CHAPTER 2

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Net cash flow Answer: e Diff: E
1
. Last year Aldrin Co. had negative net cash flow, yet its cash on the
balance sheet increased. What could explain these events?

a. Aldrin issued long-term debt.

b. Aldrin repurchased some of its common stock.
c. Aldrin sold some of its assets.
d. Statements a and b are correct.
e. Statements a and c are correct.

Net cash flow Answer: d Diff: E

2
. Last year, Blanda Brothers had positive net cash flow, yet cash on the
balance sheet decreased. Which of the following could explain the
company’s financial performance?

a. The company issued new common stock.

b. The company issued new long-term debt.
c. The company sold off some of its assets.
d. The company purchased a lot of new fixed assets.

1
. Net cash flow Answer: e Diff: E

Long-term debt is a source of cash. Companies issue debt to get more

cash. Therefore, statement a is true. If the company repurchases common
stock, it must use cash to pay for the repurchases. So, cash on the
balance sheet would decrease. Therefore, statement b is false. If the
company sold assets, total assets would be unchanged but there would be
an increase in cash and a decrease in other assets. Therefore, statement
c is true. Since both statements a and c are true, the correct choice is
statement e.
2
. Net cash flow Answer: d Diff: E

If the company issued new stock, cash on the balance sheet would
increase. Therefore, statement a is false. If it issued long-term debt,
cash on the balance sheet would increase. Consequently, statement b is
also false. If it sold assets, cash on the balance sheet would increase.
So, statement c is also false. If it bought assets, cash would decrease
and net cash flow would not be affected. (So, if cash flow were positive
before, it would stay positive.) Therefore, statement d is true. If the
company eliminated its dividend, cash on the balance sheet would
increase. So, statement e is also false.

Chapter 2 - Page 1
 e. The company eliminated its dividend.

Net cash flow Answer: c Diff: E R

3
. Last year, Sewickley Shoes had negative net cash flow; however, cash on
its balance sheet increased. Which of the following could explain this?

a. The company repurchased some of its common stock.

b. The company had large depreciation and amortization expenses.
c. The company issued a large amount of long-term debt.
d. The company dramatically increased its capital expenditures.
e. All of the statements above are correct.

3
. Net cash flow Answer: c Diff: E R

NCF = NI + DEP and AMORT.

If NCF is negative, then NI must be negative, meaning that the company

had no profits. If the company had no profits, it must have found some
other way to increase its cash on the balance sheet. It could do so by
selling assets or issuing new securities. So, we can immediately
eliminate statements a, b, and d. Statement a, repurchasing stock, is
the opposite of issuing securities, so it is a use of cash, not a source
of it. Therefore, statement a is false. Large depreciation and
amortization expenses would make NCF less negative than it otherwise
would have been. However, depreciation and amortization expenses are
non-cash charges, so they would not affect cash on the balance sheet in
any way. Therefore, statement b is false. Statement c, issuing
long-term debt, would increase cash on the balance sheet, so statement c
is true. Statement d would be a use of cash and would decrease cash on
the balance sheet. Therefore, statement d is false. Consequently,
statement e is false.

Chapter 2 - Page 2
Net cash flow Answer: d Diff: E N
4
. Which of the following factors could explain why last year Cleaver Energy
had negative net cash flow, but the cash on its balance sheet increased?

a. The company paid a large dividend.

b. The company had large depreciation and amortization expenses.
c. The company repurchased common stock.
d. The company issued new debt.
e. The company made a large investment in new plant and equipment.

4
. Net cash flow Answer: d Diff: E N

The correct answer is statement d. NCF = NI + DEP and AMORT. If the

company pays a large dividend, it is a use of cash, so cash on the
balance sheet decreases. Therefore, statement a is incorrect. If the
company has large depreciation and amortization expenses, it makes NCF
less negative. Depreciation and amortization expenses are non-cash
charges, so they will not affect cash on the balance sheet. Therefore,
statement b is incorrect. Repurchasing common stock is a use of cash, so
cash on the balance sheet decreases. Therefore, statement c is
incorrect. If the company issues debt, NCF can still be negative, but
cash on the balance sheet will increase. (The company sells bonds. It
receives cash for the bonds and gives the investors paper with a promise
to pay in return.) Therefore, statement d could explain a negative NCF
while cash on the balance sheet increases. A large investment in new
plant and equipment is a use of cash, so cash on the balance sheet
decreases. Therefore, statement e is incorrect.

Chapter 2 - Page 3
Net cash flow Answer: c Diff: E
5
. Analysts who follow Sierra Nevada Inc. recently noted that, relative to
the previous year, the company’s net cash flow was larger but cash on the
firm’s balance sheet had declined. What factors could explain these
changes?

a. The company sold a division and received cash in return.

b. The company cut its dividend.
c. The company made a large investment in new plant and equipment.
d. Statements a and b are correct.
e. Statements b and c are correct.

Net cash flow and net income Answer: a Diff: E

5
. Net cash flow Answer: c Diff: E

NCF = NI + DEP and AMORT. If the company had sold a division and
received cash, cash on the firm’s balance sheet would have increased.
Therefore, statement a is false. If the company cut its dividend, it
would have more cash left over from net income, so cash on the firm’s
balance sheet would have increased. Therefore, statement b is false. If
the company made a large investment in new plant and equipment, it would
have larger depreciation expense, so net cash flow would increase. In
addition, it had to pay for the equipment somehow, so cash on the balance
sheet would decline. Therefore, statement c is true.

Chapter 2 - Page 4
6
. A stock analyst has acquired the following information for Palmer
Products:

● Retained earnings on the year-end 2001 balance sheet was $700,000.

● Retained earnings on the year-end 2002 balance sheet was $320,000.
● The company does not pay dividends.
● The company’s depreciation expense is its only non-cash expense.
● The company has no non-cash revenues.
● The company’s net cash flow for 2002 was $150,000.

On the basis of this information, which of the following statements is

most correct?

a. Palmer Products had negative net income in 2002.

b. Palmer Products had positive net income in 2002, but it was less than
its net income in 2001.
c. Palmer Products’ depreciation expense in 2002 was less than $150,000.
d. Palmer Products’ cash on the balance sheet at the end of 2002 must be
lower than the cash it had on its balance sheet at the end of 2001.
e. Palmer Products’ net cash flow in 2002 must be higher than its net
cash flow in 2001.

6
. Net cash flow and net income Answer: a Diff: E

According to the balance sheet, retained earnings declined. Additions to

RE = NI – Div. So, the only two things that can change retained earnings
are net income and dividends. The company does not pay dividends, so
retained earnings declined because net income was negative. Therefore,
statement a is correct. (Retained earnings fell by $380,000 and
dividends are 0, so net income was -$380,000.) Statement b is false,
because it states that net income was positive. Statement c is false. If
we use the NCF equation and the net income number calculated above, we
calculate that depreciation is $530,000. (Note that it was given in the
problem that depreciation was the firm’s only non-cash expense, so
amortization is zero.)

NCF = NI + DEP and AMORT

$150,000 = -$380,000 + DEP
$530,000 = DEP.

This is definitely greater than $150,000. Statement d is false because

changes in cash do not change retained earnings. Even though net income
is negative, cash on the balance sheet can change by changing
receiv-ables, payables, or issuing new debt or equity. Statement e is
also false. NCF = NI + DEP and AMORT. We know that net income for 2002
was
-$380,000, and we are told that NCF in 2002 was $150,000, so we can find
DEP of $530,000 (since amortization expenses are zero). However, we know
nothing about earnings or depreciation and amortization in the previous
year, so we can say nothing about NCF for 2001.

Chapter 2 - Page 5
Net cash flow and net income Answer: b Diff: E R
7
. Holmes Aircraft recently announced an increase in its net income, yet its
net cash flow declined relative to last year. Which of the following
could explain this performance?

a. The company’s interest expense increased.

b. The company’s depreciation and amortization expenses declined.
c. The company’s operating income declined.
d. All of the statements above are correct.
e. None of the statements above is correct.

Net cash flow and net income Answer: a Diff: E R

8
. Kramer Corporation recently announced that its net income was lower than
last year. However, analysts estimate that the company’s net cash flow
increased. What factors could explain this discrepancy?

a. The company’s depreciation and amortization expenses increased.

b. The company’s interest expense declined.
c. The company had an increase in its noncash revenues.
d. Statements a and b are correct.
e. Statements b and c are correct.

Net cash flow, free cash flow, and cash Answer: c Diff: E N
9
. Last year, Owen Technologies reported negative net cash flow and negative
free cash flow. However, its cash on the balance sheet increased. Which
of the following could explain these changes in its cash position?

a. The company had a sharp increase in its depreciation and amortization

7
. Net cash flow and net income Answer: b Diff: E R

Statement b is correct. Statement a is false, since it would reduce net

income. Statement b is true; a decline in depreciation and amortization
expenses would increase net income but decrease net cash flow. Statement
c is false; since a decline in operating income would cause net income to
decline. The remaining statements are false.
8
. Net cash flow and net income Answer: a Diff: E R
9
. Net cash flow, free cash flow, and cash Answer: c Diff: E N

The correct answer is statement c. Recall Net cash flow = NI + DEP and
AMORT. Free cash flow = EBIT(1 - T) + Depreciation and amortization –
Capital expenditures – ΔNOWC.

An increase in depreciation and amortization expenses increases both NCF

and FCF, and may reduce taxes. This does not explain why NCF and FCF are
negative with an increase in cash flow. So, statement a is not correct.
An increase in inventories is paid either in cash or accounts payable.
This suggests cash either decreases or remains the same. So, statement b
is incorrect. By issuing new stock, cash does increase. And this has no
impact on either NCF or FCF, so statement c is the correct response.

Chapter 2 - Page 6
 expenses.
b. The company had a sharp increase in its inventories.
c. The company issued new common stock.
d. Statements a and b are correct.
e. Statements a and c are correct.

Current assets Answer: d Diff: E

10
. Which of the following items is included as part of a company’s current
assets?

a. Accounts payable.
b. Inventory.
c. Accounts receivable.
d. Statements b and c are correct.
e. All of the statements above are correct.

10
. Current assets Answer: d Diff: E

Accounts payable are current liabilities, so they are not part of a

firm’s current assets. Therefore, statement d is the correct choice.

Chapter 2 - Page 7
Current assets Answer: a Diff: E N
11
. Which of the following items can be found on a firm’s balance sheet
listed as a current asset?

a. Accounts receivable.
b. Depreciation.
c. Accrued wages.
d. Statements a and b are correct.
e. Statements a and c are correct.

Balance sheet Answer: c Diff: E

12
. On its 2001 balance sheet, Sherman Books had retained earnings equal to
$510 million. On its 2002 balance sheet, retained earnings were also
equal to $510 million. Which of the following statements is most
correct?

a. The company must have had net income equal to zero in 2002.
b. The company did not pay dividends in 2002.
c. If the company’s net income in 2002 was $200 million, dividends paid
must have also equaled $200 million.
d. If the company lost money in 2002, they must have paid dividends.
e. None of the statements above is correct.

Balance sheet Answer: b Diff: E

13
. Below is the equity portion (in millions) of the year-end balance sheet
that Glenn Technology has reported for the last two years:

11
. Current assets Answer: a Diff: E N

The correct answer is statement a. Depreciation is an expense item found

on the income statement and accrued wages are a current liability on the
balance sheet.
12
. Balance sheet Answer: c Diff: E

Statement c is correct; the others are false. Simply because the change
in retained earnings between the two years was zero, doesn’t mean that
net income was zero. Remember, Beginning retained earnings + Net income
- Dividends = Ending retained earnings. Just because the change in
retained earnings was zero, doesn’t mean that dividends were zero.
13
. Balance sheet Answer: b Diff: E

If Glenn had issued preferred stock, the dollar value of preferred stock
would have increased. Statement a is false. The amount of common stock
did increase between 2001 and 2002. Therefore, statement b is true.
Glenn had negative net income in 2002. When a company has positive net
income, it pays a dividend first (in this case Div = $0) and whatever is
left over is added to retained earnings. Since retained earnings
declined and no dividends were paid, net income must have been negative
in 2002. So statement c is false.

Chapter 2 - Page 8
 2002 2001
Preferred stock $ 80 $ 80
Common stock 2,000 1,000
Retained earnings 2,000 2,340
Total equity $4,080 $3,420

Glenn does not pay a dividend to its common stockholders. Which of the
following statements is most correct?

a. Glenn issued preferred stock in both 2001 and 2002.

b. Glenn issued common stock in 2002.
c. Glenn had positive net income in both 2001 and 2002, but the company’s
net income in 2002 was lower than it was in 2001.
d. Statements b and c are correct.
e. None of the statements above is correct.

Chapter 2 - Page 9
Balance sheet Answer: a Diff: E N
14
. All else equal, which of the following actions will increase the amount
of cash on a company’s balance sheet?

a. The company issues new common stock.

b. The company repurchases common stock.
c. The company pays a dividend.
d. The company purchases a new piece of equipment.
e. All of the statements above are correct.

Balance sheet Answer: b Diff: E N

15
. Below are the 2001 and 2002 year-end balance sheets for Kewell
Boomerangs:

Assets: 2002 2001

Cash $ 100,000 $ 85,000
Accounts receivable 432,000 350,000
Inventories 1,000,000 700,000
Total current assets $1,532,000 $1,135,000
Net fixed assets 3,000,000 2,800,000
Total assets $4,532,000 $3,935,000

Liabilities and equity:

Accounts payable $ 700,000 $ 545,000
Notes payable 800,000 900,000
Total current liabilities $1,500,000 $1,445,000
Long-term debt 1,200,000 1,200,000
Common stock 1,500,000 1,000,000
Retained earnings 332,000 290,000

14
. Balance sheet Answer: a Diff: E N

The correct answer is statement a. Issuing new stock means that the
company sells stock to shareholders and receives cash in return;
therefore, statement a is correct. If the company repurchases common
stock, they are spending money and reducing cash; therefore, statement b
is incorrect. If the company pays a dividend, it is giving cash to its
shareholders. This reduces cash on the balance sheet; therefore,
statement c is incorrect. If the company purchases new equipment, it is
spending money; therefore, statement d is incorrect.
15
. Balance sheet Answer: b Diff: E N

The correct answer is statement b. Since its retained earnings

increased, net income had to be positive in 2002, so statement a is
incorrect. Statement c is incorrect since outstanding long-term debt did
not change from 2001 to 2002. Statement b, then, is the only correct
answer.

Chapter 2 - Page 10
 Total common equity $1,832,000 $1,290,000
Total liabilities and equity $4,532,000 $3,935,000

Kewell Boomerangs has never paid a dividend on its common stock. Kewell
issued $1,200,000 of long-term debt in 1997. This debt was non-callable
and is scheduled to mature in 2027. As of the end of 2002, none of the
principal on this debt has been repaid. Assume that 2001 and 2002 sales
were the same in both years. Which of the following statements is most
correct?

a. Kewell had negative net income in 2002.

b. Kewell issued new common stock in 2002.
c. Kewell issued long-term debt in 2002.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 2 - Page 11
Changes in depreciation Answer: c Diff: E
16
. Which of the following are likely to occur if Congress passes legislation
that forces Carter Manufacturing to depreciate their equipment over a
longer time period?

a. The company’s physical stock of assets would increase.

b. The company’s reported net income would decline.
c. The company’s cash position would decline.
d. All of the statements above are correct.
e. Statements b and c are correct.

Changes in depreciation Answer: d Diff: E

17
. Assume that a company currently depreciates its fixed assets over
7 years. Which of the following would occur if a tax law change forced
the company to depreciate its fixed assets over 10 years instead?

a. The company’s tax payment would increase.

b. The company’s cash position would increase.
c. The company’s net income would increase.
d. Statements a and c are correct.
e. Statements b and c are correct.

Changes in depreciation Answer: d Diff: E

18
. Keaton Enterprises is a very profitable company, which recently purchased
some equipment. It plans to depreciate the equipment on a straight-line
basis over the next 10 years. Congress, however, is considering a change
in the Tax Code that would allow Keaton to depreciate the equipment on a
straight-line basis over 5 years instead of 10 years.

If Congress were to change the law, and Keaton does decide to depreciate
the equipment over 5 years, what effect would this change have on the

16
. Changes in depreciation Answer: c Diff: E

Statement c is correct. In the statement of cash flows, depreciation is

a source of cash. Therefore, a decrease in depreciation means that cash
will decrease. The other statements are false. The physical stock of
assets would not change. In the income statement, depreciation is
deducted from sales; therefore, a decrease in depreciation means that net
income will increase.
17
. Changes in depreciation Answer: d Diff: E

Statements a and c are correct; therefore statement d is the correct

choice. Statement b is incorrect. The company would be paying more in
taxes, a cash expense. Thus, the company’s cash position would decrease.
18
. Changes in depreciation Answer: d Diff: E

Reducing the depreciable life will increase the amount of depreciation

expense. This results in lower taxable income, lower net income, and a
higher net cash flow. Therefore, the correct choice is statement d.

Chapter 2 - Page 12
company’s financial statements for the coming year? (Note that the
change in the law would have no effect on the economic or physical value
of the equipment.)

a. The company’s net income would decline.

b. The company’s net cash flow would decline.
c. The company’s tax payments would decline.
d. Statements a and c are correct.
e. All of the statements above are correct.

Chapter 2 - Page 13
Changes in depreciation Answer: e Diff: E
19
. Congress recently passed a provision that will enable Piazza Cola to
double its depreciation expense for the upcoming year. The new provision
will have no effect on the company’s sales revenue. Prior to the new
provision, Piazza’s net income was forecasted to be $4 million. The
company’s tax rate is 40 percent. Which of the following best describes
the impact that this provision will have on Piazza’s financial
statements?

a. The provision will increase the company’s net income.

b. The provision will reduce the company’s net cash flow.
c. The provision will increase the company’s tax payments.
d. All of the statements above are correct.
e. None of the statements above is correct.

Changes in depreciation Answer: e Diff: E N

20
. The Campbell Corporation just purchased an expensive piece of equipment.
Originally, the firm was planning on depreciating the equipment over
5 years on a straight-line basis. However, Congress just passed a
provision that will force the company to depreciate its equipment over

19
. Changes in depreciation Answer: e Diff: E

By increasing depreciation, the firm will have lower taxable income. As

a result, the firm will pay less taxes. However, its net income will be
lower--doubling the depreciation expense has a greater effect on net
income than the lowered tax payments. Net cash flow will be higher since
depreciation is a non-cash charge that reduces the amount of cash paid in
taxes. So, statements a, b, c, and d are false. Therefore, the correct
choice is statement e.
20
. Changes in depreciation Answer: e Diff: E N

Statement a is true; if the provision passes, Campbell will be forced to

depreciate their equipment more slowly, resulting in lower depreciation
expenses. As a result, Campbell Corporation’s net income will be higher
than it would have been otherwise. Statement b is true; for the reasons
stated above, Campbell Corporation’s tax liability will be higher.
Statement c is also true; remember, changes in depreciation have no
effect on physical assets, therefore gross fixed assets remain unchanged.
However, if the depreciation expense is lower, net fixed assets will
increase because accumulated depreciation will be lower. Therefore,
statement e is the correct choice.

Chapter 2 - Page 14
 7 years on a straight-line basis. Which of the following will occur as a
result of this Congressional action?

a. Campbell Corporation’s net income for the year will be higher.

b. Campbell Corporation’s tax liability for the year will be higher.
c. Campbell Corporation’s net fixed assets on the balance sheet will be
higher at the end of the year.
d. Statements a and b are correct.
e. All of the statements above are correct.

Depreciation, net income, cash flow, and taxes Answer: d Diff: E

21
. Armstrong Inc. is a profitable corporation with a 40 percent corporate
tax rate. The company is deciding between depreciating the equipment it
purchased this year on a straight-line basis over five years or over
three years. Changing the depreciation schedule will have no impact on
the equipment’s economic value. If Armstrong chooses to depreciate the
equipment over three years, which of the following will occur next year,
relative to what would have happened, if it had depreciated the equipment
over five years?

a. The company will have a lower net income.

b. The company will pay less in taxes.
c. The company will have a lower net cash flow.
d. Statements a and b are correct.
e. All of the statements above are correct.

21
. Depreciation, net income, cash flow, and taxes Answer: d Diff: E

If the company depreciates the same asset over a shorter time, it will
have a higher depreciation expense. Since depreciation is an expense on
the income statement, higher depreciation will reduce net income.
Therefore, statement a is true. If the company has lower net income, it
will pay less in taxes. Therefore, statement b is true. Cash flow is
equal to NI + DEP and AMORT. Because depreciation is taken out of the
income statement before taxes, it does not reduce net income dollar for
dollar. (That is, $1 of depreciation expense will equal only a $0.60
decline in net income.) However, the entire $1 is added back to net
income to calculate cash flow. Therefore, statement c is false. Since
statements a and b are true, the correct choice is statement d.

Chapter 2 - Page 15
Financial statements Answer: c Diff: E
22
. Which of the following statements is most correct?

a. Accounts receivable show up as current liabilities on the balance

sheet.
b. Dividends paid reduce the net income that is reported on a company’s
income statement.
c. If a company pays more in dividends than it generates in net income,
its balance of retained earnings reported on the balance sheet will
fall.
d. Statements a and b are correct.
e. All of the statements above are correct.

Book and market values per share Answer: e Diff: E N

23
. Haskell Motors’ common equity on the balance sheet totals $700 million,
and the company has 35 million shares of common stock outstanding.
Haskell has significant growth opportunities. Its headquarters has a
book value of $5 million, but its market value is estimated to be $10
million. Over time, Haskell has issued outstanding debt that has a book
value of $10 million and a market value of $5 million. Which of the
following statements is most correct?

a. Haskell’s book value per share is $20.

b. Haskell’s market value per share is probably less than $20.
c. Haskell’s market value per share is probably greater than $20.
d. Statements a and b are correct.
e. Statements a and c are correct.

22
. Financial statements Answer: c Diff: E

Statement a is false; accounts receivable are current assets, not current

liabilities. Statement b is false; dividends are paid out of net income,
not before net income. Statement c is correct; if dividends are greater
than the current year’s net income, retained earnings must decline.
23
. Book and market values per share Answer: e Diff: E N

The correct answer is statement e. The book value per share refers to
the book value of common equity. The problem states that the common
equity on the balance sheet totals $700 million. This is the total book
value for all of the common shares. There are 35 million shares
outstanding. Therefore, the book value per share is $700 million/35
million shares = $20 per share. Therefore, statement a is correct. The
company has significant growth opportunities. The company also has
assets on the left side of the balance sheet whose market values are
greater than their book values. Each of these factors, by itself, would
tend to increase the firm’s market value per share. Therefore, it is
likely that the firm’s market value per share would be greater than $20.
Therefore, statement b is incorrect and statement c is correct.

Chapter 2 - Page 16
EBIT, net income, and operating cash flow Answer: a Diff: E R
24
. Analysts who follow Cascade Technology recently noted that, relative to
the previous year, the company’s operating income (EBIT) and net income
had declined but its operating cash flow had increased. What could
explain these changes?

a. The company’s depreciation and amortization expenses increased.

b. The company’s interest expense decreased.
c. The company’s tax rate increased.
d. Statements a and b are correct.
e. All of the statements above are correct.

EVA, cash flow, and net income Answer: b Diff: E

25
. Which of the following statements is most correct?

a. Actions that increase net income will always increase net cash flow.
b. One way to increase EVA is to maintain the same operating income with
less capital.
c. One drawback of EVA as a performance measure is that it mistakenly
assumes that equity capital is free.
d. Statements a and b are correct.
e. Statements a and c are correct.
Medium:
Changes in depreciation Answer: d Diff: M

24
. EBIT, net income, and operating cash flow Answer: a Diff: E R

OCF = EBIT(1 - T) + DEP and AMORT. If depreciation and amortization

expenses increase, EBIT would decline by DEP and AMORT, but OCF would go
up by DEP and AMORT, so the net change to OCF would be: DEP and AMORT –
(DEP and AMORT)(1 - T) = DEP and AMORT – (DEP and AMORT) + (DEP and
AMORT)(T) = (DEP and AMORT)(T). So OCF would increase by this amount,
but EBIT and NI would decline. Therefore, statement a is true. If
interest expense decreased, this would not affect EBIT or OCF but net
income would increase, so statement b is false. If the tax rate
increased, this would have no effect on operating income but net income
would decline. In addition, if taxes increased, the term (1 - T) would
decrease, so EBIT (1 - T) would decrease. Therefore, OCF would decrease,
so statement c is false.
25
. EVA, cash flow, and net income Answer: b Diff: E

EVA = EBIT(1 - T) - (After-tax cost of capital)(Total investor-supplied

operating capital). Therefore, if less capital is used with the same

operating income, EVA will increase.

Chapter 2 - Page 17
26
. Solo Company has been depreciating its fixed assets over 15 years. It is
now clear that these assets will only last a total of 10 years. Solo’s
accountants have encouraged the firm to revise its annual depreciation to
reflect this new information. Which of the following would occur as a
result of this change?

a. The company’s earnings per share would decrease.

b. The company’s cash position would increase.
c. The company’s EBIT would increase.
d. Statements a and b are correct.
e. All of the statements above are correct.

Changes in depreciation Answer: d Diff: M

27
. A start-up firm is making an initial investment in new plant and
equipment. Currently, equipment is depreciated on a straight-line basis
over 10 years. Assume that Congress is considering legislation that will
allow the corporation to depreciate the equipment over 7 years. If the
legislation becomes law, and the firm implements the 7-year depreciation
basis, which of the following will occur?

a. The firm’s tax payments will increase.

b. The firm’s net income will increase.
c. The firm’s taxable income will increase.
d. The firm’s net cash flow will increase.
e. The firm’s operating income (EBIT) will increase.

Effects of changes in financial leverage Answer: a Diff: M

28
. The CFO of Mulroney Brothers has suggested that the company should issue
$300 million worth of common stock and use the proceeds to reduce some of

26
. Changes in depreciation Answer: d Diff: M

Statement a is correct, because an increase in depreciation would lower

net income and, consequently, EPS. Statement b is also correct because
Solo will pay less taxes because depreciation is higher. Therefore,
statement d is the correct choice. Statement c is incorrect.
Depreciation expense would increase; hence, EBIT would fall.
27
. Changes in depreciation Answer: d Diff: M

Statement d is correct. The other statements are false. The tax paid by
the firm will be less due to the larger non-cash expense of depreciation,
which increases net cash flow. The firm’s net income is lower because
depreciation will be higher, and the firm will also have less taxable
income due to higher depreciation expense.
28
. Effects of changes in financial leverage Answer: a Diff: M

Statement a is correct. Net income will increase because less interest

expense will be paid by the company. Statement b is incorrect because
reducing interest expense will increase the amount of EBT (taxable
income). Higher taxable income results in higher taxes; therefore,
statement c is incorrect.

Chapter 2 - Page 18
the company’s outstanding debt. Assume that the company adopts this
policy, and that total assets and operating income (EBIT) remain the
same. The company’s tax rate will also remain the same. Which of the
following will occur?

a. The company’s net income will increase.

b. The company’s taxable income will fall.
c. The company will pay less in taxes.
d. Statements b and c are correct.
e. All of the statements above are correct.

Chapter 2 - Page 19
Cash flow and EVA Answer: e Diff: M R
29
. An analyst has acquired the following information regarding Company A and
Company B:

● Company A has a higher net cash flow than Company B.

● Company B has higher net income than Company A.
● Company B has a higher operating cash flow than Company A.
● The companies have the same tax rate, investor-supplied operating
capital, and cost of capital (WACC).

Assume that non-cash revenues equal zero for both companies, and
depreciation is the only non-cash expense for both companies. Which of
the following statements is most correct?

a. Company A has a higher depreciation expense than Company B.

b. Company A has a lower level of operating income (EBIT) than Company B.
c. Company A has a lower EVA than Company B.
d. Statements a and b are correct.
e. All of the statements above are correct.

EVA and net income Answer: c Diff: M

30
. Assume that the depreciation level used for tax and accounting purposes
equals the true economic depreciation. Which of the following statements
is most correct?

a. If a company’s net income doubles, its Economic Value Added (EVA) will
more than double.
29
. Cash flow and EVA Answer: e Diff: M R

OCF = (EBIT)(1 - T) + DEP AND AMORT.

NCF = NI + Non-cash charges.

Statements a, b, and c are true, so the appropriate choice is statement

e. Statement a is correct. NCF = NI + DEP and AMORT. Since A has higher
NCF than B but a lower NI than B, A's depreciation (since amortization
equals 0 as given in the problem) must be greater than B’s. Statement b
is correct. OCF = EBIT(1 - T) + DEP and AMORT. Both companies have the
same tax rate, but A's depreciation is greater than B's. However, B has
a greater operating cash flow. Consequently, A must have lower operating
income than B. Statement c is correct. EVA = EBIT(1 - T) - (WACC × Total
investor-supplied operating capital). From above, we learned, EBITB >
EBITA. Also, we've been told that both companies have the same tax rate,
WACC, and investor-supplied operating capital. Thus, EVAB > EVAA.
30
. EVA and net income Answer: c Diff: M

Statement c is correct. Recall that EVA = EBIT(1 – T) – (After-tax cost

of capital)(Total investor-supplied operating capital). Even if EBIT

falls, EVA can increase by reducing either (or both) total

investor-supplied operating capital or the after-tax cost of capital.

Chapter 2 - Page 20
 b. If a company’s depreciation expense declines its net income will fall
but its Economic Value Added (EVA) will increase.
c. A firm can increase its EVA even if its operating income falls.
d. Statements a and b are correct.
e. Statements a and c are correct.

Multiple Choice: Problems

Easy:
Statement of cash flows Answer: d Diff: E
31
. At the beginning of the year, Gonzales Corporation had $100,000 in cash.
The company undertook a major expansion during this same year. Looking
at its statement of cash flows, you see that the net cash provided by its
operations was $300,000 and the company’s investing activities required
cash expenditures of $800,000. The company’s cash position at the end of
the year was $50,000. What was the net cash provided by the company’s
financing activities?

a. $350,000
b. $400,000
c. $300,000
d. $450,000
e. $500,000
Balance sheet cash Answer: c Diff: E N

31
. Statement of cash flows Answer: d Diff: E

The cash flow statement can be developed as follows:

Beginning cash $ 100,000

Additions from operating activities 300,000
Uses from investing activities -800,000
Additions from financing activities ?
Ending cash $ 50,000

For the firm to end up with $50,000 cash, it must have had a cash inflow
from financing activities of $450,000.

Chapter 2 - Page 21
32
. At the end of 2001, Lehnhoff Inc. had $75 million in cash on its balance
sheet. During 2002, the following events occurred:

● The cash flow from Lehnhoff’s operating activities totaled $325

million.
● Lehnhoff issued $500 million in common stock.
● Lehnhoff’s notes payable decreased by $100 million.
● Lehnhoff purchased fixed assets totaling $600 million.

How much cash did Lehnhoff Inc. have on its balance sheet at the end of
2002?

a. $ 50 million
b. $ 100 million
c. $ 200 million
d. $ 400 million
e. $1,400 million

Retained earnings Answer: d Diff: E N

33
. At the end of 2001, Scaringe Medical Supply had $275 million of retained
earnings on its balance sheet. During 2002, Scaringe paid a per-share
dividend of $0.25 and produced earnings per share of $0.75. Scaringe has
32
. Balance sheet cash Answer: c Diff: E N

The four transactions have the following effects:

1. Cash from operating activities

Debit Cash $325,000,000
Credit Net income $325,000,000
(or a similar income statement account)

2. Stock issuance
Debit Cash $500,000,000
Credit Common stock $500,000,000

3. Decrease in notes payable

Debit Notes payable $100,000,000
Credit Cash $100,000,000

4. Purchase of fixed assets

Debit Fixed assets $600,000,000
Credit Cash $600,000,000

So, Cash = $75,000,000 (initial balance) + $325,000,000 + $500,000,000 -

$100,000,000 - $600,000,000 = $200,000,000.
33
. Retained earnings Answer: d Diff: E N

2001 Ret. earnings $275,000,000 (given)

2002 Net income + 15,000,000 ($ 0.75 × 20,000,000)
2002 Dividends - 5,000,000 ($ 0.25 × 20,000,000)
2002 Ret. earnings $285,000,000

Chapter 2 - Page 22
 20 million shares of stock outstanding. What was the level of retained
earnings that Scaringe had on its balance sheet at the end of 2002?

a. $255 million
b. $265 million
c. $275 million
d. $285 million
e. $295 million

Statement of retained earnings Answer: d Diff: E N

34
. In its recent income statement, Smith Software Inc. reported $25 million
of net income, and in its year-end balance sheet, Smith reported $405
million of retained earnings. The previous year, its balance sheet
showed $390 million of retained earnings. What were the total dividends
paid to shareholders during the most recent year?

a. $ 3,500,000
b. $ 5,000,000
c. $ 6,750,000
d. $10,000,000
e. $11,250,000

34
. Statement of retained earnings Answer: d Diff: E N

NI = $25,000,000; R/EY/E = $405,000,000; R/EB/Y = $390,000,000; Dividends =

?
R/EB/Y + NI – Div = R/EY/E.

$390,000,000 + $25,000,000 – Div = $405,000,000

$415,000,000 – Div = $405,000,000
$10,000,000 = Div.

Chapter 2 - Page 23
Income statement Answer: b Diff: E N
35
. Cox Corporation recently reported an EBITDA of $22.5 million and $5.4
million of net income. The company has $6 million interest expense and
the corporate tax rate is 35 percent. What was the company’s
depreciation and amortization expense?

a. $ 4,333,650
b. $ 8,192,308
c. $ 9,427,973
d. $11,567,981
e. $14,307,692

EVA Answer: a Diff: E

36
. Scranton Shipyards has $20 million in total investor-supplied operating
capital. The company’s WACC is 10 percent. The company has the
following income statement:

Sales $10.0 million

Operating costs 6.0 million
Operating income (EBIT) $ 4.0 million
Interest expense 2.0 million
Earnings before taxes (EBT) $ 2.0 million
Taxes (40%) 0.8 million
Net income $ 1.2 million

What is Scranton’s EVA?

a. $ 400,000
b. -$ 800,000
c. $1,200,000
d. $2,000,000
e. $4,000,000

MVA Answer: d Diff: E

37
. Hayes Corporation has $300 million of common equity on its balance sheet

35
. Income statement Answer: b Diff: E N

36
. EVA Answer: a Diff: E

EVA = EBIT × (1 - T) - (WACC × Total investor-supplied operating capital)

= $4,000,000 × (1 - 0.4) - (0.1 × $20,000,000)
= $2,400,000 - $2,000,000
= $400,000.
37
. MVA Answer: d Diff: E

MVA = (Shares outstanding)(Stock Price) - Total common equity.

$162,000,000 = (6,000,000)P0 - $300,000,000
$462,000,000 = (6,000,000)P0
P0 = $77.00.

Chapter 2 - Page 24
and 6 million shares of common stock outstanding. The company’s Market
Value Added (MVA) is $162 million. What is the company’s stock price?

a. $ 23
b. $ 32
c. $ 50
d. $ 77
e. $138

Chapter 2 - Page 25
MVA Answer: c Diff: E
38
. Byrd Lumber has 2 million shares of common stock outstanding and its
stock price is $15 a share. On the balance sheet, the company has $40
million of common equity. What is the company’s Market Value Added
(MVA)?

a. -$80,000,000
b. -$20,000,000
c. -$10,000,000
d. $20,000,000
e. $80,000,000

Medium:
Rate of interest Answer: c Diff: M
39
. A firm has notes payable of $1,546,000, long-term debt of $13,000,000,
and total interest expense of $1,300,000. If the firm pays 8 percent
interest on its long-term debt, what interest rate does it pay on its
notes payable?

a. 8.2%
b. 13.1%
c. 16.8%
d. 18.0%
e. 15.3%

Calculating change in net income Answer: c Diff: M R

40
. Garfield Industries is expanding its operations throughout the Southeast

38
. MVA Answer: c Diff: E

MVA = (Shares outstanding)(Stock Price) - Total common equity.

MVA = (2,000,000)($15) - $40,000,000
MVA = -$10,000,000.
39
. Rate of interest Answer: c Diff: M

Long-term interest = ($13,000,000)(0.08) = $1,040,000.

Short-term interest = $1,300,000 - $1,040,000 = $260,000.
Short-term interest rate = $260,000/$1,546,000 = 16.82% ≈ 16.8%.
40
. Calculating change in net income Answer: c Diff: M R

Set up an income statement:

Sales $1,000,000
Operating costs
excl. dep. and amort. 700,000
EBITDA $ 300,000
Depreciation and amortization 50,000
EBIT $ 250,000
Interest 150,000
EBT $ 100,000
Taxes (40%) 40,000 Taxes = 0.4($100,000) =

Chapter 2 - Page 26
United States. Garfield anticipates that the expansion will increase
sales by $1,000,000 and increase operating costs (excluding depreciation
and amortization) by $700,000. Depreciation and amortization expenses
will rise by $50,000, interest expense will increase by $150,000, and the
company’s tax rate will remain at 40 percent. If the company’s forecast
is correct, how much will net income increase or decrease, as a result of
the expansion?

a. No change
b. $ 40,000 increase
c. $ 60,000 increase
d. $100,000 increase
e. $180,000 increase

$40,000.
Net income $ 60,000

Chapter 2 - Page 27
Net income Answer: b Diff: M
41
. Edge Brothers recently reported net income of $385,000. The tax rate is
40 percent. The company’s interest expense was $200,000. What would
have been the company’s net income if it would have been able to double
its operating income (EBIT), assuming that the company’s tax rate and
interest expense remain unchanged?

a. $ 770,000
b. $ 890,000
c. $ 920,000
d. $1,100,000
e. $1,275,000

Net cash flow Answer: d Diff: M

42
. Coolidge Cola is forecasting the following income statement:

Sales $30,000,000
Operating costs excluding depreciation and amortization 20,000,000

41

. Net income Answer: b Diff: M

We need to work backwards through the income statement to get the EBIT.
EBIT $841,667 ($641,667 + $200,000)
Interest 200,000
EBT $641,667 ($385,000/0.6)
Tax (40%) 256,667
NI $385,000

If EBIT doubles:
EBIT $1,683,334 ($841,667 × 2)
Interest 200,000
EBT $1,483,334
Tax (40%) 593,334
NI $ 890,000 ($1,483,334 × 0.6)

42
. Net cash flow Answer: d Diff: M

The income statement would show:

Sales $30,000,000
Oper. costs (excl. depr. and amort.) 20,000,000
EBITDA $10,000,000
Depreciation and amortization 8,000,000
EBIT $ 2,000,000
Interest exp. 2,000,000
EBT$ 0
Taxes 0
NI $ 0

NCF = NI + DEP and AMORT

NCF = 0 + $8,000,000 = $8,000,000.

Chapter 2 - Page 28
EBITDA $10,000,000
Depreciation and amortization 5,000,000
Operating income (EBIT) $ 5,000,000
Interest expense 2,000,000
Taxable income (EBT) $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000

Assume that, with the exception of depreciation, all other non-cash

revenues and expenses sum to zero.

Congress is considering a proposal that will allow companies to

depreciate their equipment at a faster rate. If this provision were put
in place, Coolidge’s depreciation expense would be $8,000,000 (instead of
$5,000,000). This proposal would have no effect on the economic value of
the company’s equipment, nor would it affect the company’s tax rate,
which would remain at 40 percent. If this proposal were to be
implemented, what would be the company’s net cash flow?

a. $2,000,000
b. $4,000,000
c. $6,800,000
d. $8,000,000
e. $9,800,000

Chapter 2 - Page 29
Net cash flow Answer: d Diff: M N
43
. An analyst has collected the following information regarding Gilligan
Grocers:

● Earnings before interest and taxes (EBIT) = $700 million.

● Earnings before interest, taxes, depreciation and amortization
(EBITDA) = $850 million.
● Interest expense = $200 million.
● The corporate tax rate is 40 percent.
● Depreciation is the company’s only non-cash expense or revenue.

What is the company’s net cash flow?

a. $850 million
b. $650 million
c. $570 million
d. $450 million
e. $500 million

Operating and net cash flows Answer: a Diff: M

44
. Brooks Sisters’ operating income (EBIT) is $500,000. The company’s tax

43
. Net cash flow Answer: d Diff: M N

NCF = NI + Depreciation and Amortization.

NI = EBIT - I - Taxes
= $700 - $200 - Taxes
= $500 – ($500 × 40%)
= $500 - $200
= $300 million.

EBIT = EBITDA – Depreciation and Amortization

$700 = $850 - DA
$150 million = DA.

So, depreciation and amortization totals $150 million.

NCF = NI + DEP and AMORT

= $300 + $150
= $450 million.

44
. Operating and net cash flows Answer: a Diff: M

NCF = NI + DEP and AMORT

EBIT $500,000 (Given)

Interest 100,000 (Given)
EBT $400,000
Taxes (40%) 160,000 (Given)

Chapter 2 - Page 30
 rate is 40 percent, and its operating cash flow is $450,000. The
company’s interest expense is $100,000. What is the company’s net cash
flow? (Assume that depreciation is the only non-cash item in the firm’s
financial statements.)

a. $ 390,000
b. $ 550,000
c. $ 600,000
d. $ 950,000
e. $1,050,000

EVA Answer: b Diff: M R

45
. Casey Motors recently reported the following information:

● Net income = $600,000.

● Tax rate = 40%.
● Interest expense = $200,000.
● Total investor-supplied operating capital employed = $9 million.
● After-tax cost of capital = 10%.

What is the company’s EVA?

a. -$300,000
b. -$180,000
c. $ 0
d. $200,000
e. $400,000

NI $240,000

Operating cash flow = EBIT(1 - T) + DEP and AMORT

$450,000 = $500,000(0.6) + DEP and AMORT
$150,000 = DEP and AMORT.

NCF = $240,000 + $150,000

= $390,000.
45
. EVA Answer: b Diff: M R

EVA = EBIT (1 - T) - .

Note that EBIT = Earnings before taxes plus interest expense.

Earnings before taxes = EBT = = $1,000,000.

EBIT = $1,000,000 + $200,000 = $1,200,000.

EVA = $1,200,000(0.6) - $9,000,000(0.10)

= -$180,000.

Chapter 2 - Page 31
Sales level Answer: e Diff: M
46
. Hebner Housing Corporation has forecast the following numbers for this
upcoming year:

● Sales = $1,000,000.
● Cost of goods sold = 600,000.
● Interest expense = 100,000.
● Net income = 180,000.

The company is in the 40 percent tax bracket. Its cost of goods sold
always represents 60 percent of its sales. That is, if the company’s
sales were to increase to $1.5 million, its cost of goods sold would
increase to $900,000.

The company’s CEO is unhappy with the forecast and wants the firm to
achieve a net income equal to $240,000. In order to achieve this level
of net income, what level of sales will the company have to achieve?
Assume that Hebner’s interest expense remains constant.

a. $ 400,000
b. $ 500,000
c. $ 750,000
d. $1,000,000
e. $1,250,000

46
. Sales level Answer: e Diff: M

This question requires working backwards through the income statement

from net income to sales. The income statement will look like this:

Sales $1,250,000 $500,000/(1 - 0.6)

CGS (60%) 750,000 $1,250,000 × 0.6
EBIT $ 500,000 $100,000 + $400,000
Interest 100,000 (Given)
EBT $ 400,000 $240,000/(1 - 0.4)
Tax (40%) 160,000
NI $ 240,000

Chapter 2 - Page 32
Sales level Answer: e Diff: M
47
. Swann Systems is forecasting the following income statement for the
upcoming year:

Sales $5,000,000
Operating costs (excluding depreciation and amortization) 3,000,000
EBITDA $2,000,000
Depreciation and amortization 500,000
EBIT $1,500,000
Interest 500,000
EBT $1,000,000
Taxes (40%) 400,000
Net income $ 600,000

The company’s president is disappointed with the forecast and would like
to see Swann generate higher sales and a forecasted net income of
$2,000,000.

Assume that operating costs (excluding depreciation and amortization) are

always 60 percent of sales. Also, assume that depreciation and
amortization, interest expense, and the company’s tax rate, which is 40
percent, will remain the same even if sales change. What level of sales
would Swann have to obtain to generate $2,000,000 in net income?

a. $ 5,800,000
b. $ 6,000,000
c. $ 7,200,000
d. $ 8,300,000
e. $10,833,333

Sales and income statement Answer: d Diff: M

48
. Ozark Industries reported net income of $75 million in 2002. The

47
. Sales level Answer: e Diff: M

Working up the income statement you calculate the new sales level should
be $10,833,333.

Sales $10,833,333 $4,333,333/(1 - 0.6)

Operating costs
(excl. depr. and amort.)(60%) 6,500,000 $10,833,333 × 0.6
EBITDA $ 4,333,333 $3,833,333 + $500,000
Depreciation and amortization 500,000
EBIT $ 3,833,333 $3,333,333 + $500,000
Interest 500,000
EBT $ 3,333,333 $2,000,000/0.6
Taxes (40%) 1,333,333
Net income $ 2,000,000
48
. Sales and income statement Answer: d Diff: M

In 2002, net income was $75 million and the tax rate was 40 percent.
Therefore, earnings before taxes (EBT) was equal to $75/(1 - 0.4) = $125
million. We know interest equals $25 million, so EBIT = $125 + $25 = $150

Chapter 2 - Page 33
 company’s corporate tax rate was 40 percent and its interest expense was
$25 million. The company had $500 million in sales and its cost of goods
sold was $350 million. Ozark’s goal is for its net income to increase by
20 percent (to $90 million) in 2003. It forecasts that the tax rate will
remain at 40 percent, interest expense will increase by 40 percent, and
cost of goods sold will remain at 70 percent of sales.
What level of sales (to the closest million) will Ozark have to produce
in 2003 in order to meet its goal for net income?

a. $550 million
b. $583 million
c. $600 million
d. $617 million
e. $650 million

million. In addition, we know that the cost of goods sold (COGS) was $350
million and sales were $500 million.

We want net income to be 20 percent larger, so net income must be $75 ×

1.2 = $90 million. Therefore, EBT = $90/(1 - 0.4) = $150 million.
Interest will increase by 40 percent, so new interest will be $25 × 1.4 =
$35 million. Therefore, EBIT = $150 + $35 = $185 million. EBIT is 30
percent of sales since COGS is 70 percent of sales. So Sales = EBIT/(1 -
0.7) = $185/0.3 = $616.67 million ≈ 617 million.

Chapter 2 - Page 34
Sales and net cash flow Answer: b Diff: M
.
49
McGwire Aerospace expects to have net cash flow of $12 million. The
company forecasts that its operating costs excluding depreciation and
amortization will equal 75 percent of the company’s sales. Depreciation
and amortization expenses are expected to be $5 million and the company
has no interest expense. All of McGwire’s sales will be collected in
cash, costs other than depreciation and amortization will be paid in cash
during the year, and the company’s tax rate is 40 percent. What is the
company’s expected sales?

a. $ 68.00 million
b. $ 66.67 million
c. $ 46.67 million
d. $133.33 million
e. $ 26.67 million

Retained earnings Answer: e Diff: M

50
. Sanguillen Corp. had retained earnings of $400,000 on its 2001 balance
sheet. In 2002, the company’s earnings per share (EPS) were $3.00 and
its dividends paid per share (DPS) were $1.00. The company has 200,000
shares of common stock outstanding. What will be the level of retained
earnings on the company’s 2002 balance sheet?

a. $400,000
b. $500,000
c. $600,000
d. $700,000
e. $800,000

49
. Sales and net cash flow Answer: b Diff: M

The firm’s income statement is determined as follows:

Sales $66.67 ($16.67/0.25)
Operating costs excl. DA (75% of sales) 50.00
EBITDA$16.67 ($11.67 + $5.00)
Depreciation and amortization 5.00 (Given)
EBIT $11.67
Interest 0.00 (Given)
EBT $11.67 ($7.00/0.6)
Taxes (40%) 4.67
Net income $ 7.00 ($12.00 - $5.00)
Depreciation and amortization 5.00 (Given)
Net cash flow $12.00 (Given)
50
. Retained earnings Answer: e Diff: M

EPS = $3, but $1 per share is paid out as dividends. This means that $2
per share is added to retained earnings. Total amount retained is
$2(200,000) = $400,000. Add this to the amount already in the retained
earnings account on the balance sheet and you get a total ending balance
of retained earnings equal to $400,000 + $400,000 = $800,000.

Chapter 2 - Page 35
Retained earnings Answer: b Diff: M
51
. New Hampshire Services reported $2.3 million of retained earnings on its
2001 balance sheet. In 2002, the company lost money--its net income was
-$500,000 (negative $500,000). Despite the loss, the company still paid
a $1.00 per share dividend. The company’s earnings per share for 2002
were -$2.50 (negative $2.50). What was the level of retained earnings on
the company’s 2002 balance sheet?

a. $1.2 million
b. $1.6 million
c. $1.8 million
d. $2.6 million
e. $2.8 million

51
. Retained earnings Answer: b Diff: M

EPS = NI/shares.
For 2002, -$2.50 = -$500,000/Shares
Shares = -$500,000/-$2.50 = 200,000.

Dividends paid in 2002 = $1.00 × 200,000 = $200,000.

Looking at additions to retained earnings in 2002:

2001 Retained earnings $2,300,000
2002 Dividends (200,000)
2002 Net income (500,000)
2002 Retained earnings $1,600,000

Chapter 2 - Page 36
Earnings per share Answer: c Diff: M
52
. Whitehall Clothiers had $5,000,000 of retained earnings on its balance
sheet at the end of 2001. One year later, Whitehall had $6,000,000 of
retained earnings on its balance sheet. Whitehall has one million shares
of common stock outstanding, and it paid a dividend of $0.80 per share in
2002. What was Whitehall’s earnings per share in 2002?

a. $0.80
b. $1.00
c. $1.80
d. $5.00
e. $6.00

Operating income Answer: d Diff: M

52
. Earnings per share Answer: c Diff: M

The company paid a dividend of $0.80 per share. The total amount paid
was:

$0.80 per share × 1 million shares = $800,000.

The change in retained earnings (the amount of money the company

reinvests) is equal to NI - Div.

($6,000,000 - $5,000,000) = NI - $800,000

$1,000,000 + $800,000 = NI
$1,800,000 = NI.

EPS = NI/Shares
= $1,800,000/1,000,000
= $1.80.

Chapter 2 - Page 37
53
. New Mexico Lumber recently reported that its earnings per share were
$3.00. The company has 400,000 shares of common stock outstanding, its
interest expense is $500,000, and its corporate tax rate is 40 percent.
What is the company’s operating income (EBIT)?

a. $ 980,000
b. $1,220,000
c. $2,000,000
d. $2,500,000
e. $3,500,000

53
. Operating income Answer: d Diff: M

EPS = NI/Shares
NI = EPS × Shares

= $3.00 × 400,000 = $1,200,000.

EBT = NI/(1 - T) = $1,200,000/(1 - 0.4) = $2,000,000.

EBIT = EBT + Interest expense = $2,000,000 + $500,000 = $2,500,000.

Chapter 2 - Page 38
Statement of cash flows Answer: e Diff: M N
54
. Cochrane, Inc. had $75,000 in cash on the balance sheet at the end of
2001. At year-end 2002, the company had $155,000 in cash. We know cash
flow from operating activities totaled $1,250,000 and cash flow from
long-term investing activities totaled -$1,000,000. Furthermore,
Cochrane issued $250,000 in long-term debt last year to fund new
projects, increase liquidity, and to buy back some common stock. If
dividends paid to common stockholders equaled $25,000, how much common
stock did Cochrane repurchase last year? (Assume that the only financing
activities in which Cochrane engaged involved long-term debt, payment of
common dividends, and common stock.)

a. $ 55,000
b. $105,000
c. $205,000
d. $255,000
e. $395,000

54
. Statement of cash flows Answer: e Diff: M N

This question involves the statement of cash flows. We know from the
statement of cash flows that the change in cash must equal cash flow from
operating activities plus long-term investing activities plus financing
activities. First, we must identify the change in cash as follows:

Cash at the end of the year $155,000

Cash at the beginning of the year -75,000
Change in cash $ 80,000

The sum of cash flows generated from operations, investment, and

financing must equal $80,000. Therefore, we can calculate the cash flow
from financing as follows:

CF from operations + CF from investing + CF from financing = Δ in cash

$1,250,000 + (-$1,000,000) + CF from financing = $ 80,000
CF from financing = -$170,000.

We have been given the cash flows from two of the three financing
activities, so we can calculate the amount of stock that was repurchased.

ΔL-T debt + ΔCommon stock – Pmt. of common dividends = CF from financing

$250,000 + ΔCommon stock - $25,000 = -$170,000
ΔCommon stock = -$395,000.

The negative change in common stock tells us that the firm repurchased
$395,000 worth of its common stock.

Chapter 2 - Page 39
Free cash flow Answer: a Diff: M N
55
. A stock market analyst has forecasted the following year-end numbers for
Raedebe Technology:

Sales $70 million

EBITDA $20 million
Depreciation $ 7 million
Amortization $ 0

The company’s tax rate is 40 percent. The company does not expect any
changes in its net operating working capital. This year the company’s
planned gross capital expenditures will total $12 million. (Gross
capital expenditures represent capital expenditures before deducting
depreciation.) What is the company’s forecasted free cash flow for the
year?

a. $ 2.8 million
b. $ 7.0 million
c. $ 8.0 million
d. $12.8 million
e. $26.8 million

Multiple Part:
(The following information applies to the next four problems.)

You have just obtained financial information for the past 2 years for Sebring
Corporation.

SEBRING CORPORATION: INCOME STATEMENTS FOR YEAR ENDING DECEMBER 31

(MILLIONS OF DOLLARS)

2002 2001
Sales $3,600.0 $3,000.0
Operating costs (excluding depreciation and amortization) 3,060.0 2,550.0
EBITDA $ 540.0 $ 450.0
Depreciation and amortization 90.0 75.0
Earnings before interest and taxes $ 450.0 $ 375.0
Interest 65.0 60.0
Earnings before taxes $ 385.0 $ 315.0
Taxes (40%) 154.0 126.0
Net income available to common stockholders $ 231.0 $ 189.0
Common dividends $ 181.5 $ 13.2

55
. Free cash flow Answer: a Diff: M N

FCF1 = EBIT(1 - T) + – - ΔNOWC

FCF1 = ($20 - $7)(1 - 0.4 ) + $7 - $12 - $0
FCF1 = $7.8 + $7 - $12 - $0
FCF1 = $2.8 million.

Chapter 2 - Page 40
 SEBRING CORPORATION: BALANCE SHEETS FOR YEAR ENDING DECEMBER 31
(MILLIONS OF DOLLARS)

2002 2001
Assets:
Cash and marketable securities $ 36.0 $ 30.0
Accounts receivable 540.0 450.0
Inventories 540.0 600.0
Total current assets $1,116.0 $1,080.0
Net plant and equipment 900.0 750.0
Total assets $2,016.0 $1,830.0

Liabilities and equity:

Accounts payable $ 324.0 $ 270.0
Notes payable 201.0 155.0
Accruals 216.0 180.0
Total current liabilities $ 741.0 $ 605.0
Long-term bonds 450.0 450.0
Total debt $1,191.0 $1,055.0
Common stock (50 million shares) 150.0 150.0
Retained earnings 675.0 625.0
Total common equity $ 825.0 $ 775.0
Total liabilities and equity $2,016.0 $1,830.0

NOPAT Answer: d Diff: E

56
. What is Sebring’s net operating profit after taxes (NOPAT) for 2002?

a. $100,000,000
b. $150,000,000
c. $225,000,000
d. $270,000,000
e. $375,000,000

Net operating working capital Answer: b Diff: E

57
. What is Sebring’s net operating working capital for 2002?

a. $ 540,000,000
b. $ 576,000,000
c. $ 750,000,000
d. $ 985,000,000
e. $1,116,000,000

Operating capital Answer: e Diff: E

56
. NOPAT Answer: d Diff: E

NOPAT02 = EBIT(1 - T)
= $450,000,000(0.6)
= $270,000,000.
57
. Net operating working capital Answer: b Diff: E

= $1,116,000,000 - $540,000,000 = $576,000,000.

Chapter 2 - Page 41
58
. What is Sebring’s amount of total investor-supplied operating capital for
2002?

a. $ 576,000,000
b. $ 888,000,000
c. $ 900,000,000
d. $1,275,000,000
e. $1,476,000,000
Free cash flow Answer: c Diff: M
59
. What is Sebring’s free cash flow for 2002?

a. $ 85,000,000
b. $146,000,000
c. $174,000,000
d. $255,000,000
e. $366,000,000

(The following information applies to the next four problems.)

Last year, Sharpe Radios had a net operating profit after-taxes (NOPAT) of $7.8
million. Its EBITDA was $15.5 million and net income amounted to $3.8 million.
During the year, Sharpe Radios made $5.5 million in net capital expenditures
(that is, capital expenditures net of depreciation). Finally, Sharpe Radios’
finance staff has concluded that the firm’s total after-tax capital costs were
$5.9 million and its tax rate was 40 percent.

Depreciation and amortization expense Answer: c Diff: M N

60
. What is Sharpe Radios’ depreciation and amortization expense?

58
. Operating capital Answer: e Diff: E

= $900,000,000 + $576,000,000 = $1,476,000,000.

59
. Free cash flow Answer: c Diff: M

NOWC01 = Current assets - Non-interest charging current liabilities

= $1,080,000,000 - $450,000,000 = $630,000,000.

= Net plant & equipment + NOWC

= $750,000,000 + $630,000,000 = $1,380,000,000.

FCF02 = NOPAT02 - Net investment in operating capital

= $270,000,000 - $1,476,000,000 - $1,380,000,000 = $174,000,000.
60
. Depreciation and amortization expense Answer: c Diff: M N

Looking back at the income statement, we realize that the depreciation

and amortization expense can be found as the difference between EBITDA
and EBIT. Therefore, we need to break down NOPAT to determine EBIT:

NOPAT = EBIT(1 - T)
$7,800,000 = EBIT(1 - 0.4)
$7,800,000 = EBIT(0.6)
$13,000,000 = EBIT.

Chapter 2 - Page 42
 a. $1.5 million
b. $2.1 million
c. $2.5 million
d. $3.3 million
e. $4.0 million

Interest expense Answer: b Diff: M N

61
. What is Sharpe Radios’ interest expense?

a. $ 6.33 million
b. $ 6.67 million
c. $ 8.33 million
d. $ 9.17 million
e. $10.13 million

Now that we have EBIT, we can find the depreciation and amortization
expense by subtracting EBIT from EBITDA, which is given in the problem.

EBITDA $15,500,000
Depr. & Amort. - ?????????
EBIT $13,000,000

Therefore, depreciation and amortization expense is equal to $2.5

million.
61
. Interest expense Answer: b Diff: M N

To get the firm’s interest expense, we must use the income statement to
determine earnings before taxes (EBT). Then, we can subtract EBT from
EBIT to find the interest expense.

EBIT $13,000,000
Int -??????????
EBT
Taxes
NI $ 3,800,000

NI = EBT(1 - T)
$3,800,000 = EBT(0.6)
$6,333,333 = EBT.

Interest expense simply becomes the difference between EBIT and EBT.

EBIT – Int = EBT

$13,000,000 – Int = $6,333,333
$6,666,667 = Int.

So, interest expense is $6.67 million.

Chapter 2 - Page 43
Free cash flow Answer: b Diff: E N
62
. What is Sharpe Radios’ free cash flow?

a. $1.9 million
b. $2.3 million
c. $4.0 million
d. $4.8 million
e. $6.3 million

62
. Free cash flow Answer: b Diff: E N

Remember, free cash flow (FCF) can be calculated as after-tax operating

income less net capital expenditures. Therefore,

FCF = EBIT(1 - T) – Net capital expenditures

FCF = $13,000,000(1 - 0.4) – $5,500,000
FCF = $ 7,800,000 – $5,500,000
FCF = $ 2,300,000.

Chapter 2 - Page 44
EVA Answer: a Diff: E N
63
. What is Sharpe Radios’ EVA?

a. $1.9 million
b. $2.3 million
c. $4.0 million
d. $7.2 million
e. $9.6 million

(The following information applies to the next four problems.)

Laiho Industries recently reported the following information in its annual

report:

● Net income = $7.0 million.

● NOPAT = $60 million.
● EBITDA = $120 million.
● Net profit margin = 5.0%.

Laiho has depreciation expense, but it does not have amortization expense.
Laiho has $300 million in operating capital, its after-tax cost of capital is
10 percent (that is, its WACC = 10%), and the firm’s tax rate is 40 percent.

Depreciation expense Answer: a Diff: M N

64
. What is Laiho’s depreciation expense?

a. $20.0 million
b. $30.0 million

63
. EVA Answer: a Diff: E N

Recall, EVA is after-tax operating income less the after-tax capital

costs.

EVA = EBIT(1 - T) – AT capital costs

EVA = $7,800,000 - $5,900,000
EVA = $1,900,000.
64
. Depreciation expense Answer: a Diff: M N

NOPAT = EBIT(1 - T)
$60,000,000 = EBIT(1 - 0.4)
EBIT = $100,000,000.

EBITDA $120,000,000
Depr. X
Amort. 0 (given)
EBIT $100,000,000

EBITDA – DA = EBIT
$120,000,000 - X = $100,000,000
Depreciation = $20,000,000.

Chapter 2 - Page 45
 c. $53.0 million
d. $60.0 million
e. $77.1 million

Interest expense Answer: c Diff: M N

65
. What is Laiho’s interest expense?

a. $60.0 million
b. $82.5 million
c. $88.3 million
d. $92.0 million
e. $95.0 million

Sales level Answer: b Diff: E N

66
. What is Laiho’s sales?

a. $120.0 million
b. $140.0 million
c. $160.0 million
d. $180.0 million
e. $200.0 million

65
. Interest expense Answer: c Diff: M N

EBIT $100,000,000 (from previous problem)

Int X
EBT
Taxes
NI $ 7,000,000 (given)

NI = EBT(1 – T)
$7,000,000 = EBT(0.6)
$11,666,667 = EBT.

Interest expense is simply the difference between EBIT and EBT.

EBIT – Int = EBT

$100,000,000 – Int = $11,666,667
$88,333,333 = Int.

So interest expense is $88.3 million.

66
. Sales level Answer: b Diff: E N

Net profit margin = NI/Sales = 5%.

$7,000,000/Sales = 5%
0.05Sales = $7,000,000
Sales = $140,000,000.

Chapter 2 - Page 46
EVA Answer: a Diff: E N
67
. What is Laiho’s EVA?

a. $30.0 million
b. $40.0 million
c. $50.0 million
d. $60.0 million
e. $70.0 million

(The following information applies to the next three problems.)

Beckham Broadcasting Company (BBC) has operating income (EBIT) of $2,500,000.

The company’s depreciation expense is $500,000 and it has no amortization
expense. The company is 100 percent equity financed (that is, its interest
expense is zero). The company has a 40 percent tax rate, and its net
investment in operating capital is $1,000,000.

Net income Answer: d Diff: E N

68
. What is BBC’s net income?

a. $1,000,000
b. $1,200,000
c. $1,250,000
d. $1,500,000
e. $1,550,000

NOPAT Answer: d Diff: E N

69
. What is BBC’s net operating profit after taxes (NOPAT)?

a. $1,000,000
b. $1,200,000
c. $1,250,000

67
. EVA Answer: a Diff: E N

EVA = EBIT(1 - T) - (Total operating capital × WACC)

= $100,000,000(1 - 0.40) - ($300,000,000 × 0.10)
= $60,000,000 - $30,000,000
= $30,000,000.
68
. Net income Answer: d Diff: E N

EBIT $2,500,000
Int 0
EBT $2,500,000
Taxes (40%) 1,000,000
NI $1,500,000
69
. NOPAT Answer: d Diff: E N

NOPAT = EBIT(1 – T) = $2,500,000(1 – 0.40) = $1,500,000.

Chapter 2 - Page 47
 d. $1,500,000
e. $1,550,000

Free cash flow Answer: b Diff: E N

70
. What is BBC’s free cash flow?

a. $ 0
b. $ 500,000
c. $ 900,000
d. $1,000,000
e. $1,500,000

70
. Free cash flow Answer: b Diff: E N

FCF = EBIT (1 – T) – Net investment in operating capital

= $2,500,000(1 – 0.40) – $1,000,000 = $500,000.

Chapter 2 - Page 48
Chapter 2 - Page 49
 Web Appendix 2A
Multiple Choice: Conceptual

Easy:
Personal taxes Answer: c Diff: E
71
2A- . Current tax laws have which of the following effects?

a. Favor dividends because there are no capital gains taxes on

dividends.
b. Do not favor capital gains because the tax must be paid as the value
of the stock increases, whether or not the stock is sold.
c. Favor capital gains because the rate generally applicable to
long-term capital gains is 20 percent and the tax does not have to be
paid until the stock is sold.
d. Do not favor dividends or capital gains for most people because
different people are in different tax brackets.
e. Favor dividends since dividends are tax-deductible for the paying
corporation whereas retained earnings, which produce capital gains,
are not tax-deductible.

Taxes Answer: b Diff: E

2A-72. Which of the following statements is most correct?

a. Corporations are allowed to exclude 70 percent of their interest

income from corporate taxes.
b. Corporations are allowed to exclude 70 percent of their dividend
income from corporate taxes.
c. Individuals pay taxes on only 30 percent of the income realized from
municipal bonds.
d. Statements a and b are correct.
e. None of the statements above is correct.

Taxes Answer: b Diff: E

73
2A- . Which of the following statements is most correct?

71
WEB APPENDIX 2A SOLUTIONS

2A-. Personal taxes Answer: c Diff: E

72
2A-. Taxes Answer: b Diff: E

Statement b is correct. The other statements are false. Corporations

cannot exclude interest income from corporate taxes and individuals pay
no taxes on municipal bond income.
73
2A-. Taxes Answer: b Diff: E

Statement b is correct. The other statements are false. Corporations

cannot exclude interest income from corporate taxes. Recall that

Chapter 2 - Page 50
a. 70 percent of a corporation’s interest income is excluded from
corporate income taxes.
b. 70 percent of a corporation’s dividend income is excluded from
corporate income taxes.
c. A municipal bond will generally trade at a higher yield than a
corporate bond of equal risk.
d. All of the statements above are correct.
e. Statements b and c are correct.

municipal bonds are not taxed.

=
or
= (1 – T).

Munis trade at lower yields than equivalent corporate bonds because

investors do not have to pay taxes on munis.

Chapter 2 - Page 51
Carry-back, carry-forward Answer: b Diff: E
74
2A- . A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a
row.
b. Can be carried back 2 years, then carried forward up to 20 years
following the loss.
c. Can be carried back 5 years and forward 3 years.
d. Cannot be used to reduce taxes in other years except with special
permission from the IRS.
e. Can be carried back 3 years or forward 10 years, whichever is more
advantageous to the firm.

Miscellaneous concepts Answer: c Diff: E

75
2A- . Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the

amount of cash a company has available to pay out as dividends to
shareholders.
b. 70 percent of the interest received by corporations is excluded from
taxable income.
c. 70 percent of the dividends received by corporations is excluded from
taxable income.
d. None of the statements above is correct.
e. Statements a and c are correct.

Multiple Choice: Problems

Easy:
Corporate taxes Answer: b Diff: E
76
2A- . Your corporation has the following cash flows:
74
2A-. Carry-back, carry-forward Answer: b Diff: E
75
2A-. Miscellaneous concepts Answer: c Diff: E

Statement c is correct. The other statements are false. Retained

earnings do not represent cash and all of the firm’s interest income is
taxed.
76
2A-. Corporate taxes Answer: b Diff: E

Operating income $250,000

Interest received 10,000
Interest paid (45,000)
Dividends received (taxable) 6,000*
Taxable income $221,000

*Taxable dividends = $20,000(0.30) = $6,000.

Taxes = 0.4($221,000) = $88,400.

Chapter 2 - Page 52
 Operating income $250,000
Interest received 10,000
Interest paid 45,000
Dividends received 20,000
Dividends paid 50,000

If the applicable income tax rate is 40 percent (federal and state

combined), and if 70 percent of dividends received are exempt from
taxes, what is the corporation’s tax liability?

a. $ 74,000
b. $ 88,400
c. $ 91,600
d. $100,000
e. $106,500

Chapter 2 - Page 53
Corporate taxes Answer: b Diff: E N
77
2A- . Lintner Beverage Corp. reported the following information from their
financial statements:

Operating income (EBIT) = $13.2 million.

Interest payments on long-term debt = $1.75 million.
Dividend income = $1 million.

Calculate Lintner’s total tax liability using the corporate tax schedule
below:

Tax on Base Percentage on

Taxable Income of Bracket Excess above Base
$0-$50,000 $ 0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

a. $3,995,000
b. $4,012,500
c. $4,233,000
d. $4,257,500
e. $4,653,000

Corporate taxes Answer: c Diff: E N

2A-78. Last year, Martyn Company had $500,000 in taxable income from its
77
2A-. Corporate taxes Answer: b Diff: E N

We must use the corporate tax table to answer this question. First,
find the firm’s taxable income. Don’t forget only 30% of dividend
income received by corporations is taxed.

Operating income $13,200,000

Interest payments -1,750,000
Dividend income 300,000
Taxable income $11,750,000

Tax on base $3,400,000

Tax on excess of base $1,750,000 × 0.35 = 612,500
Tax liability $4,012,500
78
2A-. Corporate taxes Answer: c Diff: E N

Operating income $500,000

Interest income + 50,000
Dividend income + 30,000 [$100,000(1 – 0.7)]
Taxable income $580,000

Tax on base $113,900

Chapter 2 - Page 54
operations, $50,000 in interest income, and $100,000 in dividend income.
Using the corporate tax rate table given below, what was the company’s
tax liability for the year?

Tax on Base Percentage on

Taxable Income of Bracket Excess above Base
$0-$50,000 $ 0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

a. $ 83,300
b. $182,274
c. $197,200
d. $210,800
e. $296,174

Tax on excess of base $245,000 × 0.34 = 83,300

Tax liability $197,200

Chapter 2 - Page 55
After-tax returns Answer: b Diff: E
79
2A- . A corporation with a marginal tax rate of 35 percent would receive what
after-tax dividend yield on a 12 percent coupon rate preferred stock
bought at par, assuming a 70 percent dividend exclusion?

a. 11.03%
b. 10.74%
c. 6.48%
d. 7.31%
e. 5.52%

After-tax returns Answer: b Diff: E

80
2A- . Carter Corporation has some money to invest, and its treasurer is
choosing between City of Chicago municipal bonds and U.S. Treasury
bonds. Both have the same maturity, and they are equally risky and
liquid. If Treasury bonds yield 6 percent, and Carter’s marginal income
tax rate is 40 percent, what yield on the Chicago municipal bonds would
make Carter’s treasurer indifferent between the two?

a. 2.40%
b. 3.60%
c. 4.50%
d. 5.25%
e. 6.00%

After-tax returns Answer: c Diff: E

2A-81. A corporation can earn 7.5 percent if it invests in municipal bonds. The
corporation can also earn 8.5 percent (before-tax) by investing in
preferred stock. Assume that the two investments have equal risk. What
is the break-even corporate tax rate that makes the corporation
indifferent between the two investments?

a. 17.65%

79
2A-. After-tax returns Answer: b Diff: E

12%[1 - 0.30(0.35)] = 10.74%.

80
2A-. After-tax returns Answer: b Diff: E

Chicago municipal bonds = Tax Exempt; BT yield = AT yield.

U.S. Treasury bonds = AT yield = 6%(1 - 0.4) = 3.60%.
3.60% = yield where indifferent between the two.
81
2A-. After-tax returns Answer: c Diff: E

70% of the preferred stock dividends are not taxable, thus we need to
solve the following for T (the tax rate):

7.5% = 8.5% - 8.5%(1 - 0.7)(T)

1% = 2.55%T
T = 0.3922 = 39.22%.

Chapter 2 - Page 56
 b. 24.88%
c. 39.22%
d. 44.15%
e. 49.33%

After-tax returns Answer: a Diff: E

82
2A- . A 5-year corporate bond yields 9 percent. A 5-year municipal bond of
equal risk yields 6.5 percent. Assume that the state tax rate is zero.
At what federal tax rate are you indifferent between the two bonds?

a. 27.78%
b. 38.46%
c. 41.22%
d. 54.33%
e. 72.22%

After-tax returns Answer: d Diff: E

2A-83. A corporation recently purchased some preferred stock that has a
before-tax yield of 7 percent. The company has a tax rate of 40
percent. What is the after-tax return on the preferred stock?

a. 4.20%
b. 5.04%
c. 5.65%
d. 6.16%
e. 7.00%

After-tax returns Answer: a Diff: E

84
2A- . A corporate bond currently yields 8.5 percent. Municipal bonds with the
same risk, maturity, and liquidity currently yield 5.5 percent. At what
tax rate would investors be indifferent between the two bonds?

a. 35.29%
b. 40.00%

82
2A-. After-tax returns Answer: a Diff: E

9%(1 - T) = 6.5%
(1 - T) = 6.5%/9%
T = 1 -
T = 27.78%.

83
2A-. After-tax returns Answer: d Diff: E

After-tax yield = 7% - 7%[0.4(1 - 0.7)] = 6.16%.

(Remember, 70 percent of preferred dividends are not taxable.)
84
2A-. After-tax returns Answer: a Diff: E

Compare the two after-tax rates: 0.085(1 - T) = 0.055. T = 0.3529 ≈

35.29%.

Chapter 2 - Page 57
 c. 24.67%
d. 64.71%
e. 30.04%

After-tax returns Answer: d Diff: E R

85
2A- . A 7-year municipal bond yields 4.8 percent. Your marginal tax rate
(including state and federal taxes) is 27 percent. What interest rate
on a 7-year corporate bond of equal risk would provide you with the same
after-tax return?

a. 3.46%
b. 4.80%
c. 6.14%
d. 6.58%
e. 17.14%

After-tax returns Answer: b Diff: E

2A-86. Lovell Co. purchased preferred stock in another company. The preferred
stock’s before-tax yield was 8.4 percent. The corporate tax rate is
40 percent. What is the after-tax return on the preferred stock?

a. 3.36%
b. 7.39%
c. 5.05%
d. 6.89%
e. 3.53%

85
2A-. After-tax returns Answer: d Diff: E R

Equivalent pre-tax yield on corporate bond = = 6.58%.

86
2A-. After-tax returns Answer: b Diff: E

Remember, that if a company buys preferred stock in another company,

70 percent of the dividends are excluded from taxes. Therefore, the
after-tax return will be:

AT return = 8.4%[1 – (0.4)(1 – 0.7)]

= 8.4%[1 – (0.4)(0.3)]
= 8.4%(0.88)
= 7.39%.

Chapter 2 - Page 58
After-tax returns Answer: c Diff: E
87
2A- . A company with a 35 percent tax rate buys preferred stock in another
company. The preferred stock has a before-tax yield of 8 percent. What
is the preferred stock’s after-tax return?

a. 10.80%
b. 5.20%
c. 7.16%
d. 6.04%
e. 6.30%

After-tax returns Answer: c Diff: E N

88
2A- . Van Dyke Corporation has a corporate tax rate equal to 30 percent. The
company recently purchased preferred stock in another company. The
preferred stock has an 8 percent before-tax yield. What is Van Dyke’s
after-tax yield on the preferred stock?

a. 7.90%
b. 5.60%
c. 7.28%
d. 6.32%
e. 9.10%

After-tax returns Answer: d Diff: E N

89
2A- . Granville Co. recently purchased several shares of Kalvaria Electronics’

87
2A-. After-tax returns Answer: c Diff: E

Remember, only 30 percent of the preferred dividends are taxable.

After-tax return = 8% – [8% × 0.35 × 0.3] = 7.16%.
88
2A-. After-tax returns Answer: c Diff: E N

After-tax yield = 8% – 8%[0.3(1 - 0.7)]

= 8% - 0.72%
= 7.28%.
89
2A-. After-tax returns Answer: d Diff: E N

AT yield = BT yield[1 - (0.3)T]

= 8.6%[1 - (0.3)(0.4)]
= 7.568% ≈ 7.57%.

Chapter 2 - Page 59
 preferred stock. The preferred stock has a before-tax yield of 8.6
percent. If the company’s tax rate is 40 percent, what is Granville
Co.’s after-tax yield on the preferred stock?

a. 3.44%
b. 5.16%
c. 6.19%
d. 7.57%
e. 9.63%

Chapter 2 - Page 60
Carry-back, carry-forward Answer: c Diff: E
90
2A- . Appalachian Airlines began operating in 1998. The company lost money
the first year but has been profitable ever since. The company’s taxable
income (EBT) for its first five years is listed below. Each year the
company’s corporate tax rate has been 40 percent.

Year Taxable Income

1998 -$4 million
1999 1 million
2000 2 million
2001 3 million
2002 5 million

Assume that the company has taken full advantage of the Tax Code’s
carry-back, carry-forward provisions and that the current provisions
were applicable in 1998. How much did the company pay in taxes in 2001?

a. $ 120,000
b. $ 400,000
c. $ 800,000
d. $1,200,000
e. $1,800,000

Carry-back, carry-forward Answer: d Diff: E

91
2A- . Collins Co. began operations in 1999. The company lost money the first

90
2A-. Carry-back, carry-forward Answer: c Diff: E

Step 1: Determine how far the loss can be carried forward.

Carry- EBT After Carryable

Taxable forward Carry-forward Amount
Year Income (EBT) Used Applied Unused
1998 -$4,000,000 $ 0 $ 0 $4,000,000
1999 1,000,000 1,000,000 0 3,000,000
2000 2,000,000 2,000,000 0 1,000,000
2001 3,000,000 1,000,000 2,000,000 0
2002 5,000,000 0 5,000,000 0

Step 2: Calculate the 2001 tax liability:

In 2001, the company has $2 million in EBT after applying the
tax loss carry forward. The tax rate is 40 percent. Taxes paid
are calculated as follows:

Taxes paid = 40% × $2 million

= $800,000.

91
2A-. Carry-back, carry-forward Answer: d Diff: E

Carry-back/ Taxable Income Taxes Carryable

forward After Carry- Paid Amount Still
Year EBT Used forward Applied (EBT × T) Unused
1999 -$3,000,000 $ 0 $ 0 $ 0 -$3,000,000

Chapter 2 - Page 61
 two years, but has been profitable ever since. The company’s taxable
income (EBT) for its first four years are summarized below:

Year EBT
1999 -$3.0 million
2000 -5.2 million
2001 4.2 million
2002 8.3 million

The corporate tax rate has remained at 40 percent. Assume that the
company has taken full advantage of the Tax Code’s carry-back,
carry-forward provisions, and assume that the current provisions were
applicable in 1999. What is Collins’ tax liability for 2002?

a. $3.32 million
b. $0.04 million
c. $2.84 million
d. $1.72 million
e. $1.24 million

2000 -5,200,000 0 0 0 -8,200,000

2001 4,200,000 -4,200,000 0 0 -4,000,000
2002 8,300,000 -4,000,000 4,300,000 1,720,000 0

Chapter 2 - Page 62
Carry-back, carry-forward Answer: e Diff: E
92
2A- . Salinger Software was founded in 1999. The company lost money each of
its first three years, but was able to turn a profit in 2002.
Salinger’s operating income (EBIT) for its first four years of
opera-tions is reported below.

Year EBIT
1999 -$300 million
2000 -150 million
2001 -100 million
2002 700 million

The company has no debt, so operating income equals earnings before

taxes. The corporate tax rate has remained constant at 40 percent.
Assume that the company took full advantage of the carry-back,
carry-forward provisions in the Tax Code, and assume that the current
provisions were applicable in 1999. How much tax did the company pay in
2002?

a. $ 90 million
b. $180 million
c. $280 million
d. $270 million
e. $ 60 million

Medium:
After-tax returns Answer: b Diff: M N
93
2A- . Allen Corporation can (1) build a new plant that should generate a

92
2A-. Carry-back, carry-forward Answer: e Diff: E

The company can carry all of its losses forward against the 2002 profit
of $700 million. (Remember, you can carry forward for 20 years.)

Accumulated losses = (-$300,000,000) + (-$150,000,000) + (-$100,000,000)

= -$550,000,000.

This means it can carry forward $550 million of losses, against $700
million of profits, leaving $700 - $550 = $150 million taxable income.

Taxes = 0.40 × $150,000,000 = $60,000,000.

93
2A-. After-tax returns Answer: b Diff: M N

After-tax return on the new project:

0.11(1 - T) = 0.11(0.75) = 0.0825 = 8.25%.

After-tax return on the preferred stock:

0.09[1 - 0.3(0.25)] = 0.09(1 - 0.075) = 0.09(0.925)
= 0.08325 = 8.325%.

Therefore, invest 100 percent in the preferred stock.

Chapter 2 - Page 63
 before-tax return of 11 percent, or (2) invest the same funds in the
preferred stock of Florida Power & Light (FPL), which should provide
Allen with a before-tax return of 9 percent, all in the form of
dividends. Assume that Allen’s marginal tax rate is 25 percent, and
that 70 percent of dividends received are excluded from taxable income.
If the plant project is divisible into small increments, and if the two
investments are equally risky, what combination of these two
possibilities will maximize Allen’s effective return on the money
invested?

a. All in the plant project.

b. All in FPL preferred stock.
c. 60% in the project; 40% in FPL.
d. 60% in FPL; 40% in the project.
e. 50% in each.

Chapter 2 - Page 64
After-tax returns Answer: b Diff: M
94
2A- . Solarcell Corporation has $20,000 that it plans to invest in marketable
securities. It is choosing between AT&T bonds that yield 11 percent,
State of Florida municipal bonds that yield 8 percent, and AT&T
preferred stock with a dividend yield of 9 percent. Solarcell’s
corporate tax rate is 40 percent, and 70 percent of the preferred stock
dividends it receives are tax exempt. Assuming that the investments are
equally risky and that Solarcell chooses strictly on the basis of
after-tax returns, which security should be selected? Answer by giving
the after-tax rate of return on the highest yielding security.

a. 8.46%
b. 8.00%
c. 7.92%
d. 9.00%
e. 9.16%

After-tax returns Answer: a Diff: M R

95
2A- . A bond issued by the State of Pennsylvania provides a 9 percent yield.
What yield on a Synthetic Chemical Company bond would cause the two
bonds to provide the same after-tax rate of return to an investor in the
35 percent tax bracket?

a. 13.85%
b. 17.50%
c. 7.00%
d. 12.50%
e. 9.00%

94
2A-. After-tax returns Answer: b Diff: M

Florida municipal bond:

After-tax yield on FLA bond = 8%. (The munis are tax exempt.)

AT&T bond:
After-tax yield on AT&T bond = 11% - Taxes = 11% - 11%(0.4) = 6.6%.

Alternative solution for AT&T bond:

Invest $20,000 @ 11% = $2,200 interest.
Pay 40% tax, so after-tax income = $2,200(1 - T) = $2,200(0.6) = $1,320.
After-tax rate of return = $1,320/$20,000 = 6.6%.

AT&T preferred stock:

After-tax yield = 9% - Taxes = 9% - 0.3(9%)(0.4) = 9% - 1.08% = 7.92%.

Therefore, invest in the Florida municipal bonds that yield 8% after

taxes.
95
2A-. After-tax returns Answer: a Diff: M R

Before-tax return(1 - T) = 9%
Before-tax return(0.65) = 9%
Before-tax return = 9%/0.65 = 13.85%.

Chapter 2 - Page 65
After-tax returns Answer: c Diff: M
2A-96. Mantle Corporation is considering two equally risky investments:

● A $5,000 investment in preferred stock that yields 7 percent.

● A $5,000 investment in a corporate bond that yields 10 percent.

What is the breakeven corporate tax rate that makes the company
indifferent between the two investments?

a. 33.17%
b. 34.00%
c. 37.97%
d. 42.15%
e. 42.86%

96
2A-. After-tax returns Answer: c Diff: M

The tax rate that equates the after-tax yields of the alternative
investments will make the corporation indifferent between the
securities. The after-tax yield of the alternatives are:

Bond: Before-tax yield(1 - Tax rate) or 10%(1 - T).

Preferred stock: Before-tax yield[1 - 0.3(Tax rate)] or 7%(1 - 0.3T).

70% of corporate dividend income is exempt from taxes.

Solving 10%(1 - T) = 7%(1 - 0.3T) for T will give the tax rate that
makes the firm indifferent.

10%(1 - T) = 7%(1 - 0.3T)

10% - 10%T = 7% - 2.1%T
3% = 7.9%T
T = 37.97%.

Chapter 2 - Page 66
After-tax returns Answer: a Diff: M
97
2A- . West Corporation has $50,000 that it plans to invest in marketable
securities. The corporation is choosing between the following three
equally risky securities: Alachua County tax-free municipal bonds
yielding 6 percent; Exxon Mobil bonds yielding 9.5 percent; and GM
preferred stock with a dividend yield of 9 percent. West’s corporate
tax rate is 35 percent. What is the after-tax return on the best
investment alternative? (Assume the company chooses on the basis of
after-tax returns.)

a. 8.055%
b. 7.125%
c. 6.175%
d. 6.550%
e. 6.000%

After-tax returns Answer: b Diff: M R

2A-98. A municipal bond issued by the City of Gainesville provides a 7.6
percent after-tax return. For an individual investor in the 30 percent
tax bracket, (1) what return on a corporate bond and (2) what return on
a preferred stock would produce the same after-tax return to the
investor as the municipal bond?

a. 8.28% and 10.25%, respectively.

b. 10.86% and 10.86%, respectively.
c. 10.86% and 8.38%, respectively.
d. 24.52% and 10.86%, respectively.
e. 24.52% and 9.58%, respectively.

97
2A-. After-tax returns Answer: a Diff: M

The after-tax yield on the municipal bond is 6%. The after-tax yield on
the Exxon Mobil bonds is 9.5%(1 - 0.35)= 6.175%. Finally, the after-tax
yield on the preferred stock (remember 70% of dividends are excluded
from taxes) is 9%(1 - (0.3)(0.35)) = 8.055%. Thus, the preferred stock
is the best alternative based on after-tax returns.

98
2A-. After-tax returns Answer: b Diff: M R

For individual investors, the tax rates on interest income and dividend
income are identical. Therefore, without any calculations you may
properly conclude that statement b is the correct answer. To prove that
this is correct, consider the following:

Muni yield = Bond yield(1 - Tax rate)

and/or
Muni yield = Preferred stock yield(1 - Tax rate)

7.6% = Before-tax yield(1 - 0.30)

7.6% = Before-tax yield(0.70)
Before-tax yield = 10.8571% ≈ 10.86%.

Chapter 2 - Page 67
After-tax returns Answer: e Diff: M R
2A-99. Arvo Corporation is trying to choose between three alternative
investments. The three securities that the company is considering are
as follows:

● Tax-free municipal bonds with a return of 7 percent.

● Wooli Corporation bonds with a return of 10 percent.
● CFI Corp. preferred stock with a return of 9 percent.

The company’s tax rate is 25 percent. What is the after-tax return on

the best investment alternative?

a. 7.00%
b. 7.50%
c. 6.48%
d. 9.00%
e. 8.33%

99
2A-. After-tax returns Answer: e Diff: M R

After-tax return on the municipal bond is 7%. (No federal tax on

municipals).
After-tax return on the Wooli Corp. bond is 10%(1 - 0.25) = 7.50%.
After-tax return on the preferred stock is 9%(1 - (0.3)(0.25)) = 8.325%
≈ 8.33%.

Chapter 2 - Page 68
Corporate taxes Answer: d Diff: M
100
2A- . Corporations face the following corporate tax schedule:

Tax on Base Percentage on

Taxable Income of Bracket Excess above Base
Up to $50,000 $ 0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

Company Z has $80,000 of taxable income from its operations, $5,000 of

interest income, and $30,000 of dividend income from preferred stock it
holds in other corporations. What is Company Z’s tax liability?

a. $12,250
b. $13,750
c. $16,810

100
2A-. Corporate taxes Answer: d Diff: M

Calculate taxable income:

Taxable income from operations $80,000
Int. income +5,000
Div. income +9,000*
Total income $94,000

*Taxable dividend income = $30,000(1 - 0.7) = $9,000. Only 30% of

pre-ferred dividends are taxable to corporations.

Calculate Taxes:
0 - $75,000 = $13,750
+ ($94,000 - $75,000) × 0.34 = 6,460
$20,210

Chapter 2 - Page 69
 d. $20,210
e. $28,100

Corporate taxes Answer: d Diff: M

101
2A- . Griffey Communications recently realized $125,000 in operating income.
The company had interest income of $25,000 and realized $70,000 in
dividend income. The company’s interest expense was $40,000.

Tax on Base Percentage on

Taxable Income of Bracket Excess above Base
Up to $50,000 $ 0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

Using the corporate tax schedule above, what is Griffey’s tax liability?

a. $45,260
b. $53,450
c. $27,515
d. $34,340
e. $33,950

101
2A-. Corporate taxes Answer: d Diff: M

Determine the firm’s taxable income:

Operating income $125,000
Interest expense -40,000
Interest income + 25,000
Dividend income (30%)* +21,000
Taxable income $131,000

*Only 30 percent of corporate dividends are included as taxable income:

0.30 × $70,000 = $21,000.

Looking this up in the tax table above, the base tax amount is $22,250
and the tax above the base is 39 percent of $31,000($131,000 - $100,000)
= (0.39 × $31,000) = $12,090. Griffey’s total tax liability is $22,250
+ $12,090 = $34,340.

Chapter 2 - Page 70
Average corporate tax rate Answer: b Diff: M
102
2A- . Last year, Baldwin Brothers had net cash flow of $1.2 million. Its
depreciation expense of $500,000 was the company’s only non-cash
expense, and the company has zero non-cash revenues. Baldwin’s
operating income (EBIT) was $1.5 million, and its interest expense was
$500,000. What was the company’s average tax rate for the year?

a. 20%
b. 30%
c. 33%
d. 40%
e. 50%

Personal taxes Answer: c Diff: M R

103
2A- . Single individuals face the following tax schedule:

102
2A-. Average corporate tax rate Answer: b Diff: M

NCF = NI + DEP and AMORT

$1,200,000 = NI + $500,000
$700,000 = NI.

EBIT - I = EBT
$1,500,000 - $500,000 = EBT
$1,000,000 = EBT.

EBT × (1 - T) = NI
$1,000,000 × (1 - T) = $700,000
1 - T = 0.7
T = 0.3 = 30%.
103
2A-. Personal taxes Answer: c Diff: M R

First, find the taxable income:

Salary $60,000
Dividends 7,000
Personal Exempt. (3,000)
Item. Deduct. (6,000)
Taxable Income $58,000

Next, use the table to find that Bob is in the 27% marginal bracket, so
calculate his taxes:

Tax liability = $3,892.50 + (0.27)($58,000 - $27,950) = $12,006.00.

Finally, calculate Bob’s average tax rate using the tax liability and
taxable income:

Average tax rate = $12,006/$58,000 = 0.2070, or 20.70%.

Chapter 2 - Page 71
 Tax on Base Percentage on
Taxable Income of Bracket Excess above Base
Up to $6,000 $ 0.00 10.0%
$6,000-$27,950 600.00 15.0
$27,950-$67,700 3,892.50 27.0
$67,700-$141,250 14,625.00 30.0
$141,250-$307,050 36,690.00 35.0
Over $307,050 94,720.00 38.6

Bob Turley, a single individual, received a salary of $60,000 last year.

Turley also received $7,000 in dividend income during the year. His
personal exemption is $3,000, and his itemized deductions are $6,000.
What is Turley’s marginal and average tax rate for the year?

a. 27% marginal; 24.66% average

b. 30% marginal; 18.92% average
c. 27% marginal; 20.70% average
d. 30% marginal; 27.61% average
e. 35% marginal; 31.60% average

Chapter 2 - Page 72
Carry-back, carry-forward Answer: a Diff: M
104
2A- . Mays Industries was established in 1997. Since its inception, the
company has generated the following levels of taxable income (EBT):

Year Taxable Income

1997 $ 50,000
1998 40,000
1999 30,000
2000 20,000
2001 -100,000
2002 60,000

Assume that each year the company has faced a 40 percent income tax
rate. Also, assume that the company has taken full advantage of the Tax
Code’s carry-back, carry-forward provisions, and assume that the current
provisions were applicable in 1997. What is the company’s tax liability
for 2002?

a. $ 4,000
b. $ 5,000
c. $ 6,000
d. $ 8,000
e. $10,000

Carry-back, carry-forward Answer: c Diff: M

105
2A- . Blass Brothers opened for business in 1998. The company lost money its
first year, but has been profitable ever since. Specifically, its
taxable income (EBT) has been as follows:

Year Taxable Income

1998 -$1,000,000
1999 100,000
2000 200,000

104
2A-. Carry-back, carry-forward Answer: a Diff: M

The tax loss in 2001 can be carried back two years. The tax loss
available is $100,000 × 40% or $40,000. Taxes paid in 1999 and 2000
were $12,000 and $8,000, respectively. Thus, $20,000 of the 2001 tax
loss can be carried back. That leaves $20,000 available to carry
forward. The tax liability for 2002 before the carry forward is $60,000
× 40% = $24,000. Therefore, the 2002 tax liability net of the $20,000
carry forward is $4,000.
105
2A-. Carry-back, carry-forward Answer: c Diff: M

The loss in 1998 can be carried forward to offset taxes for up to 20

years. By 2002, $800,000 of the loss will have been used up leaving
$200,000 that can be offset against the profit of $600,000. Tax =
($600,000 - $200,000) × 0.4 = $160,000.

Chapter 2 - Page 73
 2001 500,000
2002 600,000

The company’s tax rate is 40 percent. Assume that the company has taken
full advantage of the Tax Code’s carry-back, carry-forward provisions,
and assume that the current provisions were applicable in 1998. What is
the amount of tax the company paid in 2002?

a. $ 80,000
b. $120,000
c. $160,000
d. $200,000
e. $240,000

Chapter 2 - Page 74
Carry-back, carry-forward Answer: c Diff: M
106
2A- . Sundowner Corporation began operations in 1996. The company’s taxable
income has been as follows:

Year Taxable Income

1996 -$200,000
1997 50,000
1998 75,000
1999 85,000
2000 -90,000
2001 65,000
2002 75,000

Assume the company faced a tax rate of 40 percent each year. Also,
assume that the company has taken full advantage of the Tax Code’s
carry-back, carry-forward provisions, and assume that the current
provisions were applicable in 1996. What was the tax liability for
Sundowner Corporation in 2002?

a. $36,000
b. $40,000
c. $24,000
d. $20,000
e. $30,000

Carry-back, carry-forward Answer: c Diff: M

107
2A- . Pierce Company lost $600,000 during 2002. (Its net income was

106
2A-. Carry-back, carry-forward Answer: c Diff: M

The $200,000 loss in 1996 can be carried forward to cover 1997, 1998,
and all but $10,000 of 1999 income. $10,000 of the $90,000 loss in 2000
can be carried back to cover that portion of 1999 income not covered by
the 1996 loss. Additionally, the remaining $80,000 of the 2000 loss can
be carried forward to cover all of 2001 income and $15,000 of 2002
income. Thus, taxable income for 2002 is $75,000 - $15,000 = $60,000.
Given a 40 percent tax rate, Sundowner’s tax liability is $60,000 × 0.4
= $24,000.
107

2A-. Carry-back, carry-forward Answer: c Diff: M

First, figure out your taxable income for the last two years:
Year Taxes Paid Taxable Income
2000 $ 40,000 $100,000 Taxable income = $ 40,000/0.40
2001 100,000 250,000 Taxable income = $100,000/0.40
Note: Tax losses can be carried back only two years.

Next, add up the taxable income for the past two years. It sums to
$350,000.

Finally, compute the tax credit on the carry-back:

($350,000)(0.40) = $140,000.

Chapter 2 - Page 75
 -$600,000.) The corporate tax rate is 40 percent. The company paid the
following amount in taxes over the past five years:

Year Taxes Paid

1997 $ 50,000
1998 75,000
1999 60,000
2000 40,000
2001 100,000

Assume that the company has taken full advantage of the Tax Code’s
carry-back, carry-forward provisions, and assume that the current
provisions were applicable in 1997. What will be Pierce’s tax credit or
tax payment?

a. Payment of $240,000
b. Payment of $40,000
c. Credit of $140,000
d. Credit of $180,000
e. Credit of $600,000

Chapter 2 - Page 76
Carry-back, carry-forward Answer: b Diff: M
108
2A- . Below is the level of taxable income (EBT) reported by Indiana Iron
Works over the past several years:

Year Taxable Income

1997 $ 300,000
1998 600,000
1999 750,000
2000 200,000
2001 -1,150,000
2002 800,000

The company was founded in 1997. The corporate tax rate has been and
will continue to be 40 percent. Assume that the company has taken full
advantage of the Tax Code’s carry-back, carry-forward provisions, and
assume that the current provisions were applicable in 1997. What was
the company’s tax liability for 2002?

a. $220,000
b. $240,000
c. $320,000
d. $360,000
e. $700,000

Carry-back, carry-forward Answer: c Diff: M

109
2A- . Garner Grocers began operations in 1999. Garner has reported the
following levels of taxable income (EBT) over the past several years.
The corporate tax rate was 40 percent each year. Assume that the
company has taken full advantage of the Tax Code’s carry-back,
carry-forward provisions, and assume that the current provisions were
applicable in 1999. What is the amount of taxes the company paid in
2002?

108
2A-. Carry-back, carry-forward Answer: b Diff: M

Indiana can carry back its losses for 2 years. The total taxable income
over 1999 and 2000 was $750,000 + $200,000 = $950,000. This leaves
$1,150,000 - $950,000 = $200,000 that can be carried forward for up to
20 years. Applying this against the 2002 income of $800,000 leaves
taxable income of $600,000. At a 40 percent tax rate, the tax owed for
2002 is 0.4($600,000) = $240,000.

109
2A-. Carry-back, carry-forward Answer: c Diff: M

The company has $3,200,000 taxable income with which it can offset
future taxes. In 2000 and 2001, it uses up $700,000 of that income. It
has $2,500,000 left to apply to 2002 taxable income. It can use all of
this in 2002 to help offset the $2,800,000 taxable income. However, it
still leaves $300,000 of income that will be taxed. At 40 percent, this
yields $120,000 in taxes.

Chapter 2 - Page 77
 Year Taxable Income
1999 -$3,200,000
2000 200,000
2001 500,000
2002 2,800,000

a. $320,000
b. $100,000
c. $120,000
d. $ 40,000
e. $ 20,000

Chapter 2 - Page 78
Carry-back, carry-forward Answer: a Diff: M
110
2A- . Bradshaw Beverages began operations in 1998. The table below contains
the company’s taxable income during each year of its operations. Notice
that the company lost money in each of its first three years. The
corporate tax rate has been 40 percent each year.

Year Taxable Income

1998 -$ 700,000
1999 -500,000
2000 -200,000
2001 800,000
2002 1,000,000

Assume that the company has taken full advantage of the Tax Code’s
carry-back, carry-forward provisions, and assume that the current
provisions were applicable in 1998. How much did the company pay in
taxes during 2002?

a. $160,000
b. $240,000
c. $320,000
d. $520,000
e. $600,000

Carry-back, carry-forward Answer: d Diff: M

111
2A- . Uniontown Books began operating in 1998. The company lost money its

110
2A-. Carry-back, carry-forward Answer: a Diff: M

The total tax credit is ($700,000 + $500,000 + $200,000)0.4 = $560,000.

Taxes owed in 2001 are ($800,000)0.4 = $320,000. $560,000 - $320,000 =
$240,000 credit available for 2002. Taxes owed in 2002 are
($1,000,000)0.4 = $400,000. $400,000 - $240,000 = $160,000 taxes
actually payable.
111
2A-. Carry-back, carry-forward Answer: d Diff: M

Step 1: Determine how far the loss can be carried forward.

Taxable Carry- EBT After

Carryable
Income forward Carry-forward Taxes
Amount
Year (EBT) Used Applied Owed Unused
1998 -$3,600,000 $ 0 -$3,600,000 $ 0
-$3,600,000
1999 -2,000,000 0 -2,000,000 0
-5,600,000
2000 -1,000,000 0 -1,000,000 0
-6,600,000
2001 1,200,000 -1,200,000 0 0
-5,400,000
2002 7,000,000 -5,400,000 1,600,000 640,000
0

Chapter 2 - Page 79
 first three years of operations, but has had an operating profit during
the past two years. The company’s operating income (EBIT) for its first
five years was as follows:

Year EBIT
1998 -$3.6 million
1999 -2.0 million
2000 -1.0 million
2001 1.2 million
2002 7.0 million

The company has no debt, and therefore, pays no interest expense. Its
corporate tax rate has remained at 40 percent during this 5-year period.
What was Uniontown’s tax liability for 2002? (Assume that the company
has taken full advantage of the carry-back and carry-forward provisions,
and assume that the current provisions were applicable in 1998.)

a. $2,800,000
b. $1,920,000
c. $2,720,000
d. $ 640,000
e. $2,400,000

Carry-back, carry-forward Answer: e Diff: M N

112
2A- . Clampett Oil began operations in 1998. After losing money the first two
years, Clampett had positive earnings before taxes in each of the next
three years. The company’s earnings before taxes for its first five
years of operations are summarized below:

Year Taxable Income

1998 -$4.6 million
1999 -2.4 million
2000 4.3 million
2001 5.8 million
2002 3.2 million

Assume that the corporate tax rate has remained at 40 percent, and that
Clampett fully utilizes the carry-back, carry-forward provisions, and

Step 2: Calculate the 2002 tax liability:

Taxes paid = $1,600,000 × 40%
= $640,000.
112
2A-. Carry-back, carry-forward Answer: e Diff: M N

Taxable Loss EBT after Carryable

Income Carry Carry Loss Taxes Loss
Year (EBT) Used Applied Owed Unused
1998 -$4,600,000 $ 0 -$4,600,000 $ 0 $4,600,000
1999 -2,400,000 0 -2,400,000 0 7,000,000
2000 4,300,000 4,300,000 0 0 2,700,000
2001 5,800,000 2,700,000 3,100,000 1,240,000 0
2002 3,200,000 0 3,200,000 1,280,000 0

Chapter 2 - Page 80
 assume that the current provisions were applicable in 1998. How much in
corporate taxes did Clampett have to pay in 2001?

a. $1.36 million
b. $2.32 million
c. $0
d. $2.55 million
e. $1.24 million

Net income Answer: d Diff: M

113
2A- . Moose Industries faces the following tax schedule:

Tax on Base Percentage on

Taxable Income of Bracket Excess above Base
Up to $50,000 $ 0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

Last year the company realized $10,000,000 in operating income (EBIT).

Its annual interest expense is $1,500,000. What was the company’s net
income for the year?

a. $3,450,175
b. $4,385,100
c. $5,100,000
d. $5,610,000
e. $8,386,100

113
2A-. Net income Answer: d Diff: M

EBIT $10,000,000
Interest 1,500,000
EBT $ 8,500,000
Tax 2,890,000 = $113,900 + ($8,500,000 - $335,000)0.34
NI $ 5,610,000

Chapter 2 - Page 81
 CHAPTER 2
ANSWERS AND SOLUTIONS

Chapter 2 - Page 82