Chapter 3
Financial Statements, Cash Flow, and Taxes
ANSWERS TO END-OF-CHAPTER QUESTIONS
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Exercise Questions available in the solution:
1. Define each of the following terms:
Annual report; balance sheet; income statement
Common stockholders’ equity, or net worth; retained earnings
Statement of retained earnings; statement of cash flows
Depreciation; tangible assets; amortization; intangible assets; EBITDA
Accounting profit; net cash flow; operating cash flow
Operating assets; nonoperating assets
Operating working capital; net operating working capital
Net operating profit after taxes (NOPAT); free cash flow
Market Value Added (MVA); Economic Value Added (EVA)
Progressive tax; taxable income
Improper accumulation
2. What four statements are contained in most annual reports?
4. Explain the following statement: “While the balance sheet can be thought of as a snap-shot of the firm’s financial position at a point in time,the income statement reports on
operations over a period of time.
(3.2) Corporate bonds issued by Johnson Corporation currently yield 8 percent. Municipal
bonds of equal risk currently yield 6 percent. At what tax rate would an investor be in-different between these two bonds?
(3.3) Little Books Inc. recently reported net income of $3 million. Its operating income
(EBIT) was $6 million, and the company pays a 40 percent tax rate. What was the com-pany’s interest expense for the year?
(3.4) Pearson Brothers recently reported an EBITDA of $7.5 million and $1.8 million of net
income. The company has $2.0 million of interest expense and the corporate tax rate is
40 percent. What was the company’s depreciation and amortization expense?
(3.5) Kendall Corners Inc. recently reported net income of $3.1 million. The company’s de-preciation expense was $500,000. What is the company’s approximate net cash flow? As-sume the firm has no amortization expense.
(3.6) In its most recent financial statements, Newhouse Inc. reported $50 million of net in-come and $810 million of retained earnings. The previous year, its balance sheet showed
$780 million of retained earnings. What were the total dividends paid to shareholders
during the most recent year?
(3.7) The Talley Corporation had a taxable income of $365,000 from operations after all
operating costs but before (1) interest charges of $50,000, (2) dividends received of
$15,000, (3) dividends paid of $25,000, and (4) income taxes. What is the firm’s income
tax liability and its after-tax income? What are the company’s marginal and average tax
rates on taxable income?
(3.8) The Wendt Corporation had $10.5 million of taxable income.
a. What is the company’s federal income tax bill for the year?
b. Assume the firm receives an additional $1 million of interest income from somebonds it owns. What is the tax on this interest income?
c. Now assume that Wendt does not receive the interest income but does receive an ad-ditional $1 million as dividends on some stock it owns. What is the tax on this divi-dend income
(3.9) The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It
is choosing between AT&T bonds, which yield 7.5 %, state of Florida muni bonds,
which yield 5 %, and AT&T preferred stock, with a dividend yield of 6 %.
Shrieves’ corporate tax rate is 35 %, and 70 % of the dividends received are
tax exempt. Find the tax return on both securities.
(3.10) The Moore Corporation has operating income (EBIT) of $750,000. The company’s de-preciation expense is $200,000. Moore is 100 percent equity financed, and it faces a 40
percent tax rate. What are its net income, its net cash flow, and its operating cash flow?
(3.11) The Berndt Corporation expects to have sales of $12 million. Costs other
than depreciation are expected to be 75 percent of sales, and depreciation is expected to
be $1.5 million. All sales revenues will be collected in cash, and costs other than depre-ciation must be paid for during the year. Berndt’s federal-plus-state tax rate is 40 per-cent.
a. Set up an income statement. What is Berndt’s expected net cash flow?
b. Suppose Congress changed the tax laws so that Berndt’s depreciation expenses
doubled. No changes in operations occurred. What would happen to reported profit
and to net cash flow?
c. Now suppose that Congress, instead of doubling Berndt’s depreciation, reduced
it by 50 percent. How would profit and net cash flow be affected?
d. If this were your company, would you prefer Congress to cause your depreciation ex-pense to be doubled or halved? Why?
(3.12) You have just obtained financial information for the past 2 years for Bridge Water Equine
Corporation. Answer the following questions.
a. What is the net operating profit after taxes (NOPAT) for 2007?
b. What are the amounts of net operating working capital for both years?
c. What are the amounts of total operating capital for both years?
d. What is the free cash flow for 2007?
e. How can you explain the large increase in dividends in 2007?
(3.13) The Bookbinder Company has made $150,000 before taxes during each of the last 15
years, and it expects to make $150,000 a year before taxes in the future. However, in
2007 the firm incurred a loss of $650,000. The firm will claim a tax credit at the time it
files its 2007 income tax return, and it will receive a check from the U.S. Treasury. Show
how it calculates this credit, and then indicate the firm’s tax liability for each of the next
5 years. Assume a 40 percent tax rate on all income to ease the calculations.
(3.14) Cumberland Industries' most recent balance sheet (in thousands of dollars) are shown below and in partial model in the file:
a. The company’s sales for 2007 were $455,150,000, and EBITDA was 15 % of
sales. Furthermore, depreciation amounted to 11 % of net fixed assets, interest
charges were $8,575,000, the state-plus-federal corporate tax rate was 40 %,
and Cumberland pays 40 % of its net income out in dividends. Given this information,
construct Laiho’s 2007 income statement. (Hint: You might find it easiest to select
the balance sheets, then copy them, and then paste them to an Excel worksheet. You
might have to move the data around some in the worksheet to get things lined up
properly.)
b. Next, construct the firm’s statement of retained earnings for the year ending De-cember 31, 2007, and then its 2007 statement of cash flows.
c. Calculate net operating working capital, total operating capital, net operating profit
after taxes, operating cash flow, and free cash flow for 2007.
d. Calculate the firm’s EVA and MVA for 2007. Assume that Cumberland had 10 million
shares outstanding, that the year-end closing stock price was $17.25 per share, and its
after-tax cost of capital was 12 %
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