 in 2008. It has expenses


(excluding depreciation) of $312,640, depreciation of $65,000, and interest expense of
$41,823. It pays a marginal tax rate of 34 percent. What is the firms net income after
taxes?

Solution:
Amount
$745,000.00
312,640.00
$432,360.00
65,000.00
$367,360.00
41,823.00
$325,537.00
110,682.58
$214,854.42

Revenues
Costs
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income
Page 52 of 54

3.3

Tejada Enterprises reported an EBITDA of $7,300,125 and $3,328,950 of net income for
the fiscal year ended September 30, 2008. The company has $1,155,378 interest expense,
and the corporate tax rate is 35 percent. What was the companys depreciation and
amortization expense?

Solution:
Amount
$7,300,125
1,023,285
$6,276,840
1,155,378
$5,121,462
1,792,512
$3,328,950

EBITDA
Depreciation
EBIT
Interest
EBT
Taxes (34%)
Net income
3.4

In the year ended June 30, 2008, Tri King Company increased its investment in
marketable securities by $234,375, funded fixed assets acquisition by $1,324,766, and
sold $77,215 of long-term debt. In addition, the firm had a net inflow of $365,778 from
selling certain assets. What is the net cash used in investing activities?

Solution:
Long-Term Investing Activities
Net property, equipment and other assets
Net acquisitions and dispositions
Investments in marketable securities
Net cash used in investing activities
3.5

$(1,324,766)
365,778
(311,590)
$(1,270,578)

Triumph Soccer Club has the following cash flows during this year. It repaid existing
debt of $875,430, while raising additional debt capital of $1,213,455. It also repurchased

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stock in the open markets for a total of $71,112. What is the net cash provided by
financing activities?

Solution:
Financing Activities
Loan repayment
Increase in long-term debt
Purchase of treasury stock
Net cash provided by financing activities

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$(875,403)
1,213,455
71,112
$ 409,137