Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

CHAPTER 2
ACCOUNTING STATEMENTS AND CASH
FLOW
Concept Questions

1. Liquidity True or false: All assets are liquid at some price. Explain.
 True. Every asset can be converted to cash at some price. When we are referring to a liquid
asset, we also consider that the asset can be quickly converted to cash at or near market
value, which is important.
2. Accounting and Cash Flows Why might the revenue and cost figures shown on a standard
income statement not represent the actual cash inflows and outflows that occurred during a period?
3. Accounting Statement of Cash Flows Looking at the accounting statement of cashflows, what
does the bottom line number mean? How useful is this number for analyzing a company?
 The bottom line number shows the change in the cash balance on the balance sheet. It is not a
useful number for analyzing a company.
4. Cash Flows How do financial cash flows and the accounting statement of cash flows differ?
Which is more useful for analyzing a company?
5. Book Values versus Market Values Under standard accounting rules, it is possible for a
company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this
happen with market values? Why or why not?
6. Cash Flow from Assets Why is it not necessarily bad for the cash flow from assets to be
negative for a particular period?
7. Operating Cash Flow Why is it not necessarily bad for the operating cash flow to benegative for
a particular period?
8. Net Working Capital and Capital Spending Could a company’s change in networking capital
be negative in a given year? (Hint: Yes.) Explain how this might come about. What about net
capital spending?
9. Cash Flow to Stockholders and Creditors Could a company’s cash flow to stockholders be
negative in a given year? (Hint: Yes.) Explain how this might comeabout. What about cash flow to
creditors?
 If a company raises more money from selling stock than it pays in dividends in a particular
period, its cash flow to stockholders will be negative. If a company borrows more than it
pays in interest and principal, its cash flow to creditors will be negative.
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

10. Firm Values Referring back to the Ford example at the beginning of the chapter,note that we
suggested that Ford’s stockholders probably didn’t suffer as a result of thereported loss. What do
you think was the basis for our conclusion?
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

Exercises

1. Building a Balance Sheet Sankey, Inc., has current assets of $4,900, net fixed assets of $25,000,
current liabilities of $4,100, and long-term debt of $10,300. What is the value of the shareholders’
equity account for this firm? How much is net working capital?

CA= $4,900, NFA= $25,000, CL= $4,100, LD= $10,300

NWC= CA – CL = 4,900 – 4,100 = $800

BALANCE SHEET

CA $4,900 CL $4,100

NFA $25,000 LD $10,300

EQUITY …………
TOTAL ASSET: $29,900 TOTAL LIABILITY + EQUITY: $29,900

EQUITY = ASSET – LIABILITY = 29,900 – (4,100+ 10,300) = $15,500

2. Building an Income Statement Shelton, Inc., has sales of $435,000, costs of $216,000,
depreciation expense of $40,000, interest expense of $21,000, and a tax rate of 35 percent. What is
the net income for the firm? Suppose the company paid out $30,000 in cash dividends. What is the
addition to retained earnings?

INCOME STATEMENT
Sales $435,000
Costs $216,000
Depreciation $40,000
EBIT $179,000
Interest expense $21,000
EBT $158,000
Tax $55,300
Net income $102,700
Dividends $30,000
Additional to retained earnings (Net income – dividends) $72,700
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

3. Market Values and Book Values Klingon Cruisers, Inc., purchased new cloaking machinery
three years ago for $9.5 million. The machinery can be sold to the Romulans today for $6.5 million.
Klingon’s current balance sheet shows net fixed assets of $5.2 million, current liabilities of $2.4
million, and net working capital of $800,000. If all the current assets were liquidated today, the
company would receive $2.6 million cash.What is the book value of Klingon’s assets today? What
is the market value?

Book: NFA= $5,200,000 CL=$2,400,000 NWC= $800,000

 CA= NWC + CL = 800,000 + 2,400,000 = $3,200,000

Market: CA = $2,600,000 NFA= $6,500,000

ASSET ( BOOK VALUE) ASSET (MARKET VALUE)

CA $3,200,000 CA $2,600,000

NFA $5,200,000 NFA $6,500,000

TOTAL $8,400,000 TOTAL $9,100,000

4. Calculating Taxes The Stefani Co. had $198,000 in taxable income. Using the rates from Table
2.3 in the chapter, calculate the company’s income taxes. What is the average tax rate? What is the
marginal tax rate?

 Tax liability = 50,000 x 15% + (75,000 – 50,000) x 25% + (100,000 – 75,000) x 34% +
(198,000- 100,000) x 39% = $60,470
 The average tax rate = tax liability/taxable income = 60,470/198,000 = 30,54%
 The marginal tax rate = 39%

5. Cash Flow to Creditors The 2014 balance sheet of Jordan’s Golf Shop, Inc., showed long-term
debt of $1.625 million, and the 2015 balance sheet showed long-term debt of $1.73 million. The
2015 income statement showed an interest expense of $185,000. What was the firm’s cash flow to
creditors during 2015?

BEGINNING LD = $1,625,000 ENDING LD = $1,730,000 INTEREST = $185.000

Cash flow to creditors = INTEREST – (Ending LD – beginning LD)

= 185,000 – (1,730,000 – 1,625,000) = $80,000

Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

6. Cash Flow to Stockholders The 2014 balance sheet of Jordan’s Golf Shop, Inc., showed
$510,000 in the common stock account and $3.6 million in the additional paid-in surplus account.
The 2015 balance sheet showed $545,000 and $3.85 million in the same two accounts, respectively.
If the company paid out $275,000 in cash dividends during 2015, what was the cash flow to
stockholders for the year?

Dividends = $275,000

Common beginning = $510,000 Common ending = $545,000

APIS beginning = $3,600,000 APIS ending = $3,850,000

CF (S) = Dividends – [(Common end + APIS end) – (Common begin + APIS begin)]

= 275,000 – [(545,000 + 3,850,000) – (510,000 + 3,600,000)] = - 10,000

7. Cash Flows Ritter Corporation’s accountants prepared the following financial statements for
year-end 2015:
a. Explain the change in cash during 2015.
b. Determine the change in net working capital in 2015.
c. Determine the cash flow generated by the firm’s assets during 2015.

INCOME STATEMENT 2015 BALANCE SHEET

Revenue $790 December 31
Expenses 575 2015 2014
Depreciation 90 Assets
Net income $125 Cash 80 60
Dividends $95 Other current assets 185 170
Net fixed assets 405 385
Total assets $670 $615
Liabilities and Equity
Accounts Payable 140 125
Long-term debt 160 150
Stockholders' equity 370 340
Total liabilities and equity $670 $615

2015
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

a. The change in cash during 2015

STATEMENT OF CASH FLOW

Operations
Net income $125
Depreciation $90
Changes in Assets and Liabilities
Other current assets ($15)
Account payable $15
Total Cash flow from Operating Activities $215
Investing activities
Acquisition of fixed assets ($110)
Total Cash flow from investing activities ($110)
Financing activities
Proceeds from long-term debt $10
Dividends ($95)
Total Cash flow from financing ($85)
Change in Cash (on the balance sheet) $20
b. Changes in NWC

CA = cash + other current asset

 Changes in NWC = NWC 2015 – NWC 2014
= (CA 2015 – CL 2015) – (CA 2014 – CL 2014)
= [(80 + 185) – 140] – [(60 + 170) – 125) = $20
c. The cash flow generated by the firm’s assets during 2015
 Operating cash flow = Net income + Depereciation = 125 + 90 = 215
 Capital spending = Ending NFA – Beginning NFA + Depreciation = 405 – 385 + 90 = $110
 CF(A) = OCF – Capital spending – Additional to NWC
= 215 – 110 – 20 = $85
8. Building an Income Statement During the year, the Senbet Discount Tire Company had gross
sales of $925,000. The firm’s cost of goods sold and selling expenses were $490,000 and $220,000,
respectively. Senbet also had notes payable of $740,000. These notes carried an interest rate of 4
percent. Depreciation was $120,000. Senbet’s tax rate was 35 percent.
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

a. What was Senbet’s net income?

INCOME STATEMENT

Sales $925,000
Cost of good sold $490,000
Selling expenses $220,000
Depreciation $120,000
EBIT $95,000
Interest expense $29,600
EBT $66,000
Taxes $23,100
Net income $42,800
b. What was Senbet’s operating cash flow?

Operating cash flow = EBIT + Depreciation – Taxes

= 95,000 + 120,000 – 23,100 = $191,900

9. Calculating Total Cash Flows Schwert Corp. shows the following information on its 2015
income statement: sales = $215,000; costs = $117,000; other expenses = $6,700; depreciation
expense = $18,400; interest expense = $10,000; taxes = $25,370; dividends = $9,500. In addition,
you’re told that the firm issued $8,100 in new equity during 2015 and redeemed $7,200 in
outstanding long-term debt.

INCOME STATEMENT

Sales $215,000
Costs $117,000
Other expenses $6,700
Deprecition $18,400
EBIT $72,900
Interest expense $10,000
EBT $62,900
Taxes $25,370
Net income $37,530
Dividends $9,500
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

Additional to RE $28,030
a. What = the 2015 operating cash flow?

Operating cash flow = EBIT + Depreciation – Taxes

= 72,900 + 18,400 – 25,370 = $65,930
b. What = the 2015 cash flow to creditors?
Cash flow to creditors = Interest paid – Net new LD
= 10,000 – (-7,200) = 17,200
c. What is the 2015 cash flow to stockholders?
Cash flow to stokholders = Dividend – Net new equity raised
= 9,500 – 8,100 = $1,400
d. If net fixed assets increased by $28,400 during the year, what was the addition to networking
capital (NWC)?

We have: CF(A) = CF(B) + CF(S) = 17,200 + 1,400 = $18,600

CF(A) = Operating cash flow – Capital spending – Additional to NWC

= OCF – (Increase net fixed asset + Depreciation) – Additional to NWC

 Additional to NWC = OCF – (Increase net fixed asset + Depreciation) – CF(A)

= 65,930 – (28,400 + 18,400) – 18,600 = $530

10. Using Income Statements Given the following information for O’Hara Marine Co., calculate
the depreciation expense: sales = $44,000; costs = $27,500; addition to retained earnings = $5,200;
dividends paid = $1,670; interest expense = $1,850; tax rate = 40 percent.

INCOME STATEMENT
Sales $44,000
Cost $27,500
Depreciation …………
EBIT ………….
Interest expense $1,850
EBT ………….
Taxes …………..
Net income ………….
Additional to RE $5,200
Dividends $1,670
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

Net income = Additional to RE + Dividends = 5,200 + 1,670 = $6870

Net income = EBT – EBT x tax rate = EBT x (1- 40%) = $6870

 EBT = $11,450
 Taxes = EBT – Net income = 11,450 – 6870= 4580

EBIT = EBT + Interest expense = 11,450 + 1,850 = $13,300

 Depreciation = Sales – Costs – EBIT

= 44,000 – 27,500 – 13,300 = $3,200