A B C D E

26 MicroDrive Inc. December 31 Balance Sheets

27 (Millions of Dollars)
28 Assets
29 Cash and equivalents
30 Short-term investments
31 Accounts receivable
32 Inventories
33 Total current assets
34 Net property, plant, and equipment (PP&E)
35 Total assets
36
37 Liabilities and Equity
38 Accounts payable
39 Notes payable
40 Accruals
41 Total current liabilities
42 Long-term bonds
43 Total liabilities
44 Preferred stock (1,000,000 shares)
45 Common stock (60,000,000 shares)
46 Retained earnings
47 Total common equity
48 Total liabilities and equity
49
 F G
26
27
28 2019 2018
29 $100 $102
30 10 40
31 500 384
32 1,000 774
33 $1,610 $1,300
34 2,000 1,780
35 $3,610 $3,080
36
37
38 $200 $180
39 150 28
40 400 370
41 $750 $578
42 520 350
43 $1,270 $928
44 100 100
45 500 500
46 1,740 1,552
47 $2,240 $2,052
48 $3,610 $3,080
49
SECTION 2-2
SOLUTIONS TO SELF-TEST
A firm has $8 million in total assets. It has $3 million in current liabilities, $2 million in long-term
debt, and $1 million in preferred stock. What is the reported net worth (i.e., the reported common
equity)?

Total assets $8,000,000

Current liabilities $3,000,000
Long-term debt $2,000,000
Preferred stock $1,000,000

The net worth of shareholders, also called common equity, is equal to the total assets less all
liabilities and preferred stock.

Net worth = common equity = $2,000,000

SECTION 2-3
SOLUTIONS TO SELF-TEST

A firm has $2,000,000 million in earnings before taxes. The firm has an interest expense of $300,000 and
depreciation of $200,000; it has no amortization. What is its EBITDA?

Earnings before taxes $2,000,000

Interest $300,000
Depreciation $200,000
Amortization $0

EBITDA stands for earnings before interest, taxes, and depreciation. To calculate EBITDA using
the given information, start with earnings before taxes and add back interest, depreciation,
and amortization.

EBITDA $2,500,000

Now suppose a firm has the following information: $7 million in sales, $4 million of costs of goods sold
excluding depreciation & amortization, $500,000 of other operating expenses. What is its EBITDA?

Sales $7,000,000
Costs of goods sold excluding depreciation and amortization $4,000,000
Other operating expenses $500,000
EBITDA stands for earnings before interest, taxes, and depreciation. To calculate EBITDA using
the given information, start with sales and subtract costs of goods sold (excluding
depreciation) and other operating costs:

EBITDA $2,500,000
SECTION 2-4
SOLUTIONS TO SELF-TEST
A firm had a retained earnings balance of $3 million in the previous year. In the current year, its net
income is $2.5 million. If it pays $1 million in common dividends in the current year, what it its resulting
retained earnings balance?

Previous retained earnings balance $3,000,000

Current net income $2,500,000
Common dividends $1,000,000

This year's addition to retained earnings is the amount of net income not paid out in dividends:

Addition to retained earnings $1,500,000

The new balance of retained earnings is the previous year's balance plus this year's addition to retained
earnings:

Current retained earnings balance $4,500,000

SECTION 2-5
SOLUTIONS TO SELF-TEST

A firm has inventories of $2 million for the previous year and $1.5 million for the current year. What impact does this
have on net cash provided by operations?

Previous year's inventories $2,000,000

Current year's inventories $1,500,000

Inventories are assets that a company owns. When inventories increase (perhaps because the company bought more
goods than it sold), cash goes down due to the increase in assets owned by the company.
When inventories decrease (perhaps because the company sold more goods than it purchased), cash goes up due to
the decrease in assets owned by the company.
Therefore the cash flow due to a change in inventories is equal to the previous year's inventories minus the current
year's inventories:

Cash flow due to inventories = Previous year's inventories −Current year's inventories

Change in net cash provided by operations $500,000

SECTION 2-6
SOLUTIONS TO SELF-TEST

A firm has net income of $5 million. Assuming that depreciation of $1 million is its only noncash expense,
what is the firm’s net cash flow?

Net income $5,000,000

Depreciation $1,000,000

Net cash flow = Net income + Noncash expenses

Net cash flow $6,000,000

SECTION 2-7
SOLUTIONS TO SELF-TEST

Suppose a firm has the following information: Sales = $10 million; costs of goods sold (excluding depreciation) = $5
million; depreciation = $1.4 million; other operating expenses = $2 million; interest expense = $1 million. If the tax rate is
25%, what is NOPAT, the net operating profit after taxes?

Sales $10,000,000
Costs of goods sold (excluding depreciation) $5,000,000
Depreciation $1,400,000
Other operating expenses $2,000,000
Interest expense $1,000,000
Tax rate 25%

The first step is to calculate the earnings before interest and taxes, EBIT. This is the amount of pre-tax operating earnings.

EBIT = Sales − Costs of goods sold excluding depreciation − Depreciation − Other operating expenses

Notice that interest expense is not subtracted because interest is not an operating expense.

EBIT = pre-tax operating earnings = $1,600,000

The second step is to calculate NOPAT, which is equal to after-tax operating earnings.

NOPAT = EBIT (1−T)

NOPAT = $1,200,000

Suppose a firm has the following information: Cash = $500,000; short-term investments = $2.5 million; accounts receivable
= $1.2 million, inventories = $1 million, and net plant and equipment = $7.8 million. How much is tied up in operating
current assets?

Cash $500,000
Short-term investments $2,500,000
Accounts receivable $1,200,000
Inventories $1,000,000
Net plant and equipment $4,000,000

Operating current assets are the short-term assets used in operations. They do not include an short-term investments or
marketable securities that are not a part of normal operations. They do not include any long-term assets.

Operating CA = Cash + Accounts receivable + inventories

Operating current assets = $2,700,000

Suppose a firm has the following information: Accounts payable = $1 million; notes payable = $1.1 million; short-term debt
= $1.4 million; accruals = $500,000; and long-term bonds = $3 million. What is the amount arising from operating current
liabilities?

Accounts payable $1,000,000

Notes payable $1,100,000
Short-term debt $1,400,000
Accruals $500,000
Long-term bonds $3,000,000

Operating current liabilities are the short-term liabilities arising from operating acivities. They do not include any form of
debt, including notes payable, short-term debt, or long-term bonds.
 Operating CL = Accounts payable + accruals

Operating current liabilities = $1,500,000

Suppose a firm has the following information: Operating current assets = $2.7 million; operating current liabilities = $1.5
million, long-term bonds = $3 million, net plant and equipment = $7.8 million; and other long-term operating assets = $1
million. How much is tied up in net operating working capital? How much is tied up in total net operating capital?

Operating current assets $2,700,000

Operating current liabilities $1,500,000
Long-term bonds $3,000,000
Net plant and equipment $7,800,000
Other long-term operating assets $1,000,000

Net operating working capital (NOWC) is the net amount tied up in short-term operating assets after adjusting for the
amount arising from short-term operating liabilities. It does not include any cash ties up in long-term assets and it is not
adjusted for any cash provided by investors.

Net operating working capital = NOWC = Operating current assets − Operating current liabilities

Net operating working capital = NOWC = $1,200,000

Total net operating capital includes the net amount tied up in net operating working capital (NOWC) and the amount tied
up in all long-term operating assets. It is not adjusted for any cash provided by investors.

Total net operating capital = Net operating working capital + Net plant and equipment + Other long-term operating assets

Total net operating capital = $10,000,000

A firm’s total net operating capital for the previous year was $2 million. For the current year, its total net operating capital
is $2.5 million and its NOPAT is $1.2 million. What is its free cash flow for the current year?

Previous year's total net operating capital $9,300,000

Current year's total net operating capital $10,000,000
Current year's NOPAT $1,200,000

First, calculate the investment in total net operating capital.

Investment in total net operating capital = Current year's total net operating capital − previous year's total net operating capital

Investment in total net operating capital = $700,000

Second, calculate free cash flow.

Free cash flow = NOPAT − Investment in total net operating capital

Free cash flow = $500,000

-term operating assets

perating capital
SECTION 2-8
SOLUTIONS TO SELF-TEST

A company has sales of $200 million, NOPAT of $12 million, net income of $8 million, new operating working capital
(NOWC) of $10 million, total net operating capital of $100 million, and total assets of $110 million. What is it operating
profitability (OP) ratio? Its capital requirment (CF) ratio? Its return on invested capital (ROIC)?

Sales $200 million

NOPAT $12 million
Net income $8 million
Net operating working capital $10 million
Total net operating capital $100 million
Total assets $110 million

The operating profitability (OP) ratio measures the dollars of operating profit per dollar of sales.

OP = NOPAT / Sales

OP = 6%

The capital requirement (CR) ratio measures the dollars of total net operating capital tied up per dollar of sales.

CR = (Total net operating capital) / Sales

CR = 50%

The return on invested capital (ROIC) measures the dollars of operating profit per dollar of total net operating capital.

ROIC = NOPAT / (Total net operating capital) = OP / CR

ROIC = NOPAT / (Total net operating capital) = 12%

ROIC = OP / CR = 12.00%

A firm has $100 million in total net operating capital. Its return on invested capital is 14 percent, and its weighted average
cost of capital is 10 percent. What is its EVA?

Total net operating working capital $100,000,000

ROIC 14%
WACC 10%

Free cash flow = $4,000,000

SECTION 2-9
SOLUTIONS TO SELF-TEST

If a corporation has $85,000 in taxable income, what is its tax

liability?

Taxable income $85,000

Tax rate 21%

Tax liability $17,850

 Chapter 2 Mini Case

Situation

Jenny Cochran, a graduate of The University of Tennessee with 4 years of experience as an equities
analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a
manufacturer of computer components.
During the previous year, Computron had doubled its plant capacity, opened new sales offices outside
its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate
the impact of the changes. She began by gathering financial statements and other data.

Computron's Balance Sheets (Millions of Dollars)

2019 2020
Assets
Cash and equivalents $ 60 $ 50
Short-term investments 100 10
Accounts receivable 400 520
Inventories 620 820
Total current assets $ 1,180 $ 1,400
Gross fixed assets $ 3,900 $ 4,820
Less: Accumulated depreciation 1,000 1,320
Net fixed assets $ 2,900 $ 3,500
Total assets $ 4,080 $ 4,900

Liabilities and equity

Accounts payable $ 300 $ 400
Notes payable 50 250
Accruals 200 240
Total current liabilities $ 550 $ 890
Long-term bonds 800 1,100
Total liabilities $ 1,350 $ 1,990
Common stock 1,000 1,000
Retained earnings 1,730 1,910
Total equity $ 2,730 $ 2,910
Total liabilities and equity $ 4,080 $ 4,900

Computron's Income Statement (Millions of Dollars) 2019 2020

Net sales $ 5,500 $ 6,000
Cost of goods sold (Excluding depr. & amort.) 4,300 4,800
Depreciation and amortizationa 290 320
Other operating expenses 350 420
Total operating costs $ 4,940 $ 5,540
Earnings before interest and taxes (EBIT) $ 560 $ 460
Less interest 68 108
Pre-tax earnings $ 492 $ 352
Taxes (25%) 123 88
Net Income $ 369 $ 264

Notes:
a
Computron has no amortization charges.

Other Data 2020 2019

Stock price $57.00 $40.00
Shares outstanding (millions) 100 100
Common dividends (millions) $90 $84
Tax rate 25% 25%
Weighted average cost of capital (WACC) 10.00% 10.00%

Computron's Statement of Cash Flows (Millions of Dollars)

2020
Operating Activities
Net Income before preferred dividends ###
Noncash adjustments
Depreciation and amortization 320
Due to changes in working capital
Change in accounts receivable ###
Change in inventories ###
Change in accounts payable 100
Change in accruals 40
Net cash provided by operating activities ###

Investing activities
Cash used to acquire fixed assets ###
Change in short-term investments 90
Net cash provided by investing activities ###

Financing Activities
Change in notes payable ###
Change in long-term debt 300
Payment of cash dividends (84)
Net cash provided by financing activities ###

Net change in cash and equivalents ###

Cash and securities at beginning of the year 60
Cash and securities at end of the year $ 50
 11/20/2018

perience as an equities
Computron Industries, a

ed new sales offices outside

an was assigned to evaluate
other data.
Income tax on wage, salaries, tips, etc.

Find the marginal income tax rate, the U.S. income tax, and the average tax rate for a single person in the following
situation.

Gross income   
(all as wages reported on Form 1040 Line 7) = $70,700.00
Standard deduction = $12,000.00
Taxable Income = $58,700.00
Base taxable income = $38,700.00
Base tax = $4,453.50
Marginal tax rate = 22.0%
Tax = $8,853.50
Average tax rate = 15.08%