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# Chapter 03 - Accounting and Finance

Solutions to Chapter 3
Accounting and Finance
1.

Assets
Cash
Accounts receivable
Inventory
Store & property
Total assets

Sophies Sofas
Liabilities &
Shareholders Equity
\$ 10,000 Accounts payable
22,000 Long-term debt
200,000 Shareholders equity
100,000
Total liabilities &
\$332,000 Shareholders equity

\$ 17,000
170,000
145,000

\$332,000

## Est time: 0105

2.

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
snapshot. 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.

## Est time: 0105

3.

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.

4.

## 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.

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5.

a.

## Taxes = (0.10 \$8,500) + 0.15 (\$20,000 \$8,500) = \$2,575

Average tax rate = \$2,575/\$20,000 = 0.12875 = 12.88%
Marginal tax rate = 15%

b.

## Taxes = (0.10 \$8,500) + 0.15 (\$34,500 \$8,500) + 0.25 (\$50,000 \$34,500)

= \$8,625
Average tax rate = \$8,625/\$50,000 = 0.1725 = 17.25%
Marginal tax rate = 25%

c.

## Taxes = (0.10 \$8,500) + 0.15 (\$34,500 \$8,500) + 0.25 (\$83,600 \$34,500)

+ 0.28 (\$174,400 \$83,600) + 0.33 (\$300,000 \$174,400) = \$83,897
Average tax rate = \$83,897/\$300,000 = 0.279657 = 27.97%
Marginal tax rate = 33%

d.

## Taxes = (0.10 \$8,500) + 0.15 (\$34,500 \$8,500) + 0.25 (\$83,600 \$34,500)

+ 0.28 (\$174,400 \$83,600) + 0.33 (\$379,150 \$174,400)
+ 0.35 (\$3,000,000 \$379,150) = \$1,027,314
Average tax rate = \$1,027,314/\$3,000,000 = 0.342438 = 34.24%
Marginal tax rate = 35%

6.

## Taxes = (0.15 \$50,000) + 0.25 (\$75,000 \$50,000) + 0.34 (\$100,000 \$75,000)

= \$22,250
Average tax rate = \$22,250/\$100,000 = 0.2225 = 22.25%
Marginal tax rate = 34%

7.

## Taxes = (0.10 \$17,000) + 0.15 (\$69,000 \$17,000) + 0.25 (\$95,000 \$69,000)

= \$16,000
Average tax rate = \$16,000/\$95,000 = 0.168421 = 16.84%
Marginal tax rate = 25%

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## Chapter 03 - Accounting and Finance

8.

a.

Cash will increase as one current asset (inventory) is exchanged for another (cash).

b.

Cash will increase. The machine will bring in cash when it is sold, but the lease
payments will be made over several years.

c.

The firm will use cash to buy back the shares from existing shareholders. Cash
balance will decrease.

## Est time: 0105

9.

a.

The fact that start-up firms typically have negative net cash flows for several years
does not mean they are failing. Start-up firms invest in inventories and other assets
designed to produce income in later periods.

b.

Accounting profits for start-up businesses are also commonly negative because these
firms incur costs, such as advertising, that cannot be recorded on the balance sheet.
These costs are general administrative expenses the firm incurs in each period, not
investments like those in inventories that are built up for future sales.

## Est time: 0610

10.

a.

In early 2010 investors saw the value of assets on the books of these banks as worth
less than the value recorded, which may be historical value. Loans are the primary
assets for banks, and investors perceived a high likelihood that the loans these banks
made would default. If so, the banks would need to write down their values, reducing
income available to shareholders.

b.

In contrast to the banks, investors perceived the assets of this company to be worth
more than the historical value presented on the companys book. Consistent with the
analysis in part (a), shareholders in this company are expecting to have higher income
in future periods, and the value of the companys assets are expected to grow.

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## Chapter 03 - Accounting and Finance

11.

The table below shows the firms net income and investment in net working capital for each
month from January to April. Sales revenue and production costs are recognized at the time
of sale in February. Since the firm neither pays for goods nor receives cash for sales, cash
flow is zero in January and February. Cash flow occurs in March and April, when cash is
actually being exchanged. The sow ears are paid for in March and cash is received for the
purses in April.

a.
Sales
Cost of goods sold
Net income
Inventories
Accounts receivable
Accounts payable
Net working capital

## Value Added Inc. (in 000s)

January
February
March
\$0
\$2,000
0
\$1,000
\$0
\$1,000
\$1,000
0
\$1,000
0

0
2,000
\$1,000
\$1,000

b., c.
Cash flow
\$0
\$0
Cash flow = net income change in net working capital

April
\$0
0
\$0

\$0
0
\$0

0
2,000
0
\$2,000

\$0
0
0
\$0

\$1,000

\$2,000

12.

## Net income = increase in retained earnings + dividends

\$900,000 = (\$3,700,000 \$3,400,000) + dividends dividends = \$600,000

13.

## Taxes on your salary = (0.10 \$8,500) + 0.15 (\$34,500 \$8,500)

+ 0.25 (\$70,000 \$34,500) = \$13,625
Taxes on corporate income = 0.15 \$30,000 = \$4,500
Total taxes = \$13,625 + \$4,500 = \$18,125
If you rearrange income so that your salary and the firm's profit are both \$50,000, then:
Taxes on your salary = (0.10 \$8,500) + 0.15 (\$34,500 \$8,025)
+ 0.25 (\$50,000 \$34,500) = \$8,625
Taxes on corporate income = 0.15 \$50,000 = \$7,500

3-4

## Total taxes = \$8,625 + \$7,500 = \$16,125

Total taxes are reduced by \$18,125 \$16,125 = \$2,000.
Est time: 0610
14.

a.

Book value equals the \$200,000 the founder of the firm has contributed in tangible
assets. Market value equals the value of his patent plus the value of the production
plant: \$50,000,000 + \$200,000 = \$50,200,000.

b.

## Price per share = \$50.2 million/2 million shares = \$25.10

Book value per share = \$200,000/2 million shares = \$0.10

## Est time: 0105

15.
Sales
\$10,000
Cost of goods sold
6,500
1,000
Depreciation expense
1,000
EBIT
1,500
Interest expense
500
Taxable income
1,000
Taxes (35%)
350
Net income
\$ 650
Cash flow from operations = net income + depreciation expense = \$1,650
Est time: 0610
16.

Cash flow from operations can be positive even if net income is negative. For example,
if depreciation expenses are large, then negative net income might correspond to positive
cash flow because depreciation is treated as an expense in calculating net income but
does not represent a cash outflow.
Conversely, if net income is positive, but a large portion of sales are made on credit, cash
flow can be negative since the sales are revenue but do not yet generate cash. Look back
to Table 3.4 and you will see that increases in accounts receivable reduce cash provided
by operations.

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## Chapter 03 - Accounting and Finance

17.

The calculations are presented in the following table. Sales occur in quarters 2 and 3, so
this is when the cost of goods sold is recognized. Therefore, net income is zero in
quarters 1 and 4. In quarter 1, the production of the kits is treated as an investment in
inventories. The level of inventories then falls as goods are sold in quarters 2 and 3.
Accounts receivable in quarters 2 and 3 equal the sales in those quarters since it takes one
quarter for receivables to be collected. Notice that cash flow in quarter 1 equals the cost
of producing the kits and that in quarters 3 and 4 cash flow equals cash received for the
kits previously sold.

a.
Sales
Cost of goods sold
Net income
b., c.
Inventories
Accounts receivable
Net working capital

Quarter 1
\$0
0
\$0

Quarter 2
\$550
500
\$ 50

Quarter 3
\$600
500
\$100

\$1,000
0
\$1,000

\$ 500
550
\$1,050

Quarter 4
\$0
0
\$0

0
600
\$600

\$0
0
\$0

Cash flow
\$1,000
\$0
\$550
Cash flow = net income change in net working capital

\$600

18.

## Cash flow = profits accounts receivable

+ accounts payable
inventory

10,000
+ 5,000
(2,000)

## Cash flow = profits 10,000 + 5,000 (2,000) = profits 3,000

Therefore, cash flow is \$3,000 less than profits. This corresponds to the increase of \$3,000
in net working capital.
Est time: 0610

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## Chapter 03 - Accounting and Finance

19.

a.

If the firm paid income taxes of \$2,000, and the average tax rate was 20%,
then taxable income must have been: \$2,000/0.20 = \$10,000.
Therefore: Net income = taxable income taxes = \$8,000

b.
Revenues
Cost of goods sold
Depreciation expense
Interest expense
Taxable income

???
8,000
3,000
1,000
1,000
\$10,000 [from part (a)]

## We conclude that revenues were \$23,000.

c.
Revenues
Cost of goods sold
Depreciation expense
EBIT

\$23,000
8,000
3,000
1,000
\$11,000

## Est time: 0610

20.

a.

Sales
Cost of goods sold
Interest expense
Depreciation expense
Taxable income
Taxes (35%)
Net income

\$14.00 million
8.00
1.00
2.00
3.00
1.05
\$ 1.95 million

b.

## If depreciation expense were increased by \$1 million, net income would be

reduced by \$0.65 million. Cash flow (= net income + depreciation) would be
increased by \$0.65 million + \$1 million = \$0.35 million.
Cash flow increases because depreciation expense is not a cash outflow, but
increasing the depreciation expense for tax purposes reduces taxes paid by
\$0.35 million.

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## Chapter 03 - Accounting and Finance

c.

The impact on stock price is likely to be positive. Cash available to the firm
would increase. The reduction in net income would be recognized as
resulting entirely from accounting changes, not as a consequence of any
changes in the underlying profitability of the firm.

d.

If interest expense were \$1 million higher, both net income and cash flow
would decrease by \$0.65 million, i.e., by the \$1 million increase in expenses
less the \$0.35 million reduction in taxes. This differs from part (b) because, in
contrast to depreciation, interest expense represents an actual cash outlay.

## Est time: 1115

21.
Candy Canes, Inc.
April
May
Sales
\$
0 \$150,000
Cost of goods sold
0
100,000
Accounts receivable
0
150,000
Inventory
100,000 100,000
Cash flow*
100,000
0
Net income**
\$
0
\$ 50,000

June
0
0
150,000
0
150,000
\$
0

## *Cash flow = sales COGS A/R inventory

** Net income = sales COGS
Est time: 0610
22.
Assets
Current assets
Net fixed assets
Total assets

2010
310
1,200
1,510

2011
420
1,420
1,840

Liabilities and
Owners Equity
Current liabilities
Long-term debt
Total liabilities
Owners equity
Total

2010
210
830
1,040
470
1,510

2011
240
920
1,160
680
1,840

a.

Owners equity = total assets total liabilities (as shown in the balance sheet above)

b.

If the firm issued no stock, the increase in owners equity must be due entirely to
retained earnings. Since owners equity increased by \$210 and dividends were \$100,
net income must have been \$310.

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## Chapter 03 - Accounting and Finance

c.

Since net fixed assets increased by \$220, and the firm purchased \$300 of new fixed
assets, the depreciation charge must have been \$80.

d.

Net working capital increased by \$80, from (\$310 \$210) = \$100 in 2010 to
(\$420 \$240) = \$180 in 2011.

e.

Since long-term debt increased by \$90, and the firm issued \$200 of new long-term
debt, \$110 of outstanding debt must have been paid off.

23.

a.

## Shareholders equity = total assets total liabilities

2010: Shareholders equity = \$890 \$650 = \$240
2011: Shareholders equity = \$1,040 \$810 = \$230

b.

## Net working capital = current assets current liabilities

2010: Net working capital = \$90 \$50 = \$40
2011: Net working capital = \$140 \$60 = \$80

c.

## Taxable income = \$1,950 \$1,030 \$350 \$240 = \$330

Taxes paid = 0.35 \$330 = \$115.50
Net income = \$214.50

d.

Net income
Decrease (increase) in current assets
Increase in current liabilities
Cash provided by operations

e.

## Gross investment = increase in net fixed assets + depreciation

= \$100 + \$350 = \$450

f.

## Current liabilities increased by \$10. Therefore, current liabilities other than

accounts payable must have increased by \$45.

3-9

\$214.50
(50.00)
10.00
\$174.50

## Chapter 03 - Accounting and Finance

24.
Liabilities and
Assets
2010
2011 Shareholders Equity
2010
2011
Cash & marketable securities \$ 800 \$ 300 Accounts payable
\$ 300 \$ 350
Inventories
300
350 Notes payable
1,000
600
Accounts receivable
400
450 Long-term debt
2,000 2,400
Net fixed assets
5,000 5,800 Total liabilities
3,300 3,350
Total assets
\$6,500 \$6,900 Shareholders equity
3,200 3,550
Total liabilities plus
shareholders equity \$6,500 \$6,900
Est time: 0610

25.

Net working capital (2010) = (\$800 + \$300 + \$400) (\$300 + \$1,000) = \$200
Net working capital (2011) = (\$300 + \$350 + \$450) (\$350 + \$600) = \$150
Net working capital decreased by \$50.

## Est time: 0105

26.
Revenue
Cost of goods sold
Depreciation expense
Interest expense
Taxable income
Federal & state income taxes
Net income

2010
\$4,000
1,600
500
500
150
1,250
400
\$ 850

2011
\$4,100
1,700
550
520
150
1,180
420
\$ 760

Increase in retained earnings in 2011 = net income dividends = \$760 \$410 = \$350
In 2011, shareholders equity increased by the amount of the increase in retained earnings.
Est time: 0610
27.

## Earnings per share in 2010 = \$850,000/500,000 shares = \$1.70

Earnings per share in 2011 = \$760,000/500,000 shares = \$1.52

3-10

28.

## Average tax bracket in 2010 = taxes/taxable income = \$400/\$1,250 = 0.320 = 32.0%

Average tax bracket in 2011 = \$420/\$1180 = 0.356 = 35.6%
In order to determine the firms marginal tax bracket, one would need information
regarding tax rates applicable for both federal and state income taxes.

## Est time: 0105

29.

Net fixed assets increased by \$800,000 during 2011, while depreciation expense in 2011
was \$520,000. Therefore, gross investment in plant and equipment was \$1,320,000.

## Est time: 0105

30.
Cash provided by operations
Net income
Noncash expenses
Depreciation expense
Changes in working capital
Decrease (increase) in accounts receivable
Decrease (increase) in inventories
Increase (decrease) in accounts payable
Total change in working capital
Cash provided by operations
Cash flows from investments
Cash provided by (used for) disposal of
(additions to) property, plant & equipment
Cash provided by (used for) investments
Cash provided by (used for) financing activities
Additions to (reductions in) notes payable
Additions to (reductions in) long-term debt
Dividends paid
Cash provided by (used for ) financing activities
Net increase (decrease) in cash and cash equivalents
Est time: 0610

3-11

\$ 760
520
(50)
(50)
50
(50)
\$1,230
(1,320)
(1,320)
(400)
400
(410)
(410)
(\$500)

## Chapter 03 - Accounting and Finance

31.
Market Value Balance Sheet, 2011
(figures in thousands of dollars)
Liabilities &
Shareholders Equity
Assets
Cash
\$ 300 Accounts payable
Inventories
350 Notes payable
Accounts receivable
450 Long-term debt
Employee skills
2,900 Total liabilities
Net fixed assets
6,000 Shareholders equity*
Total liabilities &
Total assets
\$10,000
shareholders equity
* Shareholders' equity = total assets total liabilities
Price per share = \$6,850,000/500,000 shares = \$13.70
Est time: 0610

3-12

350
600
2,200
3,350
6,850

\$10,000

32.

a.

Income
10,000
20,000
40,000
80,000
100,000
150,000
200,000
250,000
300,000
350,000
450,000
550,000
650,000
750,000
1,000,000
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000

Taxes Due
1,000
2,575
6,125
16,125
21,617
35,617
50,897
67,397
83,897
100,397
134,814
169,814
204,814
239,814
327,314
677,314
1,377,314
2,077,314
2,777,314
3,477,314

Average Tax
Rate (%)
10.00
12.88
15.31
20.16
21.62
23.74
25.45
26.96
27.97
28.68
29.96
30.88
31.51
31.98
32.73
33.87
34.43
34.62
34.72
34.77

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## Chapter 03 - Accounting and Finance

b.

As shown in the table and graph above, the difference between average tax
rates and the top marginal tax rate of 35% becomes very small as income
becomes large.

c.

For corporations the marginal tax rate is 35%. When analyzing very large
firms we are content simply treating the corporate tax rate as 35% since
average taxes are likely to be equal. Very large firms are unlikely to have
incomes in the lower brackets.

## Est time: 0610

33.

To minimize taxes, you should not have income in one tax category (that is,
personal versus corporate) if you can move the income into the other category at a
lower tax rate. First, suppose that your total income is \$79,700. Then you could
allocate \$50,000 to corporate income, the maximum amount that would be taxed at
15%, and \$29,700 to personal income, the maximum amount that would be taxed
at 15%. Additional corporate income, up to an additional (\$75,000 \$50,000) =
\$25,000, would be taxed at 25%, and additional individual income, up to an
additional (\$83,600 \$29,700) = \$53,900, would also be taxed at 25%. Therefore,
you are indifferent as to whether the remaining (\$100,000 \$79,700) = \$20,300 in
income is allocated to corporate income or individual income or a combination of
the two.

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