Business 2019, Fall 2003
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1 Business 2019, Fall 2003 Assignment 1 Suggested Answers 1. Financial Statements and Cash Flows Answer the following questions using Table 2 and the following information: Bed Rock s cash flow from assets was $1,200 in 2002, the interest rate that applies to its long-term debt is 8%, its tax rate is 30% and it always pays 50% of its net income as dividends. (a) (6 points) Complete Bed Rock s balance sheets and income statement. Answer: First, total liabilities and equity in 2001, TLE 01, are given by TLE 01 = 3, , , , 000 = 17, 000. Interest expense in 2002 can be calculated as Interest Expense = 8% 8, 000 = 640 and the depreciation expense for 2002 is equal to 1, 685 1, 425 = 260. Knowing TLE 01, we can find net fixed assets in 2001, NFA 01, as follows: NFA 01 = TLE 01 CA 01 = 17, 000 4, 000 = 13, 000, where CA 01 denotes current assets in Accumulated depreciation in 2001 being 1,425, property, plant and equipment in 2001, PPE 01 is given by PPE 01 = NFA , 425 = 13, , 425 = 14,
2 Knowing depreciation and interest expense in 2002, we can complete the income statement to find that net income in 2002 is 1,610. Since Bed Rock always retains 50% of its earnings, accumulated retained earnings in 2002 are 3, % 1, 610 = 3, = 3, 805. To complete the 2002 balance sheet, we can proceed in two different ways: i. Finding Net Capital Spending in 2002 Let NCS denote net capital spending in Once we know NCS, we can find NFA 02, then total assets in 2002 and thus common stock in Recall that cash flow from assets, or CF(A), is given by CF(A) = OCF NWC NCS, where OCF is the 2002 operating cash flow, given by OCF = EBIT + Depreciation Taxes = 2, = 2, 510, and NWC is the change in net working capital from 2001 to 2002, equal to NWC = (5, 000 4, 000) (4, 000 3, 500) = 500. This gives us NCS = 2, , 200 = 810, which is the increase in PPE between 2001 and That is, PPE 02 = 14, = 15, 235, and then we can complete Big Rock s 2002 balance sheet. ii. There is a simpler way to complete the 2002 balance sheet. Knowing that the interest expense is 640 and knowing that there was no change in long-term debt in 2002, cash flow to bondholders, CF(B), is simply equal to 640. Since 2
3 cash flow from assets is equal to cash flow to bondholders plus cash flow to shareholders (CF(S)), we can find CF(S) as follows: CF(S) = CF(A) CF(B) = 1, = 560. Cash flow to shareholders is equal to dividend payments, 805, minus increase in common stock. Let CS = CS 02 CS 01 represent the change in common stock from 2001 to Then, since we have CF(S) }{{} 560 = Dividends }{{} 805 CS, CS = = 245, and thus CS 02 = CS = 2, = 2, 745, and Bed Rock s 2002 balance sheet can be completed from there. (b) (6 points) Compute Bed Rock s 2002 operating cash flow, cash flow to bondholders and cash flow to shareholders. Answer: From (a), OCF = 2, 510 CF(B) = 640 CF(S) = 560. (c) (3 points) Complete Bed Rock s 2002 statement of retained earnings. Answer: See Table Statement of Cash Flows Using Onren Corporation s 2002 statement of cash flows (Table 3), answer the following questions. Note: There was a mistake in Onren s statement of cash flows. An decrease in accounts receivable is a source of cash. Hence to have 28 as cash from accounts receivable, the latter must have increased, not decreased. Sorry about that and good for you if you noticed it. 3
4 Bed Rock Statement of Retained Earnings for the Year Ended December 31, 2002 Retained earnings balance (January 1, 2002) $3,000 Plus: Net income after taxes (for 2002) 1,610 Less: Common share dividends paid in Retained earnings balance (December 31, 2002) $3,805 Table 1: Bed Rock 2002 Statement of Retained Earnings (a) (3 points) If Onren s tax rate was 25% in 2002, what were the current taxes it paid during that year? Answer: Let NIAT, EBT, T d, T c and t denote Onren s net income after taxes, earnings before taxes, deferred taxes, current taxes and corporate tax rate, respectively. Then and NIAT = (1 t)ebt EBT = NIAT 1 t NIAT = EBT T c T d T c = EBT T d NIAT. This gives us T c = NIAT 1 t T d NIAT = = (b) (3 points) If Onren s interest expense was $84 in 2002, what was its operating cash flow for that year? Answer: Let s use the notation in (a) and let I and D denote interest and depreciation expenses in 2002, respectively. Then OCF = NIAT + T d + D }{{} Net Cash from Operations + I = = 315. (c) (3 points) If Onren s net fixed assets were $5,090 in 2001, what were they in 2002? Answer: NFA 02 = NFA 01 + NCS D = 5, = 5,
5 Bed Rock, Inc and 2001 Balance Sheets Assets Current assets 5,000 4,000 PP&E 15,235 14,425 Accum. depreciation (1,685) (1,425) Net fixed assets 13,550 13,000 Total assets 18,550 17,000 Liabilities and Owners Equity Current liabilities 4,000 3,500 Long-term debt 8,000 8,000 Common stock 2,745 2,500 Accum. retained earnings 3,805 3,000 Total liabilities and equity 18,550 17,000 Bed Rock, Inc Income Statement Sales 7,500 Cost of goods sold (3,800) Depreciation (260) Other expenses (500) EBIT 2,940 Interest (640) Taxable income 2,300 Taxes (30%) (690) Net income 1,610 Table 2: Balance sheets and income statement for Question 1. (d) (3 points) If Onren s accumulated retained earnings were $1,200 in 2001, what were they in 2002? Answer: Retained earnings are NIAT minus dividends, and thus, letting ARE denote accumulated retained earnings, ARE 02 = ARE 01 + NIAT 02 Dividends in 2002 = 1, = 1, 252. (e) (3 points) Compute Onren s free cash flow in Answer: Free cash flow, or cash flow from assets (CF(A)), can be calculated as follows: CF(A) = OCF NWC NCS = 315 ( ) 210 = 56. Note how additions to net working capital, NWC, is calculated. Since cash increases by 33 and cash is a current asset, it increases NWC. Cash flow from 5
6 non-cash working capital is 9, which means that $9 have been added to noncash working capital. Similarly, a decrease in notes payable increases net working capital, and thus $7 have been added to NWC through notes payable. Another way to compute CF(A) is CF(A) = CF(B) + CF(S) = = 56. Note that CF(B) is given by the interest expense minus the increase in longterm debt, as the latter constitutes a flow of cash from bondholders to the firm. Similarly, CF(S) is given by the dividend payments minus the increase in stocks. The goal of this exercise is to show how the statement of cash flows and free cash flow can be reconciled. The statement of cash flows looks at cash from the firm s perspective whereas free cash flow looks at cash from investors perspective. This is why many numbers that enter negatively in the statement of cash flows enter positively in the calculation of free cash flow. Dividends is a good example: From the firm s viewpoint, it is a use of cash and thus a cash outflow; from the investors viewpoint, it is a source of cash and thus a cash inflow. 3. Taxation of Business Income Using Sun-Rype Products audited financial statements for the fiscal year 2002, which can be found at answer the following questions. (a) (1 points) What is Sun-Rype s tax expense as it appears on its 2002 income statement? Answer: The tax expense on the 2002 income statement is $2,581,000. (b) (2 points) How much taxes did Sun-Rype actually pay in 2002? Answer: From Footnote 12, current taxes in 2002 were $2,236,000. (c) (4 points) Explain why the taxes actually paid are not the same as the tax amount on the income statement. 6
7 Answer: You can have your own hypothesis here but the best way to answer this question is to call or the company. (c) (3 points) Name a tax deduction Sun-Rype is entitled to. By what percentage did it reduce its tax rate in 2002? Answer: Sun-Rype can claim the manufacturing and processing tax deduction. This reduced its taxes by 4% compared to regular corporations in The company is also entitled to other deductions that reduced its taxes by 2.5%. To know what these are, you need to contact the company. 4. Mini Case In April 2003, Albert Kyle, consultant for Wellington and Associates, was called in to assist the chairman of Brick Electronics, a manufacturer of electronic calculators. The company had recently doubled its plant capacity, opened new sales offices and launched an expensive advertising campaign. As can be seen in the financial statements depicted in Table 4, Brick s late results were not satisfactory. Suppliers were being paid late, the bank was complaining about the increasing risk the firm represented and was threatening to cut off credit. Albert began gathering financial information and other data. (a) (5 points) What effect did the expansion have on sales, net income, assets and liabilities? Answer: Sales have increased by 5, 834 3, 432 3, 432 = 70.0%, net income has increased by = 207.9%, assets have increased by 2, 886 1, 467 1, 467 = 96.7%, 7
8 and liabilities have increased by 1, , 000 ( ) = 289.7%. First note that sales did not increase as much as assets and that liabilities have increased almost three times as much as assets. This large increase in liabilities implies a much larger interest expense, which explains the reduction in net income. (b) (5 points) Complete Brick s statement of cash flows for What can you conclude from this statement? Answer: The statement of cash flows is depicted in Table 5. We can see from this statement that the increases in accounts receivable and inventory are much greater than the increases in accounts payable and accrued expenses. This is not a good sign if Brick s customers are not expected to pay their bills any time soon or if inventories are not expected to be sold at all. Since Brick is in the technology business, piling up inventories is not a good idea since these goods will never be sold if they become obsolete. In terms of financing activities, we observe a huge increase in debt, both shortterm (notes payable) and long-term, while common stock has not changed. This necessarily implies a significant increase in interest payments. (c) (5 points) Compute Brick s free cash flow for 2002, its cash flow to shareholders and its cash flow to bondholders. What can you tell from these cash flows? Answer: Once we have the statement of cash flows, these cash flows become much easier to compute. Cash flow to shareholders, for instance, is simply the $10 dividend. Cash flow to bondholders, on the other hand, is equal to the interest expense in 2002 minus the increase in long-term debt, which gives CF(B) = = 501. Hence cash flow from assets, or free cash flow, is equal to CF(A) = CF(B) + CF(S) = =
9 Overall, more cash flew from investors to the firm than from the firm to investors, and this expecially for bondholders. Of course, Brick had to find the cash necessary for its acquisitions somewhere, which is why it has raised so much debt. Note, however, that the increase in assets did not generate enough sales to cover all of the firm s costs, expecially the interest expense. (d) (5 points) What recommendations would you make to this company? What needs to be improved with respect to operations? What do you think about the means used to finance the firm s expansion? What should the firm do with its dividend policy? Answer: You may have your own idea on this one but the firm should have financed some of its growth with equity. This would have reduced the interest payment and increased profits. Free cash flow would still be negative due to the large capital spending in 2002 but then the likelihood of bankruptcy would have been much smaller. 9
10 Onren Corporation 2002 Statement of Cash Flows Operating activities Net income 100 Plus: Non-cash expenses Depreciation 104 Deferred taxes 27 Net cash from operations 231 Plus: Changes in non-cash working capital accounts Increase in accounts payable 16 Decrease in inventory 15 Increase in accounts receivable (28) Decrease in accrued expenses (12) Net cash from non-cash working capital (9) Cash flow from operating activities 222 Investing activities Net capital spending (210) Cash flow from investing activities (210) Financing activities Decrease in notes payable (7) Increase in long-term debt 23 Dividends paid (48) Increase in common stock 53 Cash flow from financing activities 21 Net change in cash 33 Table 3: Statement of Cash Flows for Question 2. 10
11 Brick Electronics 2002 and 2001 Balance Sheets Assets Cash Accounts Receivable Inventories 1, Total current assets 1,946 1,123 Net fixed assets Total assets 2,886 1,467 Liabilities and Owners Equity Accounts payable Notes payable Accrued expenses Total current liabilities 1, Long-term debt 1, Common stock Retained earnings Total liabilities and equity 2,886 1,467 Brick Electronics 2002 and 2001 Income Statements Sales 5,834 3,432 Cost of goods sold (4,980) (2,864) Other expenses (720) (340) Amortization (117) (19) EBIT Interest expense EBT (159) 147 Taxes 63 (58) Net income (96) 89 Dividends paid Table 4: Balance sheets and income statement for Question 4. 11
12 Brick Electronics 2002 Statement of Cash Flows Operating activities Net income (96) Non-cash expenses Add: Amortization 117 Net cash from operations 21 Changes in non-cash working capital accounts Subtract: Increase in accounts receivable (281) Subtract: Increase in inventory (572) Add: Increase in accounts payable 179 Add: Increase in accrued expenses 149 Net cash from non-cash working capital (525) Cash flow from operating activities (504) Investing activities Subtract: Net capital spending (713) Cash flow from investing activities (713) Financing activities Add: Increase in notes payable 520 Add: Increase in long-term debt 677 Subtract: Dividends paid (10) Add: Increase in common stock 0 Cash flow from financing activities 1,187 Net change in cash (30) Table 5: Statement of Cash Flows Brick Electronics. 12
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