Homework for Chapter 3

Financial Statements, Cash Flows, and Taxes

VIII. Questions and Problems

BASIC

3.1 Balance sheet: Given the following information about the Elkridge Sporting Goods, Inc.,

construct a balance sheet for the period ending June 30, 2008. The firm had cash and

marketable securities of $25,135, accounts receivables of $43,758, inventory of

$167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts

payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and

common stock of $150,000. How much retained earnings does the firm have?

Solution:

Assets Book Value Liabilities Book Value

Cash $ 25,135 Accounts payables $ 67,855

Accounts receivable 43,758 Notes payables 36,454

Inventories 167,112

Total current assets $236,005 Total current liabilities $104,309

Net fixed assets 325,422 Long-term debt 223,125

Other assets 13,125 Common stock 150,000

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Retained earnings 97,118

Total assets $574,552 Total liabilities and

stockholders’ equity

$574,552

3.2 Inventory accounting: Differentiate between FIFO and LIFO.

Solution: FIFO (first in, first out) refers to the practice of firms, when making sales, assuming

that the inventory that came in first (at a lower price) is being sold first. LIFO (last in,

last out) implies that a firm is selling the higher cost, newer inventory first, leaving

the lower cost, older inventory on the balance sheet.

3.3 Inventory accounting: Explain how the choice of FIFO versus LIFO can affect a firm’s

balance sheet and income statement.

Solution: FIFO makes sense during times of rising prices because it allows the firm to eliminate

the lower priced inventory first, resulting in higher profit margin. This allows the firm

to leave higher valued inventory on the balance sheet. During inflationary times, a

firm using LIFO would see a lower profit margin and lower values of inventory on

the balance sheet. It is important that anyone who is analyzing firms using different

accounting methods on inventory recognize the impact on the bottom line (profit

margin and net income) and on current assets.

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3.4 Market-value accounting: How does the use of market-value accounting help

managers?

Solution: Market-value accounting of both assets and liabilities allows managers to have a truer

picture of their company’s financial condition and to do a better job of estimating

cash flows that the assets would generate. However, marking-to-market is not as easy

as it sounds because of the difficulties involved in coming up with the correct market

value of current assets and liabilities.

3.5 Working capital: Laurel Electronics reported the following information at its annual

meetings. The company had cash and marketable securities worth $1,235,455, accounts

payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121,

notes payable worth $1,151,663, and other current assets of $121,455. What is the

company’s net working capital?

Solution:

Total current assets = $1,235,455 + $3,488,121 + $7,121, 599 + 121,455

= $11,966,630

Total current liabilities = $4,159,357 + $1,151,663

= $5,311,020

Net working capital = $11,966,630 - $5,311,020 = $6,655,610

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3.6 Working capital: The financial information for Laurel Electronics referred to in Problem

3.5 is all book value. Suppose marking-to-market reveals that the market value of the

firm’s inventory is 20 percent below its book value and its receivables are 25 percent

below its book value. The market value of its current liabilities is identical to the book

value. What is the firm’s net working capital using market values? What is the percent

change in net working capital?

Solution:

Market value of inventory = $7,121,599 * 0.80 = $5,697,279

Market value of receivables = $3,488,121 * 0.75 = $2,616,091

Total current assets = $1,235,455 + $2,616,091 + $5,697,279 + 121,455

= $9,670,280

Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020

Net working capital = $9,670,280 - $5,311,020 = $4,359,260

3.7 Income statement: The Oakland Mills Company has disclosed the following financial

information in its annual reports for the period ending March 31, 2008. It produced sales

of $1.45 million, had cost of goods sold to the tune of $812,500, depreciation expenses of

$175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35

percent. What is the company’s net income? Set up an income statement to answer the

question.

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Solution:

Amount

Revenues $1,450.000.00

Costs 812,500.00

EBITDA $ 637,500.00

Depreciation 175,000.00

EBIT $ 462,500.00

Interest 89,575.00

EBT $ 372,925.00

Taxes (35%) 130,523.75

Net income $ 242,401.25

3.8 Cash flow: Describe the organization of the statement of cash flows.

Solution: The statement of cash flows identifies the cash inflows and cash outflows of the firms

for a specified period. This allows one to estimate the net cash flows from operations.

This financial statement is organized to report the cash flows resulting from the three

basic activities in any firm—operating, investing, and financing. See Exhibit 3.4 for

an example. The cash flows from operations are the results of netting all revenues

and expenses that result from the operating activities of the firm. Buying and selling a

firm’s assets lead to cash flows from investing activities. Cash flows from financing

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activities arise from the firm borrowing from its investors and/or making payments to

its lenders and shareholders.

3.9 Cash flows: During 2008, Towson Recording Company increased its investment in

marketable securities by $36,845, funded fixed assets acquisitions of $109,455, and had

marketable securities of $14,215 mature. What is the net cash used in investing activities?

Solution:

Long-Term Investing Activities

Net property, equipment, and other assets $(109,455.00)

Net acquisitions and dispositions 0.00

Investments in marketable securities (22,630.00)

Net cash used in investing activities $(132,085.00)

3.10 Cash flows: Caustic Chemicals identified the following cash flows as significant in its

meeting with analysts. During the year, it had repaid existing debt of $312,080 and raised

additional debt capital of $650,000. It also repurchased stock in the open market for a

total of $45,250. What is the net cash provided by financing activities?

Solution:

Financing Activities

Loan repayment $(312,080)

Increase in long-term debt 650,000

Purchase of treasury stock (45,250)

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Net cash provided by financing activities $ 292,670

3.11 Cash flow: Identify and explain the noncash expenses that a firm may incur.

Solution: A firm may have several items on its income statement that did not result in any cash

outflow to the firm. The two largest are depreciation expenses and amortization

expenses. Other noncash expenses include deferred taxes, wages, and depletion

charges, which is similar to depreciation and used for natural resource assets. Prepaid

expenses also fit into this category as they represent expenses to the firm that are yet

to be paid out.

3.12 Tax: Define average tax rate and marginal tax rate.

Solution: The average tax rate is defined as the total taxes paid divided by taxable income.

The marginal tax rate, meanwhile, represents the tax rate that is paid on the last

dollar of income earned, or the rate that will be paid on the next dollar earned.

3.13 Tax: What is the relevant tax rate to use when making financial decisions? Explain why.

Solution: Managers need to use the marginal tax rate for making financial decisions. This is

because any additional cash flows that result from a firm’s new projects will be taxed

at the marginal tax rate. Thus, this is the appropriate rate to use.

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3.14 Tax: Manz Property Management Company announced that in the year ended June 30,

2008, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit

3.6.

Solution:

Earnings before tax = $1,478,936

Tax rate Income Tax

15% $0 to $50,000 $ 7,500.00

25 50,001 75,000 6,250.00

34 75,001 100,000 8,500.00

39 100,001 335,000 91,650.00

34 335,001 10,000,000 388,938.24

35 10,000,001 15,000,000

38 15,000,001 18,333,333

35 More than $18,333,333

Total taxes payable $502,838.24

INTERMEDIATE

3.15 Balance sheet: Tim Dye, the chief financial officer of Blackwell Automotive, Inc., is

putting together this year’s financial statements. He has gathered the following

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information. The firm had a cash balance of $23,015, accounts payable of $163,257,

common stock of $313,299, retained earnings of $512,159, inventory of $212,444,

goodwill and other assets equal to $78,656, net plant and equipment of $711,256, and

short-term notes payable of $21,115. It also has accounts receivables of $141,228 and

other current assets of $11,223. What amount of long-term debt does Blackwell

Automotive have?

Solution:

Assets

Liabilities and Stockholders’

Equity

Cash and marketable

securities

$ 23,015 Accounts payable and accruals $ 163,257

Accounts receivable 141,258 Notes payable 21,115

Inventories 212,444

Other current assets 11,223

Total current assets $ 387,940 Total current liabilities $ 184,372

Net plant and equipment 711,256 Long-term debt 168,022

Goodwill and other assets 78,656 Total liabilities $ 352,394

Common stock 313,299

Retained earnings 512,159

Total common equity $ 825,458

Total assets $1,177,852 Total liabilities and

stockholders’ equity

$1,177,852

3.16 Balance sheet: Refer to the information for Blackwell Automotive in Problem 3.15.

What level of working capital does Blackwell Automotive have?

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Solution:

Net working capital = Total current assets – Total current liabilities

= $387,940 – $184,372 = $203,568

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