CHAPTER 2

Understanding Financial Statements, Taxes, and Cash Flows

CHAPTER ORIENTATION

In this chapter, we review the contents and meaning of a firm’s income statement and balance sheet. We also look very carefully at how to compute a firm’s cash flows from a finance perspective, which is called free cash flows.

CHAPTER OUTLINE

I. Basic Financial Statements

A. The Income Statement

1. The income statement reports the results from operating the business for a period of time, such as a year.

2. It is helpful to think of the income statement as comprising five types of activities:

a. Selling the product

b. The cost of producing or acquiring the goods or services sold

c. The expenses incurred in marketing and distributing the product or service to the customer along with administrative operating expenses

d. The financing costs of doing business: for example, interest paid to creditors and dividend payments to the preferred stockholders

e. The taxes owed based on a firm’s taxable income

3. An example of an income statement is provided in Table 2-1 for the Harley-Davidson Corporation.

9

B. The Balance Sheet

1. The balance sheet provides a snapshot of the firm’s financial position at a specific point in time, presenting its asset holdings, liabilities, and owner-supplied capital.

a. Assets represent the resources owned by the firm

(1) Current assets - consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses

(2) Fixed or long-term assets – comprising equipment, buildings, and land

(3) Other assets – all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long-term investments in securities, and goodwill

b. The liabilities and owners’ equity indicate how the assets are financed.

(1) The debt consists of such sources as credit extended from suppliers or a loan from a bank.

(2) The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.

2. The balance sheet is not intended to represent the current market value of the company, but rather reports the historical transactions recorded at their costs.

3. Balance sheets for the Harley-Davidson Corporation are presented in Table 2-2.

II Computing a Company’s Taxes

A. Types of taxpayers

1. Sole proprietors

a. Report business income on personal tax returns

b. Pay taxes at personal tax rate

2. Partnerships

a. The partnership reports income but does not pay taxes

b. Each partner reports his or her portion of income and pays the corresponding taxes.

10

3. Corporations

a. Corporation reports income and pays taxes

b. Owners do not report these earnings except when all or part of the profit is paid out as dividends.

c. Our focus is on corporate taxes.

B. Computing Taxable Income

1. Taxable income is based on gross income less tax-deductible expenses

a. Interest expense is tax deductible

b. Dividend payments are not tax deductible

2. Depreciation

a. Modified accelerated cost recovery system used for computing depreciation for tax purposes

b. We use straight-line depreciation to reduce complexity.

C. Computing Taxes Owed

1. Taxes paid are based on corporate tax structure.

2. Tax rates used to calculate tax liability are marginal tax rates, or the rate applicable to the next dollar of income.

3. Average tax rate is calculated by dividing taxes owed by the firm’s total income

4. Marginal tax rate is used in financial decision making

III. Measuring Free Cash Flows

A. While an income statement measures a company’s profits, profits are not the same as cash flows; profits are calculated on an accrual basis rather than a cash basis.

B. In measuring cash flows, we could use the conventional accountant’s presentation called a statement of cash flows. However, we are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors, rather than from an accounting view. We will instead measure the cash flow that is free and available to be distributed to the firm’s investors, both debt and equity investors, or what we will call free cash flows.

C. The cash flows that are generated through a firm’s operations and investments in assets will always equal its cash flows paid to – or received from – the company’s investors (both creditors and stockholders).

11

D. Calculating Free Cash Flows: An Asset Perspective

1. A firm's free cash flows, from an asset perspective, is the after-tax cash flows generated from operations less the firm's investments in assets. It is this same amount that will be available for distributing to the firm’s investors. That is, a firm's free cash flows for a given period is equal to:

After-tax cash flow from operations

less

the investment (increase) in net operating working capital

less

investments in fixed assets (plant and equipment) and other assets.

2. After-tax cash flows from operations as follows:

Operating income (earnings before interest and taxes) + depreciation

= Earnings before interest, taxes, depreciation and amortization (EBITDA) - cash tax payments

= After-tax cash flows from operations

3. The increase in net operating working capital is equal to the:

-

4. Investments in fixed assets includes the change in gross fixed assets and any other balance sheet assets not already considered.

12

E. Calculating Free Cash Flows: A Financing Perspective

1. Free cash flows from a financing perspective are equal to:

2. Free cash flow from an asset perspective must equal free cash flow from a financing perspective.

3. Free cash flows from a financing perspective are simply the net cash flows received by the firm’s investors, or if negative, the cash flows that the investors are paying into the firm. In the latter situation where the investors are putting money into the firm, it is because the firm’s free cash flow from assets is negative, thereby requiring an infusion of capital by the investors.

IV. Financial Statements and International Finance

A. Many countries have different guidelines for firms to use in preparing financial statements. For example, a $1 of earnings in the United States is not the same as 1.10 Euro (the equivalent of a U.S. dollar based on the exchange rate). The differences are due to the two countries having different Generally Accepted Accounting Principles which guide their firms’ financial reporting.

B. As a result of this situation, the International Accounting Standards Committee (IASC), a private body supported by the worldwide accounting profession, is trying to develop international financial-reporting standards that will minimize the problem. In spite of the work to standardize accounting practices around the world, the U.S. accounting profession has rejected efforts toward international standards. At this time, foreign companies seeking to list their shares in the United States must follow U.S. accounting standards.

13

Interest payments to creditors

plus dividends paid to stockholders

+ decrease in debt principalor- increase in debt principal

+ decrease in stockor- increase in stock

ANSWERS TOEND-OF-CHAPTER QUESTIONS

2-1. a. The balance sheet represents an enumeration of a firm’s resources (assets) along with its liabilities and owners’ equity at a given date. The income statement summarizes the net results of the operation of a firm over a specified time interval.

The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time.

b. The conventional cash flow statement as prepared by accountants provides the information we need to know about what has happened to the firm’s cash and why. But it does not present it in a way that makes clear the cash flows the firm’s creditors and investors are providing to or receiving from the firm. Thus, we choose to reformat the presentation to show the firm’s free cash flows—the cash available to distribute to the creditors and investors. We are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors, rather than from an accounting view. We instead measure the cash flow that is free and available to be distributed to the firm’s investors, both debt and equity investors, or what we will call free cash flows. Thus, what we use is similar to a conventional cash flow statement presented as part of a company’s financial statements, but “not exactly.” We also make the distinction between the cash flows generated by the firm’s assets and the financing free cash flows.

2-2. Gross profits is sales less the cost of producing or acquiring the firm’s product or service. Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business. Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes.

2-3. Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense is computed as the interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receive dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or cease paying a dividend.

14

2-4 Once preferred shares are sold, dividends are paid or accrued each year based upon preferred dividends (i.e., the percentage of the preferred stock’s par value paid as dividends) agreed to at the selling date. However, these dividends affect the income statement only. Common stock dividends, which may vary from year to year, also affect the income statement; however, the investment of common shareholders varies with the net addition to (or reduction from) retained earnings from year to year. The net addition to retained earnings equals the difference in the period’s net income and common dividends paid. Thus, the common equity section of the balance sheet (par value of common stock, paid-in capital and retained earnings) varies from year to year due to changes in the retained earnings portion of the firm’s common equity.

2.5 Net working capital is the firm’s liquid assets (current assets) less its short-term debt. Accountants include all short-term debt when computing net working capital; however, in computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts payables and accruals. With this latter method, we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business—beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer.

Gross working capital is the sum of current assets, while net working capital is the difference between current assets and current liabilities.

As already suggested, we have both interest-bearing debt and noninterest-bearing debt. The former is debt where the lender is paid interest for providing us the money. Noninterest-bearing debt charges no interest because the “lender” is really a supplier or an employee to whom we owe money, but they are not requiring the firm to pay interest.

2-6. A firm could have positive cash flows but still be in trouble because it has negative cash flows from operations. The positive cash flows would then be the result of the firm reducing its investments in working capital or long-term assets. Such a situation means that the company is not earning a satisfactory rate of return on its investments. Another company could have very attractive rates of return on its assets, but be growing so fast that the large investments in working capital and long-term assets result in negative cash flows. In this latter case, management is simply investing in the future. As the rate of growth slows, positive cash flows will occur.

2-7. Examining only the income statement and the balance sheet fails to tell us how the firm is using its cash, which is a critical issue for any company.

2-8. Free cash flows from assets equal the cash flows that are generated by the company that are then distributed to (if positive) or received from (if negative) the firm’s creditors and investors. It looks at cash flows from the firm’s perspective. Free cash flows from a financing perspective looks at the cash flows from the investors’ viewpoint. It indicates how the investor received cash in the form of interest, dividends, debt repayment or stock repurchase and how the investor infused cash in the form of additional debt or stock purchase. Whatever the company does is the exact opposite of what the investor receives or pays. That is, if a company distributes $100 in cash to the investors, then the investors must receive $100 as well. They have to be equal.

15

SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

2-1A. Belmond, Inc.Balance Sheet

December 31, 2003

ASSETSCurrent assetsCash $ 16,550 Accounts receivable 9,600 Inventory 6,500 Total current assets $ 32,650 Gross buildings & equipment $122,000 Accumulated depreciation (34,000) Net buildings & equipment $ 88,000 Total assets $120,650

LIABILITIES AND EQUITYLiabilitiesCurrent LiabilitiesNotes payable $ 600 Accounts payable 4,800 Total current liabilities $ 5,400 Long-term debt 55,000 Total liabilities $ 60,400 EquityCommon stock $ 45,000 Retained earnings 15,250 Total equity $ 60,250 Total liabilities and equity $120,650

Belmond, Inc.Income Statement

For the Year Ended December 31, 2003

Sales $ 12,800 Cost of goods sold 5,750 Gross profits $ 7,050 General & admin expense $ 850 Depreciation expense 500 Total operating expense $ 1,350 Operating income (EBIT) $ 5,700 Interest expense 900 Earnings before taxes $ 4,800 Taxes 1,440 Net income $ 3,360

16

2-2A. Sharpe Mfg. CompanyBalance Sheet

December 31, 2003

ASSETSCash $ 96,000Accounts receivable 120,000 Inventory 110,000 Total current assets $ 326,000 Machinery and equipment $ 700,000 Accumulated depreciation (236,000) Net fixed assets 464,000 Total assets $ 790,000

LIABILITIES & EQUITYLiabilitiesCurrent LiabilitiesNotes payable $ 100,000 Accounts payable 90,000 Total current liabilities $ 190,000 Long-term debt 160,000 Total liabilities $ 350,000 EquityCommon stock $ 320,000Retained earnings Prior year 100,000 Current year 20,000 Total equity $ 440,000 Total liabilities and equity $ 790,000

Sharpe Mfg. CompanyIncome Statement

For the Year Ended December 31, 2003

Sales $ 800,000 Cost of goods sold 500,000 Gross profits $ 300,000 Operating expense 280,000 Net income $ 20,000 (Assume no interest accrued or taxes)

17

2-3A. Delaney, Inc. - Corporate Income Tax

Sales $4,000,000Cost of goods sold and cash operating expenses 2,400,000Depreciation expense 100,000Operating profit $1,500,000Interest expense 150,000Taxable Income $1,350,000

Tax Liability:

$50,000 x 0.15 = $7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500

235,000 x 0.39 = 91,6501,015,000 x 0.34 = 345,100

$1,350,000 $459,000

2-4A. Potts, Inc. - Corporate Income Tax

Sales $ 6,000,000Cost of goods sold and cash operating expenses 5,600,000Operating profit $ 400,000Interest expense 30,000Taxable Income $ 370,000

Tax Liability:

$50,000 x 0.15 = $7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500

235,000 x 0.39 = 91,650 35,000 x 0.34 = 11,900$370,000 $125,800

18

2-5A. Pamplin, Inc.

Free cash flows from an asset perspective:Operating income (EBIT) $ 360,000 Depreciation 200,000 EBITDA $ 560,000 Tax expense $ 120,000 Less change in tax payable - Cash taxes $ 120,000 After-tax cash flows from operations $ 440,000

Change in net working capitalChange in current assets: Change in cash $ (50,000) Change in accounts receivable (25,000) Change in inventory 75,000Change in current assets $ -

Change in noninterest-bearing current debt: Change in accounts payable $ (50,000) Change in net operating working capital $ (50,000)

Change in long-term assets: Purchase of fixed assets (400,000)Free cash flows - asset perspective $ (10,000)

Free cash flows from a financing perspective:Interest expense $ (60,000) Less change in interest payable - Interest paid to lenders $ (60,000) Repayment of long-term debt -Increase in short-term debt 150,000Common stock dividends paid to owners (80,000)Free cash flows - financing perspective $ 10,000

Note: The dividends were computed by comparing net income against the change in retained earnings. Net income was $180,000, but retained earnings increased only by $100,000; thus the balance was distributed in the form of dividends.

Pamplin, Inc. had an after-tax operating cash flow of $440,000. Additionally, Pamplin acquired further financing though increasing short-term debt by $150,000. This cash was mainly used to purchase fixed assets of $400,000. The remainder was used to decrease payables to suppliers by $50,000, pay interest of $60,000, and pay dividends back to the investors of $80,000.

19

2-6A. T.P. JarmonFree cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 70,000 Plus interest expense 10,000 EBIT 80,000 Depreciation 30,000 EBITDA $ 110,000 Tax expense $ 27,100 Less change in tax payable - Cash taxes 27,100 After-tax cash flows from operations $ 82,900 Step 2: Change in net operating working capital Change in current assets: Change in cash $ (1,000) Change in accounts receivable (9,000) Change in inventory 33,000 Change in prepaid rent (100) Change in marketable securities 200 Change in current assets $ 23,100 Change in noninterest-bearing current debt: Change in accounts payable $ 9,000 Change in accrued expenses (1,000) Change in noninterest-bearing current debt: $ 8,000 Change in net operating working capital $ (15,100) Step 3: Change in long-term assets Purchase of fixed assets $ 14,000

(Change in net fixed assets + depr. expense) Change in other assets - Net cash used for investments $ (14,000) Asset free cash flows $ 53,800

Free cash flows from a financing perspective: Interest paid to investors $(10,000) Less change in interest payable - Interest received by investors $ (10,000) Decrease in long-term debt (10,000) Decrease in notes payable (2,000) Common stock dividends (31,800) Financing free cash flows $ (53,800)

T.P. Jarmon had a successful year, generating an after-tax cash flow of $82,900. To increase cash flow further, noninterest-bearing debt increased by $8,000. Part of this cash was consumed when current assets were increased by $23,100 (of which inventory increased by $33,000). Fixed assets of $14,000 were also purchased. The substantial part of the cash flow, however, was distributed back to the investors. Debt was decreased, both long-term and short-term, by $12,000. Interest of $10,000 was also paid on this debt. Finally, investors were paid $31,800 in dividends.

20

2-7A. Abrams Manufacturing

Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Operating Income $ 54,000 Depreciation 26,000 EBITDA $ 80,000 Tax expense $ 16,000 Less change in tax payable - Cash taxes 16,000 After-tax cash flows from operations $ 64,000

Step 2: Change in net operating working capital Change in current assets: Change in cash $ 11,000 Change in accounts receivables 6,000 Change in inventories (12,000) Change in prepaid expenses -Change in current assets $ 5,000 Change in noninterest-bearing current debt: Change in accounts payables $ 5,000 Change in accrued liabilities (5,000 ) Change in noninterest-bearing current debt: $ - Change in net operating working capital $ (5,000)

Step 3: Change in long-term assets Purchase of fixed assets $ 73,000 Change in other assets - Net cash used for investments $ (73,000 ) Asset free cash flows $ (14,000 )

Free cash flows from a financing perspective: Interest paid to investors $ (4,000) Less change in interest payable - Interest received by investors $ (4,000) Decrease in long-term debt (mortgage payable) (70,000) Increase in preferred stock 120,000 Preferred stock dividends (10,000) Common stock dividends (22,000 ) Financing free cash flows $ 14,000

Abrams generated cash through an after-tax operating profit of $64,000 and issuing preferred stock of $120,000. This cash was primarily used to pay down debt of $70,000 and purchase fixed assets of $73,000. Investors also received cash back through dividends of $32,000 and interest of $4,000. Abrams also increased current assets in total by $5,000 by increasing cash and accounts receivable while decreasing inventory.

21

2-8A. J.T. Williams

Williams generated $224,210 in after-tax operating cash flows(including other income). To further increase cash flow, accounts payable and accrued expenses were increased by $1,662 and $32,283, respectively. They also increased their short-term debt by $30,577, increased their long-term debt by $7,018 and issued more common stock for $61,806. They used the operating cash flow and increased financing to purchase $58,297 in inventory and other current assets and purchased $308,336 in fixed assets, investments, and other assets. While Williams generated a positive after-tax cash flow from operations, investors and creditors infused $99,401 into the operations to finance the increases in assets. Williams needs to analyze whether the investors are receiving an acceptable return on their investments. It should be careful not to become over-capitalized during this time of rapid growth.

2-9A. Johnson, Inc.

Johnson incurred a loss of $450,571 in after-tax operating cash flows(including other losses). In addition, interest expense of $87,966 was paid to cover the company’s current debt. The company increased their cash reserve, inventory and other current assets by $587,924. Fixed assets, investments, and other assets increased in net by $1,420,113. To finance this negative free cash flow, Johnson increased their long-term debt by $1,118,198, increased short-term debt and other current liabilities by $227,607, and issued more common stock in the amount of $851,016. Accounts payable to suppliers were also increased by $349,753. While investors in Internet companies have been satisfied with repeated annual losses, Johnson should look for ways to decrease debt, produce positive future cash flows, and provide an acceptable rate of return to its investors.

SOLUTION TO INTEGRATIVE PROBLEM

Davis & Howard had a successful year bringing in positive after-tax cash flows from operations(including other income) of $174,034. This money was used in part to increase current assets and fixed assets of $77,100 and $61,873, respectively. Investments also increased $2,730 and other assets were sold for $9,881. The noninterest-bearing current debt also increased by $59,062 to help finance the increase in current assets. However, the increase in current assets was substantially due to an increase of $57,467 in accounts receivable. Management should take measures to reduce the average collection period or utilize other tools to maintain control of this asset. Free cash flows of $101,274 were distributed to investors. Interest expense of $17,024 was paid for the current debt. Davis & Howard decreased their debt principal(including long-term debt, other liabilities, and notes payable) by a total of $27,380. Stockholders were paid dividends of $26,912. Finally, Davis & Howard used their free cash flows to repurchase common stock for $29,958.

22

Solutions to Problem Set B

2-1B. Warner CompanyBalance Sheet

December 31, 2003

ASSETSCurrent assetsCash $ 225,000 Accounts receivable 153,000 Inventory 99,300Prepaid expenses 14,500Total current assets $ 491,800 Gross buildings & equipment $ 895,000 Accumulated depreciation (263,000) Net buildings & equipment $ 632,000 Total assets $1,123,800

LIABILITIES AND EQUITYLiabilitiesCurrent LiabilitiesAccounts payable $ 102,000Notes payable 75,000Taxes payable 53,000 Accrued expense 7,900Total current liabilities $ 237,900 Long-term debt 334,000 Total liabilities $ 571,900 EquityCommon stock $ 289,000 Retained earnings 262,900 Total equity $ 551,900 Total liabilities and equity $1,123,800

Warner CompanyIncome Statement

For the Year Ended December 31, 2003

Sales $ 573,000 Cost of goods sold 297,000 Gross profits $ 276,000 General & admin expense $ 79,000 Depreciation expense 66,000 Total operating expense $ 145,000 Operating income (EBIT) $ 131,000 Interest expense 4,750 Earnings before taxes $ 126,250 Taxes 50,500 Net income $ 75,750

23

2-2B. Sabine Mfg. CompanyBalance Sheet

December 31, 2003

ASSETSCurrent assetsCash $ 90,000 Accounts receivable 150,000 Inventory 110,000 Total current assets $ 350,000 Machinery and Equipment $ 700,000 Accumulated depreciation (236,000) Net buildings & equipment $ 464,000 Total assets $ 814,000

LIABILITIES AND EQUITYLiabilitiesCurrent LiabilitiesAccounts payable $ 90,000Short-term notes payable 90,000Total current liabilities $ 180,000 Long-term debt 160,000 Total liabilities $ 340,000 EquityCommon stock $ 320,000 Retained earnings Prior year 84,000 Current year 70,000 Total equity $ 474,000 Total liabilities and equity $ 814,000

Sabine Mfg. CompanyIncome Statement

For the Year Ended December 31, 2003

Net Sales $ 900,000 Cost of goods sold 550,000 Gross profits $ 350,000 Operating expense 280,000 Net income $ 70,000

24

2-3B. Cook, Inc. - Corporate Income Tax

Sales $ 3,500,000Cost of goods sold and cash operating expenses 2,500,000Depreciation expense 100,000Operating profit $ 900,000Interest expense 165,000Taxable Income $ 735,000

Tax Liability:

$50,000 x 0.15 = $ 7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500

235,000 x 0.39 = 91,650400,000 x 0.34 = 136,000

$735,000 $249,900 2-4B. Rose, Inc. - Corporate Income Tax

Sales $7,000,000Cost of goods sold and cash operating expenses 6,600,000Operating profit $400,000Interest expense 40,000Taxable Income $ 360,000

Tax Liability:

$50,000 x 0.15 = $ 7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500

235,000 x 0.39 = 91,650 25,000 x 0.34 = 8,500$ 360,000 $122,400

25

2-5B. J.B. Chavez

Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 270,000 Plus interest expense 60,000 EBIT 330,000 Depreciation 200,000 EBITDA $ 530,000 Tax expense $ 108,000 Less change in tax payable - Cash taxes 108,000 After-tax cash flows from operations $ 422,000

Step 2: Change in net operating working capital Change in current assets: Change in cash $ (50,000) Change in accounts receivable (20,000) Change in inventory 50,000 Change in current assets $ (20,000)

Change in noninterest-bearing current debt: Change in accounts payable $(135,000) Change in accrued expenses - Change in noninterest-bearing current debt: $(135,000)

Change in net operating working capital $ (115,000)

Step 3: Change in long-term assets Purchase of fixed assets $ 300,000 Change in other assets - Net cash used for investments $ (300,000)

Asset free cash flows $ 7,000

Free cash flows from a financing perspective: Interest expense $ (60,000) Less change in interest payable - Interest paid to lenders $ (60,000) Increase in notes payable 115,000 Common stock dividends (62,000) Financing free cash flows $ (7,000)

After-tax cash flows from operations of $422,000 and an increase in notes payable of $115,000 were used to pay down the accounts payable by $135,000 and increase our inventory and fixed assets by $50,000 and $300,000, respectively. Interest of $60,000 and common stock dividends of $62,000 were paid to investors.

2-6B. RPI, Inc.

26

Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 110,000 Plus interest expense 10,000 EBIT 120,000 Depreciation 30,000 EBITDA $ 150,000 Tax expense $ 27,100 Less change in tax payable - Cash taxes 27,100 After-tax cash flows from operations $ 122,900

Step 2: Change in net operating working capital Change in current assets: Change in cash $ 1,000 Change in marketable securities 200 Change in accounts receivable (4,000) Change in prepaid rent (100) Change in inventory 43,000 Change in current assets $ 40,100 Change in noninterest-bearing current debt: Change in accounts payable $ 7,000 Change in accrued expenses (1,000) Change in noninterest-bearing current debt: $ 6,000 Change in net operating working capital $ (34,100)

Step 3: Change in long-term assets Purchase of fixed assets $ 34,000

(Change in net fixed assets + depreciation expense)

Change in other assets - Net cash used for investments $ (34,000) Asset free cash flows $ 54,800

Free cash flows from a financing perspective: Interest expense $ (10,000) Less change in interest payable - Interest paid to lenders $ (10,000) Decrease in notes payable (3,000) Decrease in long-term debt (10,000) Common stock dividends (31,800) Financing free cash flows $ (54,800)

27

RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made a decision to evenly split the cash flow between distribution to investors and investing back into the company. Net operating capital increased by $34,100, mostly in the area of inventory which increased by $43,000. Fixed assets of $34,000 were also purchased. The asset free cash flow of $54,800 was distributed back to investors through interest of $10,000, debt repayments of $13,000, and dividends of $31,800.

2-7B. Cameron Co.

Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 72,000 Plus interest expense 5,000 EBIT 77,000 Depreciation 26,000 EBITDA $ 103,000 Tax expense $ 30,000 Less change in tax payable - Cash taxes 30,000 After-tax cash flows from operations $ 73,000

Step 2: Change in net operating working capital Change in current assets: Change in cash $ (19,000) Change in accounts receivable 6,000 Change in prepaid expenses - Change in inventory (22,000) Change in current assets $ (35,000)

Change in noninterest-bearing current debt: Change in accounts payable $ (5,000) Change in accrued liabilities (5,000) Change in noninterest-bearing current debt: $ (10,000) Change in net operating working capital $ 25,000

Step 3: Change in long-term assets Purchase of fixed assets $ 63,000 Change in other assets - Net cash used for investments $ (63,000)

Asset free cash flows $ 35,000

Free cash flows from a financing perspective: Interest expense $ (5,000) Less change in interest payable - Interest paid to lenders $ (5,000) Decrease in mortgage payable (60,000) Increase in preferred stock 70,000 Preferred stock dividends (8,000) Common stock dividends (32,000) Financing free cash flows $ (35,000)

28

Cameron Co. created cash flows through after-tax profits of $73,000 and issuing $70,000 of preferred stock. Cameron also decreased current assets of $35,000 through inventory and cash. This cash was used to decrease $10,000 in noninterest-bearing current debt and to purchase $63,000 in fixed assets. Cameron also eliminated $60,000 in a mortgage payable and distributed $40,000 in dividends and $5,000 in interest to investors.

2-8B Hilary’s Ice Cream

Hilary’s had a profitable year generating after-tax operating cash flows(including other losses) of $10,953. However, it should be noted that current assets increased by $5,038 of which accounts receivable increased by $7,495. This increase was offset by increasing accounts payable by $5,456. Hilary’s should be concerned with the substantial increase in payables and the even greater threat of aging receivables. Hilary’s used some of the above operating cash flow to purchase other assets for $3,060. The asset free cash flow of $9,688 was distributed to the investors in the form of $1,634 in interest, $3,822 in long-term debt principal, and repurchasing $4,593 in common stock. It is possible that Hilary’s thought it wise to lower long term debt and repurchase stock rather than make investments in further growth.

2.9B Retail.com

In need of cash, Retail.com issued common stock for $368,463 and increased current liabilities by $9,609. This cash was used, in part, to cover an after-tax operating loss(including other income) of $63,689. Retail.com mainly used the cash to increase growth by purchasing fixed assets and other investments of $31,971 and $178,108, respectively. Retail.com also sought to increase their liquidity by increasing current assets by $84,962, consisting mainly of a $76,680 increase in their cash reserve, which was offset in part by increasing payables by $4,657. The remainder of the common stock issue was paid back to investors through a dividend of $23,612. For many years, it has been fairly easy for innovative Internet companies to raise money through the stock market. It has been more important to grow quickly than to create profits. In future years, Retail.com must turn these losses into profits and create true value for their investors.

29