# Solutions to Chapter 3. Accounting and Finance

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1 Solutions to Chapter 3 Accounting and Finance 1. Sophie s Sofas Liabilities & Assets Shareholders Equity Cash \$ 10,000 Accounts payable \$ 17,000 Accounts receivable 22,000 Long-term debt 170,000 Inventory 200,000 Shareholders equity 145,000 Store & property 100,000 Total assets \$332,000 Total liabilities & Shareholders equity \$332, The balance sheet shows the position of the firm at one point in time. It shows the amounts of assets and liabilities at that particular time. In this sense it is like a snapshot. The income statement shows the effect of business activities over the entire year. Since it captures events over an extended period, it is more like a video. The statement of cash flow is like the income statement in that it summarizes activity over the full year, so it too is like a video. 3. Accounting revenues and expenses can differ from cash flows because some items included in the computation of revenues and expenses do not entail immediate cash flows. For example, sales made on credit are considered revenue even though cash is not collected until the customer makes a payment. Also, depreciation expense reduces net income, but does not entail a cash outflow. Conversely, some cash flows are not included in revenues or expenses. For example, collection of accounts receivable results in a cash inflow but is not revenue. Purchases of inventory require cash outlays but are treated as investments in working capital, not as expenses. 4. 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. 3-1

2 5. a. Taxes = (0.10 \$8,500) (\$20,000 \$8,500) = \$2,575 Average tax rate = \$2,575/\$20,000 = = 12.88% Marginal tax rate = 15% b. Taxes = (0.10 \$8,500) (\$34,500 \$8,500) (\$50,000 \$34,500) = \$8,625 Average tax rate = \$8,625/\$50,000 = = 17.25% Marginal tax rate = 25% c. Taxes = (0.10 \$8,500) (\$34,500 \$8,500) (\$83,600 \$34,500) (\$174,400 \$83,600) (\$300,000 \$174,400) = \$83,897 Average tax rate = \$83,897/\$300,000 = = 27.97% Marginal tax rate = 33% d. Taxes = (0.10 \$8,500) (\$34,500 \$8,500) (\$83,600 \$34,500) (\$174,400 \$83,600) (\$379,150 \$174,400) (\$3,000,000 \$379,150) = \$1,027,314 Average tax rate = \$1,027,314/\$3,000,000 = = 34.24% Marginal tax rate = 35% 6. Taxes = (0.15 \$50,000) (\$75,000 \$50,000) (\$100,000 \$75,000) = \$22,250 Average tax rate = \$22,250/\$100,000 = = 22.25% Marginal tax rate = 34% 7. Taxes = (0.10 \$17,000) (\$69,000 \$17,000) (\$95,000 \$69,000) = \$16,000 Average tax rate = \$16,000/\$95,000 = = 16.84% Marginal tax rate = 25% 3-2

3 8. a. Cash will increase as one current asset (inventory) is exchanged for another (cash). b. 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 will use cash to buy back the shares from existing shareholders. Cash balance will decrease. 9. a. The fact that start-up firms typically have negative net cash flows for several years does not mean they are failing. Start-up firms invest in inventories and other assets designed to produce income in later periods. b. Accounting profits for start-up businesses are also commonly negative because these firms incur costs, such as advertising, that cannot be recorded on the balance sheet. These costs are general administrative expenses the firm incurs in each period, not investments like those in inventories that are built up for future sales. 10. a. In early 2010 investors saw the value of assets on the books of these banks as worth less than the value recorded, which may be historical value. Loans are the primary assets for banks, and investors perceived a high likelihood that the loans these banks made would default. If so, the banks would need to write down their values, reducing income available to shareholders. b. In contrast to the banks, investors perceived the assets of this company to be worth more than the historical value presented on the company s book. Consistent with the analysis in part (a), shareholders in this company are expecting to have higher income in future periods, and the value of the company s assets are expected to grow. 3-3

4 11. 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) a. January February March April Sales \$0 \$2,000 \$0 \$0 Cost of goods sold 0 \$1, Net income \$0 \$1,000 \$0 \$0 Inventories \$1,000 \$ 0 \$ 0 \$0 Accounts receivable 0 2,000 2,000 0 Accounts payable \$1,000 \$1, Net working capital 0 \$1,000 \$2,000 \$0 b., c. Cash flow \$0 \$0 \$1,000 \$2,000 Cash flow = net income change in net working capital Est time: Net income = increase in retained earnings + dividends \$900,000 = (\$3,700,000 \$3,400,000) + dividends dividends = \$600, Taxes on your salary = (0.10 \$8,500) (\$34,500 \$8,500) (\$70,000 \$34,500) = \$13,625 Taxes on corporate income = 0.15 \$30,000 = \$4,500 Total taxes = \$13,625 + \$4,500 = \$18,125 If you rearrange income so that your salary and the firm's profit are both \$50,000, then: Taxes on your salary = (0.10 \$8,500) (\$34,500 \$8,025) (\$50,000 \$34,500) = \$8,625 Taxes on corporate income = 0.15 \$50,000 = \$7,

5 Total taxes = \$8,625 + \$7,500 = \$16,125 Total taxes are reduced by \$18,125 \$16,125 = \$2, a. Book value equals the \$200,000 the founder of the firm has contributed in tangible assets. Market value equals the value of his patent plus the value of the production plant: \$50,000,000 + \$200,000 = \$50,200,000. b. Price per share = \$50.2 million/2 million shares = \$25.10 Book value per share = \$200,000/2 million shares = \$ Sales \$10,000 Cost of goods sold 6,500 General & administrative expenses 1,000 Depreciation expense 1,000 EBIT 1,500 Interest expense 500 Taxable income 1,000 Taxes (35%) 350 Net income \$ 650 Cash flow from operations = net income + depreciation expense = \$1, 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. 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. Look back to Table 3.4 and you will see that increases in accounts receivable reduce cash provided by operations. 3-5

6 17. The calculations are presented in the following table. Sales occur in quarters 2 and 3, so this is when the cost of goods sold is recognized. Therefore, net income is zero in quarters 1 and 4. In quarter 1, the production of the kits is treated as an investment in inventories. The level of inventories then falls as goods are sold in quarters 2 and 3. Accounts receivable in quarters 2 and 3 equal the sales in those quarters since it takes one quarter for receivables to be collected. Notice that cash flow in quarter 1 equals the cost of producing the kits and that in quarters 3 and 4 cash flow equals cash received for the kits previously sold. a. Quarter 1 Quarter 2 Quarter 3 Quarter 4 Sales \$0 \$550 \$600 \$ 0 Cost of goods sold Net income \$0 \$ 50 \$100 \$ 0 b., c. Inventories \$1,000 \$ 500 \$ 0 \$0 Accounts receivable Net working capital \$1,000 \$1,050 \$600 \$0 Cash flow \$1,000 \$0 \$550 \$600 Cash flow = net income change in net working capital Est time: Cash flow = profits accounts receivable 10,000 + accounts payable + 5,000 inventory ( 2,000) Cash flow = profits 10, ,000 ( 2,000) = profits 3,000 Therefore, cash flow is \$3,000 less than profits. This corresponds to the increase of \$3,000 in net working capital. 3-6

7 19. a. 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. Revenues \$??? Cost of goods sold 8,000 Administrative expenses 3,000 Depreciation expense 1,000 Interest expense 1,000 Taxable income \$10,000 [from part (a)] We conclude that revenues were \$23,000. c. Revenues \$23,000 Cost of goods sold 8,000 Administrative expenses 3,000 Depreciation expense 1,000 EBIT \$11, a. Sales \$14.00 million Cost of goods sold 8.00 Interest expense 1.00 Depreciation expense 2.00 Taxable income 3.00 Taxes (35%) 1.05 Net income \$ 1.95 million Cash flow = net income + depreciation expense = \$3.95 million b. If depreciation expense were increased by \$1 million, net income would be reduced by \$0.65 million. Cash flow (= net income + depreciation) would be increased by \$0.65 million + \$1 million = \$0.35 million. Cash flow increases because depreciation expense is not a cash outflow, but increasing the depreciation expense for tax purposes reduces taxes paid by \$0.35 million. 3-7

8 c. The impact on stock price is likely to be positive. Cash available to the firm would increase. The reduction in net income would be recognized as resulting entirely from accounting changes, not as a consequence of any changes in the underlying profitability of the firm. d. If interest expense were \$1 million higher, both net income and cash flow would decrease by \$0.65 million, i.e., by the \$1 million increase in expenses less the \$0.35 million reduction in taxes. This differs from part (b) because, in contrast to depreciation, interest expense represents an actual cash outlay. Est time: Candy Canes, Inc. April May June Sales \$ 0 \$150,000 \$ 0 Cost of goods sold 0 100,000 0 Accounts receivable 0 150, ,000 Inventory 100, ,000 0 Cash flow* 100, ,000 Net income** \$ 0 \$ 50,000 \$ 0 *Cash flow = sales COGS A/R inventory ** Net income = sales COGS 22. Assets Liabilities and Owners Equity Current assets Current liabilities Net fixed assets 1,200 1,420 Long-term debt Total assets 1,510 1,840 Total liabilities 1,040 1,160 Owners equity Total 1,510 1,840 a. Owners equity = total assets total liabilities (as shown in the balance sheet above) b. 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 \$

9 c. Since net fixed assets increased by \$220, and the firm purchased \$300 of new fixed assets, the depreciation charge must have been \$80. d. Net working capital increased by \$80, from (\$310 \$210) = \$100 in 2010 to (\$420 \$240) = \$180 in e. 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. Est time: a. Shareholders equity = total assets total liabilities 2010: Shareholders equity = \$890 \$650 = \$ : Shareholders equity = \$1,040 \$810 = \$230 b. Net working capital = current assets current liabilities 2010: Net working capital = \$90 \$50 = \$ : Net working capital = \$140 \$60 = \$80 c. Taxable income = \$1,950 \$1,030 \$350 \$240 = \$330 Taxes paid = 0.35 \$330 = \$ Net income = \$ d. Net income \$ Decrease (increase) in current assets (50.00) Increase in current liabilities Cash provided by operations \$ e. Gross investment = increase in net fixed assets + depreciation = \$100 + \$350 = \$450 f. Current liabilities increased by \$10. Therefore, current liabilities other than accounts payable must have increased by \$45. Est time:

10 24. Assets Liabilities and Shareholders Equity Cash & marketable securities \$ 800 \$ 300 Accounts payable \$ 300 \$ 350 Inventories Notes payable 1, Accounts receivable Long-term debt 2,000 2,400 Net fixed assets 5,000 5,800 Total liabilities 3,300 3,350 Total assets \$6,500 \$6,900 Shareholders equity 3,200 3,550 Total liabilities plus shareholders equity \$6,500 \$6, Net working capital (2010) = (\$800 + \$300 + \$400) (\$300 + \$1,000) = \$200 Net working capital (2011) = (\$300 + \$350 + \$450) (\$350 + \$600) = \$150 Net working capital decreased by \$ Revenue \$4,000 \$4,100 Cost of goods sold 1,600 1,700 Administrative expenses Depreciation expense Interest expense Taxable income 1,250 1,180 Federal & state income taxes Net income \$ 850 \$ 760 Increase in retained earnings in 2011 = net income dividends = \$760 \$410 = \$350 In 2011, shareholders equity increased by the amount of the increase in retained earnings. 27. Earnings per share in 2010 = \$850,000/500,000 shares = \$1.70 Earnings per share in 2011 = \$760,000/500,000 shares = \$

11 28. Average tax bracket in 2010 = taxes/taxable income = \$400/\$1,250 = = 32.0% Average tax bracket in 2011 = \$420/\$1180 = = 35.6% In order to determine the firm s marginal tax bracket, one would need information regarding tax rates applicable for both federal and state income taxes. 29. Net fixed assets increased by \$800,000 during 2011, while depreciation expense in 2011 was \$520,000. Therefore, gross investment in plant and equipment was \$1,320, Cash provided by operations Net income \$ 760 Noncash expenses Depreciation expense 520 Changes in working capital Decrease (increase) in accounts receivable (50) Decrease (increase) in inventories (50) Increase (decrease) in accounts payable 50 Total change in working capital (50) Cash provided by operations \$1,230 Cash flows from investments Cash provided by (used for) disposal of (1,320) (additions to) property, plant & equipment Cash provided by (used for) investments (1,320) Cash provided by (used for) financing activities Additions to (reductions in) notes payable (400) Additions to (reductions in) long-term debt 400 Dividends paid (410) Cash provided by (used for ) financing activities (410) Net increase (decrease) in cash and cash equivalents (\$500) 3-11

12 31. Market Value Balance Sheet, 2011 (figures in thousands of dollars) Liabilities & Shareholders Equity Assets Cash \$ 300 Accounts payable \$ 350 Inventories 350 Notes payable 600 Accounts receivable 450 Long-term debt 2,200 Employee skills 2,900 Total liabilities 3,350 Net fixed assets 6,000 Shareholders equity* 6,850 Total assets \$10,000 Total liabilities & shareholders equity \$10,000 * Shareholders' equity = total assets total liabilities Price per share = \$6,850,000/500,000 shares = \$

13 32. a. Income Taxes Due Average Tax Rate (%) 10,000 1, ,000 2, ,000 6, ,000 16, ,000 21, ,000 35, ,000 50, ,000 67, ,000 83, , , , , , , , , , , ,000, , ,000, , ,000,000 1,377, ,000,000 2,077, ,000,000 2,777, ,000,000 3,477,

14 b. As shown in the table and graph above, the difference between average tax rates and the top marginal tax rate of 35% becomes very small as income becomes large. c. For corporations the marginal tax rate is 35%. When analyzing very large firms we are content simply treating the corporate tax rate as 35% since average taxes are likely to be equal. Very large firms are unlikely to have incomes in the lower brackets. 33. To minimize taxes, you should not have income in one tax category (that is, personal versus corporate) if you can move the income into the other category at a lower tax rate. First, suppose that your total income is \$79,700. Then you could allocate \$50,000 to corporate income, the maximum amount that would be taxed at 15%, and \$29,700 to personal income, the maximum amount that would be taxed at 15%. Additional corporate income, up to an additional (\$75,000 \$50,000) = \$25,000, would be taxed at 25%, and additional individual income, up to an additional (\$83,600 \$29,700) = \$53,900, would also be taxed at 25%. Therefore, you are indifferent as to whether the remaining (\$100,000 \$79,700) = \$20,300 in income is allocated to corporate income or individual income or a combination of the two. Est time:

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