Solutions to Chapter 3 Accounting and Finance 1. Assets Cash Accounts receivable nventory !

tore & property 'otal assets 2. $ 10,000 22,000 200,000 100,000 $((2,000 Liabilities & Shareholders Equity Accounts payable Long-term debt !hareholders" e#uity 'otal liabilities & !hareholders" e#uity $ 17,000 170,000 1$%,000 $((2,000

The balance sheet shows the position of the firm at one point in time. It shows the amounts of assets and liabilities at that particular time. In this sense it is like a snap shot. The income statement shows the effect of business activities over the entire year. Since it captures events over an extended period, it is more like a video. The statement of cash flow is like the income statement in that it summarizes activity over the full year, so it too is like a video. Accounting revenues and expenses can differ from cash flows because some items included in the computation of revenues and expenses do not entail immediate cash flows. For example, sales made on credit are considered revenue even though cash is not collected until the customer makes a payment. Also, depreciation expense reduces net income, but does not entail a cash outflow. Conversely, some cash flows are not included in revenues or expenses. For example, collection of accounts receivable results in a cash inflow but is not revenue. Purchases of inventory require cash outlays, but are treated as investments in working capital, not as expenses. Working capital ought to be increasing. The firm will be building up stocks of inventory as it ramps up production. In addition, as sales increase, accounts receivable will increase rapidly. While accounts payable will probably also increase, the increase in accounts receivable will tend to dominate since sales prices exceed input costs.

3.

4.

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%.

a.

'a)es * +0.10 $,,02%- . 0.1% +$20,000 $,,02%- * $2,%// Average ta) rate * $2,%//0$20,000 * 0.12//% * 12.//%1 2arginal ta) rate * 1%1

b.

'a)es * +0.10 $,,02%- . 0.1% +$(2,%%0 $,,02%- . 0.2% +$%0,000 $(2,%%0* $,,$$ Average ta) rate * $,,,$$0$%0,000 * 0.173,, * 17.3,,1 2arginal ta) rate * 2%1

c.

'a)es * +0.10 $,,02%- . 0.1% +$(2,%%0 $,,02%- . 0.2% +$7,,,%0 $(2,%%0. 0.2, +$13$,%%0 $7,,7%0- . 0.(( +$(00,000 $13$,%%0- * $,$,7%1 Average ta) rate * $,$,7%10$(00,000 * 0.2,2% * 2,.2%1 2arginal ta) rate * ((1

d.

'a)es * +0.10 $,,02%- . 0.1% +$(2,%%0 $,,02%- . 0.2% +$7,,,%0 $(2,%%0. 0.2, +$13$,%%0 $7,,7%0- . 0.(( +$(%7,700 $13$,%%0. 0.(% +$(,000,000 4 $(%7,700- * $1,00/,%%3 Average ta) rate * $1,00/,%%30$(,000,000 * 0.((3% * ((.3%1 2arginal ta) rate * (%1

3.

'a)es * +0.1% $%0,000- . 0.2% +$7%,000 $%0,000- . 0.($ +$100,000 $7%,000* $22,2%0 Average ta) rate * $22,2%00$100,000 * 0.222% * 22.2%1 2arginal ta) rate * ($1

7.

'a)es * +0.10 $13,0%0- . 0.1% +$3%,100 $13,0%0- . 0.2% +$/%,000 $3%,100* $13,$(7.%0 Average ta) rate * $13,$(7.%00$/%,000 * 0.17(0 * 17.(01 2arginal ta) rate * 2%1

,.

a. b. c.

Cash 5ill increase as one current asset +inventory- is e)changed 6or another +cash-. Cash 5ill increase. 'he machine 5ill bring in cash 5hen it is sold, but the lease payments 5ill be made over several years. 'he 6irm 5ill use cash to buy bac7 the shares 6rom e)isting shareholders. Cash balance 5ill decrease. (-2

/.

8et income * ncrease in retained earnings . dividends $/00,000 * +$(,700,000 $(,$00,000- . dividends dividends * $300,000 'a)es on your salary * +0.10 $,,02%- . 0.1% +$(2,%%0 $,,02%. 0.2% +$70,000 $(2,%%0- * $1(,,$$ 'a)es on corporate income * 0.1% $(0,000 * $$,%00 'otal ta)es * $1(,,$$ . $$,%00 * $1,,($$ 6 you rearrange income so that your salary and the 6irm9s pro6it are both $%0,000 then: 'a)es on your salary * +0.10 $,,02%- . 0.1% +$(2,%%0 $,,02%. 0.2% +$%0,000 $(2,%%0- * $,,,$$ 'a)es on corporate income * 0.1% $%0,000 * $7,%00 'otal ta)es * $,,,$$ . $7,%00 * $13,($$ 'otal ta)es are reduced by $1,,($$ $13,($$ * $2,000

10.

11.

a.

;oo7 value e#uals the $200,000 the 6ounder o6 the 6irm has contributed in tangible assets. 2ar7et value e#uals the value o6 his patent plus the value o6 the production plant: $%0,000,000 . $200,000 * $%0,200,000 <rice per share * $%0.2 million02 million shares * $2%.10 ;oo7 value per share * $200,00002 million shares * $0.10

b.

12. !ales $ 10,000 Cost o6 goods sold 3,%00 =eneral & administrative e)penses 1,000 >epreciation e)pense 1,000 ?; ' 1,%00 nterest e)pense %00 'a)able income 1,000 'a)es +(%1(%0 8et income $ 3%0 Cash 6lo5 6rom operations * net income . depreciation e)pense * $1,3%0

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1(.

Cash 6lo5 6rom operations can be positive even i6 net income is negative. @or e)ample, i6 depreciation e)penses are large, then negative net income might correspond to positive cash 6lo5 because depreciation is treated as an e)pense in calculating net income, but does not represent a cash out6lo5. Conversely, i6 net income is positive, but a large portion o6 sales are made on credit, cash 6lo5 can be negative since the sales are revenue but do not yet generate cash. Loo7 bac7 to 'able (-(, and you 5ill see that increases in accounts receivable reduce cash provided by operations.

1$.

'he calculations are presented in the 6ollo5ing table. !ales occur in #uarters 2 and (, so this is 5hen the cost o6 goods sold is recogniAed. 'here6ore, net income is Aero in #uarters 1 and $. n #uarter 1, the production o6 the 7its is treated as an investment in inventories. 'he level o6 inventories then 6alls as goods are sold in #uarters 2 and (. Accounts receivable in #uarters 2 and ( e#ual the sales in those #uarters since it ta7es one #uarter 6or receivables to be collected. 8otice that cash 6lo5 in #uarter 1 e#uals the cost o6 producing the 7its, and in #uarters ( and $, cash 6lo5 e#uals cash received 6or the 7its previously sold. a. !ales Cost o6 goods sold 8et income b.,c. nventories Accounts receivable 8et 5or7ing capital Buarter 1 $ 0 0 $ 0 $1,000 0 $1,000 Buarter 2 $ %%0 %00 $ %0 $ %00 %%0 $1,0%0 Buarter ( $ 300 %00 $ 100 $ 0 300 $ 300 Buarter $ $ 0 0 $ 0 $ 0 0 $ 0 $ 300

$1,000 Cash 6lo5 $ 0 $ %%0 Cash 6lo5 * net income 4 change in net 5or7ing capital 1%. Cash 6lo5 * <ro6its Accounts receivable . Accounts payable nventory 10,000 . %,000 +2,000-

Cash 6lo5 * <ro6its 10,000 . %,000 +2,000- * <ro6its (,000 'here6ore, cash 6lo5 is $(,000 less than pro6its. 'his corresponds to the increase o6 $(,000 in net 5or7ing capital.

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13.

a.

6 the 6irm paid income ta)es o6 $2,000, and the average ta) rate 5as 201, then ta)able income must have been: $2,00000.20 * $10,000 'here6ore: 8et income * ta)able income ta)es * $,,000

b. DDD ,,000 (,000 1,000 1,000 $10,000 E6rom part +a-F Ge conclude that revenues 5ere $2(,000. c. Cevenues Cost o6 goods sold Administrative e)penses >epreciation e)pense ?; ' 17. a. !ales Cost o6 goods sold nterest e)pense >epreciation e)pense 'a)able income 'a)es +(%18et income $ 1$.00 million ,.00 1.00 2.00 (.00 1.0% $ 1./% million $2(,000 , ( 1 $11,000 Cevenues Cost o6 goods sold Administrative e)penses >epreciation e)pense nterest e)pense 'a)able income

Cash 6lo5 * 8et income . >epreciation e)pense * $(./% million b. 6 depreciation e)pense 5ere increased by $1 million, net income 5ould be reduced by $0.3% million. Cash 6lo5 +* net income . depreciation- 5ould be increased by: $0.3% million . $1 million * $0.(% million Cash 6lo5 increases because depreciation e)pense is not a cash out6lo5, but increasing the depreciation e)pense 6or ta) purposes reduces ta)es paid by $0.(% million. 'he impact on stoc7 price is li7ely to be positive. Cash available to the 6irm 5ould increase. 'he reduction in net income 5ould be recogniAed as resulting entirely 6rom accounting changes, not as a conse#uence o6 any changes in the underlying pro6itability o6 the 6irm.

c.

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d.

6 interest e)pense 5ere $1 million higher, both net income and cash 6lo5 5ould decrease by $0.3% million, i.e., by the $1 million increase in e)penses less the $0.(% million reduction in ta)es. 'his di66ers 6rom part +b- because, in contrast to depreciation, interest e)pense represents an actual cash outlay.

18. !ales Cost o6 goods sold Accounts receivable nventory Cash 6lo5I 8et incomeII April $ 0 0 0 100,000 100,000 $ 0 2ay $1%0,000 100,000 1%0,000 100,000 0 $ %0,000 Hune $ 0 0 1%0,000 0 1%0,000 $ 0

ICash 6lo5 * !ales CJ=! A0C nventory II 8et income * !ales CJ=! 1/. Assets Current assets 8et 6i)ed assets 'otal assets a. b. 200, (10 1,200 1,%10 200/ $20 1,$20 1,,$0 Liabilities and Owners equity Current liabilities Long-term debt 'otal liabilities J5ners" e#uity 200, 210 ,(0 1,0$0 $70 200/ 2$0 /20 1,130 3,0

J5ners" e#uity * 'otal assets 'otal liabilities +as sho5n in the balance sheet above6 the 6irm issued no stoc7, the increase in o5ners" e#uity must be due entirely to retained earnings. !ince o5ners" e#uity increased by $210, and dividends 5ere $100, net income must have been $(10. !ince net 6i)ed assets increased by $220, and the 6irm purchased $(00 o6 ne5 6i)ed assets, the depreciation charge must have been $,0. 8et 5or7ing capital increased by $,0, 6rom +$(10 $210- * $100 in 200, to +$$20 $2$0- * $1,0 in 200/. !ince long-term debt increased by $/0, and the 6irm issued $200 o6 ne5 long-term debt, $110 o6 outstanding debt must have been paid o66.

c.

d.

e.

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20.

a.

!hareholders" e#uity * 'otal assets total liabilities 200,: !hareholders" e#uity * $,/0 $3%0 * $2$0 200/: !hareholders" e#uity * $1,0$0 $,10 * $2(0

b.

8et 5or7ing capital * current assets current liabilities 200,: 8et 5or7ing capital * $/0 $%0 * $$0 200/: 8et 5or7ing capital * $1$0 $30 * $,0

c.

'a)able income * $1,/%0 $1,0(0 $(%0 $2$0 * $((0 'a)es paid * 0.(% $((0 * $11%.%0 8et income * $21$.%0

d.

8et income >ecrease +increase- in current assets ncrease in current liabilities Cash provided by operations

$21$.%0 +%0.0010.00 $17$.%0

e. 6.

=ross investment * ncrease in net 6i)ed assets . depreciation * $100 . $(%0 * $$%0 Current liabilities increased by $10. 'here6ore, current liabilities other than accounts payable must have increased by $$%.

21. Assets 200, 200/ Cash & mar7etable securities $ ,00 $ (00 nventories (00 (%0 Accounts receivable $00 $%0 8et 6i)ed assets %,000 %,,00 'otal assets $ 3,%00 $ 3,/00 Liabilities and Shareholders equity Accounts payable 8otes payable Long-term debt 'otal liabilities !hareholders" e#uity 'otal liabilities plus !hareholders" e#uity 200, $ (00 1,000 2,000 (,(00 (,200 200/ $ (%0 300 2,$00 (,(%0 (,%%0

$3,%00 $3,/00

22.

8et 5or7ing capital +200,- * +$,00 . $(00 . $$00- +$(00 . $1,000- * $200 8et 5or7ing capital +200/- * +$(00 . $(%0 . $$%0- +$(%0 . $300- * $1%0 8et 5or7ing capital decreased by $%0.

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2(. Cevenue Cost o6 goods sold Administrative e)penses >epreciation e)pense nterest e)pense 'a)able income @ederal & state income ta)es 8et income 200, $ $,000 1,300 %00 %00 1%0 1,2%0 $00 $ ,%0 200/ $$,100 1,700 %%0 %20 1%0 1,1,0 $20 $ 730

ncrease in retained earnings in 200/ * 8et income dividends * $730 $$10 * $(%0 n 200/, shareholders" e#uity increased by the amount o6 the increase in retained earnings. 2$. ?arnings per share in 200, * $,%0,0000%00,000 shares * $1.70 ?arnings per share in 200/ * $730,0000%00,000 shares * $1.%2 2%. Average ta) brac7et in 200, * ta)es0ta)able income * $$000$12%0 * 0.(20 * (2.01 Average ta) brac7et in 200/ * $$200$11,0 * 0.(%3 * (%.31 n order to determine the 6irm"s marginal ta) brac7et, one 5ould need in6ormation regarding ta) rates applicable 6or both 6ederal and state income ta)es. 23. 8et 6i)ed assets increased by $,00,000 during 200/, 5hile depreciation e)pense in 200/ 5as $%20,000. 'here6ore, gross investment in plant and e#uipment 5as $1,(20,000.

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27. Cash provided by operations 8et income 8oncash e)penses >epreciation e)pense Changes in 5or7ing capital >ecrease +increase- in accounts receivable >ecrease +increase- in inventories ncrease +decrease- in accounts payable 'otal change in 5or7ing capital Cash provided by operations Cash flows from investments Cash provided by +used 6or- disposal o6 +additions to- property, plant & e#uipment Cash provided by +used 6or- investments Cash provided by (used for) financing activities Additions to +reductions in- notes payable Additions to +reductions in- long-term debt >ividends paid Cash provided by +used 6or - 6inancing activities 8et increase +decrease- in cash and cash e#uivalents 2,. Market value balance sheet, 20096 (Figures in thousands of dollars) Liabilities & Assets Shareholders Equity Cash $ (00 Accounts payable nventories (%0 8otes payable Accounts receivable $%0 Long-term debt ?mployee s7ills 2,/00 'otal liabilities 8et 6i)ed assets 3,000 !hareholders" e#uityI 'otal liabilities & 'otal assets $10,000 !hareholders" e#uity I !hareholders9 e#uity * 'otal assets total liabilities <rice per share * $3,3%0,0000%00,000 shares * $1(.(0 $ 730 %20 +%0+%0%0 +%0$1,2(0 +1,(20+1,(20+$00$00 +$10+$10+$ %00-

$ (%0 300 2,$00 (,(%0 3,3%0 $10,000

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2/. a. ncome 10000 20000 $0000 ,0000 100000 1%0000 200000 2%0000 (00000 (%0000 $%0000 %%0000 3%0000 7%0000 1000000 2000000 $000000 3000000 ,000000 40.00%
35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 0

'a)es >ue

Average 'a) Cate

10000000

1,0/ / 10.//1 2,%/ / 12.//1 3,($ $ 1%.,31 13,(7 , 20.$71 21,/7 , 21./,1 (%,/7 , 2(.//1 %1,7% 1 2%.,,1 3,,2% 1 27.(01 ,$,7% 1 2,.2%1 101,2% 1 2,./(1 1(3,0/ 7 (0.2$1 171,0/ 7 (1.111 203,0/ 7 (1.711 2$1,0/ 7 (2.1%1 (2,,%/ 7 (2.,31 37,,%/ 7 ((./(1 1,(7,,%/ ($.$31 7 2,07,,%/ ($.3$1 Average Tax Rate v. Income 7 2,77,,%/ ($.7(1 7 (,$7,,%/ ($.7/1 7

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2000000 4000000 6000000 8000000 10000000 12000000

b.

As sho5n in the table and graph above, the di66erence bet5een average ta) rates and the top marginal ta) rate o6 (%1 becomes very small as income becomes large. @or corporations the marginal ta) rate is (%1. Ghen analyAing very large 6irms 5e are content simply treating the corporate ta) rate as (%1 since average ta)es are li7ely to be e#ual. Kery large 6irms are unli7ely to have incomes in the lo5er brac7ets.

c.

(0. 'o minimiAe ta)es, you should not have income in one ta) category +that is, personal versus corporate- i6 you can move the income into the other category at a lo5er ta) rate. @irst, suppose that your total income is $7/,700. 'hen you could allocate $%0,000 to corporate income, the ma)imum amount that 5ould be ta)ed at 1%1, and $2/,700 to personal income, the ma)imum amount that 5ould be ta)ed at 1%1. Additional corporate income, up to an additional +$7%,000 4 $%0,000- * $2%,000, 5ould be ta)ed at 2%1, and additional individual income, up to an additional +$71,/%0 4 $2/,700- * $$2,2%0, 5ould also be ta)ed at 2%1. 'here6ore, you are indi66erent as to 5hether the remaining +$100,000 4 $7/,700- * $20,(00 in income is allocated to corporate income or individual income or a combination o6 the t5o.

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