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This Document Contains Chapters 1 to 2 CHAPTER 1 Discussion Questions 1-1. Capital budgeting was the first area of study in which the financial manager was presented with analytical techniques for allocating resources among the various assets of the firm. 1-2. The student should be prepared to pay a higher price for the promised $2 from the Royal Bank. The risk is lower. 1-3. The goal of shareholder wealth maximization implies that the firm will attempt to achieve the highest possible valuation in the marketplace. It is the one overriding objective of the firm and should influence every decision. 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. 1-4. 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. 1-5. Because institutional investors such as pension funds (Ontario Teachers’, CPP) and mutual funds own a large percentage of major 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 suppose 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. 1-6. Insider trading occurs when someone has information that is not available to the public and then uses the information to profit from trading in a company’s common stock. The provincial securities commissions are responsible for protecting against insider trading. 1-7. Regulations set the “rules of the game” in which the firm operates. Shareholder wealth maximization can and should still be sought within the rules, for economic efficiency to be achieved. Society judges deregulation benefits against the costs of regulation. 1-8. Management operates within a competitive market and they should be paid their opportunity cost. If managers do not act to maximize shareholder wealth, share prices will become depressed. To the extent manager’s compensation is tied to share price performance, shareholders can fire managers, and there exists a market for corporate control, management will be compensated based on their economic contribution. 1-9. Daily functions- cash management, inventory control, receipt and disbursement of funds. Occasional- share issue, bond issue, capital budgeting and dividend decisions. 1-10. There is unlimited liability for the sole proprietorship and partnership forms of ownership. Under the limited partnership, only the general partner(s) has unlimited liability, with limited partners obligated only to the extent of their initial contribution. Finally, all shareholders in a corporation have limited liability, although owner/ shareholders of small businesses often have to give banks their personal guarantees. 1-11. The corporate form is best suited to large organizations because of the easy divisibility of ownership through issuance of shares. Also, the corporation has continued existence independent of any shareholder. 1-12. 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. 1-13. A primary market refers to the use of the financial markets to raise new funds. 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. A liquid secondary market promotes a successful primary market. 1-14. Government debt loads require financing. This puts large demands ($1 trillion in accumulated federal and provincial debt in 2011) on the capital markets, putting upward pressure on interest rates and a corporation’s ability to invest in capital projects. When governments finance their deficits abroad they place Canada’s economic levers outside of our control and debt servicing payments can impact the foreign exchange markets. As government debt loads have been reduced in recent years there has been less pressure on interest rates, corporations have borrowed more, but there have been less ‘risk free’ government securities available (causing liquidity problems particularly in the money markets). 1-15. Stakeholders include: shareholders, creditors, employees, unions, environmentalists, consumer groups, Canada Revenue Agency, government regulatory bodies, customers, managers and others. Internet Resources and Questions 1. 2. 3. 4. 5. http://nobelprize.org www.fin.gc.ca/afr/2001/frt01_e.pdf www.bankofcanada.ca www.onex.com/Principles_and_Values.aspx http://www.rbc.com/aboutus/visionandvalues.html www.bce.ca/en/responsibility Problems 1-1. Incubus Corporation a. Common stock (contributed capital) Retained earnings (deficit) $40,000 (7,000) $33,000 b. Common stock Retained earnings $40,000 2,000 $42,000 c. Common stock Retained earnings $60,000 8,000 $68,000 1-2. Puppet Corporation a. Common stock Retained earnings $20,000 2,000 $22,000 b. Common stock Retained earnings $20,000 8,000 $28,000 c. Common stock Retained earnings $30,000 10,500 $40,500 1-3. Two to Ten Dollar Corporation would be expected to have the higher valuation because the $10 per share dividend (although achieved later) is expected to be sustained for a much longer period of time. Building earnings for longer term sustainability is more valuable than quick returns that peter out. 1-4. 1-5. a. b. c. d. Share value is a combination of expected earnings (or cash flow) and the risk inherent in those cash flows. Although the financial institution reports lower earnings it is because of restructuring charges that lower reported earnings. Cash flows are not likely to be effected. Future earnings should be more reliable and therefore less risky than those of the new health services company. Therefore the market is likely to suggest a higher value for the financial institution. Board of Directors Decision A combination of high profit margins and strong consumer acceptance should be positive for share value. However a new product introduces a high degree of risk that will mitigate higher share values. More detailed financial information for investors should increase their confidence in the activities of the firm and lower the risk of their investment. This will be offset by the likely increase costs of providing this information. In an environment of questionable ethics by management this should be slightly positive to share value. Pollution control devices will increase firm costs. The local residents will view the firm more positively which should have some positive cash flow effects as they may be more willing to purchase the firm’s products and will decrease possible litigations or harassment. Overall it is likely to be a neutral or slightly negative effect on share value. Aligning management compensation motivators with shareholder goals should be positive for share values with implemented. The effect however may be small. There is no correct answer. It depends on the tradeoff between risk, returns and costs. CHAPTER 2 Discussion Questions 2-1. 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 will be higher the more positive the outlook 2-2. 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 costs of the assets. Market value per share is based on 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. The only way amortization generates cash flows for the company is by serving as a tax shield against reported income. Allowable amortization for tax purposes is known as capital cost allowance (CCA). In most instances this will be different than accounting amortization. This non-cash deduction may provide cash flow equal to the tax rate times the amortization charged. This much in taxes will be saved, while no cash payments occur. 2-4. Accumulated amortization is the sum of all past and present amortization charges, while amortization expense is the current year's charge. They are related in that the sum of all prior amortization expense should be equal to accumulated amortization (subject to some differential related to asset write-offs). 2-5. The balance sheet, for private companies, is based on historical costs. When prices are rising rapidly, historical cost data may lose much of their meaning - particularly for plant, equipment and inventory. However, the balance sheet of public companies using IFRS is based on market values and opposite order whereby non-current assets are listed ahead of current assets. The same applies to the liabilities section that lists non-current liabilities first. 2-6. 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 changes in financial position fulfills this need. The values on these statements will differ for public companies using IFRS compared to private firms. 2-7. The sections of the statement of cash flows and sources of information are: Cash flows from operating activities (Income statement) Cash flows from investing activities (non-current assets section of balance sheet) Cash flows from financing activities (non-current liabilities and equity section) The payment of cash dividends falls into the financing activities category. 2-8. We can examine the various sources that were utilized by the firm as indicated on the statement. Possible sources for the financing of an increase in assets might be profits, increases in liabilities, or decreases in other asset accounts. 2-9. 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 buy-out (a company with limited cash acquiring stocks of another company to acquire control). 2-10. 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). The firm must bear the full burden of the cash outflow of dividend payments because they are not an expense, but rather a distribution out of retained earnings. Internet Resources and Questions 1. 2. 3. 4. 5. 6. 7. www.cica.ca www.cma-canada.org www.cga-canada.org www.iasb.org. www.kpmg.ca/taxi www.pwc.com/ca/tax www.cra-arc.gc.ca Problems (The following solutions use the 2010 tax rates in the text. The 2012 rates are also shown but subject to change). 2-1. Hansen Auto Parts Income Statement Sales.......................................................................... $470,000 Cost of goods sold.................................................... 140,000 Gross Profit.......................................................... 330,000 Selling and administrative expense......................... 60,000 Amortization expense.............................................. 70,000 Operating profit.................................................... 200,000 Interest expense........................................................ 40,000 Earnings before taxes........................................... 160,000 Taxes (22%)........................................................................ 35,200 Earnings after taxes............................................... $124,800 2-2. Virginia Slim Wear Income Statement Sales……………………………………………… Cost of goods sold……………………………….. Gross profit………………………………...….. Selling and administration expense………………. Amortization expense…………………………….. Operating profit……………………………….. Interest expense…………………………………… Earnings before taxes………………………….. Taxes …………………………………………….. Earnings after taxes……………………………. $600,000 200,000 400,000 40,000 20,000 340,000 30,000 310,000 100,000 210,000 Preferred stock dividends………………………… Earnings available to common shareholders…….. Shares outstanding……………………………….. Earnings per share……………………………….. 2-3. 80,000 $130,000 100,000 $1.30 Far East Fast Foods a. 2011 Earnings after taxes Shares outstanding Earnings per share $230,000 200,000 $1.15 b. 2012 Earnings after taxes ($230,000 × 125%) Shares outstanding Earnings per share $287,500 230,000 $1.25 2-4. Sheridan Travel a. EPS = $600,000 = $2.00 per share 300,000 b. New Net Income: $600,000 x 125% = $750,000 Shares: 300,000 + 40,000 = 340,000 shares New EPS = 750,000 = $2.21 per share 340,000 2-5. Kevin Bacon and Pork Company a. Sales Cost of goods sold Gross profit Gross profit (%) = $240,000 108,000 132,000 Gross profit $132,000 = = .55 = 55% Sales $240,000 With a gross profit of 55%, Kevin Bacon and Pork Company is under performing the industry average of 60%. 2-6. Aztec Book Company Income Statement For the Year ended December 31, 2012 Sales (1,400 books at $84 each).................................... $117,600 Cost of goods sold (1,400 books at $63 each).............. 88,200 Gross Profit............................................................... 29,400 Selling expense.............................................................. 2,000 Amortization expense.................................................... 5,000 Operating profit......................................................... 22,400 Interest expense.............................................................. 5,000 Earnings before taxes................................................ 17,400 Taxes @ 20%................................................................. 3,480 Earnings after taxes.................................................... $13,920 2-7. Carr Auto Wholesalers Income Statement a. Sales…………………………………………….. Cost of goods sold @ 65%................................... $900,000 585,000 Gross profit………………………………….. Selling and administration expense @ 9%......... Amortization expense…………………………... Operating profit……………………………… Interest expense…………………………………. Earnings before taxes………………………… Taxes @ 30%........................................................ Earnings after taxes…………………………… 315,000 81,000 10,000 224,000 8,000 216,000 64,800 $151,200 b. Sales…………………………………………….. Cost of goods sold @ 60%.................................... Gross profit…………………………………... Selling and administration expense @ 12%......... Amortization expense…………………….…….. Operating profit……………………………… Interest expense…………………………………. Earnings before taxes………………………… Taxes @ 30% …………………………………… Earnings after taxes…………………………… $1,000,000 600,000 400,000 120,000 10,000 270,000 15,000 255,000 76,500 $ 178,500 Ms. Hood’s idea will increase profitability. 2-8. Sales Cost of goods sold Gross profit Selling and administrative expense Amortization expense Operating profit Interest expense Earnings before taxes Taxes Earnings after taxes Preferred stock dividends Earnings available to common shareholders Shares outstanding Earnings per share 2-9. David’s Magic Stores a. Operating profit (EBIT)......................... Interest expense................................. Earnings before taxes (EBT).................. Taxes.................................................. Earnings after taxes (EAT)...................... Preferred dividends ........................... Available to common shareholders........ Common dividends............................ Increase in retained earnings.................. $210,000 30,000 180,000 59,300 120,700 24,700 $ 96,000 36,000 $ 60,000 Earnings per Share = Earnings available to common shareholders Number of shares of common stock outstanding = $96,000/16,000 shares = $6.00 per share Dividends per Share = $36,000/16,000 shares = $2.25 per share b. Payout ratio = $2.25/ $6.00 = .375 = 37.5% c. Increase in retained earnings = $60,000 d. Price/earnings ratio = $90/ $6.00 = 15.0 2-10. Thermo Dynamics a. Retained earnings, December 31, 2011............. Less: Retained earnings, December 31, 2012.... Change in retained earnings............................... Add: Common stock dividends.......................... Earnings available to common shareholders...... $450,000 400,000 50,000 25,000 $ 75,000 b. Earnings per share = $75,000/ 20,000 shares = $3.75 per share c. Payout ratio = $25,000/ $75,000 = .333 = 33% d. Price/earnings ratio = $30.00/ $3.75 = 8x 2-11. Brandon Fast Foods Inc. a. Operating Income $210,000 – Taxes $59,300 – Interest $24,700 = Net income after taxes $120,700 EPS = $120,000 / 16,000 shares = $7.54 EPS Common Dividend Per Share = Div. paid $36,000/16,000 shares = $2.25 Div. Per Share b. Increase in RE = Income $120,700 – Div. $36,000 = $84,700. 2-12. Common stock – noncurrent Accounts payable – current Preferred stock – noncurrent Prepaid expenses – current Bonds payable – noncurrent Inventory – current Investments – noncurrent Marketable securities – current Accounts receivable – current Plant and equipment – noncurrent Accrued wages payable – current Retained earnings – noncurrent 2-13. Assets Current Assets Cash................................................... Marketable securities......................... Accounts receivable........................... Less: Allowance for bad debts...... Inventory............................................ Total Current Assets................. Other Assets: Investments........................................ Capital Assets: Plant and equipment.......................... Less: Accumulated amortization.. Net plant and equipment................... Total Assets........................................... $ 10,000 20,000 $48,000 6,000 42,000 66,000 138,000 20,000 680,000 300,000 380,000 $538,000 Liabilities and Shareholders' Equity Current Liabilities: Accounts payable.............................. $ 35,000 Notes payable.................................... 33,000 Total current Liabilities................ 68,000 Long-Term Liabilities............................ Bonds payable................................... 136,000 Total Liabilities............................. Shareholders' Equity: Preferred stock, 1,000 shares outstanding….... Common stock, 100,000 shares outstanding.... Retained earnings............................................. Total Shareholders' Equity........................... Total Liabilities and Shareholders' Equity…….... 204,000 50,000 188,000 96,000 334,000 $538,000 2-14. Bengal Wood Company Current assets…………………….. Capital assets……………………… Total assets……………………….. – Current liabilities…………….….. – Long-term liabilities…………….. Shareholders’ equity………….…… – Preferred stock obligation……….. Net worth assigned to common…… Common shares outstanding……… Book value (net worth) per share… 2-15. Monique’s Boutique a. Total assets...................................... – Current liabilities......................... – Long-term liabilities.................... Shareholders' equity........................ – Preferred stock.............................. Net worth assigned to common....... Common shares outstanding…............ Book value (net worth) per share…..... $100,000 140,000 240,000 60,000 90,000 90,000 20,000 $ 70,000 17,500 $4.00 $600,000 150,000 120,000 330,000 75,000 $255,000 30,000 $8.50 b. Earnings available to common......... $33,600 Shares outstanding........................... Earnings per share............................ 30,000 $1.12 P/E ratio × earnings per share 12 × $1.12 = price = $13.44 c. Market value per share (price) to book value per share $13.44/$8.50 = 1.58 2-16. Phelps Labs a. Total assets...................................... – Current liabilities......................... – Long-term liabilities.................... Shareholders' equity........................ – Preferred stock.............................. Net worth assigned to common....... $1,800,000 595,000 630,000 575,000 165,000 $ 410,000 Common shares outstanding…............ Book value (net worth) per share…..... 20,000 $20.50 b. Earnings available to common......... $45,000 Shares outstanding........................... Earnings per share............................ 20,000 $2.25 P/E ratio × earnings per share = price 13 × $2.25= $29.25 c. Market value per share (price) to book value per share $29.25/$20.50 = 1.43 2-17. Phelps Labs (Continued) 2 × book value 2 × $20.5 P/E ratio = price = $41.00 = $41.00/$2.25 = 18.22 2-18. 1. Balance Sheet (BS) 2. Income Statement (IS) 3. Current Assets (CA) 4. Capital Assets (Cap A) 5. Current Liabilities (CL) 6. Long-Term Liabilities (LL) 7. Shareholders Equity (SE) Indicate Whether the Item is on Balance Sheet or Income Statement BS IS BS BS BS BS IS IS BS BS BS BS If the Item is on Balance Sheet, Designate Which Item Category SE Retained earnings Income tax expense CA Accounts receivable SE Common stock LL Bonds payable maturity 2012 CL Notes payable (6 months) Net income (EAT) Selling and adm. expenses CA Inventories CL Accrued expenses CA Cash Cap A Plant and equipment Indicate Whether the Item is on Balance Sheet or Income Statement BS IS IS BS BS IS BS If the Item is on Balance Sheet, Designate Which Item Category SE Retained earnings Sales Operating expenses CA Marketable securities CL Accounts payable Interest expense CL Income tax payable 2-19. Increase in inventory -- decreases cash flow (use) Decrease in prepaid expenses -- increases cash flow (source) Decrease in accounts receivable -- increases cash flow (source) Increase in cash -- decreases cash flow (use) Decrease in inventory -- increases cash flow (source) Dividend payment -- decreases cash flow (use) Increase in short-term notes payable -- increases cash flow (source) Amortization expense – does not affect cash flow (However in the cash flow statement it is added to net income to determine cash provided by operations) Decrease in accounts payable -- decreases cash flow (use) Increase in long-term investments -- decreases cash flow (use) 2-20. Jupiter Corporation – Saturn Corporation Gross profit......................... Selling and adm. expense... Jupiter $700,000 160,000 Saturn $700,000 160,000 Amortization....................... Operating profit.................. Taxes (40%)........................ Earnings after taxes.............. Plus amortization expense... Cash Flow........................... 240,000 300,000 120,000 180,000 240,000 $420,000 400,000 140,000 56,000 84,000 400,000 $484,000 Saturn had $160,000 more in amortization, which provided $64,000 (0.40 × $160,000) more in cash flow. We observe that Saturn’s taxes were less by: $120,000 ─ $56,000 = $64,000 (0.40 × $160,000). 2-21. a. Loofa Corporation Statement of Cash Flows For the Year Ended December 31, 2012 Operating activities: Net income (earnings after taxes)............... $ 54,610 Add items not requiring an outlay of cash: Amortization................................. 8,190 8.190 Cash flow from operations 62,800 Changes in non-cash working capital: Decrease in accounts receivable.... 5,460 Increase in inventory..................... (16,385) Increase in accounts payable......... 19,115 Decrease in taxes payable............... (5,455) Net change in non-cash working capital.... 2,735 Cash provided by operating activities........ 65,535 Investing activities: Increase in plant and equipment........... (19,115) Cash used in investing activities................ Financing activities: Issue of common stock ........................ 16,385 Common stock dividends paid............. (27,305) Cash used in financing activities………... Net increase in cash (equivalents) during the year.. Cash, beginning of year………. Cash, end of year……………... b. 2-22. a. (19,115) (10,920) 35,500 21,845 $ 57,345 Major accounts contributing to positive change in cash position are: net income, payables and common stock issuance. Negative change comes from inventory, plant and equipment and dividends paid. Waif Corporation Statement of Cash Flows For the Year Ended December 31, 2012 Operating activities: Net income (earnings after taxes)............... $ 91,000 Add items not requiring an outlay of cash: Amortization................................. $ 22,000 22,000 Cash flow from operations 113,000 Changes in non-cash working capital: Increase in accounts receivable.... (12,600) Decrease in inventory..................... 7,100 Decrease in accounts payable......... (10,000) Net change in non-cash working capital.... (15,500) Cash provided by operating activities........ 97,500 Investing activities: Increase in plant and equipment........... (48,000) Sale of land…………………………… 27,000 Cash used in investing activities................ (21,000) Financing activities: Retirement of bonds payable............... (40,000) Issue of common stock........................ 40,000 Common stock dividends paid……… (39,400) Cash used in financing activities………... Net increase in cash (equivalents) during the year (39,400) 37,100 Cash, beginning of year………. Cash, end of year……………... b. 2-23. 17,400 $ 54,500 Major accounts contributing to positive change in cash position are: net income, amortization, sale of land and common stock issuance. Negative change from plant and equipment, bond retirement, and dividends paid. Maris Corporation Statement of Cash Flows For the Year Ended December 31, 2012 Operating activities: Net income (earnings after taxes)................ $250,000 Add items not requiring an outlay of cash: Amortization.............................. $ 230,000 230,000 Cash flow from operations 480,000 Increase in accounts receivable.. (10,000) Increase in inventory.................. (30,000) Decrease in prepaid expenses.... 30,000 Increase in accounts payable..... 250,000 Decrease in accrued expenses... (20,000) Net change in non-cash working capital..... 220,000 Cash provided by operating activities......... 700,000 Investing activities: Decrease in investments..................... 10,000 Increase in plant and equipment......... (600,000) Cash used in investing activities................ (590,000) Financing activities: Increase in bonds payable .................. 60,000 Preferred stock dividends paid........... (10,000) Common stock dividends paid........... (140,000) Cash used in financing activities……….. Net increase (decrease) in cash Cash, at beginning of year Cash, end of year (90,000) 20,000 100,000 $120,000 2-24. Cash flow provided by operating activities exceeds net income by $450,000. This occurs primarily because we add back amortization of $230,000 and accounts payable increases by $250,000. Thus, the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations. 2-25. The buildup in plant and equipment of $600,000 (gross) and $370,000 (net) has been financed, in part, by the large increase in accounts payable ($250,000). This is not a very satisfactory situation. Short-term sources of funds can always dry up, while capital asset needs are permanent in nature. The 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 amortization. 2-26. Book value = Shareholders' equity - Preferred stock per share Common shares outstanding Book value per share (2011) = ($1,390,000 - $90,000) = $1,300,000 = $8.67 150,000 150,000 Book value per share (2012) = ($1,490,000 - $90,000) = $1,400,000 = $9.33 150,000 150,000 2-27. Market value = 2.8 × $9.33 = $26.12 P/E ratio = $26.12/ $1.60 = 16.33 or 16x 2-28. Winfield Corporation Statement of Cash Flows December 31, 2012 Operating activities: Net income (earnings after taxes)............... $ 14,000 Add items not requiring an outlay of cash: Amortization (buildings)..... $10,500 Gain on sale of investment…….. (5,250) Loss on sale of equipment........... 1,050 6,300 Cash flow from operations: 20,300 Changes in non-cash working capital: Increase in accounts receivable... (2,450) Increase in inventory................... (5,250) Increase in prepaid expenses....... (175) Decrease in accounts payable..... (1,750) Increase in accrued expenses...... 1,925 Decrease in interest payable........ (175) Net change in non-cash working capital...... (7,875) Cash provided by operating activities…...... 12,425 Investing activities: Proceeds from the sale of stock............ 8,750 Proceeds from the sale of equipment.... 2,450 Purchase of equipment.......................... (15,750) Purchase of land (see note)................... (8,750) Cash used in investing activities………….. (13,300) Financing activities: Increase in notes payable...................... 2,625 Increase in bonds payable..................... 5,250 Common stock dividends paid.............. (6,650) Cash provided by financing activities………….. 1,225 Net increase in cash 350 Cash, beginning of year 1,400 Cash, end of year $ 1,750 Issued note of $8,750 for land purchase (non-cash); due June 30, 2013. 2-29. a. Gardner Corporation Income Statement For the Year Ending December 31, 2012 Sales…………………………………………….. Cost of goods sold @ 60%................................... Gross profit………………………………….. $220,000 132,000 88,000 Selling and administration expense…………...... Amortization expense…………………………... Operating profit……………………………… Interest expense (1)…………………………….. Earnings before taxes………………………… Taxes @ 18%........................................................ Earnings after taxes…………………………… 22,000 20,000 46.000 6,000 40,000 7,200 $32,800 (1) Interest expense = (10% × $20,000 + 8% × $50,000) = $6,000 b. Gardner Corporation Balance Sheet December 31, 2012 Cash $ 10,000 Accounts receivable 16,500 Inventory 27,500 Prepaid expenses 12,000 Current assets 66,000 Capital assets: Plant and Equipment 285,000 less: acc. amortization 70,000 Net plant & equipment 215,000 Total assets $281,000 Accounts payable Notes payable Bonds payable Current liabilities Shareholders’ equity: Common stock Retained earnings 81,000 75,000 125,000 Total liabilities & equity $281,000 Acc. Amortization = $50,000 + $20,000 = $70,000 Retained Earnings = $105,000 + $20,000 = $125,000 c. $ 15,000 26,000 40,000 Gardner Corporation Statement of Cash Flows For the Year Ended December 31, 2012 Operating activities: Net income (earnings after taxes)................ $32,800 Add items not requiring an outlay of cash: Amortization.............................. $ 20,000 20,000 Cash flow from operations 52,800 Increase in accounts receivable.. (1,500) Increase in inventory.................. (2,500) Increase in accounts payable..... 3,000 Increase in notes payable*……. 6,000 Net change in non-cash working capital..... 5,000 Cash provided by operating activities......... 57,800 Investing activities: (35,000) Increase in plant and equipment......... Cash used in investing activities................ (35,000) Financing activities: Decrease in bonds payable.................. (10,000) Common stock dividends paid........... (12,800) Cash used in financing activities……….. Net increase (decrease) in cash (22,800) 0 Cash, at beginning of year Cash, end of year 10,000 $10,000 * Note: There is a healthy debate as to whether notes payable (trade related) should be included in operating or financing activities. d. Major accounts contributing to positive change in cash position are: net income and amortization. Negative change is from plant and equipment, bonds payable and dividends paid. 2-30. a. Ron’s Aerobics Ltd.. 2011 Net income Taxes @ 16.5% Income after taxes $68,000 11,220 $56,780 2012 Net income $142,000 Taxes @ 13% (Text) 18,460 Income after taxes $123,540 Note: Manitoba 2012 tax rate was actually changed to 15% b. The average tax rate is 14.75%. 2-31. Inland Fisheries Corp. a. Cash flow from operating activities $6.00 million - Capital expenditures 2.00 - Common share dividends 0.75 - Preferred share dividends 0.35 Free cash flow $2.90 million b. Free cash flow represents the funds that are available for special financial activities, such as the acquisition of another firm. 2-32. Nix Corporation Income Statement Sales............................................................... $485,000 Cost of goods sold......................................... 205,000 Gross Profit................................................... 280,000 Selling and administrative expense............... 70,000 Amortization expense.................................... 60,000 Operating profit............................................. 150,000 Interest expense............................................. 25,000 Earnings before taxes.................................... 125,000 Taxes @ 14.5% (Text)............................................ 18,125 Earnings after taxes......................................... $106,875 Note: The B.C. 2012 tax rate is changed to 13.5% 2-33. Nix Corporation (Continued) Tax savings on amortization 2-34. Alberta Ontario = $60,000 × 14.5% = $8,700 R.E. Forms Ltd. Net income $75,000 Taxes @ 14% 10,500 Income after taxes $64,500 Net income $75,000 Taxes @ 16.5% 12,375 Income after taxes $62,625 (2012 rate changed to 15.5%) 2-35. J.B. Wands $14,000 a. Investment (bonds) Bond interest @ 6.0% x $14,000 = $840.00 Marginal tax rate (Saskatchewan) 35.00% Deduct:Combined taxes payable 35% x $840 = 294.00 After tax bond yield (return) $546.00 After tax yield = return / investment x 100% = $546.00/ $14,000 × 100% = 3.90% Investment (shares) $14,000 Share dividend @ 5.0% x $14,000 = $700.00 Marginal tax rate (Saskatchewan) 17.5% Deduct:Combined taxes payable 17.5 x $700= 122.50 After tax bond yield (return) $577.50 After tax yield = return / investment x 100% = $577.50/ $14,000 × 100% = 4.125% The dividend provides a slightly better after tax yield (return). b. Bond interest is a fixed payment. Share dividends may not be paid and shares are subject to capital gains and losses. This makes the shares riskier. The result illustrates the “risk – return tradeoff”. 2-36. Billie Fruit A. Top bracket (Investment of $20,00) Share dividend @ 7.0% x $20,000 = $1,400.00 Marginal tax rate (Yukon) $1,400 x 17.23% Deduct: Combined taxes payable 241.22 After tax dividend yield (return) $1,158.78 After tax yield = return / investment x 100% = $1158.78/ $20,000 × 100% = 5.79% Capital gain @ 7.0% x $20,000 = $1,400.00 Marginal tax rate (Yukon) $1,400 x 21.20% Deduct: Combined taxes payable 296.80 After tax bond yield (return) $1,103.20 After tax yield = return / investment x 100% Better: $1,103.20/ $20,000 × 100% = 5.52% B. Middle bracket ($35,000 to $55,280) Share dividend @ 7.0% $1,400.00 Marginal tax rate (Yukon) 4.4% Combined taxes payable (4.4 x $1,400) 61.60 After tax dividend yield (return) $1,338.40 After tax yield Better: $1,338.40/ $20,000 × 100% = 6.69% Capital gain @ 7.0% $1,400.00 Marginal tax rate (Yukon) 15.84% Combined taxes payable 221.76 After tax yield (return) $1,178.24 After tax yield $1,178.24/ $20,000 × 100% = 5.89% 2-37. Jasper Corporation Yield is 7% On each $100 investment Interest paid to bondholder Co.’s Tax savings @ 40% 2.80 Combined bondholder tax payable @ 39%...... - 2.73 Net loss to government ($2.80 - $2.73) $0.07 $7.00 Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015

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