CHAPTER 3 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

This chapter has a lot of definitions. They are important, but we don't like to make students memorize too many of them early in the course. We let our students use a formula sheet that includes the key definitions. Also, note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in multiple-choice questions. Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.

Multiple Choice: True/False

(3-1) Annual report F K Answer: a EASY 1. The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and statement of stockholders' equity.

a. True b. False

(3-1) Annual report F K Answer: a EASY 2. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows.

a. True b. False

(3-1) Financial statements F K Answer: b EASY 3. Companies typically provide four basic financial statements: the fixed income statement, the current income statement, the balance sheet, and the cash flow statement.

a. True b. False

(3-2) Balance sheet F K M Answer: a EASY 4. On the balance sheet, total assets must always equal the sum of total liabilities plus equity.

a. True b. False

Chapter 3: Financial Statements True/False Page 33 (3-2) Balance sheet F K M Answer: a EASY 5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the amounts at which the assets are carried on the books.

a. True b. False

(3-2) Balance sheet C K M Answer: b EASY 6. The amount shown on the December 31, 2009 balance sheet as "retained earnings" is equal to the firm's net income for 2009 minus any dividends it paid.

a. True b. False

(3-3) Income statement C K M Answer: a EASY 7. The income statement shows the difference between a firm's income and its costs--i.e., its profits--during a specified period of time. However, not all reported income comes in the form of cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period.

a. True b. False

(3-3) Income statement C K M Answer: a EASY 8. If we were describing the income statement and the balance sheet, it would be correct to say that the income statement is more like a video while the balance sheet is more like a snapshot.

a. True b. False

(3-3) Income statement F K Answer: a EASY 9. EBIT stands for earnings before interest and taxes, and it is often called "operating income."

a. True b. False

(3-3) Income statement F K Answer: b EASY 10. EBITDA stands for earnings before interest, taxes, debt, and assets.

a. True b. False

Page 34 True/False Chapter 3: Financial Statements (3-5) Retained earnings C K M Answer: b EASY 11. Consider the following balance sheet, for Games Inc. Because Games has $800,000 of retained earnings, we know that the company would be able to pay cash to buy an asset with a cost of $200,000.

Cash $ 50,000 Accounts payable $ 100,000 Inventory 200,000 Accruals 100,000 Accounts receivable 250,000 Total CL $ 200,000 Total CA $ 500,000 Debt 200,000 Net fixed assets $ 900,000 Common stock 200,000 Retained earnings 800,000 Total assets $1,400,000 Total L & E $1,400,000

a. True b. False

(3-5) Stockholders' equity stmt. C K M Answer: a EASY 12 Typically, the statement of stockholders' equity starts with retained earnings at the beginning of the year, adds net income, subtracts dividends paid, and ends up with retained earnings at the end of the year. Over time, a profitable company will have earnings in excess of the dividends it pays out, and the series of annual retained earnings will result in a substantial amount of retained earnings as shown on the balance sheet.

a. True b. False

(3-6) Free cash flow F K Answer: a EASY 13. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations.

a. True b. False

(3-6) Free cash flow F K Answer: a EASY 14. The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows a business is able to provide to its investors is its free cash flow. This is the reason that FCF is so important in finance.

a. True b. False

(3-6) Free cash flow C K M Answer: b EASY 15. If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow.

a. True

Chapter 3: Financial Statements True/False Page 35 b. False

Page 36 True/False Chapter 3: Financial Statements (3-7) Income taxes F K Answer: b EASY 16. The fact that 70% of the interest income received by corporations is excluded from its taxable income encourages firms to finance with more debt than they would in the absence of this tax law provision.

a. True b. False

(3-7) Income taxes F K Answer: b EASY 17. Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm's taxes.

a. True b. False

(Comp.) Financial statements F K M Answer: b EASY 18. The balance sheet measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time.

a. True b. False

(3-2) Retained earnings C K M Answer: b MEDIUM 19. Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm either sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors.

a. True b. False

(3-2) Net working capital F K Answer: a MEDIUM 20. Net working capital is equal to current assets minus accounts payable and accruals.

a. True b. False

(3-3) Income statement F K M Answer: b MEDIUM 21. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called "the bottom line."

a. True b. False

Chapter 3: Financial Statements True/False Page 37 (3-4) Statement of cash flows F K Answer: a MEDIUM 22. The statement of cash flows has four main sections, one each for operating, investing, and financing activities, and one that shows a summary of the cash and cash equivalents at the end of the year.

a. True b. False

(3-4) Statement of cash flows C K M Answer: a MEDIUM 23. An increase in accounts payable represents an increase in net cash provided by operating activities just like borrowing money from a bank. An increase in accounts payable has an effect similar to taking out a new bank loan. However, these two items show up in different sections of the statement of cash flows.

a. True b. False

(3-4) Statement of cash flows C K M Answer: b MEDIUM 24. An increase in accounts receivable represents an increase in net cash provided by operating activities because receivables will produce cash when they are collected.

a. True b. False

(3-4) Statement of cash flows C K M Answer: b MEDIUM 25. The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section is "Net Income." Then, also in the first section, we show some items that represent increases or decreases to cash, and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt.

a. True b. False

(3-4) Statement of cash flows C K M Answer: a MEDIUM 26. To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue.

a. True b. False

(3-4) Cash flow and net income F K Answer: a MEDIUM 27. Two metrics that are used to measure a company's financial performance are net income and cash flow. Accountants emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on cash flows as they do on net income.

Page 38 True/False Chapter 3: Financial Statements a. True b. False

(3-5) Retained earnings F K Answer: b MEDIUM 28. Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. If the firm has sufficient retained earnings, it can purchase assets and pay for them with cash from retained earnings.

a. True b. False

(3-5) Retained earnings F K Answer: a MEDIUM 29. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the stockholders' claim against the firm's existing assets. Put another way retained earnings are stockholders' reinvested earnings.

a. True b. False

(3-6) Free cash flow F K Answer: a MEDIUM 30. In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and changes in net working capital.

a. True b. False

(3-6) Free cash flow F K Answer: b MEDIUM 31. Free cash flow is the amount of cash that if withdrawn would harm the firm's ability to operate and to produce future cash flows.

a. True b. False

(3-7) Income taxes C K M Answer: b MEDIUM 32. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant.

a. True b. False

(3-7) Income taxes C K M Answer: a MEDIUM 33. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations.

Chapter 3: Financial Statements True/False Page 39 a. True b. False

Page 40 True/False Chapter 3: Financial Statements (3-7) Income taxes F K Answer: b MEDIUM 34. Because the U.S. tax system is a progressive tax system, a taxpayer's marginal and average tax rates are the same.

a. True b. False

(3-7) Income taxes F K Answer: a MEDIUM 35. The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions.

a. True b. False

(Comp.) Financial statements F K Answer: a MEDIUM 36. The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects specific changes in accounts over that period of time.

a. True b. False

Multiple Choice: Conceptual

(3-1) Financial statements F K Answer: b EASY 37. Which of the following statements is CORRECT?

a. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders' equity. b. The balance sheet gives us a picture of the firm’s financial position at a point in time. c. The income statement gives us a picture of the firm’s financial position at a point in time. d. The statement of cash flows tells us how much cash the firm must pay out in interest during the year. e. The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year.

Chapter 3: Financial Statements Conceptual M/C Page 41 (3-1) Financial statements F K Answer: b EASY 38. Which of the following statements is CORRECT?

a. Assets other than cash are expected to produce cash over time, and the amounts of cash they eventually produce should be exactly the same as the amounts at which the assets are carried on the books. b. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows. c. The annual report is an internal document prepared by a firm's managers solely for the use of its creditors/lenders. d. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and statement of stockholders' equity. e. Prior to the Enron scandal in the early 2000s, companies would put verbal information in their annual reports, along with the financial statements. That verbal information was often misleading, so today annual reports can contain only quantitative information--audited financial statements.

(3-2) Balance sheet C K M Answer: e EASY 39. Which of the following statements is CORRECT?

a. The balance sheet for a given year, say 2008, is designed to give us an idea of what happened to the firm during that year. b. The balance sheet for a given year, say 2008, tells us how much money the company earned during that year. c. The difference between the total assets reported on the balance sheet and the liabilities reported on this statement tells us the current market value of the stockholders' equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP). d. If a company's statements were prepared in accordance with generally accepted accounting principles (GAAP), the market value of the stock equals the book value of the stock as reported on the balance sheet. e. The assets section of a typical industrial company’s balance sheet begins with cash, then lists the assets in the order in which they will probably be converted to cash, with the longest lived assets listed last.

(3-2) Balance sheet C K M Answer: c EASY 40. Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?

a. The company repurchases common stock. b. The company pays a dividend. c. The company issues new common stock. d. The company gives customers more time to pay their bills. e. The company purchases a new piece of equipment.

Page 42 Conceptual M/C Chapter 3: Financial Statements (3-2) Current assets C K M Answer: c EASY 41. Which of the following items is NOT normally considered to be a current asset?

a. Accounts receivable. b. Inventory. c. Bonds. d. Cash. e. Short-term, highly-liquid, marketable securities.

(3-2) Current liabilities C K M Answer: d EASY 42. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?

a. Accounts payable. b. Short-term notes payable to the bank. c. Accrued wages. d. Cost of goods sold. e. Accrued payroll taxes.

(3-3) Income statement C K M Answer: e EASY 43. Which of the following statements is CORRECT?

a. The focal point of the income statement is the cash account, because that account cannot be manipulated by “accounting tricks.” b. The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow generally accepted accounting principles (GAAP). c. The reported income of two otherwise identical firms must be identical if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC). d. If a firm follows generally accepted accounting principles (GAAP), then its reported net income will be identical to its reported cash flow. e. The income statement for a given year, say 2008, is designed to give us an idea of how much the firm earned during that year.

(3-7) Income taxes F K Answer: b EASY/MEDIUM 44. Which of the following statements is most correct?

a. Corporations are allowed to exclude 70% of their interest income from corporate taxes. b. Corporations are allowed to exclude 70% of their dividend income from corporate taxes. c. Individuals pay taxes on only 30% of the income realized from municipal bonds. d. Individuals are allowed to exclude 70% of their interest income from their taxes. e. Individuals are allowed to exclude 70% of their dividend income from their taxes.

Chapter 3: Financial Statements Conceptual M/C Page 43 (3-7) Carry-back, carry-forward F K Answer: b EASY/MEDIUM 45. A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row. b. Can be carried back 2 years, then carried forward up to 20 years following the loss. c. Can be carried back 5 years and forward 3 years. d. Cannot be used to reduce taxes in other years except with special permission from the IRS. e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.

(3-2) Balance sheet C K M Answer: c MEDIUM 46. Below are the 2007 and 2008 year-end balance sheets for Tran Enterprises:

Assets: 2008 2007 Cash $ 200,000 $ 170,000 Accounts receivable 864,000 700,000 Inventories 2,000,000 1,400,000 Total current assets $3,064,000 $2,270,000 Net fixed assets 6,000,000 5,600,000 Total assets $9,064,000 $7,870,000

Liabilities and equity: Accounts payable $1,400,000 $1,090,000 Notes payable 1,600,000 1,800,000 Total current liabilities $3,000,000 $2,890,000 Long-term debt 2,400,000 2,400,000 Common stock 3,000,000 2,000,000 Retained earnings 664,000 580,000 Total common equity $3,664,000 $2,580,000 Total liabilities and equity $9,064,000 $7,870,000

The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year, non-callable, long-term debt in 2007. As of the end of 2008, none of the principal on this debt had been repaid. Assume that the company’s sales in 2007 and 2008 were the same. Which of the following statements must be CORRECT?

a. The firm increased its short-term bank debt in 2008. b. The firm issued long-term debt in 2008. c. The firm issued new common stock in 2008. d. The firm repurchased some common stock in 2008. e. The firm had negative net income in 2008.

Page 44 Conceptual M/C Chapter 3: Financial Statements (3-2) Balance sheet C K M Answer: e MEDIUM 47. On its 12/31/08 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same amount was shown the following year. Assuming that no earnings restatements were issued, which of the following statements is CORRECT?

a. If the company lost money in 2008, it must have paid dividends. b. The company must have had zero net income in 2008. c. The company must have paid out half of its 2008 earnings as dividends. d. The company must have paid no dividends in 2008. e. Dividends could have been paid in 2008, but they would have had to equal the earnings for the year.

(3-2) Balance sheet C K M Answer: b MEDIUM 48. Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets:

2008 2007 Common stock $2,000 $1,000 Retained earnings 2,000 2,340 Total common equity $4,000 $3,340

The firm has never paid a dividend to its common stockholders. Which of the following statements is CORRECT?

a. The company’s net income in 2008 was higher than in 2007. b. The firm issued common stock in 2008. c. The market price of the firm's stock doubled in 2008. d. The firm had positive net income in both 2007 and 2008, but its net income in 2008 was lower than it was in 2007. e. The company has more equity than debt on its balance sheet.

(3-3) EPS, DPS, BVPS, & stk. price C K M Answer: c MEDIUM 49. Which of the following statements is CORRECT?

a. Typically, a firm’s DPS should exceed its EPS. b. Typically, a firm’s net income should exceed its EBIT. c. If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share. d. If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation. e. The more depreciation a firm has in a given year, the higher its EPS, other things held constant.

Chapter 3: Financial Statements Conceptual M/C Page 45 (3-3) Depreciation, EBIT, and CF C K M Answer: d MEDIUM 50. Which of the following statements is CORRECT?

a. The more depreciation a firm reports, the higher its tax bill, other things held constant. b. People sometimes talk about the firm’s cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line.” c. Depreciation reduces a firm’s cash balance, so an increase in depreciation would normally lead to a reduction in the firm’s cash flow. d. Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues less Operating costs. Operating costs do not include interest or taxes. e. Depreciation is not a cash charge, so it does not have an effect on a firm’s reported profits.

(3-4) Cash flow C K M Answer: a MEDIUM 51. Which of the following factors could explain why Michigan Energy's cash balance increased even though it had a negative cash flow last year?

a. The company sold a new issue of bonds. b. The company made a large investment in new plant and equipment. c. The company paid a large dividend. d. The company had high depreciation expenses. e. The company repurchased 20% of its common stock.

(3-4) Cash flow C K M Answer: b MEDIUM 52. Analysts who follow Howe Industries recently noted that, relative to the previous year, the company’s net cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?

a. The company cut its dividend. b. The company made large investments in fixed assets. c. The company sold a division and received cash in return. d. The company issued new common stock. e. The company issued new long-term debt.

(3-4) Cash flow and net income C K M Answer: d MEDIUM 53. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash provided from operations declined. Which of the following could explain this performance?

a. The company’s dividend payment to common stockholders declined. b. The company’s expenditures on fixed assets declined. c. The company’s cost of goods sold increased. d. The company’s depreciation expense declined. e. The company’s interest expense increased.

Page 46 Conceptual M/C Chapter 3: Financial Statements (3-4) Statement of cash flows F K Answer: e MEDIUM 54. Which of the following statements is CORRECT?

a. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. b. The statement of cash flows shows where the firm’s cash is located; indeed, it provides a listing of all banks and brokerage houses where cash is on deposit. c. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital. d. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect cash obtained by selling new common stock. e. The statement of cash flows shows how much the firm’s cash--the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)--increased or decreased during a given year.

(3-4) Statement of cash flows C K M Answer: c MEDIUM 55. Which of the following statements is CORRECT?

a. In the statement of cash flows, a decrease in accounts receivable is subtracted from net income in the operating activities section. b. Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a decrease in accounts payable is subtracted from net income in the operating activities section. d. In the statement of cash flows, depreciation is subtracted from net income in the operating activities section. e. In the statement of cash flows, a decrease in inventories is subtracted from net income in the operating activities section.

(3-6) Free cash flow F K Answer: c MEDIUM 56. Which of the following statements is CORRECT?

a. Most rapidly growing companies have positive free cash flows because cash flows from existing operations generally exceed fixed asset purchases and changes to net working capital. b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as follows:

FCF = EBIT(1 - T) + Depreciation - Capital expenditures required to sustain operations - Required changes in net working capital.

d. Free cash flow (FCF) is defined as follows:

FCF = EBIT(1 - T) + Capital expenditures.

e. Managers should be less concerned with free cash flow than with accounting net income. Accounting net income is the "bottom line"

Chapter 3: Financial Statements Conceptual M/C Page 47 and represents how much the firm can distribute to all its investors--both creditors and stockholders.

Page 48 Conceptual M/C Chapter 3: Financial Statements (3-7) Income taxes F K Answer: b MEDIUM 57. Which of the following statements is CORRECT?

a. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible. b. Interest paid to an individual is counted as income for federal tax purposes and taxed at the individual’s regular tax rate, which in 2008 could go up to 35%, but dividends received were taxed at a maximum rate of 15%. a. The maximum federal tax rate on corporate income in 2008 was 50%. d. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes. e. The maximum federal tax rate on personal income in 2008 was 50%.

(3-7) Income taxes F K Answer: c MEDIUM 58. Which of the following statements is CORRECT?

a. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses, even though they report high accounting profits. b. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code. c. Small corporations that qualify under the Tax Code can elect not to pay corporate taxes, but then each stockholder must report his or her pro rata shares of the firm’s income as personal income and pay taxes on that income. d. Congress recently changed the tax laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was first taxed on the corporation's income and stockholders were taxed again on this income when it was paid to them as dividends. e. All corporations other than non-profits are subject to corporate income taxes, which are 15% for the lowest amounts of income and 38% for the highest amounts.

Chapter 3: Financial Statements Conceptual M/C Page 49 (3-7) Tax concepts F K Answer: c MEDIUM 59. Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the amount of cash a company has available to pay out as dividends to shareholders. b. 70% of the interest received by corporations is excluded from taxable income. c. 70% of the dividends received by corporations is excluded from taxable income. d. Because taxes on long-term capital gains are not paid until the gain is realized, investors must pay the top individual tax rate on that gain. e. The corporate tax system favors equity financing, as dividends paid are deductible from corporate taxes.

(Comp.) Cash flow and FCF C K M Answer: c MEDIUM 60. Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation?

a. The company had a sharp increase in its inventories. b. The company had a sharp increase in its accrued liabilities. c. The company sold a new issue of common stock. d. The company made a large capital investment early in the year. e. The company had a sharp increase in depreciation expenses.

(Comp.) Changes in depreciation C K M Answer: d MEDIUM 61. Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes.

a. Companies’ after-tax operating profits would decline. b. Companies’ physical stocks of fixed assets would increase. c. Companies’ cash flows would increase. d. Companies’ cash positions would decline. e. Companies’ reported net incomes would decline.

(Comp.) Changes in depreciation C K M Answer: e MEDIUM 62. Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate. Prior to the new provision, BBI’s net income was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BBI’s financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.

a. The provision will reduce the company’s cash flow. b. The provision will increase the company’s tax payments.

Page 50 Conceptual M/C Chapter 3: Financial Statements c. The provision will increase the firm's operating income (EBIT). d. The provision will increase the company’s net income. e. Net fixed assets on the balance sheet will decrease.

(Comp.) Changes in depreciation C K M Answer: b MEDIUM 63. The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.

a. Nantell’s taxable income will be lower. b. Nantell’s operating income (EBIT) will increase. c. Nantell’s cash position will improve (increase). d. Nantell’s reported net income for the year will be lower. e. Nantell’s tax liability for the year will be lower.

(Comp.) Changes in depreciation C K M Answer: d MEDIUM 64. Assume that Besley Golf Equipment commenced operations on January 1, 2008, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December 2008 management realized that the assets would last for only 10 years. The firm's accountants plan to report the 2008 financial statements based on this new information. How would the new depreciation assumption affect the company’s financial statements?

a. The firm’s reported net fixed assets would increase. b. The firm’s EBIT would increase. c. The firm's reported 2008 earnings per share would increase. d. The firm's cash position in 2008 and 2009 would increase. e. The provision will increase the company's tax payments.

(Comp.) Changes in depreciation C K M Answer: c MEDIUM 65. A start-up firm is making an initial investment in new plant and equipment. Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change?

a. The firm’s operating income (EBIT) would increase. b. The firm’s taxable income would increase. c. The firm’s cash flow would increase. d. The firm’s tax payments would increase. e. The firm’s reported net income would increase.

Chapter 3: Financial Statements Conceptual M/C Page 51 (Comp.) Financial statements F K Answer: e MEDIUM 66. Which of the following statements is CORRECT?

a. Dividends paid reduce the net income that is reported on a company’s income statement. b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet. c. If a company issues new long-term bonds to purchase fixed assets during the current year, this will increase both its reported current assets and current liabilities at the end of the year. d. Accounts receivable are reported as a current liability on the balance sheet. e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year's balance.

(Comp.) Financial statements F K Answer: b MEDIUM 67. For managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial statements as prepared by accountants under generally accepted accounting principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm's operations. Related to these modifications, which of the following statements is CORRECT?

a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements. b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, the firm's value is based on its future cash flows. After all, future cash flows tells us how much the firm can distribute to its investors. c. The standard statements provide useful information on the firm’s individual operating units, but management needs more information on the firm’s overall operations than the standard statements provide. d. The standard statements focus on cash flows, but managers should be less concerned with cash flows than with accounting income as defined by GAAP. e. The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to “adjust” the results to make earnings look better.

Page 52 Conceptual M/C Chapter 3: Financial Statements (Comp.) Retained earnings F K Answer: b MEDIUM 68. Which of the following statements is CORRECT?

a. Since depreciation increases the firm's net cash provided by operating activities, the more depreciation a company has, the larger its retained earnings will be, other things held constant. b. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. c. Common equity includes common stock and retained earnings, less accumulated depreciation. d. The retained earnings account as reported on the balance sheet shows the amount of cash that is available for paying dividends. e. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative.

(Comp.) Changes in leverage C K M Answer: d MEDIUM/HARD 69. The CFO of Daves Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?

a. The company’s taxable income would fall. b. The company’s interest expense would remain constant. c. The company would have less common equity than before. d. The company’s net income would increase. e. The company would have to pay less taxes.

(3-4) Cash flow C K M Answer: d HARD 70. Last year Besset Company’s operations provided a negative cash flow, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company’s financial statements were prepared under generally accepted accounting principles (GAAP)?

a. The company repurchased some of its common stock. b. The company dramatically increased its capital expenditures. c. The company retired a large amount of its long-term debt. d. The company sold some of its fixed assets. e. The company had high depreciation expenses.

Chapter 3: Financial Statements Conceptual M/C Page 53 (Comp.) Financial statements F K Answer: d HARD 71. Which of the following statements is CORRECT?

a. Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm either sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors. b. Assets other than cash are expected to produce cash over time, and the amount of cash they eventually produce must be the same as the amounts at which the assets are carried on the books. c. The income statement shows the difference between a firm's income and its costs--i.e., its profits--during a specified period of time. However, all reported income comes in the form of cash, and reported costs likewise are consistent with cash outlays. Therefore, there will not be a substantial difference between a firm's reported profits and its actual cash flow for the same period. d. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows. e. EPS stands for earnings per share, while DPS stands for dividends per share. We would normally expect to see DPS exceed EPS.

(Comp.) Financial statements F K Answer: b HARD 72. Which of the following statements is CORRECT?

a. An increase in accounts receivable is added to net income in the operating activities section because if accounts receivable increase, then when they are collected cash will come into the firm. b. In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and net working capital. Free cash flow is the amount of cash that could be withdrawn without harming the firm's ability to operate and to produce future cash flows. c. The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section is "Net Income." Then, also in the first section, we show some items that add to or subtract from cash, and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt. d. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called "the bottom line." e. Most rapidly growing companies have positive free cash flows because cash flows from existing operations will exceed fixed assets and working capital needed to support the growth.

Page 54 Conceptual M/C Chapter 3: Financial Statements (Comp.) Financial statements F K Answer: a HARD 73. Which of the following statements is CORRECT?

a. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations. b. After-tax operating income is calculated as EBIT(1 - T) + Depreciation. c. Two firms with identical sales and operating costs but with different amounts of debt and tax rates will have different operating incomes by definition. d. If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow. e. Retained earnings as reported on the balance sheet represent cash and, therefore, are available to distribute to stockholders as dividends or any other required cash payments to creditors and suppliers.

(Comp.) Cash flow and taxes F K Answer: b HARD 74. Which of the following statements is CORRECT?

a. The current cash flow from existing assets is highly relevant to investors. However, since the value of the firm depends primarily upon its growth opportunities, accounting net income projections from those opportunities are the only relevant future flows with which investors are concerned. b. Two metrics that are used to measure a company's financial performance are net income and free cash flow. Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on free cash flows as they do on net income. c. To estimate the net cash provided by operations, depreciation must be subtracted from net income because it is a non-cash charge that has been added to revenue. d. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to discourage the use of debt financing by corporations. e. If Congress changed depreciation allowances so that companies had to report higher depreciation levels for tax purposes in 2009, this would lower their free cash flows for 2009.

Chapter 3: Financial Statements Conceptual M/C Page 55 Problems

A good bit of relatively simple arithmetic is involved in some of these problems, and although the calculations are simple, it will take students some time to set up the problem and do the arithmetic. We allow for this when assigning problems for a timed test. Also, students must use a number of definitions to answer some of the questions. To avoid excessive memorization, we provide students with a list of formulas and definitions for use on exams. Problems with * in the topic line are nonalgorithmic.

(3-2) Balance sheet C K M Answer: a EASY 75. Bauer Software's current balance sheet shows total common equity of $5,125,000. The company has 530,000 shares of stock outstanding, and they sell at a price of $27.50 per share. By how much do the firm's market and book values per share differ?

a. $17.83 b. $18.72 c. $19.66 d. $20.64 e. $21.67

(3-2) Balance sheet C K M Answer: b EASY 76. Brown Fashions Inc.'s December 31, 2008 balance sheet showed total common equity of $4,050,000 and 200,000 shares of stock outstanding. During 2008, the firm had $450,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/08, assuming no common stock was either issued or retired during 2008?

a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47

(3-2) Net working capital C K M Answer: b EASY 77. Prezas Company's balance sheet showed total current assets of $4,250, all of which were required in operations. Its current liabilities consisted of $975 of accounts payable, $600 of 6% short-term notes payable to the bank, and $250 of accrued wages and taxes. What was its net working capital?

a. $2,874 b. $3,025 c. $3,176 d. $3,335 e. $3,502

Page 56 Problems Chapter 3: Financial Statements (3-3) Income statement C K M Answer: e EASY 78. Rao Construction recently reported $20.50 million of sales, $12.60 million of operating costs other than depreciation, and $3-00 million of depreciation. It had $8.50 million of bonds outstanding that carry a 7.0% interest rate, and its federal-plus-state income tax rate was 40%. What was Rao's operating income, or EBIT, in millions?

a. $3.21 b. $3.57 c. $3.97 d. $4.41 e. $4.90

(3-3) Income statement C K M Answer: b EASY 79. Brown Office Supplies recently reported $15,500 of sales, $8,250 of operating costs other than depreciation, and $1,750 of depreciation. It had $9,000 of bonds outstanding that carry a 7.0% interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm's earnings before taxes (EBT)?

a. $4,627 b. $4,870 c. $5,114 d. $5,369 e. $5,638

(3-5) Free cash flow C K M Answer: d EASY 80. Vasudevan Inc. recently reported operating income of $2.75 million, depreciation of $1.20 million, and had a tax rate of 40%. The firm's expenditures on fixed assets and net working capital totaled $0.6 million. How much was its free cash flow, in millions?

a. $1.93 b. $2.03 c. $2.14 d. $2.25 e. $2.36

(3-3) Income statement C K M Answer: d EASY/MEDIUM 81. Emery Mining Inc. recently reported $150,000 of sales, $75,500 of operating costs other than depreciation, and $10,200 of depreciation. The company had $16,500 of outstanding bonds that carry a 7.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the firm's net income? The firm uses the same depreciation expense for tax and stockholder reporting purposes.

a. $35,167.33 b. $37,018.24 c. $38,966.57 d. $41,017.44 e. $43,068.31

Chapter 3: Financial Statements Problems Page 57 (3-5) Stmt. of stockholders' equity C K M Answer: c EASY/MEDIUM 82. On 12/31/08, Hite Industries reported retained earnings of $525,000 on its balance sheet, and it reported that it had $135,000 of net income during the year. On its previous balance sheet, at 12/31/07, the company had reported $445,000 of retained earnings. No shares were repurchased during 2008. How much in dividends did the firm pay during 2008?

a. $49,638 b. $52,250 c. $55,000 d. $57,750 e. $60,638

(3-5) Stmt. of stockholders' equity C K M Answer: a EASY/MEDIUM 83. During 2008, Bascom Bakery paid out $33,525 of common dividends. It ended the year with $197,500 of retained earnings versus the prior year’s retained earnings of $159,600. How much net income did the firm earn during the year?

a. $71,425 b. $74,996 c. $78,746 d. $82,683 e. $86,818

(3-7) Corporate taxes C K M Answer: b EASY/MEDIUM 84. Your corporation has the following cash flows:

Operating income $250,000 Interest received $10,000 Interest paid $45,000 Dividends received $20,000 Dividends paid $50,000

If the applicable income tax rate is 40% (federal and state combined), and if 70% of dividends received are exempt from taxes, what is the corporation's tax liability?

a. $83,980 b. $88,400 c. $92,820 d. $97,461 e. $102,334

(3-7) After-tax returns C K M Answer: b EASY/MEDIUM 85. Your corporation has a marginal tax rate of 35% and has purchased preferred stock in another company. The before-tax dividend yield on the preferred stock is 12%. What is the company's after-tax return on the preferred, assuming a 70% dividend exclusion?

a. 10.20% b. 10.74%

Page 58 Problems Chapter 3: Financial Statements c. 11.28% d. 11.84% e. 12.43%

(3-7) After-tax returns C K M Answer: b EASY/MEDIUM 86. Lovell Co. purchased preferred stock in another company. The preferred stock’s before-tax yield was 8.4%. The corporate tax rate is 40%. What is the after-tax return on the preferred stock, assuming a 70% dividend exclusion?

a. 7.02% b. 7.39% c. 7.76% d. 8.15% e. 8.56%

(3-7) After-tax returns C K M Answer: c EASY/MEDIUM 87. A company with a 15% tax rate buys preferred stock in another company. The preferred stock has a before-tax yield of 8%. What is the preferred stock’s after-tax return?

a. 6.90% b. 7.26% c. 7.64% d. 8.02% e. 8.42%

(3-7) After-tax returns C K M Answer: c EASY/MEDIUM 88. Van Dyke Corporation has a corporate tax rate equal to 30%. The company recently purchased preferred stock in another company. The preferred stock has an 8% before-tax yield. What is Van Dyke’s after-tax yield on the preferred stock?

a. 6.57% b. 6.92% c. 7.28% d. 7.64% e. 8.03%

(3-7) After-tax returns C K M Answer: d EASY/MEDIUM 89. Granville Co. recently purchased several shares of Kalvaria Electronics’ preferred stock. The preferred stock has a before-tax yield of 8.6%. If the company’s tax rate is 40%, what is Granville Co.’s after-tax yield on the preferred stock?

a. 6.49% b. 6.83% c. 7.19% d. 7.57% e. 7.95%

Chapter 3: Financial Statements Problems Page 59 (3-2) Net working capital C K M Answer: b MEDIUM 90. Wu Systems has the following balance sheet. How much net working capital does the firm have?

Cash $ 100 Accounts payable $ 200 Accounts receivable 650 Accruals 350 Inventory 550 Notes payable 350 Current assets $1,300 Current liabilities $ 900 Net fixed assets 1,000 Long-term debt 600 Common equity 300 Retained earnings 500 Total assets $2,300 Total liab. & equity $2,300

a. $675 b. $750 c. $825 d. $908 e. $998

(3-3) Income statement C K M Answer: b MEDIUM 91. Last year Almazan Software reported $10.50 million of sales, $6.25 million of operating costs other than depreciation, and $1.30 million of depreciation. The company had $5.00 million of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $0.70 million. By how much will net income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes.

a. -$0.432 b. -$0.455 c. -$0.478 d. -$0.502 e. -$0.527

(3-6) After-tax operating income C K M Answer: e MEDIUM 92. C. F. Lee Inc. has the following income statement. How much after-tax operating income does the firm have?

Sales $2,850.00 Costs 1,850.00 Depreciation 192.00 EBIT $ 808.00 Interest expense 285.00 EBT $ 523.00 Taxes (35%) 183.05 Net income $ 339.95

a. $427.78 b. $450.29 c. $473.99 d. $498.94

Page 60 Problems Chapter 3: Financial Statements e. $525.20

Chapter 3: Financial Statements Problems Page 61 (3-6) After-tax operating income C K M Answer: c MEDIUM 93. Kwok Enterprises has the following income statement. How much after- tax operating income does the firm have?

Sales $2,250 Costs 1,400 Depreciation 250 EBIT $ 600 Interest expense 70 EBT $ 530 Taxes (40%) 212 Net income $ 318

a. $325 b. $342 c. $360 d. $378 e. $397

(3-6) Free cash flow C K M Answer: b MEDIUM 94. Hartzell Inc. had the following data for 2007, in millions: Net income = $600; after-tax operating income [EBIT (1-T)] = $700; and Total assets = $2,000. Information for 2008 is as follows: Net income = $825; after-tax operating income [EBIT (1-T)] = $925; and Total assets = $2,500. How much free cash flow did the firm generate during 2008?

a. $383 b. $425 c. $468 d. $514 e. $566

(3-6) Free cash flow C K M Answer: e MEDIUM 95. Shrives Publishing recently reported $10,750 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. During the year, the firm had expenditures on fixed assets and net working capital that totaled $1,550. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. What was its free cash flow?

a. $1,873 b. $1,972 c. $2,076 d. $2,185 e. $2,300

Page 62 Problems Chapter 3: Financial Statements (3-6) Free cash flow C K M Answer: a MEDIUM 96. Houston Pumps recently reported $185,250 of sales, $140,500 of operating costs other than depreciation, and $9,250 of depreciation. The company had $35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to spend $15,250 to buy new fixed assets and to invest $6,850 in net working capital. What was the firm's free cash flow?

a. $10,225 b. $10,736 c. $11,273 d. $11,837 e. $12,429

(3-7) Carry-back, carry-forward C K M Answer: c MEDIUM 97. Appalachian Airlines began operating in 2004. The company lost money the first year but has been profitable ever since. The company’s taxable income (EBT) for its first five years is listed below. Each year the company’s corporate tax rate has been 40%.

Year Taxable Income 2004 -$4,000,000 2005 $1,000,000 2006 $2,000,000 2007 $3,000,000 2008 $5,000,000

Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions and that the current provisions were applicable in 2004. How much did the company pay in taxes in 2007?

a. $688,500 b. $765,000 c. $800,000 d. $930,000 e. $1,023,000

(3-7) Carry-back, carry-forward C K M Answer: c MEDIUM 98. Garner Grocers began operations in 2005. Garner has reported the following levels of taxable income (EBT) over the past several years. The corporate tax rate was 34% each year. Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisions were applicable in 2005. What is the amount of taxes the company paid in 2008?

Year Taxable Income 2005 -$3,200,000 2006 $200,000 2007 $500,000 2008 $2,800,00

Chapter 3: Financial Statements Problems Page 63 a. $92,055 b. $96,900 c. $102,000 d. $107,100 e. $112,455

(3-7) After-tax returns C K M Answer: d MEDIUM 99. A corporation recently purchased some preferred stock that has a before-tax yield of 7%. The company has a tax rate of 38%. What is the after-tax return on the preferred stock?

a. 5.32% b. 5.60% c. 5.89% d. 6.20% e. 6.51%

(3-7) After-tax returns C K M Answer: a MEDIUM 100. A corporate bond currently yields 8.5%. Municipal bonds with the same risk, maturity, and liquidity currently yield 5.5%. At what tax rate would investors be indifferent between the two bonds?

a. 35.29% b. 37.06% c. 38.91% d. 40.86% e. 42.90%

(3-7) After-tax returns C K M Answer: d MEDIUM 101. A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 27%. What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax return?

a. 5.64% b. 5.93% c. 6.25% d. 6.58% e. 6.90%

(3-7) After-tax returns C K M Answer: a MEDIUM 102. A bond issued by the State of Pennsylvania provides a 9% yield. What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 35% tax bracket?

a. 13.85% b. 14.54% c. 15.27% d. 16.03% e. 16.83%

Page 64 Problems Chapter 3: Financial Statements (3-7) After-tax returns C K M Answer: b MEDIUM 103. Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6%, and Carter’s marginal income tax rate is 40%, what yield on the Chicago municipal bonds would make Carter’s treasurer indifferent between the two?

a. 3.42% b. 3.60% c. 3.78% d. 3.97% e. 4.17%

(3-7) After-tax returns C K M Answer: a MEDIUM 104. A 5-year corporate bond yields 9%. A 5-year municipal bond of equal risk yields 6.5%. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds?

a. 27.78% b. 29.17% c. 30.63% d. 32.16% e. 33.76%

(3-7) After-tax returns* C K M Answer: b MEDIUM/HARD 105. Allen Corporation can (1) build a new plant that should generate a before-tax return of 11%, or (2) invest the same funds in the preferred stock of Florida Power & Light (FPL), which should provide Allen with a before-tax return of 9%, all in the form of dividends. Assume that Allen’s marginal tax rate is 25%, and that 70% of dividends received are excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximize Allen’s effective return on the money invested?

a. All in the plant project. b. All in FPL preferred stock. c. 60% in the project; 40% in FPL. d. 60% in FPL; 40% in the project. e. 50% in each.

Chapter 3: Financial Statements Problems Page 65 (3-7) After-tax returns C K M Answer: b MEDIUM/HARD 106. Solarcell Corporation has $20,000 that it plans to invest in marketable securities. It is choosing between AT&T bonds that yield 11%, State of Florida municipal bonds that yield 8%, and AT&T preferred stock with a dividend yield of 9%. Solarcell’s corporate tax rate is 40%, and 70% of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security.

a. 7.80% b. 8.00% c. 8.20% d. 8.41% e. 8.62%

(3-7) After-tax returns C K M Answer: c MEDIUM/HARD 107. A corporation can earn 7.5% if it invests in municipal bonds. The corporation can also earn 8.5% (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate that makes the corporation indifferent between the two investments?

a. 35.39% b. 37.25% c. 39.22% d. 41.18% e. 43.24%

(3-7) After-tax returns C K M Answer: c MEDIUM/HARD 108. Mantle Corporation is considering two equally risky investments:

 A $5,000 investment in preferred stock that yields 7%.  A $5,000 investment in a corporate bond that yields 10%.

What is the breakeven corporate tax rate that makes the company indifferent between the two investments?

a. 34.27% b. 36.08% c. 37.97% d. 39.87% e. 41.87%

Page 66 Problems Chapter 3: Financial Statements (3-7) After-tax returns C K M Answer: a MEDIUM/HARD 109. West Corporation has $50,000 that it plans to invest in marketable securities. The corporation is choosing between the following three equally risky securities: Alachua County tax-free municipal bonds yielding 8.5%; Exxon Mobil bonds yielding 10.5%; and GM preferred stock with a dividend yield of 9.25%. West’s corporate tax rate is 35%. What is the after-tax return on the best investment alternative? (Assume the company chooses on the basis of after-tax returns.)

a. 8.500% b. 8.925% c. 9.371% d. 9.840% e. 10.332%

(3-7) After-tax returns C K M Answer: e MEDIUM/HARD 110. Arvo Corporation is trying to choose between three alternative investments. The three securities that the company is considering are as follows:

 Tax-free municipal bonds with a return of 8.8%.  Wooli Corporation bonds with a return of 11.75%.  CFI Corp. preferred stock with a return of 9.8%.

The company’s tax rate is 25%. What is the after-tax return on the best investment alternative?

a. 7.383% b. 7.772% c. 8.181% d. 8.612% e. 9.065%

(3-7) Carry-back, carry-forward C K M Answer: d MEDIUM/HARD 111. Collins Co. began operations in 2005. The company lost money the first two years, but has been profitable ever since. The company’s taxable income (EBT) for its first four years is summarized below:

Year EBT 2005 -$3,000,000 2006 -$5,200,000 2007 $4,200,000 2008 $8,300,000

The corporate tax rate has remained at 34%. Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisions were applicable in 2005. What is Collins’ tax liability for 2008?

a. $1,069,848 b. $1,188,720 c. $1,320,800 d. $1,462,000

Chapter 3: Financial Statements Problems Page 67 e. $1,617,200

Page 68 Problems Chapter 3: Financial Statements (3-7) Carry-back, carry-forward C K M Answer: e MEDIUM/HARD 112. Salinger Software was founded in 2005. The company lost money each of its first three years, but was able to turn a profit in 2008. Salinger’s operating income (EBIT) for its first four years of operations is reported below.

Year EBIT 2005 -$50,000,000 2006 -$150,000,000 2007 -$100,000,000 2008 $700,000,000

The company has no debt, so operating income equals earnings before taxes. The corporate tax rate has remained constant at 35%. Assume that the company took full advantage of the carry-back, carry-forward provisions in the Tax Code, and assume that the current provisions were applicable in 2005. How much tax did the company pay in 2008?

a. $114,030,875 b. $120,032,500 c. $126,350,000 d. $133,000,000 e. $140,000,000

(3-7) Carry-back, carry-forward C K M Answer: a MEDIUM/HARD 113. Bradshaw Beverages began operations in 2004. The table below contains the company’s taxable income during each year of its operations. Notice that the company lost money in each of its first three years. The corporate tax rate has been 40% each year.

Year Taxable Income 2004 -$700,000 2005 -$500,000 2006 -$200,000 2007 $800,000 2008 $1,000,000

Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisions were applicable in 2004. How much did the company pay in taxes during 2008?

a. $160,000 b. $168,000 c. $176,400 d. $185,220 e. $194,481

Chapter 3: Financial Statements Problems Page 69 (3-7) Carry-back, carry-forward C K M Answer: d MEDIUM/HARD 114. Uniontown Books began operating in 2004. The company lost money its first three years of operations, but has had an operating profit during the past two years. The company’s operating income (EBIT) for its first five years was as follows:

Year EBIT 2004 -$3,600,000 2005 -$2,000,000 2006 -$1,000,000 2007 $1,200,000 2008 $7,000,000

The company has no debt, and therefore, pays no interest expense. Its corporate tax rate has remained at 34% during this 5-year period. What was Uniontown’s tax liability for 2008? (Assume that the company has taken full advantage of the carry-back and carry-forward provisions, and assume that the current provisions were applicable in 2004.)

a. $466,412 b. $490,960 c. $516,800 d. $544,000 e. $571,200

(3-7) Carry-back, carry-forward C K M Answer: a MEDIUM/HARD 115. Mays Industries was established in 2003. Since its inception, the company has generated the following levels of taxable income (EBT):

Year Taxable Income 2003 $50,000 2004 $40,000 2005 $30,000 2006 $20,000 2007 -$100,000 2008 $60,000

Assume that each year the company has faced a 40% income tax rate. Also, assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisions were applicable in 2003. What is the company’s tax liability for 2008?

a. $4,000 b. $4,200 c. $4,410 d. $4,631 e. $4,862

Page 70 Problems Chapter 3: Financial Statements (3-7) Net income C K M Answer: d MEDIUM/HARD 116. Moose Industries faces the following tax schedule:

Tax on Base Percentage on Taxable Income of Bracket Excess above Base Up to $50,000 $0 15% $50,000-$75,000 7,500 25 $75,000-$100,000 13,750 34 $100,000-$335,000 22,250 39 $335,000-$10,000,000 113,900 34 $10,000,000-$15,000,000 3,400,000 35 $15,000,000-$18,333,333 5,150,000 38 Over $18,333,333 6,416,667 35

Last year the company realized $10,000,000 in operating income (EBIT). Its annual interest expense is $1,500,000. What was the company’s net income for the year?

a. $4,809,874 b. $5,063,025 c. $5,329,500 d. $5,610,000 e. $5,890,500

(3-7) Corporate taxes C K M Answer: d MEDIUM/HARD 117. Corporations face the following tax schedule:

Tax on Base Percentage on Taxable Income of Bracket Excess above Base Up to $50,000 $0 15% $50,000-$75,000 7,500 25 $75,000-$100,000 13,750 34 $100,000-$335,000 22,250 39 $335,000-$10,000,000 113,900 34 $10,000,000-$15,000,000 3,400,000 35 $15,000,000-$18,333,333 5,150,000 38 Over $18,333,333 6,416,667 35

Company Z has $80,000 of taxable income from its operations, $5,000 of interest income, and $30,000 of dividend income from preferred stock it holds in other corporations. What is Company Z’s tax liability?

a. $17,328 b. $18,240 c. $19,200 d. $20,210 e. $21,221

Chapter 3: Financial Statements Problems Page 71 (3-7) Corporate taxes C K M Answer: b MEDIUM/HARD 118. Lintner Beverage Corp. reported the following information from their financial statements:

Operating income (EBIT) = $20,000,000 Interest payments on long-term debt = $1,750,000 Dividend income = $1,000,000

Calculate Lintner's total tax liability using the corporate tax schedule below:

Tax on Base Percentage on Taxable Income of Bracket Excess above Base $0-$50,000 $0 15% $50,000-$75,000 7,500 25 $75,000-$100,000 13,750 34 $100,000-$335,000 22,250 39 $335,000-$10,000,000 113,900 34 $10,000,000-$15,000,000 3,400,000 35 $15,000,000-$18,333,333 5,150,000 38 Over $18,333,333 6,416,667 35

a. $6,167,875 b. $6,492,500 c. $6,817,125 d. $7,157,982 e. $7,515,881

(3-7) Corporate taxes C K M Answer: c MEDIUM/HARD 119. Last year, Martyn Company had $500,000 in taxable income from its operations, $50,000 in interest income, and $100,000 in dividend income. Using the corporate tax rate table given below, what was the company’s tax liability for the year?

Tax on Base Percentage on Taxable Income of Bracket Excess above Base $0-$50,000 $0 15% $50,000-$75,000 7,500 25 $75,000-$100,000 13,750 34 $100,000-$335,000 22,250 39 $335,000-$10,000,000 113,900 34 $10,000,000-$15,000,000 3,400,000 35 $15,000,000-$18,333,333 5,150,000 38 Over $18,333,333 6,416,667 35

a. $177,973 b. $187,340 c. $197,200 d. $207,060 e. $217,413

Page 72 Problems Chapter 3: Financial Statements (3-7) Corporate taxes C K M Answer: d MEDIUM/HARD 120. Griffey Communications recently realized $125,000 in operating income. The company had interest income of $25,000 and realized $70,000 in dividend income. The company’s interest expense was $40,000.

Tax on Base Percentage on Taxable Income of Bracket Excess above Base Up to $50,000 $0 15% $50,000-$75,000 7,500 25 $75,000-$100,000 13,750 34 $100,000-$335,000 22,250 39 $335,000-$10,000,000 113,900 34 $10,000,000-$15,000,000 3,400,000 35 $15,000,000-$18,333,333 5,150,000 38 Over $18,333,333 6,416,667 35

Using the corporate tax schedule above, what is Griffey’s tax liability?

a. $29,442 b. $30,992 c. $32,623 d. $34,340 e. $36,057

(3-6) Net income vs. FCF C K M Answer: e HARD 121. Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During last year, the firm had expenditures on fixed assets and net working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause (1) the firm's net income and (2) its free cash flow to change? Note that the company uses the same depreciation for tax and stockholder reporting purposes.

a. -$383.84; $206.68 b. -$404.04; $217.56 c. -$425.30; $229.01 d. -$447.69; $241.06 e. -$471.25; $253.75

Chapter 3: Financial Statements Problems Page 73 (3-6) Net income vs. FCF C K M Answer: c HARD 122. Watson Oil recently reported (in millions) $8,250 of sales, $5,750 of operating costs other than depreciation, and $650 of depreciation. The company had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net working capital. By how much did the firm's net income exceed its free cash flow?

a. $718 b. $756 c. $796 d. $836 e. $878

Page 74 Problems Chapter 3: Financial Statements CHAPTER 3 ANSWERS AND SOLUTIONS

Chapter 3: Financial Statements Answers Page 75 1. (3-1) Annual report F K Answer: a EASY

2. (3-1) Annual report F K Answer: a EASY

3. (3-1) Financial statements F K Answer: b EASY

4. (3-2) Balance sheet F K M Answer: a EASY

5. (3-2) Balance sheet F K M Answer: a EASY

6. (3-2) Balance sheet C K M Answer: b EASY

7. (3-3) Income statement C K M Answer: a EASY

8. (3-3) Income statement C K M Answer: a EASY

9. (3-3) Income statement F K Answer: a EASY

10. (3-3) Income statement F K Answer: b EASY

11. (3-5) Retained earnings C K M Answer: b EASY

Note that the firm has only $50,000 of cash. It would have to either sell assets or borrow $150,000 to pay cash for the new asset. That might not be possible.

12. (3-5) Stockholders' equity stmt. C K M Answer: a EASY

13. (3-6) Free cash flow F K Answer: a EASY

14. (3-6) Free cash flow F K Answer: a EASY

15. (3-6) Free cash flow C K M Answer: b EASY

There is no reason to think that net income would be equal to FCF. For example, a company that is not growing might report zero net income yet have high FCF because of depreciation.

16. (3-7) Income taxes F K Answer: b EASY

17. (3-7) Income taxes F K Answer: b EASY

18. (Comp.) Financial statements F K M Answer: b EASY

19. (3-2) Retained earnings C K M Answer: b MEDIUM

One firm might choose to use straight-line depreciation, the other an accelerated method, and this would lead to differences in reported depreciation and therefore reported net fixed assets.

20. (3-2) Net working capital F K Answer: a MEDIUM

21. (3-3) Income statement F K M Answer: b MEDIUM

22. (3-4) Statement of cash flows F K Answer: a MEDIUM

23. (3-4) Statement of cash flows C K M Answer: a MEDIUM

24. (3-4) Statement of cash flows C K M Answer: b MEDIUM

25. (3-4) Statement of cash flows C K M Answer: b MEDIUM

Rapidly growing firms often require additions to inventory and receivables that are larger than net income, with the deficit being made up by borrowings and/or the sale of new stock.

26. (3-4) Statement of cash flows C K M Answer: a MEDIUM 27. (3-4) Cash flow and net income F K Answer: a MEDIUM

28. (3-5) Retained earnings F K Answer: b MEDIUM

29. (3-5) Retained earnings F K Answer: a MEDIUM

30. (3-6) Free cash flow F K Answer: a MEDIUM

31. (3-6) Free cash flow F K Answer: b MEDIUM

32. (3-7) Income taxes C K M Answer: b MEDIUM

33. (3-7) Income taxes C K M Answer: a MEDIUM

34. (3-7) Income taxes F K Answer: b MEDIUM

35. (3-7) Income taxes F K Answer: a MEDIUM

36. (Comp.) Financial statements F K Answer: a MEDIUM

37. (3-1) Financial statements F K Answer: b EASY

38. (3-1) Financial statements F K Answer: b EASY

39. (3-2) Balance sheet C K M Answer: e EASY

40. (3-2) Balance sheet C K M Answer: c EASY

41. (3-2) Current assets C K M Answer: c EASY

42. (3-2) Current liabilities C K M Answer: d EASY

43. (3-3) Income statement C K M Answer: e EASY

44. (3-7) Income taxes F K Answer: b EASY/MEDIUM

Statement a is false, corporations cannot exclude interest income from corporate taxes. Statement b is true, because the 70% exclusion rule gets around the issue of triple taxation. Statements c, d, and e are false, because individuals pay no taxes on municipal bond income and individuals cannot exclude 70% of their income from either interest or dividends.

45. (3-7) Carry-back, carry-forward F K Answer: b EASY/MEDIUM

46. (3-2) Balance sheet C K M Answer: c MEDIUM

47. (3-2) Balance sheet C K M Answer: e MEDIUM

48. (3-2) Balance sheet C K M Answer: b MEDIUM

49. (3-3) EPS, DPS, BVPS, & stk. price C K M Answer: c MEDIUM

50. (3-3) Depreciation, EBIT, and CF C K M Answer: d MEDIUM

51. (3-4) Cash flow C K M Answer: a MEDIUM

52. (3-4) Cash flow C K M Answer: b MEDIUM

53. (3-4) Cash flow and net income C K M Answer: d MEDIUM

54. (3-4) Statement of cash flows F K Answer: e MEDIUM

55. (3-4) Statement of cash flows C K M Answer: c MEDIUM

56. (3-6) Free cash flow F K Answer: c MEDIUM 57. (3-7) Income taxes F K Answer: b MEDIUM

58. (3-7) Income taxes F K Answer: c MEDIUM

59. (3-7) Tax concepts F K Answer: c MEDIUM

Statement a is false, because retained earnings represent the cumulative accrued value to shareholders that a firm has amassed. Statement b is false, because interest income does not benefit from tax exclusion. Statement c is true, because dividend income does benefit from tax exclusion. Statement d is false, because long-term capital gains are taxed at the L-T capital gains rate, which depends upon the investor’s taxable income but is usually significantly lower than personal tax rates. Statement e is false, because the tax deductibility of interest paid shows the tax system favors debt financing.

60. (Comp.) Cash flow and FCF C K M Answer: c MEDIUM

61. (Comp.) Changes in depreciation C K M Answer: d MEDIUM

62. (Comp.) Changes in depreciation C K M Answer: e MEDIUM

63. (Comp.) Changes in depreciation C K M Answer: b MEDIUM

64. (Comp.) Changes in depreciation C K M Answer: d MEDIUM

65. (Comp.) Changes in depreciation C K M Answer: c MEDIUM

66. (Comp.) Financial statements F K Answer: e MEDIUM

67. (Comp.) Financial statements F K Answer: b MEDIUM

68. (Comp.) Retained earnings F K Answer: b MEDIUM

69. (Comp.) Changes in leverage C K M Answer: d MEDIUM/HARD

70. (3-4) Cash flow C K M Answer: d HARD

71. (Comp.) Financial statements F K Answer: d HARD

72. (Comp.) Financial statements F K Answer: b HARD

73. (Comp.) Financial statements F K Answer: a HARD

74. (Comp.) Cash flow and taxes F K Answer: b HARD

75. (3-2) Balance sheet C K M Answer: a EASY

Shares outstanding 530,000 Price per share $27.50 Total book common equity $5,125,000 Book value per share = Total book equity/Number of shares $9.67 Difference between book and market values $17.83

76. (3-2) Balance sheet C K M Answer: b EASY

12/31/08 common equity $4,050,000 2008 net income $450,000 2008 dividends $100,000 2008 addition to retained earnings $350,000 12/31/08 common equity $4,400,000 Shares outstanding 200,000 12/31/08 BVPS $22.00

77. (3-2) Net working capital C K M Answer: b EASY

Current assets $4,250 Accounts payable 975 Accrued wages and taxes 250 Net working capital $3,025

Note that NWC represents current assets less accounts payable and accruals.

78. (3-3) Income statement C K M Answer: e EASY

Sales $20.50 Operating costs excluding depreciation $12.60 Depreciation 3.00 Operating income (EBIT) $ 4.90

Note that operating income is before interest and taxes.

79. (3-3) Income statement C K M Answer: b EASY

Bonds $9,000.00 Interest rate 7.00% Sales $15,500.00 Operating costs excluding depreciation 8,250.00 Depreciation 1,750.00 Operating income (EBIT) $ 5,500.00 Interest charges -630.00 EBT = Taxable income $ 4,870

80. (3-5) Free cash flow C K M Answer: d EASY

FCF = EBIT(1 – T) + Deprec. – (Capex + NWC)

EBIT $2.75 Tax rate 40% Depreciation $1.20 Capex + NW $0.60 FCF = $2.25

81. (3-3) Income statement C K M Answer: d EASY/MEDIUM

Bonds $16,500 Interest rate 7.25% Tax rate 35% Sales $150,000 Operating costs excluding depreciation 75,500 Depreciation 10,200 Operating income (EBIT) $64,300.00 Interest charges -1,196.25 Taxable income $63,103.75 Taxes -22,086.31 Net income $41,017.44

82. (3-5) Stmt. of stockholders' equity C K M Answer: c EASY/MEDIUM

12/31/08 RE $525,000 12/31/07 RE 445,000 Change in RE $ 80,000 Net income for 2008 $135,000 Dividends = Net income − Change $ 55,000

83. (3-5) Stmt. of stockholders' equity C K M Answer: a EASY/MEDIUM

Net income = The change in retained earnings plus the dividends paid: Current RE $197,500 Previous RE = Current RE – increment 159,600 Change in RE $ 37,900 Plus dividends paid 33,525 = Net income $ 71,425

84. (3-7) Corporate taxes C K M Answer: b EASY/MEDIUM

Operating income $250,000 Interest received $10,000 Interest paid $45,000 Dividends received $20,000 Dividend exclusion % 70% Dividends paid $50,000 Tax rate (T) 40%

Taxable income = Oper. income + Interest received – Interest paid + Taxable dividends received Taxable income = Oper. income + Interest received – Interest paid + Div. received(1 – Div. exclusion %) Taxable income = $221,000

Taxes paid = Taxable income × Tax rate Taxes paid = $88,400

85. (3-7) After-tax returns C K M Answer: b EASY/MEDIUM

Preferred dividend rate 12.00% Tax rate 35% Dividend exclusion % 70%

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 10.74%

86. (3-7) After-tax returns C K M Answer: b EASY/MEDIUM

Preferred dividend rate 8.40% Tax rate 40% Dividend exclusion % 70%

If a company buys preferred stock in another company, 70% of the dividends are excluded from taxes. Therefore, the after-tax return will be:

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 7.39%

87. (3-7) After-tax returns C K M Answer: c EASY/MEDIUM

Preferred dividend rate 8.00% Tax rate 15% Dividend exclusion % 70%

If a company buys preferred stock in another company, 70% of the dividends are excluded from taxes. Therefore, the after-tax return will be:

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 7.64% 88. (3-7) After-tax returns C K M Answer: c EASY/MEDIUM

Preferred dividend rate 8.00% Tax rate 30% Dividend exclusion % 70%

If a company buys preferred stock in another company, 70% of the dividends are excluded from taxes. Therefore, the after-tax return will be:

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 7.28%

89. (3-7) After-tax returns C K M Answer: d EASY/MEDIUM

Preferred dividend rate 8.60% Tax rate 40% Dividend exclusion % 70%

If a company buys preferred stock in another company, 70% of the dividends are excluded from taxes. Therefore, the after-tax return will be:

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 7.57%

90. (3-2) Net working capital C K M Answer: b MEDIUM

Cash $ 100 Accounts payable $ 200 Accounts receivable 650 Accruals 350 Inventory 550 Notes payable 350 Current assets $1,300 Current liabilities $ 900 Net fixed assets 1,000 Long-term debt 600 Common equity 300 Retained earnings 500 Total assets $2,300 Total liab. & equity $2,300

Net working capital = Current assets − AP − Accruals NWC = $1,300.00 − $550.00 NWC = $750

91. (3-3) Income statement C K M Answer: b MEDIUM

This problem can be worked very easily--just multiply the increase in depreciation by (1 – T) to get the decrease in net income: Change in depreciation $0.700 Tax rate 0.350 Reduction in net income $0.455

We can also get the answer a longer way, which explains things more clearly:

Old New Change Bonds $5.000 $5.000 $0.000 Interest rate 0.065 0.065 0.000 Tax rate 0.350 0.350 0.000 Sales $10.500 $10.500 $0.000 Operating costs excluding depreciation $6.250 $6.250 $0.000 Depreciation $1.300 $2.000 $0.700 Operating income (EBIT) $2.950 $2.250 -$0.700 Interest charges $0.325 $0.325 $0.000 Taxable income $2.625 $1.925 -$0.700 Taxes $0.919 $0.674 -$0.245 Net income $1.706 $1.251 -$0.455

92. (3-6) After-tax operating income C K M Answer: e MEDIUM

Sales $2,850.00 Costs 1,850.00 Depreciation 192.00 EBIT $ 808.00 Interest expense 285.00 EBT $ 523.00 Taxes: rate = 35% 183.05 Net income $ 339.95

EBIT $808.00 Tax rate 35% EBIT(1 − T) = $525.20

93. (3-6) After-tax operating income C K M Answer: c MEDIUM

Sales $2,250 Costs 1,400 Depreciation 250 EBIT $ 600 Interest expense 70 EBT $ 530 Taxes: rate = 40% 212 Net income $ 318

EBIT $600.00 Tax rate 40% EBIT(1 − T) = $360

94. (3-6) Free cash flow C K M Answer: b MEDIUM

EBIT(1 − T) 2,007 2,008 Change = Net invest. in FA + NWC Total assets $2,000 $2,500 $500

2008 FCF = EBIT(1 − T) − Net investment in FA + NWC 2008 FCF = $925 − $500 2008 FCF = $425

95. (3-6) Free cash flow C K M Answer: e MEDIUM

Bonds $3,500.00 Interest rate 6.25% Tax rate 35.00%

Sales $10,750.00 Operating costs excluding depreciation 5,500.00 Depreciation 1,250.00 Operating income (EBIT) $ 4,000.00

Δ Capex + NWC = $1,550.00 Tax rate = 35%

FCF = EBIT(1 – T) + Deprec. – (Δ Capex + Δ NWC) FCF = $2,600 + $1,250 – $1,550 Free cash flow = $2,300

96. (3-6) Free cash flow C K M Answer: a MEDIUM

Tax rate 35% Required addition to net working capital $6,850 Required capital expenditures (fixed assets) $15,250

Sales $185,250 Operating costs excluding depreciation 140,500 Depreciation 9,250 Operating income (EBIT) $ 35,500

FCF = EBIT(1 − T) + Deprec. – CapEx – Δ Net WC FCF = $23,075.00 + $9,250 – $15,250 – $6,850 FCF = $10,225

97. (3-7) Carry-back, carry-forward C K M Answer: c MEDIUM

Tax rate 40% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2004 -$4,000,000 $0 $0 $4,000,000 2005 $1,000,000 $1,000,000 $0 $3,000,000 2006 $2,000,000 $2,000,000 $0 $1,000,000 2007 $3,000,000 $1,000,000 $2,000,000 $0 2008 $5,000,000 $0 $5,000,000 $0

2007 Tax liability = EBT × Tax rate 2007 Tax liability = $800,000

98. (3-7) Carry-back, carry-forward C K M Answer: c MEDIUM

Tax rate 34% EBT After Unused Carry-Forward Forward Carryable Year Income Used Applied Amount 2005 -$3,200,000 $0 $0 $3,200,000 2006 $200,000 $200,000 $0 $3,000,000 2007 $500,000 $500,000 $0 $2,500,000 2008 $2,800,000 $2,500,000 $300,000 $0 2008 Tax liability = EBT × Tax rate 2008 Tax liability = $102,000

99. (3-7) After-tax returns C K M Answer: d MEDIUM

Preferred dividend rate 7.00% Tax rate 38% Dividend exclusion % 70%

After-tax dividend yield = Preferred dividend rate[1 – (1 – Div. exclusion %)(T)] After-tax dividend yield = 6.20%

100. (3-7) After-tax returns C K M Answer: a MEDIUM

Bond yield 8.50% Municipal bond yield 5.50%

Municipal yield = After-tax bond yield 5.50% = 8.50% × (1 – T) 0.6471 = (1 – T) T = 35.29%

101. (3-7) After-tax returns C K M Answer: d MEDIUM

Municipal bond yield 4.80% Tax rate 27.00%

Municipal yield = After-tax bond yield 4.80% = BT yield × (1 – T) 4.80% = BT yield × 73.00% BT yield = 6.58%

102. (3-7) After-tax returns C K M Answer: a MEDIUM

Municipal bond yield 9.00% Tax rate 35.00%

Municipal yield = After-tax bond yield 9.00% = BT yield × (1 – T) 9.00% = BT yield × 65.00% BT yield = 13.85%

103. (3-7) After-tax returns C K M Answer: b MEDIUM

Treasury bond yield 6.00% Tax rate 40.00%

Remember that municipal bonds are tax exempt, so their BT yield = AT yield.

Municipal yield = AT bond yield Municipal yield = BT bond yield × (1 – T) Municipal yield = 3.60%

104. (3-7) After-tax returns C K M Answer: a MEDIUM

BT Bond yield 9.00% Municipal bond yield 6.50% Remember that municipal bonds are tax exempt, so their BT yield = AT yield.

Municipal yield = After-tax bond yield 6.50% = 9.00% × (1 – T) 0.7222 = (1 – T) T = 27.78%

105. (3-7) After-tax returns* C K M Answer: b MEDIUM/HARD

BT project return 11.00% BT preferred return 9.00% Tax rate 25.00% Dividend exclusion % 70.00%

After-tax return on project = BT project return × (1 – T) After-tax return on project = 8.25%

After-tax return on pref. = BT pref. return[1 – (1 – Div. exclusion %)(T)] After-tax return on pref. = 8.33%

106. (3-7) After-tax returns C K M Answer: b MEDIUM/HARD

BT bond yield 11.00% BT municipal bond yield 8.00% BT preferred yield 9.00% Tax rate 40.00% Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return AT municipal bond yield = 8.00%

AT bond yield = BT bond yield × (1 – T) AT bond yield = 6.60%

AT preferred yield = BT pref. return[1 – (1 – Div. exclusion %)(T)] AT preferred yield = 7.92%

Highest AT yield = 8.00%

107. (3-7) After-tax returns C K M Answer: c MEDIUM/HARD

BT Preferred stock yield 8.50% Municipal yield 7.50% Dividend exclusion % 70.00%

Remember that municipal bonds are tax exempt, so their BT yield = AT yield.

Municipal yield = After-tax preferred yield 7.50% = BT pref. return × [1 – (1 – Div. exclusion %)(T)] 7.50% = 8.50% × [1 – 30.00% × (T)] 88.24% = [1 – 30.00% × (T)] T = 39.22% 108. (3-7) After-tax returns C K M Answer: c MEDIUM/HARD

BT Preferred stock yield 7.00% Dividend exclusion % 70.00% BT bond yield 10.00%

AT bond yield = After-tax preferred yield

BT bond yield × (1 – T) = BT pref. return × [1 – (1 – Div. exclusion %)(T)] 10.00% × (1 – T) = 7.00% × [1 – 30.00% × (T)] 3.00% = 7.900%(T) T = 37.97%

109. (3-7) After-tax returns C K M Answer: a MEDIUM/HARD

BT municipal bond yield 8.50% BT bond yield 10.50% BT preferred yield 9.25% Tax rate 35.00% Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return AT municipal bond yield = 8.500%

AT bond yield = BT bond yield × (1 – T) AT bond yield = 6.825%

AT preferred yield = BT pref. return[1 – (1 – Div exclusion%)(T)] AT preferred yield = 8.279%

Highest AT yield = 8.500%

110. (3-7) After-tax returns C K M Answer: e MEDIUM/HARD

BT municipal bond yield 8.80% BT bond yield 11.75% BT preferred yield 9.80% Tax rate 25.00% Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return AT municipal bond yield = 8.800%

AT bond yield = BT bond yield × (1 – T) AT bond yield = 8.813%

AT preferred yield = BT pref. return[1 – (1 – Div. exclusion %)(T)] AT preferred yield = 9.065%

Highest AT yield = 9.065%

111. (3-7) Carry-back, carry-forward C K M Answer: d MEDIUM/HARD

Tax rate 34% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2005 -$3,000,000 $0 $0 $3,000,000 2006 -$5,200,000 $0 $0 $8,200,000 2007 $4,200,000 $4,200,000 $0 $4,000,000 2008 $8,300,000 $4,000,000 $4,300,000 $0

2008 Tax liability = EBT × Tax rate 2008 Tax liability = $1,462,000

112. (3-7) Carry-back, carry-forward C K M Answer: e MEDIUM/HARD

Tax rate 35% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2005 -$50,000,000 $0 $0 $50,000,000 2006 -$150,000,000 $0 $0 $200,000,000 2007 -$100,000,000 $0 $0 $300,000,000 2008 $700,000,000 $300,000,000 $400,000,000 $0

2008 Tax liability = EBT × Tax rate 2008 Tax liability = $140,000,000

113. (3-7) Carry-back, carry-forward C K M Answer: a MEDIUM/HARD

Tax rate 40% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2004 -$700,000 $0 $0 $700,000 2005 -$500,000 $0 $0 $1,200,000 2006 -$200,000 $0 $0 $1,400,000 2007 $800,000 $800,000 $0 $600,000 2008 $1,000,000 $600,000 $400,000 $0

2008 Tax liability = EBT × Tax rate 2008 Tax liability = $160,000

114. (3-7) Carry-back, carry-forward C K M Answer: d MEDIUM/HARD

Tax rate 34% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2004 -$3,600,000 $0 $0 $3,600,000 2005 -$2,000,000 $0 $0 $5,600,000 2006 -$1,000,000 $0 $0 $6,600,000 2007 $1,200,000 $1,200,000 $0 $5,400,000 2008 $7,000,000 $5,400,000 $1,600,000 $0

2008 Tax liability = EBT × Tax rate 2008 Tax liability = $544,000

115. (3-7) Carry-back, carry-forward C K M Answer: a MEDIUM/HARD

Tax rate 40% EBT After Unused Taxable Carry-Forward Forward Carryable Year Income Used Applied Amount 2003 $50,000 $0 $50,000 $0 2004 $40,000 $0 $40,000 $0 2005 $30,000 $0 $30,000 $0 2006 $20,000 $0 $20,000 $0 2007 -$100,000 $0 $0 $100,000 2008 $60,000 $100,000 $10,000 $0

2008 Tax liability = EBT × Tax rate 2008 Tax liability = $4,000

116. (3-7) Net income C K M Answer: d MEDIUM/HARD

Operating income $10,000,000 Interest expense $1,500,000

Taxable income = Operating income – Interest expense Taxable income = Operating income – Interest expense Taxable income = $8,500,000

Taxable Tax on Base % on Income of Bracket Excess above Base $0 $0 15% $50,000 7,500 25% $75,000 13,750 34% $100,000 22,250 39% $335,000 113,900 34% $10,000,000 3,400,000 35% $15,000,000 5,150,000 38% $18,333,333 6,416,667 35%

Tax on base = $113,900 Tax on excess base = $2,776,100 Tax liability = $2,890,000

Net income = Taxable income – Taxes Net income = $5,610,000

117. (3-7) Corporate taxes C K M Answer: d MEDIUM/HARD

Taxable income $80,000 Interest income $5,000 Dividend income $30,000 Dividend exclusion % 70%

Total taxable income = Taxable income + Interest income + Taxable dividend income Total taxable income = Taxable income + Interest income + Dividend income (1 – Dividend exclusion %) Total taxable income = $94,000

Taxable Tax on Base % on Income of Bracket Excess above Base $0 $0 15% $50,000 7,500 25% $75,000 13,750 34% $100,000 22,250 39% $335,000 113,900 34% $10,000,000 3,400,000 35% $15,000,000 5,150,000 38% $18,333,333 6,416,667 35%

Tax on base = $13,750 Tax on excess base = $6,460 Tax liability = $20,210

118. (3-7) Corporate taxes C K M Answer: b MEDIUM/HARD

Operating income $20,000,000 Interest payments $1,750,000 Dividend income $1,000,000 Dividend exclusion % 70%

Taxable income = Operating income – Interest payments + Taxable dividend income Taxable income = Operating income – Interest payments + Dividend income × (1 – Dividend exclusion %) Taxable income = $18,550,000

Taxable Tax on Base % on Income of Bracket Excess above Base $0 $0 15% $50,000 7,500 25% $75,000 13,750 34% $100,000 22,250 39% $335,000 113,900 34% $10,000,000 3,400,000 35% $15,000,000 5,150,000 38% $18,333,333 6,416,667 35%

Tax on base = $6,416,667 Tax on excess base = $75,833 Tax liability = $6,492,500

119. (3-7) Corporate taxes C K M Answer: c MEDIUM/HARD

Operating income $500,000 Interest income $50,000 Dividend income $100,000 Dividend exclusion % 70% Taxable income = Operating income + Interest income + Taxable dividend income Taxable income = Operating income + Interest income + Dividend income × (1 – Dividend exclusion %) Taxable income = $580,000

Taxable Tax on Base % on Income of Bracket Excess above Base $0 $0 15% $50,000 7,500 25% $75,000 13,750 34% $100,000 22,250 39% $335,000 113,900 34% $10,000,000 3,400,000 35% $15,000,000 5,150,000 38% 18,333,333 6,416,667 35%

Tax on base = $113,900 Tax on excess base = $83,300 Tax liability = $197,200

120. (3-7) Corporate taxes C K M Answer: d MEDIUM/HARD

Operating income $125,000 Interest expense $40,000 Interest income $25,000 Dividend income $70,000 Dividend exclusion % 70%

Taxable income = Operating income – Interest expense + Interest income + Taxable dividend income Taxable income = Operating income – Interest expense + Interest income + Div. income (1-Div. exclusion %) Total taxable income = $131,000

Taxable Tax on Base % on Income of Bracket Excess above Base $0 $0 15% $50,000 7,500 25% $75,000 13,750 34% $100,000 22,250 39% $335,000 113,900 34% $10,000,000 3,400,000 35% $15,000,000 5,150,000 38% $18,333,333 6,416,667 35%

Tax on base = $22,250 Tax on excess base = $12,090 Tax liability = $34,340 121. (3-6) Net income vs. FCF C K M Answer: e HARD

This problem can be worked very easily--just multiply the increase in depreciation by (1 – T) to get the decrease in net income, and then subtract this value from the change in depreciation to get the change in free cash flow:

Change in depreciation $725 Tax rate 35.00% Reduction in net income = Change in Deprec. (1 − Tax rate) -$471.25 Increase in free cash flow = Change in Deprec. − Reduction in NI $253.75

We can also get the answer the long way, which explains things in more detail: Old New Change Bonds $3,500 $3,500 $0.00 Interest rate 6.50% 6.50% 0.00 Tax rate 35% 35% 0.00 Capex + NWC $2,000 $2,000 $0.00

Sales $11,250 $11,250 $0.00 Operating costs excluding depreciation $4,500 $4,500 $0.00 Depreciation $1,250 $1,975 $725.00 Operating income (EBIT) $5,500 $4,775 -$725.00 Interest charges $228 $228 $0.00 Taxable income $5,273 $4,548 -$725.00 Taxes $1,845 $1,592 -$253.75 Net income $3,427 $2,956 -$471.25 Free cash flow = EBIT(1 − T) + Deprec − [Capex + NWC] $2,825 $3,079 $253.75 Check on FCF: Δ FCF = Change in depreciation × Tax rate $253.75

We like this problem because it illustrates that an increase in depreciation will decrease the firm's net income yet increase its free cash flow, and cash is king.

122. (3-6) Net income vs. FCF C K M Answer: c HARD

Bonds $3,200 Interest rate 5% Tax rate 35% Required capital expenditures (fixed assets) $1,250 Required addition to net working capital $300

Sales $8,250.00 Operating costs excluding depreciation 5,750.00 Depreciation 650.00 Operating income (EBIT) $1,850.00 Interest charges 160.00 Taxable income (EBT) $1,690.00 Taxes 591.50 Net income $1,098.50

FCF = EBIT(1 − T) + Deprec. – CapEx – Δ Net WC FCF = $1,202.50 + $650 – $1,250 – -$300 = $302.50 Difference between net income and FCF = $796.00