Financial Management Chapter 02 IM 10th Ed

8/2/2019 Financial Management Chapter 02 IM 10th Ed

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Prof. Rushen Chahal

CHAPTER 2

Understanding FinancialStatements,Taxes,and Cash Flows

CHAPTER ORIENTATION

In this chapter, we review the contents and meaning of a firms income statement andbalance sheet. We also look very carefully at how to compute a firms cash flows from a

finance perspective, which is calledfree cash flows.

CHAPTER OUTLINE

I. Basic Financial Statements

A. The Income Statement

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

2. It is helpful to think of the income statement as comprising five typesof 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 theproduct or service to the customer along with administrativeoperating expenses

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

e. The taxes owed based on a firms taxable income

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

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B. The Balance Sheet

1. The balance sheet provides a snapshot of the firms financial positionat a specific point in time, presenting its asset holdings, liabilities, andowner-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 thefirms 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 arefinanced.

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

(2) The equity includes the stockholders investment in thefirm and the cumulative profits retained in the businessup to the date of the balance sheet.

2. The balance sheet is not intended to represent the current market valueof the company, but rather reports the historical transactions recordedat their costs.

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

II Computing a Companys 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 thecorresponding taxes.

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3. Corporations

a. Corporation reports income and pays taxes

b. Owners do not report these earnings except when all or part ofthe 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 computingdepreciation 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 therate applicable to the next dollar of income.

3. Average tax rate is calculated by dividing taxes owed by the firmstotal income

4. Marginal tax rate is used in financial decision making

III. Measuring Free Cash Flows

A. While an income statement measures a companys profits, profits are not thesame as cash flows; profits are calculated on an accrualbasis rather than acash basis.

B. In measuring cash flows, we could use the conventional accountantspresentation called a statement of cash flows. However, we are moreinterested in considering cash flows from the perspective of the firmsshareholders and its investors, rather than from an accounting view. We willinstead measure the cash flow that is free and available to be distributed to thefirms investors, both debt and equity investors, or what we will call free cashflows.

C. The cash flows that are generated through a firms operations and investmentsin assets will always equal its cash flows paid to or received from thecompanys investors (both creditors and stockholders).

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D. Calculating Free Cash Flows: An Asset Perspective

1. A firm's free cash flows, from an asset perspective, is theafter-tax cash flows generated from operations less the firm'sinvestments in assets. It is this same amount that will be

available for distributing to the firms investors. That is, afirm'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 otherassets.

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

Operating income (earnings before interest and taxes)+ depreciation

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

= After-tax cash flows from operations

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

assetscurrent

inchange-

sliabilitiecurrent

bearing-tnoninteresinchange

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

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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 flowfrom a financing perspective.

3. Free cash flows from a financing perspective are simply the net cashflows received by the firms investors, or if negative, the cash flowsthat the investors are paying into the firm. In the latter situation wherethe investors are putting money into the firm, it is because the firmsfree cash flow from assets is negative, thereby requiring an infusion ofcapital by the investors.

IV. Financial Statements and International Finance

A. Many countries have different guidelines for firms to use in preparingfinancial statements. For example, a $1 of earnings in the United States isnot the same as 1.10 Euro (the equivalent of a U.S. dollar based on theexchange rate). The differences are due to the two countries having differentGenerally Accepted Accounting Principles which guide their firms financialreporting.

B. As a result of this situation, the International Accounting StandardsCommittee (IASC), a private body supported by the worldwide accountingprofession, is trying to develop international financial-reporting standards thatwill minimize the problem. In spite of the work to standardize accounting

practices around the world, the U.S. accounting profession has rejected effortstoward international standards. At this time, foreign companies seeking to listtheir shares in the United States must follow U.S. accounting standards.

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Interest payments to creditors

plus dividends paid to stockholders

+ decrease in debt principalor- increase in debt principal

+ decrease in stock or- increase in stock


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ANSWERS TOEND-OF-CHAPTER QUESTIONS

2-1. a. The balance sheet represents an enumeration of a firms resources (assets)

along with its liabilities and owners equity at a given date. The incomestatement summarizes the net results of the operation of a firm over a specifiedtime interval.

The primary distinction between these two statements is that the balance sheetshows the financial condition of a firm at a given date, whereas the incomestatement deals with the revenues and expenses of the firm incurred during aspecified period of time.

b. The conventional cash flow statement as prepared by accountants providesthe information we need to know about what has happened to the firms cashand why. But it does not present it in a way that makes clear the cash flows

the firms creditors and investors are providing to or receiving from the firm.Thus, we choose to reformat the presentation to show the firms free cashflowsthe cash available to distribute to the creditors and investors. We aremore interested in considering cash flows from the perspective of the firmsshareholders and its investors, rather than from an accounting view. Weinstead measure the cash flow that is free and available to be distributed to thefirms investors, both debt and equity investors, or what we will call free cashflows. Thus, what we use is similar to a conventional cash flow statementpresented as part of a companys financial statements, but not exactly. Wealso make the distinction between the cash flows generated by the firmsassets and the financing free cash flows.

2-2. Gross profits is sales less the cost of producing or acquiring the firms product orservice. Operating profits is the gross profits less the operating expenses, whichconsist of distributing the product or service to the customer (namely, marketingexpenses) and any general and administrative expenses in operating the business. Netincome is operating profits less financing costs (interest expenses and preferred stockdividends) 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 theinterest rate times the amount borrowed. If we borrow $500,000 at an interest rate of12 percent, then our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firmsstockholders. Preferred stock typically has a fixed dividend rate, so that the preferredstockholder gets a constant dividend each year. Common stockholders, on the otherhand, usually receive dividends only if management decides to pay a dividend insteadof reinvesting the firms profits. However, typically once a dividend has been paid tocommon stockholders, management is reluctant to decrease it or cease paying adividend.

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2-4 Once preferred shares are sold, dividends are paid or accrued each year based uponpreferred dividends (i.e., the percentage of the preferred stocks par value paid asdividends) agreed to at the selling date. However, these dividends affect the incomestatement only. Common stock dividends, which may vary from year to year, also

affect the income statement; however, the investment of common shareholders varieswith the net addition to (or reduction from) retained earnings from year to year. Thenet addition to retained earnings equals the difference in the periods net income andcommon dividends paid. Thus, the common equity section of the balance sheet (parvalue of common stock, paid-in capital and retained earnings) varies from year to yeardue to changes in the retained earnings portion of the firms common equity.

2.5 Networking capital is the firms 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 onlyconsidering the assets and liabilities that are changing as a result of the normal

operating cycle of the businessbeginning with the time inventory is purchased oncredit 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 thedifference between current assets and current liabilities.

As already suggested, we have both interest-bearing debt and noninterest-bearingdebt. 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 supplieror an employee to whom we owe money, but they are not requiring the firm to payinterest.

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 thefirm reducing its investments in working capital or long-term assets. Such a situationmeans 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 begrowing so fast that the large investments in working capital and long-term assetsresult in negative cash flows. In this latter case, management is simply investing in thefuture. 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 thefirm 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 companythat are then distributed to (if positive) or received from (if negative) the firms

creditors and investors. It looks at cash flows from the firms perspective. Free cashflows from a financing perspective looks at the cash flows from the investorsviewpoint. It indicates how the investor received cash in the form of interest,dividends, debt repayment or stock repurchase and how the investor infused cash inthe form of additional debt or stock purchase. Whatever the company does is the exactopposite of what the investor receives or pays. That is, if a company distributes $100in cash to the investors, then the investors must receive $100 as well. They have to beequal.

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SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

2-1A. Belmond, Inc.Balance Sheet

December 31, 2003

ASSETS

Current assetsCash $ 16,550Accounts receivable 9,600Inventory 6,500Total current assets $ 32,650Gross buildings & equipment $122,000

Accumulated depreciation (34,000)Net buildings & equipment $ 88,000Total assets $120,650

LIABILITIES AND EQUITY

LiabilitiesCurrent LiabilitiesNotes payable $ 600Accounts payable 4,800Total current liabilities $ 5,400Long-term debt 55,000Total liabilities $ 60,400

EquityCommon stock $ 45,000Retained earnings 15,250Total equity $ 60,250Total liabilities and equity $120,650

Belmond, Inc.Income Statement

For the Year Ended December 31, 2003

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

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2-2A. Sharpe Mfg. CompanyBalance Sheet

December 31, 2003

ASSETS

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

LIABILITIES & EQUITY

LiabilitiesCurrent LiabilitiesNotes payable $ 100,000Accounts payable 90,000Total current liabilities $ 190,000Long-term debt 160,000Total liabilities $ 350,000EquityCommon stock $ 320,000Retained earnings

Prior year 100,000Current year 20,000

Total equity $ 440,000Total liabilities and equity $ 790,000

Sharpe Mfg. CompanyIncome Statement


Sales $ 800,000Cost of goods sold 500,000Gross profits $ 300,000

Operating expense 280,000Net income $ 20,000(Assume no interest accrued or taxes)

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

Sales $4,000,000Cost of goods sold and

cash operating expenses 2,400,000

Depreciation 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 = 91,650

1,015,000 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 = 91,65035,000 x 0.34 = 11,900

$370,000 $125,800

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2-5A. Pamplin, Inc.

Free cash flows from an asset perspective:Operating income (EBIT) $ 360,000Depreciation 200,000

EBITDA $ 560,000Tax expense $ 120,000Less change in tax payable -Cash taxes $ 120,000After-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 75,000

Change 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 inretained 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 wasused to decrease payables to suppliers by $50,000, pay interest of $60,000, and paydividends back to the investors of $80,000.

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2-6A. T.P. Jarmon

Free cash flows from an asset perspective:Step 1: Compute after-tax cash flows from operationsEarnings before taxes $ 70,000Plus interest expense 10,000EBIT 80,000Depreciation 30,000EBITDA $ 110,000Tax expense $ 27,100Less change in tax payable -Cash taxes 27,100After-tax cash flows from operations $ 82,900

Step 2: Change in net operating working capitalChange in current assets:

Change in cash $ (1,000)Change in accounts receivable (9,000)

Change in inventory 33,000Change in prepaid rent (100)Change in marketable securities 200Change in current assets $ 23,100

Change in noninterest-bearing current debt:Change in accounts payable $ 9,000Change in accrued expenses (1,000)

Change in noninterest-bearing current debt: $ 8,000Change in net operating working capital $ (15,100)

Step 3: Change in long-term assetsPurchase 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. Toincrease cash flow further, noninterest-bearing debt increased by $8,000. Part of thiscash was consumed when current assets were increased by $23,100 (of whichinventory increased by $33,000). Fixed assets of $14,000 were also purchased. Thesubstantial part of the cash flow, however, was distributed back to the investors. Debtwas decreased, both long-term and short-term, by $12,000. Interest of $10,000 wasalso paid on this debt. Finally, investors were paid $31,800 in dividends.

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2-7A. Abrams Manufacturing

Free cash flows from an asset perspective:Step 1: Compute after-tax cash flows from operationsOperating Income $ 54,000

Depreciation 26,000EBITDA $ 80,000Tax expense $ 16,000Less change in tax payable -Cash taxes 16,000After-tax cash flows from operations $ 64,000


Change in cash $ 11,000Change in accounts receivables 6,000Change in inventories (12,000)

Change in prepaid expenses -Change in current assets $ 5,000Change in noninterest-bearing current debt:

Change in accounts payables $ 5,000Change 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 assetsPurchase of fixed assets $ 73,000Change 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 120,000Preferred 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 backthrough dividends of $32,000 and interest of $4,000. Abrams also increased currentassets in total by $5,000 by increasing cash and accounts receivable while decreasinginventory.

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2-8A. J.T. Williams

Williams generated $224,210 in after-tax operating cash flows(including otherincome). To further increase cash flow, accounts payable and accrued expenses wereincreased 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 commonstock for $61,806. They used the operating cash flow and increased financing topurchase $58,297 in inventory and other current assets and purchased $308,336 infixed assets, investments, and other assets. While Williams generated a positiveafter-tax cash flow from operations, investors and creditors infused $99,401 into theoperations to finance the increases in assets. Williams needs to analyze whether theinvestors are receiving an acceptable return on their investments. It should be carefulnot 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 otherlosses). In addition, interest expense of $87,966 was paid to cover the companyscurrent debt. The company increased their cash reserve, inventory and other currentassets 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. Accountspayable to suppliers were also increased by $349,753. While investors in Internetcompanies have been satisfied with repeated annual losses, Johnson should look forways to decrease debt, produce positive future cash flows, and provide an acceptablerate of return to its investors.

SOLUTION TO INTEGRATIVE PROBLEM

Davis & Howard had a successful year bringing in positive after-tax cash flows fromoperations(including other income) of $174,034. This money was used in part toincrease 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. Thenoninterest-bearing current debt also increased by $59,062 to help finance theincrease in current assets. However, the increase in current assets was substantiallydue to an increase of $57,467 in accounts receivable. Management should takemeasures 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 & Howarddecreased 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.

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Solutions to Problem Set B

2-1B. Warner CompanyBalance Sheet

December 31, 2003

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

Total assets $1,123,800LIABILITIES AND EQUITYLiabilitiesCurrent LiabilitiesAccounts payable $ 102,000Notes payable 75,000Taxes payable 53,000Accrued expense 7,900Total current liabilities $ 237,900Long-term debt 334,000Total liabilities $ 571,900

EquityCommon stock $ 289,000Retained earnings 262,900Total equity $ 551,900Total liabilities and equity $1,123,800

Warner CompanyIncome Statement


Sales $ 573,000Cost of goods sold 297,000

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

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2-2B. Sabine Mfg. CompanyBalance Sheet

December 31, 2003

ASSETS

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

LIABILITIES AND EQUITY

LiabilitiesCurrent LiabilitiesAccounts payable $ 90,000Short-term notes payable 90,000Total current liabilities $ 180,000Long-term debt 160,000Total liabilities $ 340,000EquityCommon stock $ 320,000Retained earnings

Prior year 84,000Current year 70,000

Total equity $ 474,000Total liabilities and equity $ 814,000

Sabine Mfg. CompanyIncome Statement


Net Sales $ 900,000Cost of goods sold 550,000Gross profits $ 350,000

Operating expense 280,000Net income $ 70,000

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

Sales $ 3,500,000Cost of goods sold and

cash operating expenses 2,500,000

Depreciation 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 = 91,650

400,000 x 0.34 = 136,000$735,000 $249,9002-4B. 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 = 91,65025,000 x 0.34 = 8,500

$ 360,000 $122,400

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2-5B. J.B. Chavez

Free cash flows from an asset perspective:Step 1: Compute after-tax cash flows from operationsEarnings before taxes $ 270,000

Plus interest expense 60,000EBIT 330,000Depreciation 200,000EBITDA $ 530,000Tax expense $ 108,000Less change in tax payable -Cash taxes 108,000After-tax cash flows from operations $ 422,000


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 assetsPurchase of fixed assets $ 300,000Change 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 115,000Common 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 ourinventory and fixed assets by $50,000 and $300,000, respectively. Interest of $60,000and common stock dividends of $62,000 were paid to investors.

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2-6B. RPI, Inc.

Free cash flows from an asset perspective:Step 1: Compute after-tax cash flows from operationsEarnings before taxes $ 110,000

Plus interest expense 10,000EBIT 120,000Depreciation 30,000EBITDA $ 150,000Tax expense $ 27,100Less change in tax payable -Cash taxes 27,100After-tax cash flows from operations $ 122,900

Step 2: Change in net operating working capitalChange in current assets:Change in cash $ 1,000

Change in marketable securities 200Change 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 $ 7,000Change 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)

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RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made adecision to evenly split the cash flow between distribution to investors and investingback into the company. Net operating capital increased by $34,100, mostly in thearea of inventory which increased by $43,000. Fixed assets of $34,000 were alsopurchased. 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 operationsEarnings before taxes $ 72,000Plus interest expense 5,000EBIT 77,000Depreciation 26,000EBITDA $ 103,000Tax expense $ 30,000

Less change in tax payable -Cash taxes 30,000After-tax cash flows from operations $ 73,000

Step 2: Change in net operating working capitalChange in current assets:Change in cash $ (19,000)Change in accounts receivable 6,000Change 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 assetsPurchase of fixed assets $ 63,000Change 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 70,000Preferred stock dividends (8,000)Common stock dividends (32,000)Financing free cash flows $ (35,000)

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Prof. Rushen Chahal

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 $35,000through 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 alsoeliminated $60,000 in a mortgage payable and distributed $40,000 in dividends and

$5,000 in interest to investors.

2-8B Hilarys Ice Cream

Hilarys had a profitable year generating after-tax operating cash flows(includingother 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 byincreasing accounts payable by $5,456. Hilarys should be concerned with thesubstantial increase in payables and the even greater threat of aging receivables.Hilarys 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 Hilarys thought it wise to lower longterm 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 currentliabilities by $9,609. This cash was used, in part, to cover an after-tax operatingloss(including other income) of $63,689. Retail.com mainly used the cash to increasegrowth by purchasing fixed assets and other investments of $31,971 and $178,108,respectively. Retail.com also sought to increase their liquidity by increasing currentassets 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 thecommon stock issue was paid back to investors through a dividend of $23,612. Formany years, it has been fairly easy for innovative Internet companies to raise moneythrough the stock market. It has been more important to grow quickly than to createprofits. In future years, Retail.com must turn these losses into profits and create truevalue for their investors.

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Financial Management Chapter 02 IM 10th Ed

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