CHAPTER 2
Financial Management
Solutions to
problems
I. Basic Financial Statements
A.
The Income Statement
1.
The income statement reports the
results from operating the business for a period of time, such as a year.
2.
It is helpful to think of the
income statement as comprising five types of activities:
a. Selling the product
b. The cost of producing or
acquiring the goods or services sold
c. The expenses incurred in
marketing and distributing the product or service to the customer along
with administrative operating expensesd.The
financing costs of doing business: for example, interest paid to
creditors and dividend payments to the preferred stockholderse.The taxes owed based on a firm’s taxable income
3.
An example of an income statement
is provided in Table 2-1 for theHarley-Davidson Corporation.
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B.The Balance Sheet
1.The balance sheet provides a snapshot of the firm’s financial position at
a specific point in time, presenting its asset holdings, liabilities, and owner-supplied
capital.
a.Assets represent the resources owned by the firm
(1)Current assets - consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses
(2)Fixed or long-term assets – comprising equipment, buildings, and land
(3)Other assets – all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long-term
investments in securities, and goodwill
b.The liabilities and owners’ equity indicate how the assets arefinanced.
(1)The debt consists of such sources as credit extended from suppliers or a
loan from a bank.
(2)The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date
of the balance sheet.
2.The balance sheet is not intended to represent the current market value of the company,
but rather reports the historical transactions recorded at their costs.
3.Balance sheets for the Harley-Davidson Corporation are presented inTable 2-2.IIComputing a Company’s Taxes
A.Types of taxpayers
1.Sole proprietors
a. Report business income on personal
tax returns
b. Pay taxes at personal tax rate
2.Partnerships
a.
The partnership reports income but
does not pay taxes
b. Each partner reports his or her
portion of income andpays the corresponding taxes.
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a.
Corporation reports income and pays
taxes
b.
Owners do not report these earnings
except when all or part of the profit is paid out as dividends.c.Our focus is on corporate taxes.
B.Computing Taxable Income
1.
Taxable income is based on gross
income less tax-deductible expenses
a.
Interest expense is tax deductible
b.
Dividend payments are not tax
deductible
2.Depreciation
a.
Modified accelerated cost recovery
system used for computing depreciation for tax purposes.
b.We use
straight-line depreciation to reduce complexity.
C. Computing Taxes Owed
1. Taxes paid are based on corporate
tax structure.
2. Tax rates used to calculate tax
liability are marginal tax rates, or the rateapplicable to the next dollar of
income.
3. Average tax rate is calculated by
dividing taxes owed by the firm’s totalincome4.Marginal tax
rate is used in financial decision makingIII.
Measuring Free Cash Flows
A.
While an income statement measures a
company’s profits, profits are not the same as cash flows; profits are calculated on an
accrual basis rather
than a cash basis.
B.
In measuring cash flows, we could
use the conventional accountant’s presentation called a statement of cash flows. However,
we are more interested in considering cash
flows from the perspective of the firm’s shareholders and its investors,
rather than from an accounting view. We will instead measure the cash flow that
is free and available to be distributed to the firm’s investors, both debt and
equity investors, or what we will call.
free cash flows
C.
The cash flows that are generated
through a firm’s operations and investments in assets will
always equal its cash flows paid to – or received from – the company’s
investors (both creditors and stockholders).
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D. Calculating Free Cash Flows: An Asset
Perspective
1.A firm'sfree cash flows, from an asset perspective
, is the
after-tax cashflows generated from operations less the firm's investments in
assets. Itis this same amount that will be
available for distributing to the firm’sinvestors. That is, a firm's
free cash flows for a given period is equal to:After-tax cash flow from
operationslessthe investment (increase) in net operating working capitallessinvestments in fixed assets (plant and equipment)
and other assets.
2.
After-tax cash flows from operations
as follows:Operating
income (earnings before interest and taxes)
+ depreciation=Earnings before interest, taxes, depreciation andamortization
(EBITDA)- cash tax payments=After-tax cash
flows from operations
3. The increase in net operating
working capital is equal to the:
4. Investments in fixed assets
includes the change ingross fixed assets and any other balance sheet assets not
already considered.
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E. Calculating Free Cash Flows: A Financing
Perspective
1.Free cash flows from a financing perspective are equal to:
2. Free cash flow from an asset
perspective must equal free cash flow from a financing perspective.
3. Free cash flows from a financing
perspective are simply the net cash flows received by the firm’s investors, or if negative,
the cash flows that the investors are paying
into the firm. In the latter situation where the investors are putting money
into the firm, it is because the firm’s free cash flow from assets is negative, thereby requiring an infusion of capital
by the investors.
IV. Financial Statements and International Finance
A. Many countries have different guidelines for firms to use in preparing
financial statements. For
example, a $1 of earnings in the United States is not the sameas 1.10 Euro (the
equivalent of a U.S. dollar based on the exchange rate). Thedifferences are due
to the two countries having different Generally AcceptedAccounting Principles
which guide their firms’ financial reporting.
B.
As a result of this situation, the
International Accounting Standards Committee(IASC), a private body supported by the
worldwide accounting profession, is trying to develop international
financial-reporting standards that will minimize the problem. In spite of the
work to standardize accounting practices around the world, the U.S. accounting
profession has rejected efforts toward international standards. At this time,
foreign companies seeking to list their shares in the United States must follow
U.S. accounting standards.
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Interest
payments to creditors plus dividends paid to stockholders+decrease in debtprincipalor-increasin debt principal+decrease in stock or -increase in stock
ANSWERS
TOEND-OF-CHAPTER QUESTIONS
2-1.
a.
The balance sheet represents an
enumeration of a firm’s resources (assets) along with its
liabilities and owners’ equity at a given date. The income statement summarizes the net results of the operation of a firm over a specified time
interval. The primary distinction between these two
statements is that the balance sheet shows
the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of
the firm incurred during a specified period of time.
b.
The conventional cash flow
statement as prepared by accountants provides the information we
need to know about what has happened to the firm’s cash and why. But it does not present it in a way that makes clear the cash flows
the firm’s
creditors and investors are providing to or receiving from the firm. Thus, we
choose to reformat the presentation to show the firm’s free cash
flows—the cash available to distribute to
the creditors and investors. We are more interested in considering cash flows from the perspective of the firm’s
shareholders and its investors, rather than from an accounting view. We
instead measure the cash flow that is free
and available to be distributed to the firm’s investors, both debt and
equity investors, or what we will call free cash flows.Thus, what we use
is similar to a conventional cash flow statement presented as part of a
company’s financial statements, but “not exactly.” We also make the distinction between the cash flows generated by
the firm’s assets and the financing free cash flows.
2-2. Gross profits is sales
less the cost of producing or acquiring the firm’s product or service.
Operating profits is the gross profits less theoperating expenses, which consist of
distributing the product or service to the
customer (namely, marketing expenses) and any general and administrative
expenses in operating the business. Net income is operating profits less financing costs (interest
expenses and preferred stock dividends) and less income taxes.
2-3. Interest expense is the
cost of borrowing money from a banker or another lender. The re typically is a fixed interest rate so that the interest expense is computed
as the interest rate times the
amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then
our interest expense will be $60,000.While
interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a
fixed dividend rate, so that the preferred stockholder gets a constant dividend
each year. Common stockholders, on the other hand, usually receive
dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically
once a dividend has been paid to common
stockholders, management is reluctant to decrease it or cease paying a dividend.
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2-4 Once preferred shares are sold, dividends
are paid or accrued each year based
upon preferred dividends (i.e., the percentage of the preferred stock’s par
value paid as dividends) agreed to at the selling date. However, these dividends affect
the income statement only. Common stock dividends, which may vary from year to
year, also affect the income statement; however, the investment of common
shareholders varies with the net addition to (or reduction from) retained earnings from year to
year. The net addition to retained earnings
equals the difference in the period’s net income and common dividends paid. Thus, the common equity
section of the balance sheet (par value of common stock, paid-in capital
and retained earnings) varies from year to year due to changes in the retained
earnings portion of the firm’s common equity.
2.5
Net working capital is
the firm’s liquid assets (current assets) less its short-term debt.
Accountants include all short-term debt when computing net
working capital; however, in computing
free cash flows, we only subtract the noninterest-bearing debt, such as
accounts payables and accruals. With this latter method, we are only
considering the assets and liabilities that are changing as a result of the
normal operating cycle of the
business—beginning with the time inventory is purchased on credit to the
time the firm collects the cash from its customer. Gross working capital is the sum of current assets, while net working
capital is the difference between current assets and current
liabilities. As already suggested, we have both interest-bearing debt and
noninterest-bearing debt.The former is debt
where the lender is paid interest for providing us the money.
Noninterest-bearing debt charges no interest because the “lender” is really a
supplier or an employee to whom we owe
money, but they are not requiring the firm to payinterest.
2-6.
A firm could have
positive cash flows but still be in trouble because it has negative cashflows from operations. The positive cash flows would then be the result of
the firmreducing its
investments in working capital or long-term assets. Such a situation meansthat
the company is not earning a satisfactory rate of return on its investments.
Another company could have very attractive rates of return on its assets, but
be growing so fastthat the large investments in working capital and long-term
assets result in negative cashflows. In this latter case, management is simply
investing in the future. As the rate of growth slows, positive cash flows will
occur.
2-7.
Examining only the
income statement and the balance sheet fails to tell us how the firmis using its
cash, which is a critical issue for any company.
2-8.
Free cash flows
from assets equal the cash flows that are generated by the company thatare then
distributed to (if positive) or received from (if negative) the firm’s creditors
andinvestors. It looks at cash flows from
the firm’s perspective. Free cash flows from afinancing perspective
looks at the cash flows from the investors’ viewpoint. It indicateshow the investor received cash in the form of
interest, dividends, debt repayment or stock repurchase and how the investor
infused cash in the form of additional debt or stock purchase. Whatever the
company does is the exact opposite of what the investor receives or
pays. That is, if a company distributes $100 in cash to the investors, then
theinvestors must receive $100 as well. They have to be equal.
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