Chapter 002 Financial Statements, Taxes and Cash Flow

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1 Multiple Choice Questions 1. The financial statement summarizing the value of a firm's equity on a particular date is the: a. income statement. B. balance sheet. c. statement of cash flows. d. cash flow statement. e. dividend statement. TOPIC: BALANCE SHEET 2. A current asset is best defined as: a. an asset, such as equipment, that is currently owned by a firm. b. an asset the firm expects to own within the next year. C. an asset which is expected to be converted into cash within the next year. d. the amount of cash on hand the firm currently shows on its balance sheet. e. the market value of the inventory currently owned by the firm. TOPIC: CURRENT ASSETS 3. Net working capital is defined as: a. total liabilities minus shareholders' equity. b. current liabilities minus shareholders' equity. c. fixed assets minus long-term liabilities. d. total assets minus total liabilities. E. current assets minus current liabilities. TOPIC: NET WORKING CAPITAL 2-1

2 4. A(n) asset is one which can be quickly converted into cash without significant loss in value. a. tangible b. fixed c. intangible D. liquid e. marketable TOPIC: LIQUID ASSETS 5. Financial leverage refers to the: A. use of debt in a firm's capital structure. b. ratio of retained earnings to shareholders' equity. c. ratio of paid-in surplus to shareholders' equity. d. ratio of sales to total assets. e. ratio of current assets to long-term assets. TOPIC: FINANCIAL LEVERAGE 6. The common set of standards and procedures by which audited financial statements are prepared is known as the: a. Matching principle. b. Cash flow identity. C. Generally Accepted Accounting Principles (GAAP). d. Financial Leverage Reporting Principles (FLRP). e. Standard Market Value Guidelines (SMVG). AACSB TOPIC: ETHICS SECTION: 2.2 TOPIC: GAAP 2-2

3 7. The financial statement summarizing a firm's performance over a period of time is the: A. income statement. b. balance sheet. c. statement of cash flows. d. tax reconciliation statement. e. market value report. SECTION: 2.2 TOPIC: INCOME STATEMENT 8. Noncash items refer to: a. the talents of the firm's employees which are not reflected in the financial statements. b. the accounts payable of a firm. c. the costs incurred for the purchase of intangible fixed assets. D. expenses charged against revenues that do not directly affect cash flow. e. sales which are made on credit. SECTION: 2.2 TOPIC: NONCASH ITEMS 9. Your tax rate is the amount of tax payable on the next taxable dollar you earn. a. mean b. residual c. total d. average E. marginal SECTION: 2.3 TOPIC: MARGINAL TAX RATES 2-3

4 10. Your tax rate measures the total taxes you pay divided by your total taxable income. a. deductible b. residual c. total D. average e. marginal SECTION: 2.3 TOPIC: AVERAGE TAX RATES 11. Which term relates to the cash flow which results from a firm's ongoing, normal business activities? A. operating cash flow b. capital spending c. net working capital d. cash flow from assets e. cash flow to creditors TOPIC: OPERATING CASH FLOW 12. Which term refers to the net expenditures by a firm on fixed asset purchases? a. net new equity B. net capital spending c. net working capital d. cash flow from assets e. cash flow to creditors TOPIC: NET CAPITAL SPENDING 2-4

5 13. The difference between a firm's current assets and its current liabilities is called: a. operating cash flow. b. capital spending. C. net working capital. d. cash flow from assets. e. cash flow to creditors. TOPIC: NET WORKING CAPITAL 14. The net total cash flow of a firm which is available for distribution to the firm's creditors and stockholders is called the: a. operating cash flow. b. net capital spending. c. net working capital. D. cash flow from assets. e. cash flow to stockholders. TOPIC: CASH FLOW FROM ASSETS 15. The cash flow related to interest payments less any net new borrowing is called the: a. operating cash flow. b. capital spending. c. net working capital. d. cash flow from assets. E. cash flow to creditors. TOPIC: CASH FLOW TO CREDITORS 2-5

6 16. Cash flow to stockholders is defined as the: a. total amount of interest and dividends paid during the past year. b. change in total equity over the past year. c. cash flow from assets plus the cash flow to creditors. d. operating cash flow minus the cash flow to creditors. E. dividend payments less any net new equity raised. TOPIC: CASH FLOW TO STOCKHOLDERS 17. Cash flow from assets is also known as the firm's: a. capital structure. b. equity structure. c. hidden cash flow. D. free cash flow. e. historical cash flow. TOPIC: FREE CASH FLOW 18. Net income divided by the total number of outstanding shares is referred to as the: A. earnings per share. b. profit margin. c. return per share. d. market earnings. e. dividend per share. SECTION: 2.2 TOPIC: EARNINGS PER SHARE 2-6

7 19. The dividend per share is the amount of: a. net income the firm earned per share during the period. B. cash paid to investors on each share of outstanding stock. c. cash the firm received from its operations divided by the number of shares outstanding. d. interest paid during the period divided by the number of shares outstanding. e. cash received for each share of stock sold during the period. SECTION: 2.2 TOPIC: DIVIDENDS PER SHARE 20. A machine used to wrap a product for shipment to a customer is classified as: a. a current asset. b. an intangible asset. c. net working capital. D. a tangible asset. e. an inventory item. TOPIC: TANGIBLE ASSET 21. Which of the following are included in current assets? I. retained earnings II. inventory III. accounts payable IV. cash A. II and IV only b. I and III only c. I, II, and IV only d. III and IV only e. II, III, and IV only TOPIC: CURRENT ASSETS 2-7

8 22. Which one of the following represents a portion of a firm's value but yet is excluded from the assets appearing on a balance sheet? a. excess cash placed in an investment account B. good reputation of the company c. equipment owned by the firm d. money due from a customer e. an item held by the firm for future sale TOPIC: BALANCE SHEET ASSETS 23. Which of the following are included in current liabilities? I. note payable to a supplier in eight months II. amount due from a customer next month III. account payable to a supplier that is due next week IV. loan payable to the bank in fourteen months A. I and III only b. II and III only c. III and IV only d. II, III, and IV only e. I, II, and III only TOPIC: CURRENT LIABILITIES 24. Which one of the following statements concerning net working capital is correct? a. Net working capital is positive when current liabilities exceed current assets. b. Net working capital includes cash, accounts receivables, equipment, and accounts payable. C. Inventory is a part of net working capital. d. The change in net working capital is equal to the beginning net working capital minus the ending net working capital. e. Net working capital is equal to total assets minus current liabilities. TOPIC: NET WORKING CAPITAL 2-8

9 25. Which one of the following statements concerning net working capital is correct? a. The lower the net working capital the greater the ability of a firm to meet its current obligations. b. The change in net working capital is equal to current assets minus current liabilities. C. A decrease in accounts payable increases net working capital, all else constant. d. Net working capital is equal to long-term assets minus long-term liabilities. e. Net working capital is a part of the operating cash flow. TOPIC: NET WORKING CAPITAL 26. Which one of the following accounts is the most liquid? a. inventory b. building c. accounts receivable d. equipment E. cash TOPIC: LIQUIDITY 27. Which one of the following statements concerning liquidity is correct? a. If you can sell an asset today, it is a liquid asset. b. If you can sell an asset within the next twelve months it is considered highly liquid. c. Inventory is more liquid than accounts receivable. d. Balance sheet accounts are listed in order of ascending liquidity. E. An asset must be sellable quickly at full value to be considered liquid. TOPIC: LIQUIDITY 2-9

10 28. Liquidity is: a. equal to net working capital. b. another term for current assets. c. equal to the market value of a firm's total assets minus its current liabilities. D. valuable to a firm even though holding liquid assets is not very profitable. e. generally associated with intangible assets. TOPIC: LIQUIDITY 29. Which of the following accounts are included in shareholders' equity? I. retained earnings II. patents and copyrights III. paid-in surplus IV. notes payable a. I and II only b. II and IV only c. I and IV only d. II and III only E. I and III only TOPIC: SHAREHOLDERS' EQUITY 30. Shareholders' equity: a. increases anytime total assets increases. b. is equal to total assets plus total liabilities. c. decreases whenever new shares of stock are issued. d. includes long-term debt, preferred stock, and common stock. E. represents the residual value of a firm. TOPIC: SHAREHOLDERS' EQUITY 2-10

11 31. The higher the degree of financial leverage employed by a firm, the: A. higher the probability that the firm will encounter financial distress. b. lower the amount of debt incurred. c. less debt a firm has per dollar of total assets. d. higher the number of outstanding shares of stock. e. lower the balance in accounts payable. TOPIC: FINANCIAL LEVERAGE 32. The book value of a firm is: a. equivalent to the firm's market value provided that the firm has some fixed assets. B. based on historical cost. c. generally greater than the market value when fixed assets are included. d. more of a financial than an accounting valuation. e. adjusted to the market value whenever the market value exceeds the stated book value. TOPIC: BOOK VALUE 33. Which of the following are included in the market value of a firm but are not included in the firm's book value? I. management skills II. patents III. firm's reputation IV. copyrights a. I only b. III only c. IV only D. I and III only e. II and IV only TOPIC: MARKET VALUE 2-11

12 34. As seen on an income statement: a. interest is deducted from income and increases the total taxes incurred. b. the tax rate is applied to the earnings before interest and taxes when the firm has both depreciation and interest expenses. c. depreciation is shown as an expense but does not affect the taxes payable. D. depreciation reduces both the taxable income and the net income. e. interest expense is added to earnings before interest and taxes to get taxable income. SECTION: 2.2 TOPIC: INCOME STATEMENT 35. All else constant, the earnings per share will increase if the: a. net income decreases. b. number of shares outstanding increases. c. total revenue of the firm decreases. D. tax rate decreases. e. operating costs increase. SECTION: 2.2 TOPIC: EARNINGS PER SHARE 36. According to Generally Accepted Accounting Principles: a. depreciation may or may not be recorded at management's discretion. b. income is recorded based on the matching principle. c. costs are recorded based on the realization principle. d. depreciation is recorded based on the recognition principle. E. costs of goods sold are recorded based on the matching principle. AACSB TOPIC: ETHICS SECTION: 2.2 TOPIC: REALIZATION PRINCIPLE 2-12

13 37. Depreciation: A. reduces both taxes and net income. b. increases the net fixed assets as shown on the balance sheet. c. reduces both the net fixed assets and the costs of a firm. d. is a noncash expense which increases the net operating income. e. decreases net fixed assets, net income, and operating cash flows. SECTION: 2.2 TOPIC: NONCASH ITEMS 38. Fixed costs include: a. raw materials. b. manufacturing wages. c. management bonuses. D. office salaries. e. shipping and freight. SECTION: 2.2 TOPIC: FIXED COSTS 39. When you are making a financial decision, the most relevant tax rate is the rate. a. average b. fixed C. marginal d. total e. variable SECTION: 2.3 TOPIC: MARGINAL TAX RATE 2-13

14 40. The cash flow from assets is equal to: a. operating cash flow minus the change in net working capital plus net capital spending. b. cash flow to creditors minus the cash flow to shareholders. c. earnings before interest and taxes plus depreciation minus taxes. D. earnings before interest and taxes plus depreciation minus taxes minus net capital spending minus the change in net working capital. e. the cash flow to shareholders minus the cash flow to creditors. TOPIC: CASH FLOW FROM ASSETS 41. All else constant, an increase in will cause the cash flow from assets to increase. A. depreciation b. net capital spending c. net working capital d. taxes e. costs TOPIC: CASH FLOW FROM ASSETS 42. A negative cash flow from assets indicates that: a. a firm is borrowing money. b. a firm is acquiring new fixed assets. c. a firm has a net loss for the period. D. outside funding is being utilized. e. newly issued shares of stock are being sold. TOPIC: CASH FLOW FROM ASSETS 2-14

15 43. Which one of the following will decrease a firm's operating cash flow? a. a decrease in wages paid b. an increase in sales C. a decrease in the depreciation expense d. a decrease in the marginal tax rate e. a decrease in net working capital TOPIC: OPERATING CASH FLOW 44. A firm starts its year with positive net working capital. Assume that during the year, the firm acquires more short-term debt than it does short-term assets. This means: a. the ending net working capital must be negative. b. either accounts receivable or inventory had to decrease during the year. c. the beginning current assets were less than the beginning current liabilities. d. accounts payable had to decrease during the year. E. the ending net working capital might be positive, negative, or equal to zero. TOPIC: CHANGE IN NET WORKING CAPITAL 45. Net capital spending: a. is equal to ending fixed assets minus beginning fixed assets. B. is equal to zero if the decrease in the fixed assets account is equal to the depreciation expense. c. reflects the net changes in total assets over a stated period of time. d. is equivalent to the cash flow from assets minus the operating cash flow minus the change in net working capital. e. is equal to the change in the inventory balance for the period. TOPIC: NET CAPITAL SPENDING 2-15

16 46. Which one of the following must increase the cash flow to creditors? A. an increase in the cash flow from assets accompanied by a decrease in the cash flow to stockholders b. acquiring new long-term debt c. decreasing the dividend paid d. a decrease in both the cash flow to stockholders and the cash flow from assets e. the repayment of an old loan and the acquisition of a new loan TOPIC: CASH FLOW TO CREDITORS 47. Cash flow to stockholders must be positive when: A. dividends paid exceed the net new equity raised. b. the net sale of common stock exceeds the amount of dividends paid. c. no income is distributed but new shares of stock are sold. d. both the cash flow to assets and the cash flow to creditors are negative. e. both the cash flow to assets and the cash flow to creditors are positive. TOPIC: CASH FLOW TO STOCKHOLDERS 48. A firm has $680 in inventory, $2,320 in fixed assets, $280 in accounts receivables, $490 in accounts payable, and $130 in cash. What is the amount of the current assets? a. $410 b. $960 C. $1,090 d. $2,920 e. $3,410 Current assets = $680 + $280 + $130 = $1,090 TOPIC: CURRENT ASSETS 2-16

17 49. A firm has net working capital of $820. Long-term debt is $3,260, total assets are $5,920 and fixed assets are $3,410. What is the amount of the total liabilities? a. $2,440 b. $4,080 c. $4,130 d. $4,230 E. $4,950 Current assets = $5,920 $3,410 = $2,510; Current liabilities = $2,510 $820 = $1,690; Total liabilities = $1,690 + $3,260 = $4,950 TOPIC: TOTAL LIABILITIES 50. A firm has common stock of $5,500, paid-in surplus of $8,200, total liabilities of $6,600, current assets of $7,200, and fixed assets of $16,900. What is the amount of the shareholders' equity? a. $10,300 b. $13,700 c. $15,600 D. $17,500 e. $20,300 Shareholders' equity = $7,200 + $16,900 $6,600 = $17,500 (Note: The amount of retained earnings is not provided, so you must use total assets minus total liabilities to derive the correct answer.) TOPIC: SHAREHOLDERS' EQUITY 2-17

18 51. Your firm has total assets of $1,400, fixed assets of $600, long-term debt of $700, and short-term debt of $100. What is the amount of net working capital? a. $0 b. $100 c. $600 D. $700 e. $800 Net working capital = $1,400 $600 $100 = $700 TOPIC: NET WORKING CAPITAL 52. Knight Insurance has shareholders' equity of $136,900. The firm owes a total of $71,400 of which 30 percent is payable within the next year. The firm has net fixed assets of $152,800. What is the amount of the net working capital? a. $21,420 b. $25,300 C. $34,080 d. $46,720 e. $55,500 Current liabilities =.30 $71,400 = $21,420; Total assets = $71,400 + $136,900 = $208,300; Current assets = $208,300 $152,800 = $55,500; Net working capital = $55,500 $21,420 = $34,080 TOPIC: NET WORKING CAPITAL 2-18

19 53. Six years ago, Thompson Distributors purchased a mailing machine at a cost of $368,000. This equipment is currently valued at $172,200 on today's balance sheet but could actually be sold for $211,400. This is the only fixed asset the firm owns. Net working capital is $121,000 and long-term debt is $82,500. What is the book value of shareholders' equity? a. $89,700 B. $210,700 c. $211,400 d. $249,900 e. $406,500 Book value of shareholders' equity = $172,200 + $121,000 $82,500 = $210,700 TOPIC: BOOK VALUE 54. Peter owns The Train Store which he is trying to sell so that he can retire and travel. The Train Store owns the building in which it is located. This building was built at a cost of $427,000 and is currently appraised at $575,000. The display counters and fixtures originally cost $87,000 and are currently valued at $49,000. The inventory is valued on the balance sheet at $289,000 and has a retail market value equal to 1.4 times its cost. Peter expects the store to collect 97 percent of the $48,041 in accounts receivable. The firm has $11,200 in cash and has total debt of $167,400. What is the market value of this firm? a. $771,000 b. $907,800 C. $919,000 d. $945,800 e. $957,000 Market value of firm = $575,000 + $49, ($289,000) +.97($48,041) + $11,200 $167,400 = $919,000 TOPIC: MARKET VALUE 2-19

20 55. The Corner Store paid $1,100 in dividends and $850 in interest this past year. Common stock increased by $500 and retained earnings decreased by $260. What is the net income for the year? A. $840 b. $850 c. $860 d. $1,360 e. $1,0860 Net income = $1,100 + ( $260) = $840 SECTION: 2.2 TOPIC: NET INCOME 56. Amy's Dress Shoppe has sales of $421,000 with costs of $342,000. Interest expense is $18,000 and depreciation is $33,000. The tax rate is 34 percent. What is the net income? a. $9,520 b. $12,420 C. $18,480 d. $30,360 e. $52,140 Net income = ($421,000 $342,000 $18,000 $33,000) (1.34) = $18,480 SECTION: 2.2 TOPIC: NET INCOME 2-20

21 57. Given the tax rates as shown, what is the average tax rate for a firm with taxable income of $218,740? a percent b percent c percent D percent e percent Tax =.15($50,000) +.25($25,000) +.34($25,000) +.39($118,740) = $68,558.60; Average tax rate = $68, $218,740 = = percent SECTION: 2.3 TOPIC: MARGINAL TAX RATE 58. The tax rates are as shown. California Surfin' currently has taxable income of $86,750. How much additional tax will the firm owe if taxable income increases by $16,500? A. $5,773 b. $5,811 c. $6,120 d. $6,212 e. $6,435 Additional tax =.34($100,000 $86,750) +.39($86,750 + $16,500 $100,000) = $5, = $5,773 SECTION: 2.3 TOPIC: TAXES 2-21

22 59. The Burger Joint paid $420 in dividends and $611 in interest expense. The addition to retained earnings is $ and net new equity is $750. The tax rate is 34 percent. Sales are $6,250 and depreciation is $710. What are the earnings before interest and taxes? a. $1, b. $1, c. $1, d. $1, E. $1, Net income = $420 + $ = $817.74; Taxable income = $ (1.34) = $1,239; Earnings before interest and taxes = $1,239 + $611 = $1,850 TOPIC: EARNINGS BEFORE INTEREST AND TAXES 60. Toby's Pizza has total sales of $987,611 and costs of $724,268. Depreciation is $39,740 and the tax rate is 34 percent. The firm does not have any interest expense. What is the operating cash flow? a. $147, B. $187, c. $191, d. $213, e. $223, Earnings before interest and taxes = $987,611 $724,268 $39,740 = $223,603; Tax = $223, = $76,025.02; Operating cash flow = $223,603 + $39,740 $76, = $187, TOPIC: OPERATING CASH FLOW 2-22

23 61. The Picture Frame has beginning net fixed assets of $32,681 and ending net fixed assets of $33,127. During the year, assets with a combined book value of $932 were sold. Depreciation for the year was $5,364. What is the amount of net capital spending? a. $5,311 b. $5,406 C. $5,810 d. $6,289 e. $6,742 Net capital spending = $33,127 $32,681 + $5,364 = $5,810 TOPIC: NET CAPITAL SPENDING 62. At the beginning of the year, a firm has current assets of $91,807 and current liabilities of $102,343. At the end of the year, the current assets are $89,476 and the current liabilities are $92,638. What is the change in net working capital? a. $13,698 b. $8,407 c. $2,109 D. $7,374 e. $11,991 Change in net working capital = ($89,476 $92,638) ($91,807 $102,343) = $7,374 TOPIC: CHANGE IN NET WORKING CAPITAL 2-23

24 63. At the beginning of the year, long-term debt of a firm is $68,700 and total debt is $71,425. At the end of the year, long-term debt is $92,460 and total debt is $95,609. The interest paid is $5,412. What is the amount of the cash flow to creditors? A. $18,348 b. $12,936 c. $2,414 d. $23,760 e. $29,172 Cash flow to creditors = $5,412 ($92,460 $68,700) = $18,348 TOPIC: CASH FLOW TO CREDITORS 64. Morrison's Corner Bakery has beginning long-term debt of $23,509 and ending longterm debt of $19,847. The beginning and ending total debt balances are $26,847 and $24,613, respectively. The interest paid is $1,988. What is the amount of the cash flow to creditors? a. $1,674 b. $3,662 C. $5,650 d. $7,418 e. $7,629 Cash flow to creditors = $1,988 ($19,847 $23,509) = $5,650 TOPIC: CASH FLOW TO CREDITORS 2-24

25 65. Hi-Performance Motors has net income of $62,408. The firm pays out 55 percent of the net income to its shareholders as dividends. During the year, the company sold $125,000 worth of common stock. What is the cash flow to stockholders? a. $125, B. $90, c. $48, d. $22, e. $51, Cash flow to stockholders =.55($62,408) $125,000 = $90, TOPIC: CASH FLOW TO STOCKHOLDERS 66. The Row Boat Cafe has operating cash flow of $36,407. Depreciation is $4,609 and interest paid is $1,105. A net total of $3,780 was paid on long-term debt. The firm spent $18,000 on fixed assets and increased net working capital by $3,247. What is the amount of the cash flow to stockholders? A. $10,275 b. $12,933 c. $15,160 d. $19,998 e. $20,045 Cash flow from assets = $36,407 $3,247 $18,000 = $15,160; Cash flow to creditors = $1,105 ( $3,780) = $4,885; Cash flow to stockholders = $15,160 $4,885 = $10,275 TOPIC: CASH FLOW TO STOCKHOLDERS 2-25

26 67. What is the change in the net working capital from 2006 to 2007? a. $1,379 B. $553 c. $1,887 d. $2,280 e. $4,007 Change in net working capital = ($4,074 $1,794) ($3,795 $2,068) = $553 TOPIC: CHANGE IN NET WORKING CAPITAL 2-26

27 68. What is the amount of the noncash expenses for 2007? a. $210 b. $467 c. $1,333 D. $1,509 e. $1,719 The noncash expense is the depreciation in the amount of $1,509. TOPIC: NONCASH EXPENSES 69. What is the amount of the net capital spending for 2007? a. $780 B. $2,238 c. $2,918 d. $3,747 e. $3,841 Net capital spending = $6,342 $5,613 + $1,509 = $2,238 TOPIC: NET CAPITAL SPENDING 70. What is the operating cash flow for 2007? a. $1,847 B. $2,900 c. $3,308 d. $3,536 e. $4,172 Operating cash flow = $2,027 + $1,509 $636 = $2,900 TOPIC: OPERATING CASH FLOW 2-27

28 71. What is the cash flow from assets for 2007? A. $109 b. $247 c. $508 d. $967 e. $1,215 Cash flow from assets = $2,900 $553 $2,238 = $109 (See questions 67, 69, and 70.) TOPIC: CASH FLOW FROM ASSETS 72. What is the amount of net new borrowing for 2007? a. $540 B. $300 c. $0 d. $300 e. $540 Net new borrowing = $3,100 $3,400 = $300 TOPIC: NET NEW BORROWING 73. What is the cash flow to creditors for 2007? a. $353 b. $210 c. $300 D. $510 e. $647 Cash flow to creditors = $210 ( $300) = $510 (See question 72.) TOPIC: CASH FLOW TO CREDITORS 2-28

29 74. What is the amount of dividends paid in 2007? a. $0 b. $217 C. $349 d. $2,013 e. $2,357 Dividends paid = $1,181 ($2,272 $1,440) = $349 TOPIC: DIVIDENDS PAID 75. What is the cash flow to stockholders for 2007? a. $582 B. $401 c. $87 d. $1,099 e. $2,013 Cash flow to stockholders = $349 ($3,250 $2,500) = -$401 (See question 74.) TOPIC: CASH FLOW TO STOCKHOLDERS 2-29

30 76. What is the net working capital for 2007? a. $26 b. $225 c. $262 D. $434 e. $643 Net working capital = $63 + $172 + $408 $209 = $434 TOPIC: NET WORKING CAPITAL 2-30

31 77. What is the change in net working capital from 2006 to 2007? a. $65 B. $70 c. $135 d. $140 e. $275 Change in net working capital = ($63 + $172 + $408 $209) ($56 + $157 + $326 $175) = $70 TOPIC: CHANGE IN NET WORKING CAPITAL 78. What is the net capital spending for 2007? A. $260 b. $434 c. $580 d. $869 e. $1,022 Net capital spending = $641 $609 + $228 = $260 TOPIC: NET CAPITAL SPENDING 79. What is the operating cash flow for 2007? a. $226 b. $367 C. $541 d. $682 e. $823 Earnings before interest and taxes = $1,418 $736 $228 = $454; Taxable income = $454 $38 = $416; Taxes =.34($416) = $141 (Rounded); Operating cash flow = $454 + $228 $141 = $541 TOPIC: OPERATING CASH FLOW 2-31

32 80. What is the cash flow from assets for 2007? A. $211 b. $281 c. $293 d. $801 e. $871 Cash flow from assets = $541 $70 $260 = $211 (See problems 77 to 79) TOPIC: CASH FLOW FROM ASSETS 81. What is net new borrowing for 2007? a. $46 B. $39 c. $0 d. $39 e. $46 Net new borrowing = $417 $456 = $39 TOPIC: NET NEW BORROWING 2-32

33 82. What is the cash flow to creditors for 2007? a. $1 b. $5 c. $34 d. $56 E. $77 Cash flow to creditors = $38 ( $39) = $77 (See problem 81.) TOPIC: CASH FLOW TO CREDITORS 83. What is the cash flow to stockholders for 2007? a. $72 B. $134 c. $209 d. $288 e. $315 Cash flow to stockholders = $211 $77 = $134 (See problems 80 and 82) TOPIC: CASH FLOW TO STOCKHOLDERS 2-33

34 84. What is the taxable income for 2007? a. $209 b. $389 c. $554 D. $920 e. $1,019 Net income = $228 + $370 = $598; Taxable income = $598 (1.35) = $920 TOPIC: TAXABLE INCOME 85. What is the operating cash flow for 2007? A. $1,677 b. $1,741 c. $1,999 d. $2,212 e. $2,321 Earnings before interest and taxes = $920 + $187 = $1,107 (See problem 84); Operating cash flow = $1,107 + $892.35($920) = $1,677 (See problem 84) TOPIC: OPERATING CASH FLOW 86. What are the sales for 2007? a. $2,321 b. $3,419 c. $4,311 D. $5,418 e. $6,632 Sales = $1,107 + $892 + $3,419 = $5,418 (See problem 85) TOPIC: SALES 2-34

35 Essay Questions 87. What is a liquid asset and why is it necessary for a firm to maintain a reasonable level of liquid assets? Liquid assets are those that can be sold quickly with little or no loss in value. A firm that has sufficient liquidity will be less likely to experience financial distress. AACSB TOPIC: REFLECTIVE THINKING TOPIC: LIQUID ASSETS 88. Why is interest expense excluded from the operating cash flow calculation? Operating cash flow is the cash flow a firm generates from its day-to-day operating activities. Interest expense arises out of a financing choice and is part of the cash flow to creditors. AACSB TOPIC: REFLECTIVE THINKING TOPIC: OPERATING CASH FLOW 89. Explain the effects depreciation has on both the cash flows and the income statements of a firm. Depreciation reduces both the taxable and net income of a firm as reflected on the income statements. While depreciation itself is a noncash expense it does affect the cash flows indirectly by reducing the cash outflow for taxes. AACSB TOPIC: REFLECTIVE THINKING SECTION: 2.2 TOPIC: CASH FLOW AND ACCOUNTING STATEMENTS 2-35

36 90. Discuss the difference between book values and market values on the balance sheet and explain which is more important to the financial manager and why. The accounts on the balance sheet are generally carried at historical cost, not market values. Although the book value of the current assets and the liabilities may closely approximate market values, the same cannot be said for the rest of the balance sheet accounts. Market values are more relevant as they reflect today's value of an item whereas the balance sheet reflects historical costs as adjusted by accounting methods. In addition, the financial manager should focus on the firm's stock price, which is a market value measure. Hence, market values are more meaningful than book values for a variety of reasons. AACSB TOPIC: REFLECTIVE THINKING TOPIC: BOOK VALUE AND MARKET VALUE 91. Explain how a tax cut enacted by Congress will affect the cash flows of a firm. Assuming that a firm has taxable income and pays taxes, the operating cash flows will vary indirectly with a change in the tax rate. For example, assume the tax rate is lowered. This will lower the tax payment which is a cash outflow and will thereby increase the operating cash flow along with the cash flow from assets. This increase can then be passed to either, or both, cash flow to creditors and/or cash flow to stockholders. AACSB TOPIC: REFLECTIVE THINKING TOPIC: OPERATING CASH FLOW 2-36

37 92. Sometimes when businesses are critically delinquent on their tax liabilities, the tax authority comes in and literally seizes the business by chasing all of the employees out of the building and changing the locks. What does this tell you about the importance of taxes relative to our discussion of cash flow? Taxes must be paid in cash. If a firm is sufficiently delinquent in their tax payments, the firm can be confiscated by the taxing authority. Should such a confiscation occur, even if on a temporary basis, the reputation of the firm may be irreparably harmed. If the owners cannot raise sufficient capital to pay the tax amount due, the firm can be permanently shut down. Thus, firms need to maintain an ample cash flow such that all obligations are paid in a timely manner and events, such as a tax seizure, are avoided. AACSB TOPIC: REFLECTIVE THINKING TOPIC: TAX LIABILITIES AND CASH FLOW 93. Interpret in words, what cash flow from assets represents by discussing operating cash flow, changes in net working capital, and additions to fixed assets. Operating cash flow is the cash flow a firm generates from its day-to-day operations. In other words, it is the cash inflow generated as a result of putting the firm's assets to work. Changes in net working capital and fixed assets represent investments a firm makes in these assets. That is, a firm typically takes some of the cash flow it generates from using assets and reinvests it in new assets. Cash flow from assets, then, is the cash flow a firm generates by employing its assets, net of any fixed asset or net working capital acquisitions. AACSB TOPIC: REFLECTIVE THINKING TOPIC: CASH FLOW FROM ASSETS 2-37

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