Homework 3
3-1. The four financial statements contained in most annual reports are the
balance sheet, income statement, statement of stockholders' equity, and
statement of cash flows.
3-2. Bankers and investors use financial statements to make intelligent
decisions about what firms to extend credit or in which to invest, managers
need financial statements to operate their businesses efficiently, and taxing
authorities need them to assess taxes in a reasonable way.
3-3. No, because the $20 million of retained earnings would probably not
be held as cash. The retained earnings figure represents the reinvestment
of earnings by the firm over its life. Consequently, the $20 million would be
an investment in all of the firm's assets.
3-4. The balance sheet shows the firm's financial position on a specific
date, It shows each account balance at that particular point in time.
The income statement reports on the firm's operations over a period of
time. It reports revenues and expenses that the firm has incurred over a
particular time period.
3-5. Investors need to be cautious when they review financial statements.
While companies are required to follow GAAP, managers still have quite a
lot of discretion in deciding how and when to report certain transactions.
Consequently, two firms in exactly the same operating situation may report
financial statements that convey different impressions about their financial
strength. Some variations may stem from legitimate differences of opinion
about the correct way to record transactions. In other cases, managers
may choose to report numbers in a way that helps them present either
higher earnings or more stable earnings over time. As long as they follow
GAAP, such actions are not illegal, but these differences make it harder for
investors to compare companies and gauge their true performances.
3-10. This statement means that the higher one's income, the larger the
percentage paid in taxes.
3-12. Because interest paid is tax deductible but dividend payments are
not, the after-tax cost of debt is lower than the after-tax cost of equity. This
encourages the use of debt rather than equity. This point is discussed in
detail in Chapters 10 and 13.
3-14.a) For 2017:
Current Assets: $71,000$
Cash: $14,000$ (excess cash)
Current Liabilities: $20,050$
Notes Payable: $5,050$
NOWC2017=(71,000−14,000)−(20,050−5,050)=57,000−15,000=$42,000
For 2018:
Current Assets: $83,320$
Cash: $15,000$ (excess cash)
Current Liabilities: $25,100$
Notes Payable: $7,000$
NOWC2018=(83,320−15,000)−(25,100−7,000)=68,320−18,100=$50,220
b) Free Cash Flow (FCF) is calculated as: FCF=EBIT×(1−Tax Rate)
+Depreciation and Amortization−Capital Expenditures−Increase in NOWC
From the statement:
EBIT for 2018: $44,000$
Depreciation and Amortization for 2018: $6,000$
Assume Capital Expenditures are equal to the change in Net Plant and
Equipment:
o Net Plant and Equipment (2018): $48,000$
o Net Plant and Equipment (2017): $46,000$
o Capital Expenditures: $48,000 - $46,000 = $2,000$
Increase in NOWC: $50,220 - $42,000 = $8,220$
Assuming a tax rate of 40%:
FCF=44,000×(1−0.40)+6,000−2,000−8,220=26,400+6,000−2,000−8,220=$22,180
c) To construct the statement of stockholders' equity, we'll consider the retained
earnings, common stock, and any changes:
Retained Earnings Calculation:
Beginning Retained Earnings (2017)=$36,950
Add: Net Income (EBT - Taxes)=$38,650×(1−0.40)=$23,190
Ending Retained Earnings (2018)=36,950+23,190=$60,140
Statement of Stockholders' Equity for 2018:
Common Stock (2018):$40,000
Retained Earnings (2018):$60,140
Total Equity (2018):$100,140
d) Economic Value Added (EVA) is calculated as: EVA=EBIT×(1−Tax Rate)−
(Cost of Capital×Total Capital)
Using the given values:
EBIT: $44,000$
Tax Rate: 40%
Cost of Capital: 10%
Total Capital (Equity + Long-term Bonds): $100,140 + $20,000 =
$120,140$
EVA=44,000×(1−0.40)−(0.10×120,140)=26,400−12,014=$14,386
e) Market Value Added (MVA) is calculated as:
MVA=Market Value of Equity−Book Value of Equity
Number of shares = 4,000
Market Value of Equity = 4,000 shares × $25/share = $100,000$
Book Value of Equity = $40,000$ (Common Stock) + $60,140$ (Retained
Earnings) = $100,140$
MVA=100,000 - 100,140 = -$140
3-16. a) Retained Earnings Calculation:
Beginning Retained Earnings = Retained Earnings (2017) = Ending Retained
Earnings (2018) -Net Income + Dividends Paid
From the given data:
- Net Income = $372
- Dividends Paid = $146
- Ending Retained Earnings (2018) = $1,600
Assuming no other changes, beginning retained earnings would be:
Beginning Retained Earnings = 1,600 - 372 + 146 = 1,374
Statement of Stockholders' Equity:
Common Stock (2018) : $260
Retained Earnings (2018) : $1,600
Total Stockholders' Equity (2018) :$1,860
(b) The amount reinvested in the firm over the years is reflected in the retained
earnings.
- Retained Earnings (2018) = $1,600$ million
This amount represents the total earnings retained in the company after paying
dividends over the years.
(c)
- Total Current Assets (2018) = $1,410$ million
- Total Current Liabilities (2018) = $620$ million
The maximum check that can be written without bouncing:
Net Current Assets = 1,410 - 620 = $790 million
(d) The amount to be paid to current creditors within the next year is reflected in
the total current liabilities:
- Total Current Liabilities (2018) = $620 million
This includes accounts payable, accruals, and notes payable that are due within one
year.