Name: ________________________ Class: ___________________ Date: __________ ID: A

Homework Ch. 3

____ 1. The annual report contains four basic financial statements: the income statement, the balance sheet, the cash
flow statement, and statement of stockholders' equity.

____ 2. The primary reason the annual report is important in finance is that it is used by investors when they form
expectations about the firm's future earnings and dividends, and the riskiness of those cash flows.

____ 3. Companies typically provide four basic financial statements: the fixed income statement, the current income
statement, the balance sheet, and the cash flow statement.

____ 4. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the
company has made the investments in current and fixed assets that are necessary to sustain ongoing
operations.

____ 5. The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows
a business is able to provide to its investors is its free cash flow. This is the reason that FCF is so important
in finance.

____ 6. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the
dividends the company paid. Therefore, the dividends are frequently called "the bottom line."

____ 7. An increase in accounts payable represents an increase in net cash provided by operating activities just like
borrowing money from a bank. An increase in accounts payable has an effect similar to taking out a new
bank loan. However, these two items show up in different sections of the statement of cash flows.

____ 8. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as
a tax-deductible expense, this would probably encourage companies to use more debt financing than they
presently do, other things held constant.

____ 9. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not
deductible. This treatment, other things held constant, tends to encourage the use of debt financing by
corporations.

____ 10. The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy
individuals to avoid paying taxes through the use of various deductions.

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Name: ________________________ ID: A

____ 11. Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets:
The firm has never paid a dividend to its common stockholders. Which of the following statements is
CORRECT?

2011 2010
Common stock 2,000 1,000
Retained earnings 2,000 2,340
Total common equity $4,000 $3,340

a. The company’s net income in 2011 was higher than in 2010.

b. The firm issued common stock in 2011.
c. The market price of the firm's stock doubled in 2011.
d. The firm had positive net income in both 2010 and 2011, but its net income in 2011 was
lower than it was in 2010.
e. The company has more equity than debt on its balance sheet.

____ 12. 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, BBI’s net income was forecasted to be $4 million. Which of the following best
describes the impact of the new provision on BBI’s financial statements versus the statements without the
provision? Assume that the company uses the same depreciation method for tax and stockholder reporting
purposes.
a. The provision will reduce the company’s cash flow.
b. The provision will increase the company’s tax payments.
c. The provision will increase the firm's operating income (EBIT).
d. The provision will increase the company’s net income.
e. Net fixed assets on the balance sheet will decrease.

____ 13. 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.

____ 14. Brown Office Supplies recently reported $13,500 of sales, $8,250 of operating costs other than depreciation,
and $1,750 of depreciation. It had $9,000 of bonds outstanding that carry a 7.0% interest rate, and its
federal-plus-state income tax rate was 40%. How much was the firm's earnings before taxes (EBT)?
a. $3,272
b. $2,870
c. $2,784
d. $2,755
e. $2,841

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Name: ________________________ ID: A

____ 15. Scranton Shipyards has $7 million in total investor-supplied operating capital, and its WACC is 10%.
Scranton has the following income statement:

Sales $10.0 million

Operating costs 6.0 million
Operating income (EBIT) $ 4.0 million
Interest expense 2.0 million
Earnings before taxes (EBT) $ 2.0 million
Taxes (40%) 0.8 million
Net income $ 1.2 million

What is Scranton’s EVA?

a. $1,785,000
b. $1,360,000
c. $1,700,000
d. $1,445,000
e. $1,615,000

____ 16. Lovell Co. purchased preferred stock in another company. The preferred stock’s before-tax yield was 9.6%.
The corporate tax rate is 40%. What is the after-tax return on the preferred stock, assuming a 70% dividend
exclusion?
a. 7.69%
b. 8.45%
c. 8.62%
d. 8.19%
e. 6.50%

____ 17. Houston Pumps recently reported $185,000 of sales, $140,500 of operating costs other than depreciation, and
$9,250 of depreciation. The company had $35,250 of outstanding bonds that carry a 6.75% interest rate, and
its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate future sales
and cash flows, the firm was required to spend $15,250 to buy new fixed assets and to invest $6,850 in net
operating working capital. What was the firm's free cash flow?
a. $9,861
b. $10,868
c. $10,465
d. $7,547
e. $10,063

____ 18. A corporation recently purchased some preferred stock that has a before-tax yield of 6.75%. The company
has a tax rate of 38%. What is the after-tax return on the preferred stock? Assume a 70% dividend exclusion
for Tax on Dividends.
a. 6.34%
b. 6.16%
c. 4.55%
d. 5.98%
e. 7.06%

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Name: ________________________ ID: A

____ 19. A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 25%.
What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax return?
a. 6.34%
b. 7.49%
c. 7.23%
d. 6.46%
e. 6.40%

____ 20. Last year, Martyn Company had $400,000 in taxable income from its operations, $50,000 in interest income,
and $100,000 in dividend income. Using the corporate tax rate table given below, what was the company’s
tax liability for the year?

Taxable Income Tax on Base of Bracket Percentage on Excess above Base

$0-$50,000 $0 15%
$50,000-$75,000 7,500 25
$75,000-$100,000 13,750 34
$100,000-$335,000 22,250 39
$335,000-$10,000,000 113,900 34
$10,000,000-$15,000,000 3,400,000 35
$15,000,000-$18,333,333 5,150,000 38
Over $18,333,333 6,416,667 35

a. $150,144
b. $176,256
c. $163,200
d. $200,736
e. $168,096

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 ID: A

Homework Ch. 3
Answer Section

1. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-1) Annual report
2. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-1) Annual report and expectations
3. ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-1) Financial statements
4. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-7) Free cash flow
5. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-7) Free cash flow
6. ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-3) Income statement "the bottom line."
7. ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-4) Statement of cash flows
8. ANS: F PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) Income taxes
9. ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) Income taxes
10. ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (3-7) Income taxes
11. ANS: B PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-2) Balance sheet

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 ID: A

12. ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (Comp.) Changes in depreciation
13. ANS: B PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. TOP: (Comp.) Retained earnings
14. ANS: B PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-3) Income statement
15. ANS: C PTS: 1 DIF: EASY/MEDIUM
NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-8) MVA
16. ANS: B PTS: 1 DIF: EASY/MEDIUM
NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) After-tax returns
17. ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-7) Free cash flow
18. ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) After-tax returns
19. ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) After-tax returns
20. ANS: C PTS: 1 DIF: MEDIUM/HARD
NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial forecasting, and
cash flows. | Students will understand and be able to articulate the goals of the firm, the role of the finance
function in the enterprise's organization, and as an analyst using public information.
TOP: (3-9) Corporate taxes