Chapter 3 Financial Statements, Cash Flow, and Taxes 95

Questions

3-1 What four financial statements are contained in most annual reports?

3-2 Who are some of the basic users of financial statements, and how do they use them?

3-3 If a “typical” firm reports $20 million of retained earnings on its balance sheet, could its
directors declare a $20 million cash dividend without having any qualms about what they
were doing? Explain your answer.

3-4 Explain the following statement: Although the balance sheet can be thought of as a snap-
shot of a firm’s financial position at a point in time, the income statement reports on opera-
tions over a period of time.

3-5 Financial statements are based on generally accepted accounting principles (GAAP) and
are audited by CPA firms. Do investors need to worry about the validity of those state-
ments? Explain your answer.

3-6 Refer to the box titled, “The Balance Sheet of an Average American Household” when
answering parts a and b.

a. Based on this evidence, did the financial position of the average household improved
during 2004–2007? During 2007–2010? During 2010–2016? Explain your answers.
b. What do you think the average household balance sheet looks like today? Explain
your answer.

3-7 What is free cash flow? If you were an investor, why might you be more interested in free
cash flow than net income?

3-8 Would it be possible for a company to report negative free cash flow and still be highly
valued by investors; that is, could a negative free cash flow ever be viewed optimistically
by investors? Explain your answer.

3-9 How are management’s actions incorporated in EVA and MVA? How are EVA and MVA
interconnected?

3-10 Explain the following statement: Our tax rates are progressive.

3-11 What does double taxation of corporate income mean? Could income ever be subject to triple
taxation? Explain your answer.

3-12 How does the deductibility of interest and dividends by the paying corporation affect the
choice of financing (i.e., the use of debt versus equity)?

Problems

Easy 3-1 BALANCE SHEET  The assets of Dallas & Associates consist entirely of current assets and net
Problems plant and equipment, and the firm has no excess cash. The firm has total assets of $2.5 mil-
1–8 lion and net plant and equipment equals $2 million. It has notes payable of $150,000, long-
term debt of $750,000, and total common equity of $1.5 million. The firm does have accounts
payable and accruals on its balance sheet. The firm only finances with debt and common
equity, so it has no preferred stock on its balance sheet.

a. What is the company’s total debt?

b. What is the amount of total liabilities and equity that appears on the firm’s balance sheet?
c. What is the balance of current assets on the firm’s balance sheet?
d. What is the balance of current liabilities on the firm’s balance sheet?
e. What is the amount of accounts payable and accruals on its balance sheet? (Hint:
Consider this as a single line item on the firm’s balance sheet.)
f. What is the firm’s net working capital?
g. What is the firm’s net operating working capital?
h. What is the explanation for the difference in your answers to parts f and g?

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96 Part 2 Fundamental Concepts in Financial Management

3-2 INCOME STATEMENT  Byron Books Inc. recently reported $13 million of net income. Its
EBIT was $20.8 million, and its tax rate was 35%. What was its interest expense? (Hint:
Write out the headings for an income statement, and fill in the known values. Then divide
$13 million of net income by (1 2T) 5 0.65 to find the pretax income. The difference
between EBIT and taxable income must be interest expense. Use this same procedure to
complete similar problems.)

3-3 INCOME STATEMENT  Patterson Brothers recently reported an EBITDA of $7.5 million and
net income of $2.1 million. It had $2.0 million of interest expense, and its corporate tax rate
was 30%. What was its charge for depreciation and amortization?

3-4 STATEMENT OF STOCKHOLDERS’ EQUITY In its most recent financial statements, Nessler
Inc. reported $75 million of net income and $825 million of retained earnings. The previous
retained earnings were $784 million. How much in dividends were paid to shareholders
during the year? Assume that all dividends declared were actually paid.

3-5 MVA  Harper Industries has $900 million of common equity on its balance sheet, its stock
price is $80 per share, and its market value added (MVA) is $50 million. How many com-
mon shares are currently outstanding?

3-6 MVA  Over the years, Masterson Corporation’s stockholders have provided $34,000,000 of
capital when they purchased new issues of stock and allowed management to retain some
of the firm’s earnings. The firm now has 2,000,000 shares of common stock outstanding,
and the shares sell at a price of $28 per share. How much value has Masterson’s manage-
ment added to stockholder wealth over the years, that is, what is Masterson’s MVA?

3-7 EVA  Barton Industries has operating income for the year of $3,500,000 and a 36% tax rate.
Its total invested capital is $20,000,000 and its after-tax percentage cost of capital is 8%.
What is the firm’s EVA?

3-8 PERSONAL TAXES  Susan and Stan Britton are a married couple who file a joint income tax
return, where the tax rates are based on the tax tables presented in the chapter. Assume that
their taxable income this year was $375,000.

a. What is their federal tax liability?

b. What is their marginal tax rate?
c. What is their average tax rate?

Intermediate 3-9 BALANCE SHEET Which of the following actions are most likely to directly increase cash as
Problems shown on a firm’s balance sheet? Explain and state the assumptions that underlie your answer.
9–14
a. It issues $4 million of new common stock.
b. It buys new plant and equipment at a cost of $3 million.
c. It reports a large loss for the year.
d. It increases the dividends paid on its common stock.

3-10 STATEMENT OF STOCKHOLDERS’ EQUITY Electronics World Inc. paid out $22.4 million in
total common dividends and reported $144.7 million of retained earnings at year-end. The
prior year’s retained earnings were $95.5 million. What was the net income? Assume that
all dividends declared were actually paid.

3-11 EVA  For 2018, Gourmet Kitchen Products reported $22 million of sales and $19 million
of operating costs (including depreciation). The company has $15 million of total invested
capital. Its after-tax cost of capital is 10%, and its federal-plus-state income tax rate was
36%. What was the firm’s economic value added (EVA), that is, how much value did man-
agement add to stockholders’ wealth during 2018?

3-12 STATEMENT OF CASH FLOWS  Hampton Industries had $39,000 in cash at year-end 2017
and $11,000 in cash at year-end 2018. The firm invested in property, plant, and equipment
totaling $210,000. Cash flow from financing activities totaled 1$120,000.

a. What was the cash flow from operating activities?

b. If accruals increased by $15,000, receivables and inventories increased by $50,000, and
depreciation and amortization totaled $25,000, what was the firm’s net income?

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 Chapter 3 Financial Statements, Cash Flow, and Taxes 97

3-13 STATEMENT OF CASH FLOWS  You have just been hired as a financial analyst for Barrington
Industries. Unfortunately, company headquarters (where all of the firm’s records are kept)
has been destroyed by fire. So, your first job will be to recreate the firm’s cash flow state-
ment for the year just ended. The firm had $100,000 in the bank at the end of the prior
year, and its working capital accounts except cash remained constant during the year. It
earned $5 million in net income during the year but paid $800,000 in dividends to com-
mon shareholders. Throughout the year, the firm purchased $5.5 million of machinery that
was needed for a new project. You have just spoken to the firm’s accountants and learned
that annual depreciation expense for the year is $450,000; however, the purchase price for
the machinery represents additions to property, plant, and equipment before depreciation.
Finally, you have determined that the only financing done by the firm was to issue long-
term debt of $1 million at a 6% interest rate. What was the firm’s end-of-year cash balance?
Recreate the firm’s cash flow statement to arrive at your answer.

3-14 FREE CASH FLOW Arlington Corporation’s financial statements (dollars and shares are in
millions) are provided here.

Balance Sheets as of December 31

2018 2017
Assets
Cash and equivalents $ 15,000 $ 14,000
Accounts receivable 35,000 30,000
Inventories 33,320 27,000
Total current assets $ 83,320 $ 71,000
Net plant and equipment 48,000 46,000
Total assets $131,320 $ 117,000
Liabilities and Equity
Accounts payable $ 10,100 $ 9,000
Accruals 8,000 6,000
Notes payable 7,000 5,050
Total current liabilities $ 25,100 $ 20,050
Long-term bonds 20,000 20,000
Total liabilities $ 45,100 $ 40,050
Common stock (4,000 shares) 40,000 40,000
Retained earnings 46,220 36,950
Common equity $ 86,220 $ 76,950
Total liabilities and equity $131,320 $ 117,000

Income Statement for Year Ending December 31, 2018

Sales $210,000
Operating costs excluding depreciation and amortization 160,000
EBITDA $ 50,000
Depreciation and amortization 6,000
EBIT $ 44,000
Interest 5,350
EBT $ 38,650
Taxes (40%) 15,460
Net income $ 23,190
Dividends paid $ 13,920

a. What was net operating working capital for 2017 and 2018? Assume that all cash is
excess cash; i.e., this cash is not needed for operating purposes.
b. What was Arlington’s 2018 free cash flow?
c. Construct Arlington’s 2018 statement of stockholders’ equity.

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98 Part 2 Fundamental Concepts in Financial Management

d. What was Arlington’s 2018 EVA? Assume that its after-tax cost of capital is 10%.
e. What was Arlington’s MVA at year-end 2018? Assume that its stock price at
December 31, 2018 was $25.

Challenging 3-15 INCOME STATEMENT  Edmonds Industries is forecasting the following income statement:
Problems
15–18 Sales $10,000,000
Operating costs excluding depreciation and amortization 5,500,000
EBITDA $ 4,500,000
Depreciation and amortization 1,200,000
EBIT $ 3,300,000
Interest 500,000
EBT $ 2,800,000
Taxes (40%) 1,120,000
Net income $ 1,680,000

The CEO would like to see higher sales and a forecasted net income of $2,100,000. Assume
that operating costs (excluding depreciation and amortization) are 55% of sales and that
depreciation and amortization and interest expenses will increase by 6%. The tax rate,
which is 40%, will remain the same. (Note that while the tax rate remains constant, the taxes
paid will change.) What level of sales would generate $2,100,000 in net income?

3-16 FINANCIAL STATEMENTS  The Davidson Corporation’s balance sheet and income state-
ment are provided here.

Davidson Corporation: Balance Sheet as of December 31, 2018

(Millions of Dollars)
Assets Liabilities and Equity

Cash and equivalents $ 15 Accounts payable $ 120

Accounts receivable 515 Accruals 280
Inventories 880 Notes payable 220
Total current assets $1,410 Total current liabilities $ 620
Net plant and equipment 2,590 Long-term bonds 1,520
Total liabilities $2,140
Common stock (100 million shares) 260
Retained earnings 1,600
Common equity $1,860
Total assets $4,000 Total liabilities and equity $4,000

Davidson Corporation: Income Statement for Year Ending

December 31, 2018 (Millions of Dollars)
Sales $ 6,250
Operating costs excluding depreciation and amortization 5,230
EBITDA $ 1,020
Depreciation and amortization 220
EBIT $ 800
Interest 180
EBT $ 620
Taxes (40%) 248
Net income $ 372
Common dividends paid $ 146
Earnings per share $ 3.72

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 Chapter 3 Financial Statements, Cash Flow, and Taxes 99

a. Construct the statement of stockholders’ equity for December 31, 2018. No common
stock was issued during 2018.
b. How much money has been reinvested in the firm over the years?
c. At the present time, how large a check could be written without it bouncing?
d. How much money must be paid to current creditors within the next year?

3-17 FREE CASH FLOW Financial information for Powell Panther Corporation is shown here.

Powell Panther Corporation: Income Statements for Year Ending December 31 (Millions of Dollars)

2018 2017

Sales $ 1,200.0 $1,000.0

Operating costs excluding depreciation and amortization 1,020.0 850.0
EBITDA $ 180.0 $ 150.0
Depreciation and amortization 30.0 25.0
Earnings before interest and taxes (EBIT) $ 150.0 $ 125.0
Interest 21.7 20.2
Earnings before taxes (EBT) $ 128.3 $ 104.8
Taxes (40%) 51.3 41.9
Net income $ 77.0 $ 62.9
Common dividends $ 60.5 $ 46.4

Powell Panther Corporation: Balance Sheets as of December 31

(Millions of Dollars)

2018 2017
Assets
Cash and equivalents $ 12.0 $ 10.0
Accounts receivable 180.0 150.0
Inventories 180.0 200.0
Total current assets $ 372.0 $ 360.0
Net plant and equipment 300.0 250.0
Total assets $ 672.0 $ 610.0
Liabilities and Equity
Accounts payable $108.0 $ 90.0
Accruals 72.0 60.0
Notes payable 67.0 51.5
Total current liabilities $247.0 $ 201.5
Long-term bonds 150.0 150.0
Total liabilities $397.0 $ 351.5
Common stock (50 million shares) 50.0 50.0
Retained earnings 225.0 208.5
Common equity $275.0 $ 258.5
Total liabilities and equity $672.0 $ 610.0

a. What was net operating working capital for 2017 and 2018? Assume the firm has no
excess cash.
b. What was the 2018 free cash flow?
c. How would you explain the large increase in 2018 dividends?

3-18 PERSONAL TAXES  Mary Jarvis is a single individual who is working on filing her tax
return for the previous year. She has assembled the following relevant information:
●● She received $82,000 in salary.
●● She received $12,000 of dividend income.

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