This Document Contains Chapters 1 to 2 Chapter 1 The Goals and Activities of Financial Management Discussion Questions 1-1. How did the recession of 2007–2009 compare with other recessions since the Great Depression in terms of length? It was the longest. 1-2. What effect did the recession of 2007–2009 have on government regulation? It was greatly increased. 1-3. What advantages does a sole proprietorship offer? What is a major drawback of this type of organization? A sole proprietorship offers the advantage of simplicity of decision making and low organizational and operating costs. A major drawback is that there is unlimited liability to the owner. 1-4. What form of partnership allows some of the investors to limit their liability? Explain briefly. A limited partnership allows some of the partners to limit their liability. Under this arrangement, one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners are designated limited partners and are liable only for their initial contribution. The limited partners are normally prohibited from being active in the management of the firm. 1-5. In a corporation, what group has the ultimate responsibility for protecting and managing the stockholders' interests? The board of directors. 1-6. What document is necessary to form a corporation? The articles of incorporation. 1-7. What issue does agency theory examine? Why is it important in a public corporation rather than in a private corporation? Agency theory examines the relationship between the owners of the firm and the managers of the firm. In privately owned firms, management and the owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements and the like. As a company moves from private to public ownership, management now represents all owners. This places management in the agency position of making decisions in the best interest of all shareholders. 1-8. Why are institutional investors important in today's business world? Because institutional investors such as pension funds and mutual funds own a large percentage of major U.S. companies, they are having more to say about the way publicly owned companies are managed. As a group, they have the ability to vote large blocks of shares for the election of a board of directors, which is supposed to run the company in an efficient, competitive manner. The threat of being able to replace poor performing boards of directors makes institutional investors quite influential. Since these institutions, like pension funds and mutual funds, represent individual workers and investors, they have a responsibility to see that the firm is managed in an efficient and ethical way. 1-9. Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of maximization of shareholder wealth? The problem with a profit maximization goal is that it fails to take account of risk, the timing of the benefits is not considered, and profit measurement is a very inexact process. The goal of shareholders’ wealth maximization implies that the firm will attempt to achieve the highest possible total valuation in the marketplace. It is the one overriding objective of the firm and should influence every decision. 1-10. When does insider trading occur? What government agency is responsible for protecting against the unethical practice of insider trading? Insider trading occurs when anyone with non-public information buys or sells securities to take advantage of that private information. The Securities and Exchange Commission is responsible for protecting markets against insider trading. In the past, people have gone to jail for trading on non-public information. This has included company officers, investment bankers, printers who have information before it is published, and even truck drivers who deliver business magazines and read positive or negative articles about a company before the magazine is on the newsstands and then place trades or have friends place trades based on that information. The SEC has prosecuted anyone who profits from inside information. 1-11. In terms of the life of the securities offered, what is the difference between money and capital markets? Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Capital markets refer to securities with a life of more than one year. 1-12. What is the difference between a primary and a secondary market? A primary market refers to the use of the financial markets to raise new funds for the corporation. After the securities are sold to the public (institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. 1-13. Assume you are looking at many companies with equal risk. Which ones will have the highest stock prices? Given companies with equal risk, those companies with expectations of high return will have higher common stock prices relative to those companies with expectations of poor returns. 1-14. What changes can take place under restructuring? In recent times, what group of investors has often forced restructuring to take place? Restructuring can result in changes in the capital structure (liabilities and equity on the balance sheet). It can also result in the selling of low-profit-margin divisions with the proceeds reinvested in better investment opportunities, and sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring has also included mergers and acquisitions. Institutional investors have been very influential in forcing restructuring to take place in recent years. 1-15. How did the Sarbanes–Oxley Act impact corporations’ financial reports? The Sarbanes–Oxley Act (SOX) significantly impacted corporations' financial reports by imposing stricter regulations on financial disclosures and corporate governance. It required CEOs and CFOs to personally certify the accuracy of financial statements. SOX also mandated enhanced internal controls and auditing procedures to detect and prevent fraud. The act introduced harsher penalties for financial misstatements and fraud. Additionally, it increased the accountability of both executives and auditors in ensuring transparent financial reporting. 1-16. Name five requirements of the Dodd–Frank legislation. The Dodd–Frank Wall Street Reform and Consumer Protection Act includes several key requirements for financial institutions and markets. First, it established the Consumer Financial Protection Bureau (CFPB) to oversee financial products and services. Second, it mandated stricter regulation of financial derivatives and created the Volcker Rule to limit proprietary trading by banks. Third, it required increased transparency in credit ratings and the reporting of risk exposures. Fourth, it implemented "stress tests" for large banks to ensure financial stability. Finally, it provided whistleblower protections and financial incentives for reporting fraud or misconduct. Chapter 2 Review of Accounting Discussion Questions 2-1. Discuss some financial variables that affect the price-earnings ratio. The price-earnings ratio will be influenced by the earnings and sales growth of the firm, the risk or volatility in performance, the debt-equity structure of the firm, the dividend payment policy, the quality of management, and a number of other factors. The ratio tends to be future-oriented, and the more positive the outlook, the higher it will be. 2-2. What is the difference between book value per share of common stock and market value per share? Why does this disparity occur? Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and preferred stock and dividing by the number of common shares outstanding. It is based on the historical cost of the assets. Market value per share is based on the current assessed value of the firm in the marketplace and may bear little relationship to original cost. Besides the disparity between book and market value caused by the historical cost approach, other contributing factors are the growth prospects for the firm, the quality of management, and the industry outlook. To the extent these are quite negative or positive; market value may differ widely from book value. 2-3. Explain how depreciation generates actual cash flows for the company. The only way depreciation generates cash flows for the company is by serving as a tax shield against reported income. This non-cash deduction may provide cash flow equal to the tax rate times the depreciation charged. This much in taxes will be saved, while no cash payments occur. 2-4. What is the difference between accumulated depreciation and depreciation expense? How are they related? Accumulated depreciation is the sum of all past and present depreciation charges, while depreciation expense is the current year’s charge. They are related in that the sum of all prior depreciation expense should be equal to accumulated depreciation (subject to some differential related to asset write-offs). 2-5. How is the income statement related to the balance sheet? The earnings (less dividends) reported in the income statement is transferred to the ownership section of the balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the ownership interest in the balance sheet. 2-6. Comment on why inflation may restrict the usefulness of the balance sheet as normally presented. The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data may lose much of their meaning—particularly for plant and equipment and inventory. 2-7. Explain why the statement of cash flows provides useful information that goes beyond income statement and balance sheet data. The income statement and balance sheet are based on the accrual method of accounting, which attempts to match revenues and expenses in the period in which they occur. However, accrual accounting does not attempt to properly assess the cash flow position of the firm. The statement of cash flows fulfills this need. 2-8. What are the three primary sections of the statement of cash flows? In what section would the payment of a cash dividend be shown? The sections of the statement of cash flows are: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities The payment of cash dividends falls into the financing activities category. 2-9. What is free cash flow? Why is it important to leveraged buyouts? Free cash flow is equal to cash flow from operating activities: Minus: Capital expenditures required to maintain the productive capacity of the firm. Minus: Dividends (required to maintain the payout on common stock and to cover any preferred stock obligation). The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buyout. 2-10. Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay? Interest expense is a tax deductible item to the corporation, while dividend payments are not. The net cost to the corporation of interest expense is the amount paid multiplied by the difference of one minus the applicable tax rate. For example, $100 of interest expense costs the company $65 after taxes when the corporate tax rate is 35 percent—for example, $100 × (1 – 0.35) = $65. Chapter 2 Problems 1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $420,000 in the year 2012 with 309,000 shares outstanding. On January 1, 2013, the firm issued 20,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent. a. Compute earnings per share for the year 2012. b. Compute earnings per share for the year 2013. 2-1. Solution: Frantic Fast Foods a. Year 2012 b. Year 2013 2. Income statement (LO1) Sosa Diet Supplements had earnings after taxes of $800,000 in the year 2011 with 200,000 shares of stock outstanding. On January 1, 2012, the firm issued 50,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent. a. Compute earnings per share for the year 2011. b. Compute earnings per share for the year 2012. 2-2. Solution: Sosa Diet Supplements a. Year 2011 b. Year 2012 3. a. Gross profit (LO1) Hillary Swank Clothiers had sales of $383,000 and cost of goods sold of $260,000. What is the gross profit margin (ratio of gross profit to sales)? b. If the average firm in the clothing industry had a gross profit of 25 percent, how is the firm doing? 2-3. Solution: Hillary Swank Clothiers a. Sales $383,000 Cost of goods sold 260,000 Gross Profit $123,000 b. With a gross profit of 32 percent, the firm is outperforming the industry average of 25 percent. 4. Operating profit (LO1) A-Rod Fishing Supplies had sales of $2,500,000 and cost of goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s operating profit? 2-4. Solution: A-Rod Fishing Supplies Sales $2,500,000 Cost of goods sold 1,710,000 Gross Profit 790,000 Selling and administrative expense* 250,000 Depreciation expense** 280,800 Operating profit $ 259,200 * 10% × $2,500,000 = $250,000 ** 6% × $4,680,000 = $280,800 5. Income statement (LO1) Arrange the following income statement items so they are in the proper order of an income statement: Taxes Earnings per share Shares outstanding Earnings before taxes Interest expense Cost of goods sold Depreciation expense Earnings after taxes Preferred stock dividends Earnings available to common Operating profit stockholders Sales Selling and administrative expense Gross profit 2-5. Solution: Sales – Cost of goods sold Gross profit – Selling and administrative expense – Depreciation expense Operating profit – Interest expense Earnings before taxes – Taxes Earnings after taxes – Preferred stock dividends Earnings available to common stockholders Shares outstanding Earnings per share 6. Income statement (LO1) Given the following information, prepare in good form an income statement for the Dental Drilling Company. Selling and administrative expense $ 112,000 Depreciation expense 73,000 Sales 489,000 Interest expense 45,000 Cost of goods sold 156,000 Taxes 47,000 2-6. Solution: Dental Drilling Company Income Statement Sales $ 489,000 Cost of goods sold $ 156,000 Gross profit $ 333,000 Selling and administrative expense $ 112,000 Depreciation expense $ 73,000 Operating profit $ 148,000 Interest expense $ 45,000 Earnings before taxes $ 103,000 Taxes $ 47,000 Earnings after taxes $ 56,000 7. Income statement (LO1) Given the following information, prepare in good form an income statement for Jonas Brothers Cough Drops. Selling and administrative expense $ 328,000 Depreciation expense 195,000 Sales 1,660,000 Interest expense 129,000 Cost of goods sold 560,000 Taxes 171,000 2-7. Solution: Jonas Brothers Cough Drops Income Statement Sales $1,660,000 Cost of goods sold 560,000 Gross profit 1,100,000 Selling and administrative expense 328,000 Depreciation expense 195,000 Operating profit 577,000 Interest expense 129,000 Earnings before taxes 448,000 Taxes 171,000 Earnings after taxes $ 277,000 8. Determination of profitability (LO1) Prepare in good form an income statement for Franklin Kite Co. Inc. Take your calculations all the way to computing earnings per share. Sales $900,000 Shares outstanding 50,000 Cost of goods sold 400,000 Interest expense 40,000 Selling and administrative expense 60,000 Depreciation expense 20,000 Preferred stock dividends 80,000 Taxes 50,000 2-8. Solution: Franklin Kite Company Income Statement Sales $900,000 Cost of goods sold 400,000 Gross profit 500,000 Selling and administrative expense 60,000 Depreciation expense 20,000 Operating profit $420,000 Interest expense 40,000 Earnings before taxes $390,000 Taxes 120,000 Earnings after taxes $270,000 Preferred stock dividends 80,000 Earnings available to common stockholders 190,000 Shares outstanding 50,000 Earnings per share $3.80 9. Determination of profitability (LO1) Prepare in good form an income statement for Virginia Slim Wear. Take your calculations all the way to computing earnings per share. Sales $1,360,000 Shares outstanding 104,000 Cost of goods sold 700,000 Interest expense 34,000 Selling and administrative expense 49,000 Depreciation expense 23,000 Preferred stock dividends 86,000 Taxes 100,000 2-9. Solution: Virginia Slim Wear Income Statement Sales $1,360,000 Cost of goods sold 700,000 Gross profit 660,000 Selling and administrative expense 49,000 Depreciation expense 23,000 Operating profit 588,000 Interest expense 34,000 Earnings before taxes 554,000 Taxes 100,000 Earnings after taxes 454,000 Preferred stock dividends 86,000 Earnings available to common stockholders $ 368,000 Shares outstanding 104,000 Earnings per share $ 3.54 10. Income statement (LO1) Precision Systems had sales of $820,000, cost of goods of $510,000, selling and administrative expense of $60,000, and operating profit of $103,000. What was the value of depreciation expense? Set this problem up as a partial income statement, and determine depreciation expense as the plug figure. 2-10. Solution: Precision Systems Sales $820,000 Cost of goods sold 510,000 Gross profit 310,000 Selling and administrative expense 60,000 Depreciation (plug figure) 147,000 Operating profit $103,000 11. Depreciation and earnings (LO1) Stein Books Inc. sold 1,900 finance textbooks for $250 each to High Tuition University in 2013. These books cost $210 to produce. Stein Books spent $12,200 (selling expense) to convince the university to buy its books. Depreciation expense for the year was $15,200. In addition, Stein Books borrowed $104,000 on January 1, 2013, on which the company paid 12 percent interest. Both the interest and principal of the loan were paid on December 31, 2013. The publishing firm’s tax rate is 30 percent. Did Stein Books make a profit in 2013? Please verify with an income statement presented in good form. 2-11. Solution: Stein Books Inc. Income Statement For the Year Ending December 31, 2013 Sales (1,900 books at $250 each) $475,000 Cost of goods sold (1,900 books at $210 each) 399,000 Gross profit 76,000 Selling expense 12,200 Depreciation expense 15,200 Operating profit…… $ 48,600 Interest expense ($104,000 × 12%) 12,480 Earnings before taxes 36,120 Taxes @ 30% 10,836 Earnings after taxes $ 25,284 12. Determination of profitability (LO1) Lemon Auto Wholesalers had sales of $1,000,000 in 2013 and cost of goods sold represented 78 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was $11,000 and interest expense for the year was $8,000. The firm’s tax rate is 30 percent. a. Compute earnings after taxes. b. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to $1,050,900. The extra sales effort will also reduce cost of goods sold to 74 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at $11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to $15,800. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. Will her ideas increase or decrease profitability? 2-12. Solution: Lemon Auto Wholesalers Income Statement a. Sales $1,000,000 Cost of goods sold (78% of sales) $ 780,000 Gross profit $ 220,000 Selling and administrative expense (12% of sales) $ 120,000 Depreciation $ 11,000 Operating profit $ 89,000 Interest expense $ 8,000 Earnings before taxes $ 81,000 Taxes @ 30% $ 24,300 Earnings after taxes $ 56,700 2-12. (Continued) b. Sales $1,050,900 Cost of goods sold (74% of sales) $ 777,666 Gross profit $ 273,234 Selling and administrative expense (14% of sales) $ 147,126 Depreciation $ 11,000 Operating profit $ 115,108 Interest expense $ 15,800 Earnings before taxes $ 99,308 Taxes @ 30% $ 29,792 Earnings after taxes $ 69,516 Ms. Carr’s ideas will increase profitability. 13. Balance sheet (LO3) Classify the following balance sheet items as current or noncurrent: Retained earnings Bonds payable Accounts payable Accrued wages payable Prepaid expenses Accounts receivable Plant and equipment Capital in excess of par Inventory Preferred stock Common stock Marketable securities 2-13. Solution: Retained earnings – noncurrent Accounts payable – current Prepaid expense – current Plant and equipment – noncurrent Inventory – current Common stock – noncurrent Bonds payable – noncurrent Accrued wages payable – current Accounts receivable – current Capital in excess of par – noncurrent Preferred stock – noncurrent Marketable securities – current 14. Balance sheet and income statement classification (LO1 & 3) Fill in the blank spaces with categories 1 through 7: 1. Balance sheet (BS) 5. Current liabilities (CL) 2. Income statement (IS) 6. Long-term liabilities (LL) 3. Current assets (CA) 7. Stockholders’ equity (SE) 4. Fixed assets (FA) Indicate Whether Item Is on Balance Sheet (BS) or Income Statement (IS) If on Balance Sheet, Designate Which Category Item _____ _____ Accounts receivable _____ _____ Retained earnings _____ _____ Income tax expense _____ _____ Accrued expenses _____ _____ Cash _____ _____ Selling and administrative expenses _____ _____ Plant and equipment _____ _____ Operating expenses _____ _____ Marketable securities _____ _____ Interest expense _____ _____ Sales _____ _____ Notes payable (6 months) _____ _____ Bonds payable, maturity 2019 _____ _____ Common stock _____ _____ Depreciation expense _____ _____ Inventories _____ _____ Capital in excess of par value _____ _____ Net income (earnings after taxes) _____ _____ Income tax payable 2-14. Solution: 1. Balance Sheet (BS) 2. Income Statement (IS) 3. Current Assets (CA) 4. Fixed Assets (FA) 5. Current Liabilities (CL) 6. Long-Term Liabilities (LL) 7. Stockholders Equity (SE) 2-14. (Continued) Indicate Whether Item is on Income Statement or Balance Sheet If Item Is on Balance Sheet, Designate Which Category Item BS CA Accounts Receivable BS SE Retained Earnings IS Income Tax Expense BS CL Accrued Expenses BS CA Cash IS Selling and Administrative expenses BS FA Plant & Equipment IS Operating Expenses BS CA Marketable Securities IS Interest Expense IS Sales BS CL Notes Payable (6 Months) BS LL Bonds Payable (Maturity 2019) BS SE Common Stock IS Depreciation Expense BS CA Inventories BS SE Capital in Excess of Par Value IS Net Income (Earnings after Taxes) BS CL Income Tax Payable 15. Development of balance sheet (LO3) Arrange the following items in proper balance sheet presentation: Accumulated depreciation............................. $309,000 Retained earnings.................................... 187,000 Cash................................................. 14,000 Bonds payable........................................ 136,000 Accounts receivable.................................. 54,000 Plant and equipment—original cost.................... 775,000 Accounts payable..................................... 35,000 Allowance for bad debts.............................. 9,000 Common stock, $1 par, 100,000 shares outstanding..... 100,000 Inventory............................................ 70,000 Preferred stock, $59 par, 1,000 shares outstanding... 59,000 Marketable securities................................ 24,000 Investments.......................................... 20,000 Notes payable........................................ 34,000 Capital paid in excess of par (common stock)......... 88,000 2-15. Solution: Assets Current Assets: Cash $ 14,000 Marketable securities 24,000 Accounts receivable $ 54,000 Less: Allowance for bad debts 9,000 45,000 Inventory 70,000 Total current assets $153,000 Other Assets: Investments 20,000 Fixed Assets: Plant and equipment $775,000 Less: Accumulated depreciation 309,000 Net plant and equipment 466,000 Total assets $ 639,000 2-15. (Continued) Liabilities and Stockholders’ Equity Current Liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities Bonds payable Total liabilities Stockholders’ equity: Preferred stock, $59 par, 1,000 shares outstanding Common stock, $1 par, 100,000 shares outstanding Capital paid in excess of par (common stock) Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity $ 35,000 34,000 $ 69,000 136,000 $205,000 59,000 100,000 88,000 187,000 $434,000 $639,000 16. Earnings per share and retained earnings (LO1 and 3) Elite Trailer Parks has an operating profit or $200,000. Interest expense for the year was $10,000; preferred dividends paid were $18,750; and common dividends paid were $30,000. The tax was $61,250. The firm has 20,000 shares of common stock outstanding. a. Calculate the earnings per share and the common dividends per share for Elite Trailer Parks. b. What was the increase in retained earnings for the year? 2-16. Solution: Elite Trailer Parks a. Operating profit (EBIT) $200,000 Interest expense 10,000 Earnings before taxes (EBT) $190,000 Taxes 61,250 Earnings after taxes (EAT) $128,750 Preferred dividends 18,750 Available to common stockholders $110,000 Common dividends 30,000 Increase in retained earnings $80,000 Dividends per share = $30,000/20,000 shares = $1.50 per share b. Increase in retained earnings = $80,000 17. Earnings per share and retained earnings (LO1 and 3) Quantum Technology had $669,000 of retained earnings on December 31, 2013. The company paid common dividends of $35,500 in 2013 and had retained earnings of $576,000 on December 31, 2012. How much did Quantum Technology earn during 2013, and what would earnings per share be if 47,400 shares of common stock were outstanding? 2-17. Solution: Quantum Technology Retained earnings, December 31, 2013 $669,000 Less: Retained earnings, December 31, 2012 576,000 Change in retained earnings $93,000 Add: Common stock dividends 35,500 Earnings available to common stockholders $128,500 Earnings per share 18. Price/earning ratio (LO2) Botox Facial Care had earnings after taxes of $370,000 in 2012 with 200,000 shares of stock outstanding. The stock price was $31.50. In 2013, earnings after taxes increased to $436,000 with the same 200,000 shares outstanding. The stock price was $42.00. a. Compute earnings per share and the P/E ratio for 2012. (The P/E ratio equals the stock price divided by earnings per share.) b. Compute earnings per share and the P/E ratio for 2013. c. Give a general explanation of why the P/E ratio changed. 2-18. Solution: Botox Facial Care a. EPS (2012) = $1.85 P/E ratio (2012) = Price/EPS = = 17.03x b. EPS (2013) = $2.18 P/E ratio (2013) = Price/EPS = = 19.27x c. The stock price increased by 33.33% while EPS only increased 17.84%. 19. Price/earning ratio (LO2) Stilley Corporation had earnings after taxes of $436,000 in 2013 with 200,000 shares outstanding. The stock price was $42.00. In 2014, earnings after taxes declined to $206,000 with the same 200,000 shares outstanding. The stock price declined to $27.80. a. Compute earnings per share and the P/E ratio for 2013. b. Compute earnings per share and the P/E ratio for 2014. c. Give a general explanation of why the P/E changed. You might want to consult the textbook to explain this surprising result. 2-19. Solution: Stilley Corporation a. EPS (2013) = $2.18 P/E ratio (2013) = Price/EPS = = 19.27x b. EPS (2014) P/E ratio (2014) = Price/EPS = c. As explained in the text, when EPS drops rapidly, the stock price might not decline as much, and the P/E ratio rises. A higher P/E ratio under adverse conditions is not a positive. 20. Cash flow (LO4) Identify whether each of the following items increases or decreases cash flow: Increase in accounts receivable Decrease in prepaid expenses Increase in notes payable Increase in inventory Depreciation expense Dividend payment Increase in investments Increase in accrued expenses Decrease in accounts payable 2-20. Solution: Increase in accounts receivable – decreases cash flow (use) Increase in notes payable – increases cash flow (source) Depreciation expense – increases cash flow (source) Increase in investments – decreases cash flow (use) Decrease in accounts payable – decreases cash flow (use) Decrease in prepaid expense – increases cash flow (source) Increase in inventory – decreases cash flow (use) Dividend payment – decreases cash flow (use) Increase in accrued expenses – increases cash flow (source) 21. Depreciation and cash flow (LO5) The Rogers Corporation has a gross profit of $880,000 and $360,000 in depreciation expense. The Evans Corporation also has $880,000 in gross profit, with $60,000 in depreciation expense. Selling and administrative expense is $120,000 for each company. Given that the tax rate is 40 percent, compute the cash flow for both companies. Explain the difference in cash flow between the two firms. 2-21. Solution: Rogers Corporation – Evans Corporation Rogers Evans Gross profit Selling and adm. expense Depreciation $880,000 120,000 360,000 $880,000 120,000 60,000 Operating profit Taxes (40%) $400,000 160,000 $700,000 280,000 Earnings after taxes Plus depreciation expense $240,000 $360,000 $420,000 $60,000 Cash flow $600,000 $480,000 Rogers had $300,000 more in depreciation which provided $120,000 (0.40 $300,000) more in cash flow. 22. Free cash flow (LO4) Nova Electrics anticipated cash flow from operating activities of $6 million in 2011. It will need to spend $1.2 million on capital investments in order to remain competitive within the industry. Common stock dividends are projected at $.4 million and preferred stock dividends at $0.55 million. a. What is the firm’s projected free cash flow for the year 2011? b. What does the concept of free cash flow represent? 2-22. Solution: Nova Electronics a. Cash flow from operations activities $6.00 million – Capital expenditures 1.20 – Common stock dividends 0.40 – Preferred stock dividends 0.55 Free cash flow $3.85 million b. Free cash flow represents the funds that are available for special financial activities, such as a leveraged buyout, increased dividends, common stock repurchases, acquisitions, or repayment of debt. 23. Book value (LO3) Landers Nursery and Garden Stores has current assets of $220,000 and fixed assets of $170,000. Current liabilities are $80,000 and long-term liabilities are $140,000. There is $40,000 in preferred stock outstanding and the firm has issued 25,000 shares of common stock. Compute book value (net worth) per share. 2-23. Solution: Landers Nursery and Garden Stores Current assets Fixed assets Total assets – Current liabilities – Long-term liabilities Stockholders’ equity – Preferred stock obligation Net worth assigned to common Common shares outstanding Book value (net worth) per share $220,000 170,000 $390,000 80,000 140,000 $170,000 40,000 $130,000 25,000 $ 5.20 24. Book value and market value (LO2 and 3) The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and long-term liabilities of $100,000. There is $40,000 in preferred stock outstanding; 20,000 shares of common stock have been issued. a. Compute book value (net worth) per share. b. If there is $22,000 in earnings available to common stockholders, and Holtzman’s stock has a P/E of 18 times earnings per share, what is the current price of the stock? c. What is the ratio of market value per share to book value per share? 2-24. Solution: Holtzman Corporation a. Total assets – Current liabilities – Long-term liabilities – Stockholders’ equity – Preferred stock Net worth assigned to common Common shares outstanding Book values (net worth) per share b. Earnings available to common Shares outstanding Earnings per share $400,000 50,000 100,000 $250,000 40,000 $210,000 20,000 $10.50 $22,000 20,000 $1.10 c. Market value per share (price) to book value per share $19.80/$10.50 = 1.89 25. Book value and market value (LO2 and 3) Amigo Software Inc. has total assets of $889,000, current liabilities of $192,000, and long-term liabilities of $154,000. There is $87,000 in preferred stock outstanding. Thirty thousand shares of common stock have been issued. a. Compute book value (net worth) per share. b. If there is $56,300 in earnings available to common stockholders, and the firm’s stock has a P/E of 23 times earnings per share, what is the current price of the stock? c. What is the ratio of market value per share to book value per share? (Round to two places to the right of the decimal point.) 2-25. Solution: Amigo Software, Inc. a. Total assets – Current liabilities – Long-term liabilities Stockholders’ equity – Preferred stock Net worth assigned to common Common shares outstanding Book value (net worth) per share b. Earnings available to common Shares outstanding Earnings per share $889,000 192,000 154,000 $543,000 87,000 $456,000 30,000 $ 15.20 $ 56,300 30,000 $ 1.88 c. Market value per share (price) to book value per share $43.24/$15.20 = 2.84 26. Book value and P/E ratio (LO2 and 3) Vriend Software Inc.’s book value per share is $15.20. Earnings per share is $1.88, and the firm’s stock trades in the stock market at 3.5 times book value per share, what will the P/E ratio be? (Round to the nearest whole number.) 2-26. Solution: Vriend Software Inc. 3.5 × book value per share = price 3.5 × $15.20 = $53.20 round to 28x 27. Construction of income statement and balance sheet (LO1 and 3) For December 31, 2012, the balance sheet of Baxter Corporation was as follows: ________________________________________________________________________ Current Assets Liabilities Cash $ 15,000 Accounts payable $ 17,000 Accounts receivable 20,000 Notes payable 25,000 Inventory 30,000 Bonds payable 55,000 Prepaid expenses 12,500 Fixed Assets Stockholders’ Equity Plant and equipment (gross)…. $255,000 Preferred stock 25,000 Less: Accumulated Common stock 60,000 depreciation 51,000 Paid-in capital 30,000 Net plant and equipment 204,000 Retained earnings 69,500 Total liabilities and Total assets $281,500 stockholders’ equity $281,500 ________________________________________________________________________ Sales for 2013 were $245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was $24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 2012 balances. The tax rate averaged 20 percent. $2,500 in preferred stock dividends were paid and $5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding. During 2013, the cash balance and prepaid expenses balances were unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 2013, at a cost of $40,000. Accounts payable increased by 20 percent. Notes payable increased by $6,500 and bonds payable decreased by $12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change. a. Prepare an income statement for 2013. b. Prepare a statement of retained earnings for 2013. c. Prepare a balance sheet as of December 31, 2013. 2-27. Solution: Baxter Corporation 2013 Income Statement a. Sales $245,000 Cost of good sold (60%) 147,000 Gross profit $ 98,000 Selling and administrative expense 24,500 Depreciation expense (8%) 20,400 Operating profit (EBIT) $ 53,100 Interest expense 9,100 Earnings before taxes $ 44,000 Taxes (20%) 8,800 Earnings after taxes (EAT) $ 35,200 Preferred stock dividends 2,500 Earnings available to common stockholder $ 32,700 Shares outstanding 10,000 Earnings per share $ 3.27 b. 2013 Statement of Retained Earnings Retained earnings balance, January 1, 2013 $ 69,500 Add: Earnings available to common stockholders, 2013 32,700 Deduct: Cash dividend declared in 2013 5,500 Retained earnings balance, December 31, 2013 $96,700 2-27. (Continued) c. 2013 Balance Sheet Current Assets Liabilities Cash………….. $ 15,000 Accounts payable $20,400 Accounts receivable…….. 22,000 Notes payable…. 31,500 Inventory……… 33,000 Bonds payable… 42,500 Prepaid expenses 12,500 _______ $82,500 $94,400 Fixed Assets Stockholders’ Equity Gross plant…... $295,000 Preferred stock... Common stock... $ 25,000 60,000 Accumulated depr………… (71,400) Paid in capital in excess of par… 30,000 Net plant…….. 223,600 Retained earnings 96,700 Total assets….. $306,100 Total liability & equity……….. $306,100 28. Statement of cash flows (LO4) Refer to the following financial statements for Crosby Corporation: a) Prepare a statement of cash flows for the Crosby Corporation using the general procedures indicated in Table 2–10. b) Describe the general relationship between net income and net cash flows from operating activities for the firm. c) Has the buildup in plant and equipment been financed in a satisfactory manner? Briefly discuss. d) Compute the book value per common share for both 2010 and 2011 for the Crosby Corporation. e) If the market value of a share of common stock is 3.3 times book value for 2004, what is the firm’s P/E ratio for 2011? _______________________________________________________________________ CROSBY CORPORATION Income Statement For the Year Ended December 31, 2011 Sales $2,200,000 Cost of goods sold 1,300,000 Gross profits 900,000 Selling and administrative expense 420,000 Depreciation expense 150,000 Operating income 330,000 Interest expense 90,000 Earnings before taxes 240,000 Taxes 80,000 Earnings after taxes 160,000 Preferred stock dividends 10,000 Earnings available to common stockholders $ 150,000 Shares outstanding 120,000 Earnings per share $ 1.25 Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, balance, January 1, 2011 $500,000 Add: Earnings available to common stockholders, 2011 150,000 Deduct: Cash dividends declared and paid in 2011 50,000 Retained earnings, balance, December 31, 2011 $600,000 Comparative Balance Sheets For 2010 and 2011 Year-End Year-End Assets 2010 2011 Current assets: Cash $ 70,000 $100,000 Accounts receivable (net) 300,000 350,000 Inventory 410,000 430,000 Prepaid expenses 50,000 30,000 Total current assets 830,000 910,000 Investments (long-term securities) 80,000 70,000 Plant and equipment 2,000,000 2,400,000 Less: Accumulated depreciation 1,000,000 1,150,000 Net plant and equipment 1,000,000 1,250,000 Total assets $1,910,000 $2,230,000 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 250,000 $ 440,000 Notes payable 400,000 400,000 Accrued expenses 70,000 50,000 Total current liabilities 720,000 890,000 Long-term liabilities: Bonds payable, 2011 70,000 120,000 Total liabilities 790,000 1,010,000 Stockholders’ equity: Preferred stock, $100 par value 90,000 90,000 Common stock, $1 par value 120,000 120,000 Capital paid in excess of par 410,000 410,000 Retained earnings 500,000 600,000 Total stockholders’ equity 1,120,000 1,220,000 Total liabilities and stockholders’ equity $1,910,000 $2,230,000 _______________________________________________________________________ (The following questions apply to the Crosby Corporation, as presented in Problem 27.) Solution 2-28 a): Crosby Corporation Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Net income (earnings after taxes) Adjustments to determine cash flow from operating activities: Add back depreciation Increase in accounts receivable Increase in inventory Decrease in prepaid expenses Increase in accounts payable Decrease in accrued expenses Total adjustments Net cash flows from operating activities Cash flows from investing activities: Decrease in investments Increase in plant and equipment Net cash flows from investing activities Cash flows from financing activities: Increase in bonds payable Preferred stock dividends paid Common stock dividends paid Net cash flows from financing Net increase (decrease) in cash flows $150,000 (50,000) (20,000) 20,000 190,000 (20,000) 10,000 (400,000) 50,000 (10,000) (50,000) $160,000 $270,000 $430,000 (390,000) (10,000) $ 30,000 The student should observe that the increase in cash flows of $30,000 equals the $30,000 change in the cash account on the balance sheet. This indicates the statement is correct. Solution 2-28 b): Cash flows from operating activities far exceed net income. This occurs primarily because we add back depreciation of $319,000 and accounts payable increase by $248,000. Thus, the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations. Solution 2-28 c): The buildup in plant and equipment of $690,000 (gross) and $371,000 (net) has been financed, in part, by the large increase in accounts payable (248,000). This is not a very satisfactory situation. Short-term sources of funds can always dry up, while fixed asset needs are permanent in nature. This firm may wish to consider more long-term financing, such as a mortgage, to go along with profits, the increase in bonds payable, and the add-back of depreciation. Solution 2-28 d): Book value per share Book value per share (2010) Book value per share (2011) Solution 2-28 e): Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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