CHAPTER 3

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

1.

Below are the 2007 and 2008 year-end balance sheets for Tran Enterprises:
Assets:
Cash
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets

2008
$ 200,000
864,000
2,000,000
$3,064,000
6,000,000
$9,064,000

2007
$ 170,000
700,000
1,400,000
$2,270,000
5,600,000
$7,870,000

Liabilities and equity:

Accounts payable
Notes payable
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total common equity
Total liabilities and equity

$1,400,000
1,600,000
$3,000,000
2,400,000
3,000,000
664,000
$3,664,000
$9,064,000

$1,090,000
1,800,000
$2,890,000
2,400,000
2,000,000
580,000
$2,580,000
$7,870,000

The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year, non-callable,
long-term debt in 2007. As of the end of 2008, none of the principal on this debt had been repaid. Assume
that the companys sales in 2007 and 2008 were the same. Which of the following statements must be
CORRECT?
a. The firm increased its short-term bank debt in 2008.
b. The firm issued long-term debt in 2008.
c. The firm issued new common stock in 2008.
d. The firm repurchased some common stock in 2008.
e. The firm had negative net income in 2008.
Answer: c
2.

On its 12/31/08 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same
amount was shown the following year. Assuming that no earnings restatements were issued, which of the
following statements is CORRECT?
a. If the company lost money in 2008, it must have paid dividends.
b. The company must have had zero net income in 2008.
c. The company must have paid out half of its 2008 earnings as dividends.
d. The company must have paid no dividends in 2008.
e. Dividends could have been paid in 2008, but they would have had to equal the earnings for the year.
Answer: e

3.

Below is the common equity section (in millions) of Timeless Technologys last two year-end balance
sheets:
Common stock
Retained earnings
Total common equity

2008
$2,000
2,000
$4,000

2007
$1,000
2,340
$3,340

The firm has never paid a dividend to its common stockholders. Which of the following statements is
CORRECT?
a.
b.
c.
d.

The companys net income in 2008 was higher than in 2007.

The firm issued common stock in 2008.
The market price of the firm's stock doubled in 2008.
The firm had positive net income in both 2007 and 2008, but its net income in 2008 was lower than it
was in 2007.
e. The company has more equity than debt on its balance sheet.
Answer: b
4.

Which of the following statements is CORRECT?

a.
b.
c.

Typically, a firms DPS should exceed its EPS.

Typically, a firms net income should exceed its EBIT.
If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price
exceed its book value per share.
d. If a firm is more profitable than most other firms, we would normally expect to see its book value per
share exceed its stock price, especially after several years of high inflation.
e. The more depreciation a firm has in a given year, the higher its EPS, other things held constant.
Answer: c
5.

Which of the following statements is CORRECT?

a.
b.

The more depreciation a firm reports, the higher its tax bill, other things held constant.
People sometimes talk about the firms cash flow, which is shown as the lowest entry on the income
statement, hence it is often called "the bottom line.
c. Depreciation reduces a firms cash balance, so an increase in depreciation would normally lead to a
reduction in the firms cash flow.
d. Operating income is derived from the firm's regular core business. Operating income is calculated as
Revenues less Operating costs. Operating costs do not include interest or taxes.
e. Depreciation is not a cash charge, so it does not have an effect on a firms reported profits.
Answer: d
6.

Which of the following factors could explain why Michigan Energy's cash balance increased even though it
had a negative cash flow last year?
a. The company sold a new issue of bonds.
b. The company made a large investment in new plant and equipment.
c. The company paid a large dividend.
d. The company had high depreciation expenses.
e. The company repurchased 20% of its common stock.
Answer: a

7.

Analysts who follow Howe Industries recently noted that, relative to the previous year, the companys net
cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the
following factors could explain this situation?
a. The company cut its dividend.
b. The company made large investments in fixed assets.
c. The company sold a division and received cash in return.
d. The company issued new common stock.
e. The company issued new long-term debt.
Answer: b

8.

Austin Financial recently announced that its net income increased sharply from the previous year, yet its

net cash provided from operations declined. Which of the following could explain this performance?
a. The companys dividend payment to common stockholders declined.
b. The companys expenditures on fixed assets declined.
c. The companys cost of goods sold increased.
d. The companys depreciation expense declined.
e. The companys interest expense increased.
Answer: d
9.

Which of the following statements is CORRECT?

a.

The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of
buying or selling fixed assets.
b. The statement of cash flows shows where the firms cash is located; indeed, it provides a listing of all
banks and brokerage houses where cash is on deposit.
c. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the
effects of changes in working capital.
d. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not
reflect cash obtained by selling new common stock.
e. The statement of cash flows shows how much the firms cash--the total of currency, bank deposits, and
short-term liquid securities (or cash equivalents)--increased or decreased during a given year.
Answer: e
10.

Which of the following statements is CORRECT?

a.

In the statement of cash flows, a decrease in accounts receivable is subtracted from net income in the
operating activities section.
b. Dividends do not show up in the statement of cash flows because dividends are considered to be a
financing activity, not an operating activity.
c. In the statement of cash flows, a decrease in accounts payable is subtracted from net income in the
operating activities section.
d. In the statement of cash flows, depreciation is subtracted from net income in the operating activities
section.
e. In the statement of cash flows, a decrease in inventories is subtracted from net income in the operating
activities section.
Answer: c
11.

Which of the following statements is CORRECT?

a.
b.
c.

Most rapidly growing companies have positive free cash flows because cash flows from existing
operations generally exceed fixed asset purchases and changes to net working capital.
Changes in working capital have no effect on free cash flow.
Free cash flow (FCF) is defined as follows:
FCF =

d.

EBIT(1 - T)
+ Depreciation
- Capital expenditures required to sustain operations
- Required changes in net working capital.

Free cash flow (FCF) is defined as follows:

FCF = EBIT(1 - T) + Capital expenditures.

e.

Managers should be less concerned with free cash flow than with accounting net income. Accounting
net income is the "bottom line" and represents how much the firm can distribute to all its
investors--both creditors and stockholders.
Answer: c
12.

Which of the following statements is CORRECT?

a.

The income of certain small corporations that qualify under the Tax Code is completely exempt from
corporate income taxes. Thus, the federal government receives no tax revenue from these businesses,
even though they report high accounting profits.
b. All businesses, regardless of their legal form of organization, are taxed under the Business Tax
Provisions of the Internal Revenue Code.
c. Small corporations that qualify under the Tax Code can elect not to pay corporate taxes, but then each
stockholder must report his or her pro rata shares of the firms income as personal income and pay
taxes on that income.
d. Congress recently changed the tax laws to make dividend income received by individuals exempt from
income taxes. Prior to the enactment of that law, corporate income was subject to double taxation,
where the firm was first taxed on the corporation's income and stockholders were taxed again on this
income when it was paid to them as dividends.
e. All corporations other than non-profits are subject to corporate income taxes, which are 15% for the
lowest amounts of income and 38% for the highest amounts.
Answer: c
13.

Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and
(3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this
situation?
a. The company had a sharp increase in its inventories.
b. The company had a sharp increase in its accrued liabilities.
c. The company sold a new issue of common stock.
d. The company made a large capital investment early in the year.
e. The company had a sharp increase in depreciation expenses.
Answer: c

14.

Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax
revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that
sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is
used for tax and stockholder reporting purposes.
a. Companies after-tax operating profits would decline.
b. Companies physical stocks of fixed assets would increase.
c. Companies cash flows would increase.
d. Companies cash positions would decline.
e. Companies reported net incomes would decline.
Answer: d

15.

Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to double its
depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate.
Prior to the new provision, BBIs net income was forecasted to be $4 million. Which of the following best
describes the impact of the new provision on BBIs financial statements versus the statements without the
provision? Assume that the company uses the same depreciation method for tax and stockholder reporting
purposes.
a.
b.

The provision will reduce the companys cash flow.

The provision will increase the companys tax payments.

c. The provision will increase the firm's operating income (EBIT).

d. The provision will increase the companys net income.
e. Net fixed assets on the balance sheet will decrease.
Answer: e
16.

A start-up firm is making an initial investment in new plant and equipment. Assume that currently its
equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering
legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes
law, which of the following would occur in the year following the change?
a. The firms operating income (EBIT) would increase.
b. The firms taxable income would increase.
c. The firms cash flow would increase.
d. The firms tax payments would increase.
e. The firms reported net income would increase.
Answer: c

17.

Which of the following statements is CORRECT?

a.
b.

Dividends paid reduce the net income that is reported on a companys income statement.
If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this
will cause a decline in its current assets as shown on the balance sheet.
c. If a company issues new long-term bonds to purchase fixed assets during the current year, this will
increase both its reported current assets and current liabilities at the end of the year.
d. Accounts receivable are reported as a current liability on the balance sheet.
e. If a company pays more in dividends than it generates in net income, its retained earnings as reported
on the balance sheet will decline from the previous year's balance.
Answer: e
18.

Which of the following statements is CORRECT?

a.

Since depreciation increases the firm's net cash provided by operating activities, the more depreciation
a company has, the larger its retained earnings will be, other things held constant.
b. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to
make required payments.
c. Common equity includes common stock and retained earnings, less accumulated depreciation.
d. The retained earnings account as reported on the balance sheet shows the amount of cash that is
available for paying dividends.
e. If a firm reports a loss on its income statement, then the retained earnings account as shown on the
balance sheet will be negative.
Answer: b
19.

Emery Mining Inc. recently reported $150,000 of sales, $75,500 of operating costs other than depreciation,
and $10,200 of depreciation. The company had $16,500 of outstanding bonds that carry a 7.25% interest
rate, and its federal-plus-state income tax rate was 35%. How much was the firm's net income? The firm
uses the same depreciation expense for tax and stockholder reporting purposes.
a. $35,167.33
b. $37,018.24
c. $38,966.57
d. $41,017.44
e. $43,068.31
Answer: d
Bonds
Interest rate

$16,500
7.25%

Tax rate
Sales
Operating costs excluding depreciation
Depreciation
Operating income (EBIT)
Interest charges
Taxable income
Taxes
Net income
20.

On 12/31/08, Hite Industries reported retained earnings of $525,000 on its balance sheet, and it reported
that it had $135,000 of net income during the year. On its previous balance sheet, at 12/31/07, the company
had reported $445,000 of retained earnings. No shares were repurchased during 2008. How much in
dividends did the firm pay during 2008?
a. $49,638
b. $52,250
c. $55,000
d. $57,750
e. $60,638
Answer: c
12/31/08 RE
12/31/07 RE
Change in RE
Net income for 2008
Dividends = Net income Change

21.

35%
$150,000
75,500
10,200
$64,300.00
-1,196.25
$63,103.75
-22,086.31
$41,017.44

$525,000
445,000
$ 80,000
$135,000
$ 55,000

During 2008, Bascom Bakery paid out $33,525 of common dividends. It ended the year with $197,500 of
retained earnings versus the prior years retained earnings of $159,600. How much net income did the firm
earn during the year?
a. $71,425
b. $74,996
c. $78,746
d. $82,683
e. $86,818
Answer: a
Net income = The change in retained earnings plus the dividends paid:
Current RE
$197,500
Previous RE = Current RE increment
159,600
Change in RE
$ 37,900
Plus dividends paid
33,525
= Net income
$ 71,425

22.

A company with a 15% tax rate buys preferred stock in another company. The preferred stock has a beforetax yield of 8%. What is the preferred stocks after-tax return?
a. 6.90%
b. 7.26%
c. 7.64%
d. 8.02%
e. 8.42%
Answer: c
Preferred dividend rate

8.00%

Tax rate
Dividend exclusion %

15%
70%

If a company buys preferred stock in another company, 70% of the dividends are excluded from taxes.
Therefore, the after-tax return will be:
After-tax dividend yield = Preferred dividend rate[1 (1 Div. exclusion %)(T)]
After-tax dividend yield = 7.64%
23.

Wu Systems has the following balance sheet. How much net working capital does the firm have?
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets

$ 100
650
550
$1,300
1,000

Total assets

$2,300

a. $675
b. $750
c. $825
d. $908
e. $998
Answer: b
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets

$ 100
650
550
$1,300
1,000

Total assets

$2,300

Accounts payable
Accruals
Notes payable
Current liabilities
Long-term debt
Common equity
Retained earnings
Total liab. & equity

$ 200
350
350
$ 900
600
300
500
$2,300

Accounts payable
Accruals
Notes payable
Current liabilities
Long-term debt
Common equity
Retained earnings
Total liab. & equity

$ 200
350
350
$ 900
600
300
500
$2,300

Net working capital = Current assets AP Accruals

NWC = $1,300.00 $550.00
NWC = $750
24.

Last year Almazan Software reported $10.50 million of sales, $6.25 million of operating costs other than
depreciation, and $1.30 million of depreciation. The company had $5.00 million of bonds that carry a 6.5%
interest rate, and its federal-plus-state income tax rate was 35%. This year's data are expected to remain
unchanged except for one item, depreciation, which is expected to increase by $0.70 million. By how
much will net income change as a result of the change in depreciation? The company uses the same
depreciation calculations for tax and stockholder reporting purposes.
a. -$0.432
b. -$0.455
c. -$0.478
d. -$0.502
e. -$0.527
Answer: b
This problem can be worked very easily--just multiply the increase in depreciation by (1 T) to get
the decrease in net income:

Change in depreciation
Tax rate
Reduction in net income

$0.700
0.350
$0.455

We can also get the answer a longer way, which explains things more clearly:
Bonds
Interest rate
Tax rate
Sales
Operating costs excluding depreciation
Depreciation
Operating income (EBIT)
Interest charges
Taxable income
Taxes
Net income
25.

New
$5.000
0.065
0.350
$10.500
$6.250
$2.000
$2.250
$0.325
$1.925
$0.674
$1.251

Change
$0.000
0.000
0.000
$0.000
$0.000
$0.700
-$0.700
$0.000
-$0.700
-$0.245
-$0.455

C. F. Lee Inc. has the following income statement. How much after-tax operating income does the firm
have?
Sales
Costs
Depreciation
EBIT
Interest expense
EBT
Taxes (35%)
Net income
a. $427.78
b. $450.29
c. $473.99
d. $498.94
e. $525.20
Answer: e
Sales
Costs
Depreciation
EBIT
Interest expense
EBT
Taxes: rate = 35%
Net income
EBIT
Tax rate
EBIT(1 T) =

26.

Old
$5.000
0.065
0.350
$10.500
$6.250
$1.300
$2.950
$0.325
$2.625
$0.919
$1.706

$2,850.00
1,850.00
192.00
$ 808.00
285.00
$ 523.00
183.05
$ 339.95

$2,850.00
1,850.00
192.00
$ 808.00
285.00
$ 523.00
183.05
$ 339.95
$808.00
35%
$525.20

Hartzell Inc. had the following data for 2007, in millions: Net income = $600; after-tax operating income
[EBIT (1-T)] = $700; and Total assets = $2,000. Information for 2008 is as follows: Net income = $825;
after-tax operating income [EBIT (1-T)] = $925; and Total assets = $2,500. How much free cash flow did
the firm generate during 2008?

a. $383
b. $425
c. $468
d. $514
e. $566
Answer: b
EBIT(1 T)
Total assets

2,007
$2,000

2,008
$2,500

Change = Net invest. in FA + NWC

$500

2008 FCF = EBIT(1 T) Net investment in FA + NWC

2008 FCF = $925 $500
2008 FCF = $425
27.

Shrives Publishing recently reported $10,750 of sales, $5,500 of operating costs other than depreciation,
and $1,250 of depreciation. The company had $3,500 of bonds that carry a 6.25% interest rate, and its
federal-plus-state income tax rate was 35%. During the year, the firm had expenditures on fixed assets and
net working capital that totaled $1,550. These expenditures were necessary for it to sustain operations and
generate future sales and cash flows. What was its free cash flow?
a. $1,873
b. $1,972
c. $2,076
d. $2,185
e. $2,300
Answer: e
Bonds
Interest rate
Tax rate

$3,500.00
6.25%
35.00%

Sales
Operating costs excluding depreciation
Depreciation
Operating income (EBIT)
Capex + NWC =
Tax rate =

$10,750.00
5,500.00
1,250.00
$ 4,000.00
$1,550.00
35%

FCF = EBIT(1 T) + Deprec. ( Capex + NWC)

FCF = $2,600 + $1,250 $1,550
Free cash flow = $2,300
28.

A corporate bond currently yields 8.5%. Municipal bonds with the same risk, maturity, and liquidity
currently yield 5.5%. At what tax rate would investors be indifferent between the two bonds?
a. 35.29%
b. 37.06%
c. 38.91%
d. 40.86%
e. 42.90%
Answer: a
Bond yield
Municipal bond yield

8.50%
5.50%

Municipal yield = After-tax bond yield

5.50% = 8.50% (1 T)

0.6471 = (1 T)
T = 35.29%
29.

A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 27%.
What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax
return?
a. 5.64%
b. 5.93%
c. 6.25%
d. 6.58%
e. 6.90%
Answer: d
Municipal bond yield
Tax rate
Municipal yield
4.80%
4.80%
BT yield

30.

4.80%
27.00%

= After-tax bond yield

= BT yield (1 T)
= BT yield 73.00%
= 6.58%

Moose Industries faces the following tax schedule:

Tax on Base
of Bracket
$0
7,500
13,750
22,250
113,900
3,400,000
5,150,000
6,416,667

Taxable Income
Up to $50,000
$50,000-$75,000
$75,000-$100,000
$100,000-$335,000
$335,000-$10,000,000
$10,000,000-$15,000,000
$15,000,000-$18,333,333
Over $18,333,333

Percentage on
Excess above Base
15%
25
34
39
34
35
38
35

Last year the company realized $10,000,000 in operating income (EBIT). Its annual interest expense is
$1,500,000. What was the companys net income for the year?
a. $4,809,874
b. $5,063,025
c. $5,329,500
d. $5,610,000
e. $5,890,500
Answer: d
Operating income
Interest expense

$10,000,000
$1,500,000

Taxable income = Operating income Interest expense

Taxable income = Operating income Interest expense
Taxable income = $8,500,000
Taxable
Income
$0
$50,000

Tax on Base
of Bracket
$0
7,500

% on
Excess above Base
15%
25%

$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333

13,750
22,250
113,900
3,400,000
5,150,000
6,416,667

34%
39%
34%
35%
38%
35%

Tax on base = $113,900

Tax on excess base = $2,776,100
Tax liability = $2,890,000
Net income = Taxable income Taxes
Net income = $5,610,000
31.

Corporations face the following tax schedule:

Tax on Base
of Bracket
$0
7,500
13,750
22,250
113,900
3,400,000
5,150,000
6,416,667

Taxable Income
Up to $50,000
$50,000-$75,000
$75,000-$100,000
$100,000-$335,000
$335,000-$10,000,000
$10,000,000-$15,000,000
$15,000,000-$18,333,333
Over $18,333,333

Percentage on
Excess above Base
15%
25
34
39
34
35
38
35

Company Z has $80,000 of taxable income from its operations, $5,000 of interest income, and $30,000 of
dividend income from preferred stock it holds in other corporations. What is Company Zs tax liability?
a. $17,328
b. $18,240
c. $19,200
d. $20,210
e. $21,221
Answer: d
Taxable income
Interest income
Dividend income
Dividend exclusion %

$80,000
$5,000
$30,000
70%

Total taxable income = Taxable income + Interest income + Taxable dividend income
Total taxable income = Taxable income + Interest income + Dividend income (1 Dividend exclusion %)
Total taxable income = $94,000
Taxable
Income
$0
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333

Tax on Base
of Bracket
$0
7,500
13,750
22,250
113,900
3,400,000
5,150,000
6,416,667

% on
Excess above Base
15%
25%
34%
39%
34%
35%
38%
35%

Tax on base = $13,750

Tax on excess base = $6,460
Tax liability = $20,210