Financial Management Theory and Practice 12th Edition By Eugene F. Brigham

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Sample Test

CHAPTER 3

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

True/False

Easy:

(3.1) Annual report

Answer: a

EASY

[1].

The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of retained earnings.

True

False

(3.1) Annual report and expectations

Answer: a

EASY

[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.

True

False

(3.2) Retained earnings versus cash

Answer: b

EASY

[3].

Consider the balance sheet of Wilkes Industries as shown below. Because Wilkes has $800,000 of retained earnings, the company would be able to pay cash to buy an asset with a cost of $200,000.

Cash

$ 50,000

Accounts payable

$ 100,000

Inventory

200,000

Accruals

100,000

Accounts receivable

250,000

Total CL

$ 200,000

Total CA

$ 500,000

Debt

200,000

Net fixed assets

$ 900,000

Common stock

200,000

Retained earnings

800,000

Total assets

$1,400,000

Total L & E

$1,400,000

True

False

(3.2) Balance sheet

Answer: a

EASY

[4].

On the balance sheet, total assets must always equal total liabilities and equity.

True

False

	(3.2) Balance sheet: non-cash assets		Answer: a	EASY
[5].	Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the values at which these assets are carried on the books.

	a.	True
	b.	False

	(3.3) Income statement		Answer: a	EASY
[6].	The income statement shows the difference between a firm’s income and its costs–i.e., its profits–during a specified period of time. However, not all reported income comes in the form or cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm’s reported profits and its actual cash flow for the same period.

	a.	True
	b.	False

	(3.7) Net operating working capital		Answer: a	EASY
[7].	Net operating working capital is equal to operating current assets minus operating current liabilities.

	a.	True
	b.	False

	(3.7) Total net operating capital		Answer: b	EASY
[8].	Total net operating capital is equal to net fixed assets.

	a.	True
	b.	False

	(3.7) Net operating profit after taxes (NOPAT)		Answer: a	EASY
[9].	Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from its operations if it had no interest income or interest expense.

	a.	True
	b.	False

	(3.9) Federal income taxes: interest income		Answer: b	EASY
[10].	The fact that 70% of the interest income received by a corporation is excluded from its taxable income encourages firms to use more debt financing than they would in the absence of this tax law provision.

	a.	True
	b.	False

	(3.9) Federal income taxes: interest expense		Answer: b	EASY
[11].	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.

	a.	True
	b.	False

	(3.9) Federal income taxes: int expense and dividends		Answer: b	EASY
[12].	The interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm’s tax liability.

	a.	True
	b.	False

	(Comp: 3.2,3.3) Financial statements		Answer: b	EASY
[13].	The balance sheet is a financial statement that measures the flow of funds into and out of various accounts over time, while the income statement measures the firm’s financial position at a point in time.

	a.	True
	b.	False

Medium:

	(3.4) Retained earnings		Answer: b	MEDIUM
[14].	Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will always be equal to the firm’s total retained earnings.

	a.	True
	b.	False

	(3.4) Retained earnings		Answer: a	MEDIUM
[15].	The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of stockholders’ claims against the firm’s existing assets. This implies that retained earnings are in fact stockholders’ reinvested earnings.

	a.	True
	b.	False

	(3.5) Cash flow and net income		Answer: b	MEDIUM
[16].	In accounting, emphasis is placed on determining net income in accordance with generally accepted accounting principles. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary financial consideration is cash flow, because cash is needed to operate the business.

	a.	True
	b.	False

	(3.6) Statement of cash flows		Answer: a	MEDIUM
[17].	To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue.

	a.	True
	b.	False

	(3.7) Future cash flows		Answer: b	MEDIUM
[18].	The current cash flow from existing assets is highly relevant to the investor. However, since the value of the firm depends primarily upon its growth opportunities, profit projections from those opportunities are the only relevant future flows with which investors are concerned.

	a.	True
	b.	False

	(3.9) Federal income taxes: int exp and dividends		Answer: a	MEDIUM
[19].	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.

	a.	True
	b.	False

	(Comp: 3.1-3.3,3.6) Financial stmts: time dimension		Answer: a	MEDIUM
[20].	The time dimension is important in financial statement analysis. The balance sheet shows the firm’s financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects changes in the firm’s accounts over that period of time.

	a.	True
	b.	False

Multiple Choice: Conceptual

Easy:

	(3.1) Financial statements		Answer: b	EASY
[21].	Which of the following statements is CORRECT?

	a.	The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of retained earnings.
	b.	The balance sheet gives us a picture of the firm’s financial position at a point in time.
	c.	The income statement gives us a picture of the firm’s financial position at a point in time.
	d.	The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.
	e.	The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year.

	(3.2) Balance sheet		Answer: e	EASY
[22].	Which of the following statements is CORRECT?

	a.	The balance sheet for a given year, say 2006, is designed to give us an idea of what happened to the firm during that year.
	b.	The balance sheet for a given year, say 2006, tells us how much money the company earned during that year.
	c.	The difference between the total assets reported on the balance sheet and the debts reported on this statement tells us the current market value of the stockholders’ equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP).
	d.	For most companies, the market value of the stock equals the book value of the stock as reported on the balance sheet.
	e.	A typical industrial company’s balance sheet lists the firm’s assets that will be converted to cash first, and then goes on down to list the firm’s longest lived assets last.

	(3.2) Balance sheet		Answer: c	EASY
[23].	Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?

	a.	The company repurchases common stock.
	b.	The company pays a dividend.
	c.	The company issues new common stock.
	d.	The company gives customers more time to pay their bills.
	e.	The company purchases a new piece of equipment.

	(3.2) Current assets		Answer: c	EASY
[24].	Which of the following items is NOT included in current assets?

	a.	Accounts receivable.
	b.	Inventory.
	c.	Bonds.
	d.	Cash.
	e.	Short-term, highly liquid, marketable securities.

	(3.2) Current liabilities		Answer: d	EASY
[25].	Which of the following items cannot be found on a firm’s balance sheet under current liabilities?

	a.	Accounts payable.
	b.	Short-term notes payable to the bank.
	c.	Accrued wages.
	d.	Cost of goods sold.
	e.	Accrued payroll taxes.

	(3.3) Income statement		Answer: e	EASY
[26].	Which of the following statements is CORRECT?

	a.	The focal point of the income statement is the cash account, because that account cannot be manipulated by “accounting tricks.”
	b.	The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow Generally Accepted Accounting Principles (GAAP).
	c.	The reported income of two otherwise identical firms must be identical if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC).
	d.	If a firm follows Generally Accepted Accounting Principles (GAAP), then its reported net income will be identical to its reported net cash flow.
	e.	The income statement for a given year, say 2006, is designed to give us an idea of how much the firm earned during that year.

Medium:

(3.2) Balance sheet

Answer: c

MEDIUM

[27].

Below are the 2005 and 2006 year-end balance sheets for Wolken Enterprises:

Assets:

2006

2005

Cash

$ 200,000

$ 170,000

Accounts receivable

864,000

700,000

Inventories

2,000,000

1,400,000

Total current assets

$ 3,064,000

$2,270,000

Net fixed assets

6,000,000

5,600,000

Total assets

$ 9,064,000

$7,870,000

Liabilities and equity:

Accounts payable

$ 1,400,000

$1,090,000

Notes payable

1,600,000

1,800,000

Total current liabilities

$ 3,000,000

$2,890,000

Long-term debt

2,400,000

Common stock

3,000,000

2,000,000

Retained earnings

664,000

580,000

Total common equity

$ 3,664,000

$2,580,000

Total liabilities and equity

$ 9,064,000

$7,870,000

Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year non-callable, long-term debt in 2005. As of the end of 2006, none of the principal on this debt had been repaid. Assume that the company’s sales in 2005 and 2006 were the same. Which of the following statements must be CORRECT?

Wolken increased its short-term bank debt in 2006.

Wolken issued long-term debt in 2006.

Wolken issued new common stock in 2006.

Wolken repurchased some common stock in 2006.

Wolken had negative net income in 2006.

(3.2) Balance sheet

Answer: e

MEDIUM

[28].

On its 2007 balance sheet, Barngrover Books 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?

If the company lost money in 2007, they must have paid dividends.

The company must have had zero net income in 2007.

The company must have paid out half of its earnings as dividends.

The company must have paid no dividends in 2007.

Dividends could have been paid in 2007, but they would have had to equal the earnings for the year.

	(3.2) Balance sheet			Answer: b		MEDIUM
[29].	Below is the common equity section (in millions) of Teweles Technology’s last two year-end balance sheets:

			2006		2005
	Common stock		$2,000		$1,000
	Retained earnings		2,000		2,340
	Total common equity		$4,000		$3,340

	Teweles has never paid a dividend to its common stockholders. Which of the following statements is CORRECT?

	a.	The company’s net income in 2006 was higher than in 2005.
	b.	Teweles issued common stock in 2006.
	c.	The market price of Teweles’ stock doubled in 2006.
	d.	Teweles had positive net income in both 2005 and 2006, but the company’s net income in 2006 was lower than it was in 2005.
	e.	The company has more equity than debt on its balance sheet.

	(3.3) EPS, DPS, BVPS, and stock price			Answer: c		MEDIUM
[30].	Which of the following statements is CORRECT?

	a.	Typically, a firm’s DPS should exceed its EPS.
	b.	Typically, a firm’s EBIT should exceed its EBITDA.
	c.	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.

	(3.5) Depreciation, amortization, and net cash flow			Answer: d		MEDIUM
[31].	Which of the following statements is CORRECT?

	a.	The more depreciation a firm reports, the higher its tax bill, other things held constant.
	b.	People sometimes talk about the firm’s net 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 firm’s cash balance, so an increase in depreciation would normally lead to a reduction in the firm’s net cash flow.
	d.	Net cash flow (NCF) is often defined as follows:
		Net Cash Flow = Net Income + Depreciation and Amortization Charges.
	e.	Depreciation and amortization are not cash charges, so neither of them has an effect on a firm’s reported profits.

	(3.5) Changes in depreciation		Answer: d	MEDIUM
[32].	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’ net operating profits after taxes (NOPAT) would decline.
	b.	Companies’ physical stocks of fixed assets would increase.
	c.	Companies’ net cash flows would increase.
	d.	Companies’ cash positions would decline.
	e.	Companies’ reported net incomes would decline.

	(3.6) Net cash flow		Answer: a	MEDIUM
[33].	Which of the following factors could explain why Dellva Energy had a negative net cash flow last year, even though the cash on its balance sheet increased?

	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 amortization expenses.
	e.	The company repurchased 20% of its common stock.

	(3.6) Net cash flow		Answer: b	MEDIUM
[34].	Analysts who follow Howe Industries recently noted that, relative to the previous year, the company’s operating net cash flow 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 a large investment in a profitable new plant.
	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.

	(3.6) Net cash flow and net income		Answer: a	MEDIUM
[35].	A security analyst obtained the following information from Prestopino Products’ financial statements:

	· Retained earnings at the end of 2006 were $700,000, but retained earnings at the end of 2007 had declined to $320,000.
	· The company does not pay dividends.
	· The company’s depreciation expense is its only non-cash expense; it has no amortization charges.
	· The company has no non-cash revenues.
	· The company’s net cash flow (NCF) for 2007 was $150,000.

	On the basis of this information, which of the following statements is CORRECT?

	a.	Prestopino had negative net income in 2007.
	b.	Prestopino’s depreciation expense in 2007 was less than $150,000.
	c.	Prestopino had positive net income in 2007, but its income was less than its 2006 income.
	d.	Prestopino’s NCF in 2007 must be higher than its NCF in 2006.
	e.	Prestopino’s cash on the balance sheet at the end of 2007 must be lower than the cash it had on the balance sheet at the end of 2006.

	(3.6) Net cash flow and net income		Answer: d	MEDIUM
[36].	Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance?

	a.	The company’s operating income declined.
	b.	The company’s expenditures on fixed assets declined.
	c.	The company’s cost of goods sold increased.
	d.	The company’s depreciation and amortization expenses declined.
	e.	The company’s interest expense increased.

	(3.6) Statement of cash flows		Answer: e	MEDIUM
[37].	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 firm’s 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 firm’s cash–the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)–increased or decreased during a given year.
	(3.6) Statement of cash flows		Answer: c	MEDIUM
[38].	Which of the following statements is CORRECT?

	a.	In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.
	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 reported as a use of cash.
	d.	In the statement of cash flows, depreciation charges are reported as a use of cash.
	e.	In the statement of cash flows, a decrease in inventories is reported as a use of cash.

	(3.7) Modifying acct data for managerial purposes		Answer: b	MEDIUM
[39].	For managerial purposes, i.e., making decisions regarding the firm’s operations, the standard financial statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm’s operations. Related to these modifications, which of the following statements is CORRECT?

	a.	The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements.
	b.	The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions’ performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units.
	c.	The standard statements provide useful information on the firm’s individual operating units, but management needs more information on the firm’s overall operations than the standard statements provide.
	d.	The standard statements focus on cash flows, but managers are less concerned with cash flows than with accounting income as defined by GAAP.
	e.	The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to “adjust” the results to make earnings look better.

	(3.7) Depreciation, amortization, and free cash flow				Answer: c	MEDIUM
[40].	Which of the following statements is CORRECT?

	a.	Operating cash flow (OCF) is defined as follows:
		OCF = EBIT(1-T) – Depreciation and Amortization.
	b.	Changes in working capital have no effect on free cash flow.
	c.	Free cash flow (FCF) is defined as follows:
			FCF =	EBIT(1 – T)
				+ Depreciation and Amortization
				– Capital expenditures required to sustain operations
				– Required changes in net operating working capital.
	d.	Free cash flow (FCF) is defined as follows:
		FCF = EBIT(1-T)+ Depreciation and Amortization + Capital expenditures.
	e.	Operating cash flow is the same as free cash flow (FCF).

	(3.8) MVA and EVA				Answer: d	MEDIUM
[41].	Which of the following statements is CORRECT?

	a.	The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses.
	b.	MVA gives us an idea about how much value a firm’s management has added during the last year.
	c.	MVA stands for market value added, and it is defined as follows:
		MVA = (Shares outstanding)(Stock price) + Book value of common equity.
	d.	EVA stands for economic value added, and it is defined as follows:
		EVA = EBIT(1-T) – (Investor-supplied op. capital) x (A-T cost of capital).
	e.	EVA gives us an idea about how much value a firm’s management has added over the firm’s life.

	(3.9) Federal income tax system				Answer: b	MEDIUM
[42].	Which of the following statements is CORRECT?

	a.	Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible.
	b.	Interest paid to an individual is counted as income for tax purposes and taxed at the individual’s regular tax rate, which in 2006 could go up to 35%, but dividends received were taxed at a maximum rate of 15%.
	c.	The maximum federal tax rate on corporate income in 2006 was 50%.
	d.	Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.
	e.	The maximum federal tax rate on personal income in 2006 was 50%.

	(3.9) Federal income tax system		Answer: c	MEDIUM
[43].	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.
	b.	All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code.
	c.	Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm’s 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 income and stockholders were taxed again on the income when it was paid to them as dividends.
	e.	All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income.

	(Comp: 3.6,3.7) NCF, FCF, and cash		Answer: c	MEDIUM
[44].	Last year, Tucker Technologies had (1) a negative net 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 its depreciation and amortization expenses.

	(Comp: 3.2,3.3,3.6,3.9) Changes in depreciation		Answer: e	MEDIUM
[45].	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 tax rate. Prior to the new provision, BBI’s net income after taxes 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 net cash flow.
	b.	The provision will increase the company’s tax payments.
	c.	Net fixed assets on the balance sheet will increase.
	d.	The provision will increase the company’s net income.
	e.	Net fixed assets on the balance sheet will decrease.

	(Comp: 3.2,3.3,3.6,3.9) Changes in depreciation		Answer: b	MEDIUM
[46].	The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.

	a.	Nantell’s taxable income will be lower.
	b.	Nantell’s net fixed assets as shown on the balance sheet will be higher at the end of the year.
	c.	Nantell’s cash position will improve (increase).
	d.	Nantell’s reported net income after taxes for the year will be lower.
	e.	Nantell’s tax liability for the year will be lower.

	(Comp: 3.2,3.3,3.6) Changes in depreciation		Answer: d	MEDIUM
[47].	Assume that Pappas Company commenced operations on January 1, 2007, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December 2007 management realized that the assets would last for only 10 years. The firm’s accountants plan to report the 2007 financial statements based on this new information. How would the new depreciation assumption affect the company’s financial statements?

	a.	The firm’s reported net fixed assets would increase.
	b.	The firm’s EBIT would increase.
	c.	The firm’s reported 2007 earnings per share would increase.
	d.	The firm’s cash position in 2007 and 2008 would increase.
	e.	The firm’s net liabilities would increase.

	(Comp: 3.2,3.3,3.9) Changes in depreciation		Answer: c	MEDIUM
[48].	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 firm’s operating income (EBIT) would increase.
	b.	The firm’s taxable income would increase.
	c.	The firm’s net cash flow would increase.
	d.	The firm’s tax payments would increase.
	e.	The firm’s reported net income would increase.

	(Comp: 3.1-3.3,3.6) Financial statements		Answer: e	MEDIUM
[49].	Which of the following statements is CORRECT?

	a.	Dividends paid reduce the net income that is reported on a company’s income statement.
	b.	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 during the current year, this will increase its reported 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.

	(Comp: 3.5,3.6,3.8) EVA, CF, and net income		Answer: d	MEDIUM
[50].	Which of the following statements is CORRECT?

	a.	One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital.
	b.	If a firm reports positive net income, its EVA must also be positive.
	c.	One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free.
	d.	One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital.
	e.	Actions that increase reported net income will always increase net cash flow.

	(Comp: 3.2,3.3,3.6) Retained earnings		Answer: b	MEDIUM
[51].	Which of the following statements is CORRECT?

	a.	Since depreciation is a source of funds, 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 shown 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.

Medium/Hard:

	(Comp: 3.2,3.3,3.9) Changes in leverage		Answer: d	MEDIUM/HARD
[52].	The CFO of Shalit Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?

	a.	The company’s taxable income would fall.
	b.	The company’s interest expense would remain constant.
	c.	The company would have less common equity than before.
	d.	The company’s net income would increase.
	e.	The company would have to pay less taxes.

Hard:

	(3.6) Net cash flow		Answer: d	HARD
[53].	Last year Roussakis Company’s operations provided a negative net cash flow, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company’s financial statements were prepared under generally accepted accounting principles?

	a.	The company repurchased some of its common stock.
	b.	The company dramatically increased its capital expenditures.
	c.	The company retired a large amount of its long-term debt.
	d.	The company sold some of its fixed assets.
	e.	The company had high depreciation expenses.

Multiple Choice: Problems

Easy:

A good bit of relatively simple arithmetic is involved in some of these problems, and although the calculations are simple, it will take students some time to set up the problem and do the arithmetic. We allow for this when assigning problems for a timed test. Also, students must use a number of definitions to answer some of the questions, and to avoid excessive memorization, we provide students with a list of formulas and definitions for use on exams.

	(3.2) Balance sheet: market value vs. book value		Answer: a	EASY
[54].	Tucker Electronic System’s current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm’s market and book values per share differ?

	a.	$27.50
	b.	$28.88
	c.	$30.32
	d.	$31.83
	e.	$33.43

	(3.2) Balance sheet: change in BVPS from RE addition		Answer: b	EASY
[55].	Hunter Manufacturing Inc.’s December 31, 2006 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2007, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/07, assuming that Hunter neither issued nor retired any common stock during 2007?

	a.	$20.90
	b.	$22.00
	c.	$23.10
	d.	$24.26
	e.	$25.47

	(3.3) Income statement: EBIT		Answer: e	EASY
[56].	Companies generate income from their “regular” operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was Lindley’s operating income, or EBIT?

	a.	$3,462
	b.	$3,644
	c.	$3,836
	d.	$4,038
	e.	$4,250
	(3.3) Income statement: taxable income		Answer: b	EASY
[57].	Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm’s taxable income, or earnings before taxes (EBT)?

	a.	$3,230.00
	b.	$3,400.00
	c.	$3,570.00
	d.	$3,748.50
	e.	$3,935.93

	(3.5) Net cash flow		Answer: d	EASY
[58].	JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash flow, assuming it had no amortization expense and sold none of its fixed assets.

	a.	$4,831.31
	b.	$5,085.59
	c.	$5,353.25
	d.	$5,635.00
	e.	$5,916.75

	(3.7) Net operating working capital		Answer: b	EASY
[59].	Swinnerton Clothing Company’s balance sheet showed total current assets of $2,250, all of which were required in operations. Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed by investors?

	a.	$1,454
	b.	$1,530
	c.	$1,607
	d.	$1,687
	e.	$1,771

	(3.8) MVA		Answer: e	EASY
[60].	Over the years, Janjigian Corporation’s stockholders have provided $15,250 of capital, part when they purchased new issues of stock and part when they allowed management to retain some of the firm’s earnings. The firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How much value has Janjigian’s management added to stockholder wealth over the years, i.e., what is Janjigian’s MVA?

	a.	$21,788
	b.	$22,935
	c.	$24,142
	d.	$25,413
	e.	$26,750

Easy/Medium:

	(3.3) Income statement: net after-tax income		Answer: d	EASY/MEDIUM
[61].	Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the firm’s net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes.

	a.	$3,284.55
	b.	$3,457.42
	c.	$3,639.39
	d.	$3,830.94
	e.	$4,022.48

	(3.4) Statement of retained earnings: dividends		Answer: c	EASY/MEDIUM
[62].	On 12/31/07, Heaton Industries Inc. reported retained earnings of $675,000 on its balance sheet, and it reported that it had $172,500 of net income during the year. On its previous balance sheet, at 12/31/06, the company had reported $555,000 of retained earnings. No shares were repurchased during 2007. How much in dividends did Heaton pay during 2007?

	a.	$47,381
	b.	$49,875
	c.	$52,500
	d.	$55,125
	e.	$57,881

	(3.4) Statement of retained earnings: NI		Answer: a	EASY/MEDIUM
[63].	During 2007, Bascom Bakery Inc. paid out $21,750 of common dividends. It ended the year with $187,500 of retained earnings versus the prior year’s retained earnings of $132,250. How much net income did the firm earn during the year?

	a.	$77,000
	b.	$80,850
	c.	$84,893
	d.	$89,137
	e.	$93,594

	(3.7) Total operating capital		Answer: d	EASY/MEDIUM
[64].	NNR Inc.’s balance sheet showed total current assets of $1,875,000 plus $4,225,000 of net fixed assets. All of these assets were required in operations. The firm’s current liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and common equity. What was NNR’s total investor-provided operating capital?

	a.	$4,694,128
	b.	$4,941,188
	c.	$5,201,250
	d.	$5,475,000
	e.	$5,748,750

Medium:

(3.3) Income statement: change in net income

Answer: b

MEDIUM

[65].

Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating costs other than depreciation, and $1,300 of depreciation. The company had no amortization charges, it had $5,000 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 $750. By how much will net after-tax income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes.

-463.13

-487.50

-511.88

-537.47

-564.34

(3.7) Free cash flow

Answer: b

MEDIUM

[66].

TSW Inc. had the following data for last year: Net income = $800; Net operating profit after taxes (NOPAT) = $700; Total assets = $3,000; and Total operating capital = $2,000. Information for the just-completed year is as follows: Net income = $1,000; Net operating profit after taxes (NOPAT) = $925; Total assets = $2,600; and Total operating capital = $2,500. How much free cash flow did the firm generate during the just-completed year?

$383

$425

$468

$514

$566

	(3.7) Net operating working capital					Answer: b		MEDIUM
[67].	Rao Corporation has the following balance sheet. How much net operating working capital does the firm have?

	Cash			$ 10	Accounts payable		$ 20
	Short-term investments				Accruals		20
	Accounts receivable			50	Notes payable		50
	Inventory			40	Current liabilities		$ 90
	Current assets			$130	Long-term debt		0
	Net fixed assets			100	Common equity		30
					Retained earnings		50
	Total assets			$230	Total liab. & equity		$230

	a.	$54.00
	b.	$60.00
	c.	$66.00
	d.	$72.60
	e.	$79.86

	(3.7) Net operating profit after taxes (NOPAT)					Answer: e		MEDIUM
[68].	Bae Inc. has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

	Sales		$2,000.00
	Costs		1,200.00
	Depreciation		100.00
	EBIT		$ 700.00
	Interest expense		200.00
	EBT		$ 500.00
	Taxes (35%)		175.00
	Net income		$ 325.00

	a.	$370.60
	b.	$390.11
	c.	$410.64
	d.	$432.25
	e.	$455.00

(3.7) Net operating profit after taxes (NOPAT)

Answer: c

MEDIUM

[69].

EP Enterprises has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

Sales

$1,800.00

Costs

1,400.00

Depreciation

250.00

EBIT

$ 150.00

Interest expense

70.00

EBT

$ 80.00

Taxes (40%)

32.00

Net income

$ 48.00

$81.23

$85.50

$90.00

$94.50

$99.23

(3.7) Return on invested capital (ROIC)

Answer: d

MEDIUM

[70].

Tibbs Inc. had the following data for the year ending 12/31/06: Net income = $300; Net operating profit after taxes (NOPAT) = $400; Total assets = $2,500; Short-term investments = $200; Stockholders’ equity = $1,800; Total debt = $700; and Total operating capital = $2,300. What was its return on invested capital (ROIC)?

14.91%

15.70%

16.52%

17.39%

18.26%

(3.7) Total operating capital

Answer: b

MEDIUM

[71].

Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have?

Cash

$ 20.00

Accounts payable

$ 30.00

Short-term investments

50.00

Accruals

50.00

Accounts receivable

20.00

Notes payable

30.00

Inventory

60.00

Current liabilities

$110.00

Current assets

$150.00

Long-term debt

70.00

Gross fixed assets

$140.00

Common stock

30.00

Accumulated deprec.

40.00

Retained earnings

40.00

Net fixed assets

$100.00

Total common equity

$ 70.00

Total assets

$250.00

Total liab. & equity

$250.00

$114.00

$120.00

$126.00

$132.30

$138.92

(3.8) Economic Value Added (EVA)

Answer: e

MEDIUM

[72].

Barnes’ Brothers has the following data for the year ending 12/31/07: Net income = $600; Net operating profit after taxes (NOPAT) = $700; Total assets = $2,500; Short-term investments = $200; Stockholders’ equity = $1,800; Total debt = $700; and Total operating capital = $2,100. Barnes’ weighted average cost of capital is 10%. What is its economic value added (EVA)?

$399.11

$420.11

$442.23

$465.50

$490.00

(Comp: 3.3,3.5) Income statement: net cash flow

Answer: e

MEDIUM

[73].

Edwards Electronics recently reported $11,250 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was its net cash flow?

$3,284.75

$3,457.63

$3,639.61

$3,831.17

$4,032.81

(Comp: 3.3,3.7) Income statement: free cash flow

Answer: a

MEDIUM

[74].

Wells Water Systems recently reported $8,250 of sales, $4,500 of operating costs other than depreciation, and $950 of depreciation. The company had no amortization charges, it had $3,250 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 sales and cash flows in the future, the firm was required to spend $750 to buy new fixed assets and to invest $250 in net operating working capital. How much free cash flow did Wells generate?

$1,770.00

$1,858.50

$1,951.43

$2,049.00

$2,151.45

Hard:

(3.8) EVA

Answer: c

HARD

[75].

HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 9.5%, and the federal-plus-state income tax rate was 40%. What was HHH’s Economic Value Added (EVA), i.e., how much value did management add to stockholders’ wealth during the year?

$1,357.13

$1,428.56

$1,503.75

$1,578.94

$1,657.88

(Comp: 3.3,3.7) Changes in net income and NCF

Answer: e

HARD

[76].

Last year, Michelson Manufacturing reported $10,250 of sales, $3,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds outstanding 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 $725. By how much will the depreciation change cause the firm’s net after-tax income and its net cash flow to change? Note that the company uses the same depreciation calculations for tax and stockholder reporting purposes.

-$383.84; $206.68

-$404.04; $217.56

-$425.30; $229.01

-$447.69; $241.06

-$471.25; $253.75

[77].

(Comp: 3.3,3.7) Income stmt: FCF vs. net income

Answer: c

HARD

Bartling Energy Systems recently reported $9,250 of sales, $5,750 of operating costs other than depreciation, and $700 of depreciation. The company had no amortization charges, it had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital. By how much did the firm’s net income exceed its free cash flow?

$673.27

$708.70

$746.00

$783.30

$822.47

CHAPTER 3

ANSWERS AND SOLUTIONS

[1]. (3.1) Annual report Answer: a EASY

[2]. (3.1) Annual report and expectations Answer: a EASY

[3]. (3.2) Retained earnings versus cash Answer: b EASY

[4]. (3.2) Balance sheet Answer: a EASY

[5]. (3.2) Balance sheet: non-cash assets Answer: a EASY

[6]. (3.3) Income statement Answer: a EASY

[7]. (3.7) Net operating working capital Answer: a EASY

[8]. (3.7) Total net operating capital Answer: b EASY

[9]. (3.7) Net operating profit after taxes (NOPAT) Answer: a EASY

[10]. (3.9) Federal income taxes: interest income Answer: b EASY

[11]. (3.9) Federal income taxes: interest expense Answer: b EASY

[12]. (3.9) Federal income taxes: int expense and dividends Answer: b EASY

[13]. (Comp: 3.2,3.3) Financial statements Answer: b EASY

[14]. (3.4) Retained earnings Answer: b MEDIUM

[15]. (3.4) Retained earnings Answer: a MEDIUM

[16]. (3.5) Cash flow and net income Answer: b MEDIUM

[17]. (3.6) Statement of cash flows Answer: a MEDIUM

[18]. (3.7) Future cash flows Answer: b MEDIUM

[19]. (3.9) Federal income taxes: int exp and dividends Answer: a MEDIUM

[20]. (Comp: 3.1-3.3,3.6) Financial stmts: time dimension Answer: a MEDIUM

[21]. (3.1) Financial statements Answer: b EASY

[22]. (3.2) Balance sheet Answer: e EASY

[23]. (3.2) Balance sheet Answer: c EASY

[24]. (3.2) Current assets Answer: c EASY

[25]. (3.2) Current liabilities Answer: d EASY

[26]. (3.3) Income statement Answer: e EASY

[27]. (3.2) Balance sheet Answer: c MEDIUM

[28]. (3.2) Balance sheet Answer: e MEDIUM

[29]. (3.2) Balance sheet Answer: b MEDIUM

[30]. (3.3) EPS, DPS, BVPS, and stock price Answer: c MEDIUM

[31]. (3.5) Depreciation, amortization, and net cash flow Answer: d MEDIUM

[32]. (3.5) Changes in depreciation Answer: d MEDIUM

[33]. (3.6) Net cash flow Answer: a MEDIUM

[34]. (3.6) Net cash flow Answer: b MEDIUM

[35]. (3.6) Net cash flow and net income Answer: a MEDIUM

[36]. (3.6) Net cash flow and net income Answer: d MEDIUM

[37]. (3.6) Statement of cash flows Answer: e MEDIUM

[38]. (3.6) Statement of cash flows Answer: c MEDIUM

[39]. (3.7) Modifying acct data for managerial purposes Answer: b MEDIUM

[40]. (3.7) Depreciation, amortization, and free cash flow Answer: c MEDIUM

[41]. (3.8) MVA and EVA Answer: d MEDIUM

[42]. (3.9) Federal income tax system Answer: b MEDIUM

[43]. (3.9) Federal income tax system Answer: c MEDIUM

[44]. (Comp: 3.6,3.7) NCF, FCF, and cash Answer: c MEDIUM

[45]. (Comp: 3.2,3.3,3.6,3.9) Changes in depreciation Answer: e MEDIUM

[46]. (Comp: 3.2,3.3,3.6,3.9) Changes in depreciation Answer: b MEDIUM

[47]. (Comp: 3.2,3.3,3.6) Changes in depreciation Answer: d MEDIUM

[48]. (Comp: 3.2,3.3,3.9) Changes in depreciation Answer: c MEDIUM

[49]. (Comp: 3.1-3.3,3.6) Financial statements Answer: e MEDIUM

[50]. (Comp: 3.5,3.6,3.8) EVA, CF, and net income Answer: d MEDIUM

[51]. (Comp: 3.2,3.3,3.6) Retained earnings Answer: b MEDIUM

[52]. (Comp: 3.2,3.3,3.9) Changes in leverage Answer: d MEDIUM/HARD

[53]. (3.6) Net cash flow Answer: d HARD

[54]. (3.2) Balance sheet: market value vs. book value Answer: a EASY

Shares outstanding 125,000

Price per share $52.50

Total book common equity $3,125,000

Book value per share $25.00

Difference between book and market values $27.50

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