BUS201/BUS2201 - 1
CHAPTER 2
FINANCIAL STATEMENTS, TAXES AND CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1.
Liquidity measures how quickly and easily an asset can be converted to cash without
significant loss in value. It’s desirable for firms to have high liquidity so that they have a large
factor of safety in meeting short-term creditor demands. However, since liquidity also has an
opportunity cost associated with it—namely that higher returns can generally be found by
investing the cash into productive assets—low liquidity levels are also desirable to the firm.
It’s up to the firm’s financial management staff to find a reasonable compromise between
these opposing needs.
4.
Depreciation is a non-cash deduction that reflects adjustments made in asset book values in
accordance with the matching principle in financial accounting. Interest expense is a cash
outlay, but it’s a financing cost, not an operating cost.
8.
For example, if a company were to become more efficient in inventory management, the
amount of inventory needed would decline. The same might be true if it becomes better at
collecting its receivables. In general, anything that leads to a decline in ending NWC relative
to beginning would have this effect. Negative net capital spending would mean more long-
lived assets were liquidated than purchased.
Solutions to Questions and Problems
2.
The income statement for the company is
Income Statement
Sales $586,000
Costs 247,000
Depreciation 43,000
EBIT $296,000
Interest 32,000
EBT $264,000
Taxes (35%) 92,400
Net Income $171,600
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BUS201/BUS2201 - 2
3.
One equation for net income is:
Net income = Dividends + Addition to retained earnings
Rearranging, we get:
Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,600
5.
To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for
current assets, we get:
CA = NWC + CL = $380,000 + 1,100,000 = $1,480,000
The market value of current assets and fixed assets is given, so:
Book value CA = $1,480,000
Book value NFA = $3,700,000
Book value assets = $5,180,000
Market value CA = $1,600,000
Market value NFA = $4,900,000
Market value assets = $6,500,000
11.
Cash flow to creditors = Interest paid – Net new borrowing
Cash flow to creditors = Interest paid – (LTDend – LTDbeg)
Cash flow to creditors = $170,000 – ($2,900,000 – 2,600,000)
Cash flow to creditors = –$130,000
12.
Cash flow to stockholders = Dividends paid – Net new equity
Cash flow to stockholders = Dividends paid – [(Commonend + APISend) – (Commonbeg +
APISbeg)]
Cash flow to stockholders = $490,000 – [($815,000 + 5,500,000) – ($740,000 + 5,200,000)]
Cash flow to stockholders = $115,000
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BUS201/BUS2201 - 3
19.
Income Statement
Sales $730,000
COGS 580,000
A&S expenses 105,000
Depreciation 135,000
EBIT -$90,000
Interest 75,000
Taxable income -$165,000
Taxes (35%) 0
a. Net income -$165,000
b. OCF = EBIT + Depreciation – Taxes = –$90,000 + 135,000 – 0 = $45,000
c. Net income was negative because of the tax deductibility of depreciation and interest
expense. However, the actual cash flow from operations was positive because
depreciation is a non-cash expense and interest is a financing expense, not an operating
expense.
Copyright © 2012 Asia Global Edition, McGraw Hill/Irwin.