Solutions to Chapter 3

Accounting and Finance

1. The balance sheet shows the position of the firm at one point in time. It shows the
amounts of assets and liabilities at that particular time. In this sense it is like a
snapshot. The income statement shows the effect of business activities over the
entire year. Since it captures events over an extended period, it is more like a video.
The statement of cash flow is like the income statement in that it summarizes
activity over the full year, so it too is like a video.
Est time: 01–05
Financial statements

2.
a. Cash and marketable securities
b. Accounts receivable
c. Inventories
d. Total current assets
e. Net fixed assets
f. Debt due for repayment
g. Accounts payable
h. Total current liabilities
i. Long- term debt
j. Equity
Est time: 01–05
Financial statements

3.

Sophie's Sofas
Liabilities &
Assets Shareholders' Equity

Cash 10,000 Accounts payable 17,000

Accounts
receivable 22,000 Long term debt 170,000

Inventory 200,000 Shareholders' equity 145,000

Store & property 100,000

Total Liabilities &
Total assets 332,000 Shareholders' Equity 332,000

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Est time: 01–05
Balance sheet

4.
a. If the firm paid income taxes of $2,000, and the average tax rate was 20%,
then taxable income must have been: $2,000/0.20 = $10,000.
Therefore: Net income = taxable income  taxes = $8,000

k.

Revenues $ ???
 Cost of goods sold 8,000
 Administrative expenses 3,000
 Depreciation expense 1,000
 Interest expense 1,000
Taxable income $10,000 [from part (a)]
We conclude that revenues were $23,000.

l.

Revenues $23,000
 Cost of goods sold
 Administrative expenses 8
 Depreciation expense 3
EBIT 1 $11,000
Est time: 06–10
Income statement

5. Net income = increase in retained earnings + dividends

$900,000 = ($3,700,000  $3,400,000) + dividends  dividends = $600,000
Est time: 01–05
Financial statements

6.
a.
Shareholders’ equity = total assets  total liabilities

2013: Shareholders’ equity = $890  $650 = $240

2014: Shareholders’ equity = $1,040  $810 = $230

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 b.
Net working capital = current assets  current liabilities
2013: Net working capital = $90  $50 = $40
2014: Net working capital = $140  $60 = $80

c.
Taxable income = $1,950  $1,030  $350  $240 = $330
Taxes paid = 0.35  $330 = $115.50
Net income = $214.50

d.
Net income $214.50
Decrease (increase) in current assets (50.00)
Increase in current liabilities 10.00
Cash provided by operations $174.50

e.
Gross investment = increase in net fixed assets + depreciation
= $100 + $350 = $450

f.Current liabilities increased by $10. Therefore, current liabilities other than

accounts payable must have increased by $45.
Est time: 11–15
Financial statement analysis

7.

Liabilities &
Assets Shareholders' Equity
2013 2014 2013 2014
Current
Current assets 310 420 210 240
liabilities
Net fixed
1,200 1,420 Long-term debt 830 920
assets
Total assets 1,510 1,840 Total liabilities 1,040 1,160
Owners’ equity 470 680
Total 1,510 1,840

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 a. Owners’ equity = total assets  total liabilities (as shown in the balance sheet
above)

b. If the firm issued no stock, the increase in owners’ equity must be due entirely to
retained earnings. Since owners’ equity increased by $210 and dividends were
$100, net income must have been $310.

c. Since net fixed assets increased by $220, and the firm purchased $300 of new
fixed assets, the depreciation charge must have been $80.

d. Net working capital increased by $80, from ($310  $210) = $100 in 2013 to
($420  $240) = $180 in 2014.

e. Since long-term debt increased by $90, and the firm issued $200 of new long-term
debt, $110 of outstanding debt must have been paid off.
Est time: 11–15
Financial statement analysis

8. See answers in financial statements.

Balance Sheet
Liabilities & Shareholders' Equity
Assets Shareholders' Equity
Cash 15 Debt due for repayment 25
Receivables 35 Payables 35
Inventories 50 Total current liabilities 60
Total current assets 100
Long- term debt 350
Property, plant and
520 Total liabilities 410
equipment
Less accumulated
120 Shareholders' equity 90
depreciation
Net fixed assets 400
Total liabilities and
Total assets 500 500
shareholders' equity

Income Statement
Net sales 700
Cost of goods sold 580
Selling, G & A expenses 38
Depreciation 12
EBIT 70
Interest expense 25
Taxable income 45

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 Taxes 15
Net Income 30

Est time: 11–15

Financial statements

9.
a. Book value equals the $200,000 the founder of the firm has contributed in
tangible assets. Market value equals the value of his patent plus the value of the
production plant: $50,000,000 + $200,000 = $50,200,000.

b. Price per share = $50.2 million/2 million shares = $25.10

Book value per share = $200,000/2 million shares = $0.10
Est time: 01–05
Balance sheet

10.
a. Increase, because the announcement is likely to increase the market value of the
firm.

b. Increase, because an increase in the depreciation provision will decrease the

value of the assets. This will be reflected in a lower book value of equity.

c. Decrease, because an increase in inflation is likely to cause a drop in the market

value of its assets.
Est time: 01–05
Market and book values

11.
a. In early 2013 investors saw the value of assets on the books of these banks as
worth less than the value recorded, which may be historical value. Loans are the
primary assets for banks, and investors perceived a high likelihood that the loans
these banks made would default. If so, the banks would need to write down their
values, reducing income available to shareholders.

c. In contrast to the banks, investors perceived the assets of this company to be

worth more than the historical value presented on the company’s book.
Consistent with the analysis in part (a), shareholders in this company are
expecting to have higher income in future periods, and the value of the
company’s assets are expected to grow.
Est time: 01–05
Market and book values

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12. Accounting revenues and expenses can differ from cash flows because some items
included in the computation of revenues and expenses do not entail immediate cash
flows. For example, sales made on credit are considered revenue even though cash
is not collected until the customer makes a payment. Also, depreciation expense
reduces net income, but does not entail a cash outflow. Conversely, some cash
flows are not included in revenues or expenses. For example, collection of accounts
receivable results in a cash inflow but is not revenue. Purchases of inventory
require cash outlays but are treated as investments in working capital, not as
expenses.
Est time: 01–05
Noncash items

13.
a. Cash will increase as one current asset (inventory) is exchanged for another
(cash).

d. Cash will increase. The machine will bring in cash when it is sold, but the lease
payments will be made over several years.

e. The firm will use cash to buy back the shares from existing shareholders. Cash
balance will decrease.
Est time: 01–05
Cash flows

14. a.
Sales (mil) $14.00
 Cost of goods sold million
8.00
 Interest expense 1.00
 Depreciation expense 2.00
Taxable income 3.00
 Taxes (35%) 1.05
Net income $ 1.95 million
Net Cash flow = net income + depreciation expense = $3.95 million

b. If depreciation expense were increased by $1 million, net income would be

reduced by $0.65 million. Cash flow (= net income + depreciation) would be
increased by $0.65 million + $1 million = $0.35 million.
Cash flow increases because depreciation expense is not a cash outflow, but
increasing the depreciation expense for tax purposes reduces taxes paid by $0.35
million.

c. The impact on stock price is likely to be positive. Cash available to the firm
would increase. The reduction in net income would be recognized as resulting

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 entirely from accounting changes, not as a consequence of any changes in the
underlying profitability of the firm.

d. The net income would not change. The taxable income would remain the
same, as would net income.

e. If interest expense was $1 million higher and the depreciation was $1 million
lower, the taxes will be the same, but the drop in depreciation would cause a
decrease in cash flow by $1 million.
Est time: 11–15
Cash flows

15. Working capital ought to be increasing. The firm will be building up stocks of
inventory as it ramps up production. In addition, as sales increase, accounts
receivable will increase rapidly. While accounts payable will probably also
increase, the increase in accounts receivable will tend to dominate since sales prices
exceed input costs.
Est time: 01–05
Change in net working capital

16.
Sales $10,000
Cost of goods sold 6,500
General & administrative expenses 1,000
Depreciation expense 1,000
EBIT 1,500
Interest expense 500
Taxable income 1,000
Taxes (35%) 350
Net income $ 650
Cash flow from operations = net income + depreciation expense = $1,650
Est time: 06–10
Income statement

17.
a. The fact that start-up firms typically have negative net cash flows for several
years does not mean they are failing. Start-up firms invest in inventories and
other assets designed to produce income in later periods.

b. Accounting profits for start-up businesses are also commonly negative because
these firms incur costs, such as advertising, that cannot be recorded on the
balance sheet. These costs are general administrative expenses the firm incurs in
each period, not investments like those in inventories that are built up for future
sales.
Est time: 06–10

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Cash flows

18. Cash flow from operations can be positive even if net income is negative. For
example, if depreciation expenses are large, then negative net income might
correspond to positive cash flow because depreciation is treated as an expense in
calculating net income but does not represent a cash outflow.

Conversely, if net income is positive, but a large portion of sales are made on credit, cash
flow can be negative since the sales are revenue but do not yet generate cash.
Est time: 01–05
Operating cash flow

19. An increase in accounts receivable reduces cash flow by $10,000. An increase in

accounts payable increases cash flow by $5,000. A decrease in inventory increases
cash flow by $2,000. The total impact is a reduction in cash flow by $3,000.
Est time: 01–05
Operating cash flow

20.

Candy Canes, Inc.

April May June
Sales $ 0 $150,000 $ 0
Cost of goods sold 0 100,000 0
Accounts receivable 0 150,000 150,000
Inventory 100,000 100,000 0
Cash flow* 100,000 0 150,000
Net income** $ 0 $ 50,000 $ 0
*Cash flow = sales  COGS  A/R inventory
** Net income = sales  COGS
Est time: 06–10
Operating cash flow

21. The calculations are presented in the following table. Sales occur in quarters 2 and
3, so this is when the cost of goods sold is recognized. Therefore, net income is
zero in quarters 1 and 4. In quarter 1, the production of the kits is treated as an
investment in inventories. The level of inventories then falls as goods are sold in
quarters 2 and 3. Accounts receivable in quarters 2 and 3 equal the sales in those
quarters since it takes one quarter for receivables to be collected. Notice that cash
flow in quarter 1 equals the cost of producing the kits and that in quarters 3 and 4
cash flow equals cash received for the kits previously sold.
a. Quarter 1 Quarter 2 Quarter 3 Quarter 4

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 Sales $0 $550 $600 $0
Cost of goods sold 0 500 500 0
Net income $0 $ 50 $100 $0

b., c.
Inventories $1,000 $ 500 $ 0 $0
Accounts receivable 0 550 600 0
Net working capital $1,000 $1,050 $600 $0
Cash flow $1,000 $0 $550 $600

f. Cash flow = net income – change in net working capital

Est time: 11–15
Operating cash flow

22. The table below shows the firm’s net income and investment in net working capital
for each month from January to April. Sales revenue and production costs are
recognized at the time of sale in February. Since the firm neither pays for goods nor
receives cash for sales, cash flow is zero in January and February. Cash flow occurs
in March and April, when cash is actually being exchanged. The sow ears are paid
for in March and cash is received for the purses in April.

Value Added Inc. (in 000s)

January February March April
Sales $0 $2,000 $0 $0
Cost of goods sold 0 $1,000 0 0
Net income $0 $1,000 $0 $0

Inventories $1,000 $ 0 $ 0 $0
Accounts receivable 0 2,000 2,000 0
Accounts payable $1,000 $1,000 0 0
Net working capital 0 $1,000 $2,000 $0

Cash flow $0 $0 –$1,000 $2,000

Cash flow = net income – change in net working capital
Est time: 11–15
Operating cash flow

23. The free cash flow is listed as $6,117 million. Total cash distributed to shareholders
was $5,727 million. Of this, $1,743 was paid as a dividend and $3,984 was paid to
shareholders to repurchase stock. The Statement of Cash Flows shows $507 million
was added to cash reserves. The numbers do not add up because Home Depot had
many other transactions which impacted the cash flows of the company.
Est time: 11–15
Operating cash flow

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24.
a. Cash flow from operations = net income + interest + depreciation – additions to
net working capital

Free cash flow = cash flow from operations – capital expenditures

Net working capital = (3,403 − 3,143) − (1,375 − 1,335) − (122 − 117) − (1,089 − 616) =
−258
Cash flow from operations = 5,465 + 517 + 1,402 − 258 = 7,126
Capital expenditures = 3,049
Free cash flow = 7,126 − 3,049 = 4,077

b.

Est time: 11–15

Operating cash flow

25. For a married couple, the marginal tax rate on $90,000 of income is 25%.
Taxes = ($18,150 × .10) + (($73,800 – 18,150) × .15) + (($90,000 – 73,800) × .25) =
$14,212.50
The average tax rate = $14,212.50 / $90,000 = 15.79%

For a single person, the marginal tax rate on $90,000 of income is 28%.
Taxes = ($9,075 × .10) + (($36,900 – 9,075) × .15) + (($89,350 – 36,900) × .25) +
(($90,000 - 89,350) × .28) = $18,375.78
The average tax rate = $18,375.78 / $90,000 = 20.42%
Est time: 01–05
Taxes

26.
a. Taxes = (0.10  $9,075) + 0.15  ($20,000  $9,075) = $2,546.25

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 Average tax rate = $2,546.25/$20,000 = 0.1273 = 12.73%
Marginal tax rate = 15%

b. Taxes = (0.10  $9,075) + 0.15  ($36,900  $9,075) + 0.25  ($50,000 

($36,900) = $8,356.25
Average tax rate = $8,356.25/$50,000 = 0.1671 = 16.71%
Marginal tax rate = 25%

c. Taxes = (0.10  $9,075) + 0.15  ($36,900  $9,075) + 0.25  ($89,350 

$36,900) + 0.28  ($186,350  $89,350) + 0.33  ($300,000  $186,350) =
$82,858
Average tax rate = $82,858/$300,000 = 0.2762 = 27.62%
Marginal tax rate = 33%

d. Taxes = (0.10  $9,075) + 0.15  ($36,900  $9,075) + 0.25  ($89,350 

$36,900) + 0.28  ($186,350  $89,350) + 0.33  ($405,100  $186,350) +
0.35  ($406,750 – $405,100) + 0.396  ($3,000,000 – $406,750) =
$1,145,046
Average tax rate = $1,145,046/$3,000,000 = 0.3817 = 38.17%
Marginal tax rate = 39.6%
Est time: 06–10
Taxes

27. Taxes = (0.10  $18,150) + 0.15  ($73,800  $18,150) + 0.25  ($95,000 

$73,800)
= $15,462.50
Average tax rate = $15,462.50/$95,000 = 0.1628 = 16.28%
Marginal tax rate = 25%
Est time: 01–05
Taxes

28. Taxes = (0.15  $50,000) + 0.25  ($75,000  $50,000) + 0.34  ($100,000 

$75,000)
= $22,250
Average tax rate = $22,250/$100,000 = 0.2225 = 22.25%
Marginal tax rate = 34%
Est time: 01–05
Taxes

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29. a.
Income Taxes Due Average Tax
Rate (%)
$ $ 10.00%
10,000 1,000
12.73%
20,000 2,546
14.64%
40,000 5,856
19.82%
80,000 15,856
21.18%
100,000 21,176
23.45%
150,000 35,176
24.93%
200,000 49,858
26.54%
250,000 66,358
27.62%
300,000 82,858
28.39%
350,000 99,358
30.05%
450,000 135,246
31.79%
550,000 174,846
32.99%
650,000 214,446
33.87%
750,000 254,046
35.30%
1,000,000 353,046
37.45%
2,000,000 749,046
38.53%
4,000,000 1,541,046
38.88%
6,000,000 2,333,046

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 39.06%
8,000,000 3,125,046
39.17%
10,000,000 3,917,046

b. As shown in the table and graph above, the difference between average tax
rates and the top marginal tax rate of 39.6% becomes very small as income
becomes large.
Est time: 06–10
Taxes

30.
Liabilities and
Assets 2013 Shareholders’ Equity 2013 2014
2014
Cash & marketable securities $ 800 $ 300 Accounts payable $ 300 $ 350
Inventories 300 350 Notes payable 1,000 600
Accounts receivable 400 450 Long-term debt 2,000 2,400
Net fixed assets 5,000 5,800 Total liabilities 3,300 3,350
Total assets $6,500 $6,900 Shareholders’ equity 3,200 3,550
Total liabilities plus
shareholders’ equity $6,500 $6,900

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Est time: 06–10
Financial statements

31.
Net working capital (2013) = ($800 + $300 + $400)  ($300 + $1,000) = $200
Net working capital (2014) = ($300 + $350 + $450)  ($350 + $600) = $150
Net working capital decreased by $50.
Est time: 01–05
Net working capital

32.
2013 2014
Revenue $4,000 $4,100
Cost of goods sold 1,600 1,700
Administrative expenses 500 550
Depreciation expense 500 520
Interest expense 150 150
Taxable income 1,250 1,180
Federal & state income taxes 400 420
Net income $ 850 $ 760
Increase in retained earnings in 2014 = net income  dividends = $760  $410 = $350.
In 2014, shareholders’ equity increased by the amount of the increase in retained earnings.
Est time: 06–10
Income statement

33. Earnings per share in 2013 = $850,000/500,000 shares = $1.70

Earnings per share in 2014 = $760,000/500,000 shares = $1.52
Est time: 01–05
Income statement

34. Net fixed assets increased by $800,000 during 2014, while depreciation expense in
2014 was $520,000. Therefore, gross investment in plant and equipment was
$1,320,000.
Est time: 01–05
Financial statements

35.

Market Value Balance Sheet, 2014

(figures in thousands of dollars)

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 Liabilities &
Shareholders’ Equity
Assets
Cash $ 300 Accounts payable $ 350
Inventories 350 Notes payable 600
Accounts receivable 450 Long-term debt 2,200
Employee skills 2,900 Total liabilities 3,350
Net fixed assets 6,000 Shareholders’ equity* 6,850
Total liabilities &
Total assets $10,000 shareholders’ equity $10,000
* Shareholders' equity = total assets  total liabilities
Price per share = $6,850,000/500,000 shares = $13.70
Est time: 06–10
Market and book values

36.
Cash provided by operations
Net income $ 760
Noncash expenses
Depreciation expense 520
Changes in working capital
Decrease (increase) in accounts receivable (50)
Decrease (increase) in inventories (50)
Increase (decrease) in accounts payable 50
Total change in working capital (50)
Cash provided by operations $1,230
Cash flows from investments
Cash provided by (used for) disposal of (1,320)
(additions to) property, plant & equipment
Cash provided by (used for) investments (1,320)
Cash provided by (used for) financing activities
Additions to (reductions in) notes payable (400)
Additions to (reductions in) long-term debt 400
Dividends paid (410)
Cash provided by (used for ) financing activities (410)
Net increase (decrease) in cash and cash equivalents ($500)

Est time: 06–10

Operating cash flow

37. Average tax bracket in 2013 = taxes/taxable income = $400/$1,250 = 0.320 =

32.0%
Average tax bracket in 2014 = $420/$1180 = 0.356 = 35.6%

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 In order to determine the firm’s marginal tax bracket, one would need information
regarding tax rates applicable for both federal and state income taxes.
Est time: 01–05
Taxes

38. Taxes on your salary = (0.10  $9,075) + 0.15  ($36,900  $9,075)

+ 0.25  ($70,000  $36,900) = $13,356
Taxes on corporate income = 0.15  $30,000 = $4,500
Total taxes = $13,356 + $4,500 = $17,856

a. If you rearrange income so that your salary and the firm's profit are both $50,000,
then:
Taxes on your salary = (0.10  $9,075) + 0.15  ($36,900  $9,075)
+ 0.25  ($50,000  $36,900) = $8,356
Taxes on corporate income = 0.15  $50,000 = $7,500
Total taxes = $8,356 + $7,500 = $15,856
Total taxes are reduced by $17,856  $15,856 = $2,000.

b. Any income between $36,900 and $50,000 will create the same tax bill of $15,856.
The reason is that personal income between $36,900 and $50,000 is taxed at 25%. Any
money in this range, moved to corporate income, will also be taxed at 25%.
Est time: 06–10
Taxes

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