FIinance Chapter 3

Chapter 3 A firm’s income statement included the following data. The firm’s average tax   $ $ $ $ $ Cost of goods sold Income taxes paid Administrative expenses Interest expense Depreciation rate was 20%.  8,000 2,000 3,000 1,000 1,000 a. What was the firm’s net income? If the firm paid income taxes of $2,000 and the average tax rate was 20%, then taxable income must have been: $2,000 / 0.20 = $10,000. Therefore: Net income = Taxable income − Taxes = $8,000 b.What must have been the firm's revenues?  Revenues Cost of goods sold Administrative expenses Depreciation expense Interest expense Taxable income  $      ??? 8,000 3,000 1,000 1,000 10,00 $ 0       [from part (a)] We conclude that revenues were $23,000. c. What was EBIT?   Revenues Cost of goods sold Administrative expenses Depreciation expense EBIT  23,00 0  8,000  3,000  1,000 11,00 $ 0 $ The year-end 2015 balance sheet of Brandex Inc. listed common stock and other paid-in capital at $1,100,000 and retained earnings at $3,400,000. The next year, retained earnings were listed at $3,700,000. The firm’s net income in 2016 was $900,000. There were no stock repurchases during the year. What were the dividends paid by the firm in 2016? Net income = Increase in retained earnings + Dividends $900,000 = ($3,700,000 − 3,400,000) + Dividends ⇒⇒Dividends = $600,000 South Sea Baubles has the following (incomplete) balance sheet and income statement. BALANCE SHEET AT END (Figures in $ millions) Assets Current assets Net fixed assets INCOME STATEMENT, 2016 (Figures in $ millions) Revenue $1,950 Cost of goods  1,030 sold Depreciation  350 Interest  240 expense OF YEAR 2015 2016 Liabilities and Shareholders' Equity $ 90  $ 140  Current liabilities  800   900  Long-term debt     a&b. What is shareholders’ equity in 2015 and 2016? Shareholders' equity = Total assets – Total liabilities 2015: Shareholders' equity = $890 – 650 = $240 2016: Shareholders' equity = $1,040 – 810 = $230 c&d. What is net working capital in 2015 and 2016? Net working capital = Current assets – Current liabilities 2015: Net working capital = $90 – 50 = $40 2016: Net working capital = $140 – 60 = $80 e. What are taxes paid in 2016? Assume the firm pays taxes equal to 35% of taxable income. Taxable income = $1,950 – 1,030 – 350 – 240 = $330 Taxes paid = .35 × $330 = $115.50 Net income = $214.50 f. What is cash provided by operations during 2016?  Net income Depreciation Decrease (increase) in current assets Increase (decrease) in current liabilities Cash provided by operations    214.  50 350.   00 (50.0  ) 0 10.0   0 524.  $ 50 $ g. Net fixed assets increased from $800 million to $900 million during 2016. What must have been South Sea’s gross investment in fixed assets during 2016? Gross investment = Increase in net fixed assets + Depreciation = $100 + 350 = $450 2015 2016 $ 50  $ 60   600   750  Here are the 2015 and 2016 (incomplete) balance sheets for Newble Oil Corp. BALANCE SHEET AT END OF YEAR (Figures in $ millions) Assets 2015 2016 Liabilities and Shareholders' Equity Current assets $ 310  $ 420  Current liabilities 1,20 1,42 Net fixed assets  0   0  Long-term debt 2015 2016 $ 210  $ 240   830   920  a&b.What was owners’ equity at the end of 2015 and 2016? Owners’ equity = Total assets – Total liabilities (as shown in the balance sheet above) 470 = 1,510 − 1,040 680 = 1,840 − 1,160 c. If Newble paid dividends of $100 million in 2016 and made no stock issues, what must have been net income during the year? If the firm issued no stock, the increase in owners’ equity must be due entirely to retained earnings. Since owners’ equity increased by $210 and dividends were $100, net income must have been $310. d.If Newble purchased $300 million in fixed assets during 2016, what must have been the depreciation charge on the income statement? Since net fixed assets increased by $220, and the firm purchased $300 of new fixed assets, the depreciation charge must have been $80. e. What was the change in net working capital between 2015 and 2016? Net working capital increased by $80, from ($310 – 210) = $100 in 2015 to ($420 – 240) = $180 in 2016. f. If Newble issued $200 million of new long-term debt, how much debt must have been paid off during the year? Since long-term debt increased by $90, and the firm issued $200 of new long-term debt, $110 of outstanding debt must have been paid off. The founder of Alchemy Products Inc. discovered a way to turn gold into lead and patented this new technology. He then formed a corporation and invested $200,000 in setÝng up a production plant. He believes that he could sell his patent for $50 million. a.What is the book value of the firm? Book value equals the $200,000 the founder of the firm has contributed in tangible assets. b.What is the market value of the firm? Market value equals the value of his patent plus the value of the production plant: $50,000,000 + 200,000 = $50,200,000. c.If there are two million shares of stock in the new corporation, what would be the price per share? Price per share = $50.2 million / 2 million shares = $25.10 d.What would be the book value per share? Book value per share = $200,000 / 2 million shares = $0.10 State whether each of the following events would increase or decrease the ratio of market value to book value. a. Big oil announces the discovery of a major Increase, because the announcement is likely to increase the new oil field in Costaguana. market value of the firm. Big Autos increases its depreciation b. provision. c. Since Big Stores purchased its assets, inflation has risen sharply. Increase, because an increase in the depreciation provision will decrease the value of the assets. This will be reflected in a lower book value of equity. Increase, because an increase in inflation is likely to cause an increase in the market value of its assets. Will the following actions increase or decrease the firm’s cash balance? a.The firm sells some goods from inventory. Cash will increase as one current asset (inventory) is exchanged for another (cash). b.The firm sells some machinery to a bank and leases it back for a period of 20 years. Cash will increase. The machine will bring in cash when it is sold, but the lease payments will be made over several years. c.The firm buys back 1 million shares of stock from existing shareholders. The firm will use cash to buy back the shares from existing shareholders. Cash balance will decrease. Butterfly Tractors had $14 million in sales last year. Cost of goods sold was $8.00 million, depreciation expense was $2 million, interest payment on outstanding debt was $1 million, and the firm’s tax rate was 35%. What was the firm’s net income?  Sales Cost of goods sold Interest expense Depreciation expense Taxable income Taxes (35%) Net income ($ in millions)  $ 14.00     8.00     1.00     2.00    $ 3.00     1.05    $ 1.95   b. What was the firm’s cash flow? Net cash flow = net income + depreciation expense = $3.95 million QuickGrow is in an expanding market, and its sales are increasing by 25% per year. Would you expect its net working capital to be increasing or decreasing? Working capital ought to be increasing. The firm will be building up stocks of inventory as it ramps up production. In addition, as sales increase, accounts receivable will increase rapidly. While accounts payable will probably also increase, the increase in accounts receivable will tend to dominate since sales prices exceed input costs. Sheryl’s Shipping had sales last year of $10,000. The cost of goods sold was $6,500, general and administrative expenses were $1,000, interest expenses were $500, and depreciation was $1,000. The firm’s tax rate is 35%. What are earnings before interest and taxes? What is net income? a. & b.   Sales $10,0 Cost of goods sold General & administrative expenses Depreciation expense EBIT Interest expense Taxable income Taxes (35%) Net income 00 6,50 0 1,00 0 1,00  0 1,50 $ 0  500 1,00 $0  350 $650  c. What is cash flow from operations? Cash flow from operations = net income + depreciation expense = $1,650 Can cash flow from operations be positive if net income is negative? Cash flow from operations can be positive even if net income is negative. For example, if depreciation expenses are large, then negative net income might correspond to positive cash flow because depreciation is treated as an expense in calculating net income but does not represent a cash outflow. Can it be negative if net income is positive? Conversely, if net income is positive, but a large portion of sales are made on credit, cash flow can be negative since the sales are revenue but do not yet generate cash. During the last year of operations, Theta’s accounts receivable increased by $10,000, accounts payable increased by $5,000, and inventories decreased by $2,000. What is the total impact of these changes on the difference between profits and cash flow? An increase in accounts receivable reduces cash flow by $10,000. An increase in accounts payable increases cash flow by $5,000. A decrease in inventory increases cash flow by $2,000. The total impact is a reduction in cash flow by $3,000. Value Added Inc. buys $1 million of sow's ears at the beginning of January but doesn't pay immediately. Instead, it agrees to pay the bill in March. It processes the ears into silk purses, which it sells for $2 million in February. However, it will not collect payment on the sales until April. a. What is the firm’s net income in February? b. What is its net income in March? c.What is the firm’s net new investment in working capital in January? d. What is its net new investment in working capital in April? e.What is the firm’s cash flow in January? f.What is the firm’s cash flow in February? g.What is the cash flow in March? h.What is the cash flow in April? The table below shows the firm’s net income and investment in net working capital for each month from January to April. Sales revenue and production costs are recognized at the time of sale in February. Since the firm neither pays for goods nor receives cash for sales, cash flow is zero in January and February. Cash flow occurs in March and April, when cash is actually being exchanged. The sow ears are paid for in March and cash is received for the purses in April. Value Added Inc. (in 000s)  January February March April Sales $0  $2,000 $ 0  $0  Cost of goods sold 0  $1,000  0 0  Net income $0  $1,000 $ 0  $0  Inventories $1,000  $0 $ 0  $0  Accounts receivable Accounts payable 0 $1,000   2,000  $1,000   2,000 0 0  0   Net working capital 0  $1,000  $ 2,000  $0  Cash flow $0  $0  -$ 1,000  $2,000  The following table shows an abbreviated income statement and balance sheet for Quick Burger Corporation for 2016. INCOME STATEMENT OF QUICK BURGER CORP., 2016 (Figures in $ millions) 27,56 Net sales $ 7 17,56 Costs  9 Depreciation  1,402 Earnings before interest and taxes $8,596 (EBIT) Interest expense  517 Pretax income  8,079 Taxes  2,614 Net income $5,465 BALANCE SHEET OF QUICK BURGER CORP., (Figures in $ millions) Assets 2016 Current assets  Cash and marketable securities 2,336 Receivables 1,375 Inventories 122 Other current assets Total current assets Fixed assets Property, plant, and equipment Intangible assets (goodwill) Other long-term assets Total assets 1,089 4,922  24,677 2,804 2,983 35,386         2016 2015  2,336 1,335 117 Liabilities and Shareholders' Equity Current liabilities Debt due for repayment Accounts payable Total current liabilities 2016 2015   — 367 3,403 3,143 3,403 3,510      616 4,404  22,835 2,653 3,099 32,991   Long-term debt Other long-term liabilities Total liabilities Total shareholders’ equity Total liabilities and shareholders’ equity   13,633 3,057 20,093 15,293 35,386        In 2016 Quick Burger had capital expenditures of $3,049. a.Calculate Quick Burger’s free cash flow in 2016 Cash flow from operations = net income + interest + depreciation – additions to net working capital   12,134 2,957 18,601 14,390 32,991 Free cash flow = cash flow from operations – capital expenditures Additions to net working capital = (3,403 − 3,143) − (1,375 − 1,335) − (122 − 117) − (1,089 − 616) = −258 Cash flow from operations = 5,465 + 517 + 1,402 − 258 = 7,126 Capital expenditures = $3,049 Free cash flow = $7,126 – 3,049 = $4,077 b.If Quick Burger was financed entirely by equity, how much more tax would the company have paid? Tax increase due to $517 million more in taxable income $ 180.95 = (517 × 0.35) c.What would the company’s free cash flow have been if it was all-equity financed? Additions to net working capital = (3,403 − 3,143) − (1,375 − 1,335) − (122 − 117) − (1,089 − 616) = −258 Cash flow from operations = 5,801 + 0 + 1,402 − 258 = 6,945 Free cash flow = 6,945 − 3,049 = 3,896 Using Table 3.7, calculate the marginal and average tax rates for a single taxpayer with the following incomes: Income $20,000 Taxes = (0.10 × $9,275) + 0.15 × ($20,000 - $9,275) = $2,535.95 Average tax rate = $2,535.95 / $20,000 = 0.127 = 12.7% Marginal tax rate = 15% $50,000 Taxes = (0.10 × $9,275) + 0.15 × ($37,650 - $9,275) + 0.25 × ($50,000 - ($37,650) = $8,270.75 Average tax rate = $8,270.75 / $50,000 = 0.165 = 16.5% Marginal tax rate = 25% $300,000 Taxes = (0.10 × $9,275) + 0.15 × ($37,650 - $9,275) + 0.25 × ($91,150 - $37,650) + 0.28 × ($190,150 - $91,150) + 0.33 × ($300,000 - $190,150) = $82,528.59 Average tax rate = $82,528.59/$300,000 = 0.275 = 27.5% Marginal tax rate = 33% $3,000,000 Taxes = (0.10 × $9,275) + 0.15 × ($37,650 - $9,275) + 0.25 × ($91,150 - $37,650) + 0.28 × ($190,150 - $91,150) + 0.33 × ($413,350 - $190,150) + 0.35 × ($415,050 – $413,350) + 0.396 × ($3,000,000 – $415,050) = $1,144,170 Average tax rate = $1,144,170 / $3,000,000 = 0.381 = 38.1% Marginal tax rate = 39.6% Average tax rate = $1,145,046 / $3,000,000 = 0.3817, or 38.17% Marginal tax rate = 39.6%