ࡱ> @ bjbjFF Q,,a5    T TTTTZV 0WXYYY```wwww2wlEl$RL~՘ =e_0`=e=e՘  YY iii=e Y( Ywi=ewiirq 6 tYW 7TSeVsAwd00sVʝUg>t*       5t `aiSb|bn```՘՘ dGTi TChapter 3 Financial Statements, Cash Flow, and Taxes Learning Objectives After reading this chapter, students should be able to: Briefly explain the history of accounting and financial statements, and how financial statements are used. List the types of information found in a corporations annual report. Explain what a balance sheet is, the information it provides, and how assets and claims on assets are arranged on a balance sheet. Explain what an income statement is and the information it provides. Differentiate between net cash flow and accounting profit. Identify the purpose of the statement of cash flows, list the factors affecting a firms cash position that are reflected in this statement, and identify the three categories of activities that are separated out in this statement. Specify the changes reported in a firms statement of retained earnings. Discuss what questions can be answered by looking through the financial statements, and explain why investors need to be cautious when they review financial statements. Discuss how certain modifications to the accounting data are needed and used for corporate decision making and stock valuation purposes. In the process, explain the terms: net operating working capital, total operating capital, NOPAT, operating cash flow, and free cash flow; and explain how each is calculated. Define the terms Market Value Added (MVA) and Economic Value Added (EVA), explain how each is calculated, and differentiate between them. Explain why financial managers must be concerned with taxation, and list some of the most important elements of the current tax law, such as the differences between the treatment of dividends and interest paid and interest and dividend income received. Lecture Suggestions The goal of financial management is to take actions that will maximize the value of a firms stock. These actions will show up, eventually, in the financial statements, so a general understanding of financial statements is critically important. Note that Chapter 3 provides a bridge between accounting, which students have just covered, and financial management. Unfortunately, many non-accounting students did not learn as much as they should have in their accounting courses, so we find it necessary to spend more time on financial statements than we would like. Also, at Florida and many other schools, students vary greatly in their knowledge of accounting, with accounting majors being well-grounded because they have had more intense introductory courses and, more importantly, because they are taking advanced financial accounting concurrently with finance. This gives the accountants a major, and somewhat unfair, advantage over the others in dealing with Chapters 3 and 4 on exams. We know of no good solution to this problem, but what we do is pitch the coverage of this material to the non-accountants. If we pitch the lectures (and exams) to the accountants, they simply blow away and demoralize our non-accountants, and we do not want that. Perhaps Florida has more of a difference between accounting and non-accounting students, but at least for us there really is a major difference. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 3, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the Lecture Suggestions in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 2 OF 58 DAYS (50-minute periods) Answers to End-of-Chapter Questions 3-1 The four financial statements contained in most annual reports are the balance sheet, income statement, statement of retained earnings, and statement of cash flows. 3-2 Accountants translate physical quantities into numbers when they construct the financial statements. The numbers shown on balance sheets generally represent historical costs. When examining a set of financial statements, one should keep in mind the physical reality that lies behind the numbers, and the fact that the translation from physical assets to numbers is far from precise. 3-3 Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or invest in, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way. 3-4 No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the firms assets. 3-5 The balance sheet shows the firms financial position on a specific date, for example, December 31, 2005. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2005. The income statement, on the other hand, reports on the firms operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2005, would represent the firms sales over the period from January 1, 2005, through December 31, 2005, not just sales for December 31, 2005. 3-6 Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legitimate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting practices. 3-7 The emphasis in accounting is on the determination of accounting income, or net income, while the emphasis in finance is on net cash flow. Net cash flow is the actual net cash that a firm generates during some specified period. The value of an asset (or firm) is determined by the cash flows generated. Cash is necessary to purchase assets to continue operations and to pay dividends. Thus, financial managers should strive to maximize cash flows available to investors over the long run. Although companies with relatively high accounting profits generally have a relatively high cash flow, the relationship is not precise. A businesss net cash flow generally differs from net income because some of the expenses and revenues listed on the income statement are not paid out or received in cash during the year. Most other companies have little if any noncash revenues, but this item can be important for construction companies that work on multi-year projects, report income on a percentage of completion basis, and then are paid only after the project is completed. Also, if a company has a substantial amount of deferred taxes, which means that taxes actually paid are less than that reported in the income statement, then this amount could also be added to net income when estimating the net cash flow. The relationship between net cash flow and net income can be expressed as: Net cash flow = Net income + Non-cash charges Non-cash revenues. The primary examples of non-cash charges are depreciation and amortization. These items reduce net income but are not paid out in cash, so we add them back to net income when calculating net cash flow. Likewise, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash flow. Typically, depreciation and amortization represent the largest non-cash items, and in many cases the other non-cash items roughly net to zero. For this reason, many analysts assume that net cash flow equals net income plus depreciation and amortization. 3-8 Operating cash flow arises from normal, ongoing operations, whereas net cash flow reflects both operating and financing decisions. Thus, operating cash flow is defined as the difference between sales revenues and operating expenses paid, after taxes on operating income. Operating cash flow can be calculated as follows: Operating cash flow = EBIT (1 T) + Depreciation and amortization = NOPAT + Depreciation and amortization. Note that net cash flow can be calculated as follows: Net cash flow = Net income + Depreciation and amortization. Thus, the difference between the two equations is that net cash flow includes after-tax interest expense. 3-9 NOPAT is the profit a company would generate if it had no debt and held only operating assets. Net income is the profit available to common stockholders; thus, both interest and taxes have been deducted. NOPAT is a better measure of the performance of a companys operations than net income because debt lowers income. In order to get a true reflection of a companys operating performance, one would want to take out debt to get a clearer picture of the situation. 3-10 Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets, new products, and operating working capital necessary to sustain ongoing operations. It is defined as net operating profit after taxes (NOPAT) minus the amount of net investment in operating working capital and fixed assets necessary to sustain the business. It is the most important measure of cash flows because it shows the exact amount available to all investors (stockholders and debtholders). The value of a companys operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit. 3-11 Yes. Negative free cash flow is not necessarily bad. It depends on why the free cash flow was negative. If free cash flow was negative because NOPAT was negative, this is definitely bad, and it suggests that the company is experiencing operating problems. However, many high-growth companies have positive NOPAT but negative free cash flow because they must invest heavily in operating assets to support rapid growth. There is nothing wrong with a negative cash flow if it results from profitable growth. 3-12 Double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received. Income could even be subject to triple taxation; therefore, corporations that receive dividend income can exclude some of the dividends from its taxable income. This provision in the Tax Code minimizes the amount of triple taxation that would otherwise occur. 3-13 Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in later chapters: The Cost of Capital and Capital Structure and Leverage. Solutions to End-of-Chapter Problems 3-1 NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ? Need to set up an income statement and work from the bottom up. EBIT $6,000,000 Interest 1,000,000 EBT $5,000,000 EBT = Taxes (40%) 2,000,000 NI $3,000,000 Interest = EBIT EBT = $6,000,000 $5,000,000 = $1,000,000. 3-2 EBITDA = $7,500,000; NI = $1,800,000; Int = $2,000,000; T = 40%; DA = ? EBITDA $7,500,000 DA 2,500,000 EBITDA DA = EBIT; DA = EBITDA EBIT EBIT $5,000,000 EBIT = EBT + Int = $3,000,000 + $2,000,000 Int 2,000,000 (Given) EBT $3,000,000 Taxes (40%) 1,200,000 NI $1,800,000 (Given) 3-3 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ? NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000. 3-4 NI = $50,000,000; R/EY/E = $810,000,000; R/EB/Y = $780,000,000; Dividends = ? R/EB/Y + NI Div = R/EY/E $780,000,000 + $50,000,000 Div = $810,000,000 $830,000,000 Div = $810,000,000 $20,000,000 = Div. 3-5 Statements b and d will decrease the amount of cash on a companys balance sheet. Statement a will increase cash through the sale of common stock. This is a source of cash through financing activities. On one hand, Statement c would decrease cash; however, it is also possible that Statement c would increase cash, if the firm receives a tax refund. 3-6 Ending R/E = Beg. R/E ( Net income ( Dividends $278,900,000 = $212,300,000 ( Net income ( $22,500,000 $278,900,000 = $189,800,000 ( Net income Net income = $89,100,000. 3-7 a. From the statement of cash flows the change in cash must equal cash flow from operating activities plus long-term investing activities plus financing activities. First, we must identify the change in cash as follows: Cash at the end of the year $25,000 Cash at the beginning of the year 55,000 Change in cash -$30,000 The sum of cash flows generated from operations, investment, and financing must equal a negative $30,000. Therefore, we can calculate the cash flow from operations as follows: CF from operations ( CF from investing ( CF from financing = ( in cash CF from operations ( $250,000 ( $170,000 = -$30,000 CF from operations = $50,000. b. To determine the firms net income for the current year, you must realize that cash flow from operations is determined by adding sources of cash (such as depreciation and amortization and increases in accrued liabilities) and subtracting uses of cash (such as increases in accounts receivable and inventories) from net income. Since we determined that the firms cash flow from operations totaled $50,000 in part a of this problem, we can now calculate the firms net income as follows: NI (  EMBED Equation.3  (  EMBED Equation.3  (  EMBED Equation.3  =  EMBED Equation.3  NI + $10,000 + $25,000 $100,000 = $50,000 NI $65,000 = $50,000 NI = $115,000. 3-8 EBIT = $750,000; DEP = $200,000; AMORT = 0; 100% Equity; T = 40%; NI = ?; NCF = ?; OCF = ? First, determine net income by setting up an income statement: EBIT $750,000 Interest 0 EBT $750,000 Taxes (40%) 300,000 NI $450,000 NCF = NI + DEP and AMORT = $450,000 + $200,000 = $650,000. OCF = EBIT(1 T) + DEP and AMORT = $750,000(0.6) + $200,000 = $650,000. Note that NCF = OCF because the firm is 100% equity financed. 3-9 MVA = (P0 ( Number of common shares) ( BV of equity $130,000,000 = $60X ( $500,000,000 $630,000,000 = $60X X = 10,500,000 common shares. 3-10 a. NOPAT = EBIT(1 T) = $4,000,000,000(0.6) = $2,400,000,000. b. NCF = NI + DEP and AMORT = $1,500,000,000 + $3,000,000,000 = $4,500,000,000. c. OCF = NOPAT + DEP and AMORT = $2,400,000,000 + $3,000,000,000 = $5,400,000,000. d. FCF = NOPAT Net Investment in Operating Capital = $2,400,000,000 $1,300,000,000 = $1,100,000,000. 3-11 Working up the income statement you can calculate the new sales level would be $12,681,482. Sales $12,681,482 $5,706,667/(1 ( 0.55) Operating costs (excl. D&A) 6,974,815 $12,681,482 ( 0.55 EBITDA $ 5,706,667 $4,826,667 + $880,000 Depr. & amort. 880,000 $800,000 ( 1.10 EBIT $ 4,826,667 $4,166,667 + $660,000 Interest 660,000 $600,000 ( 1.10 EBT $ 4,166,667 $2,500,000/(1 ( 0.4) Taxes (40%) 1,666,667 $4,166,667 ( 0.40 Net income $ 2,500,000 3-12 a. Because were interested in net cash flow available to common stockholders, we exclude common dividends paid. CF05 = NI available to common stockholders + Depreciation and amortization = $372 + $220 = $592 million. The net cash flow number is larger than net income by the current years depreciation and amortization expense, which is a noncash charge. b. Balance of RE, December 31, 2004 $1,374 Add: NI, 2005 372 Less: Div. paid to common stockholders (146) Balance of RE, December 31, 2005 $1,600 The RE balance on December 31, 2005 is $1,600 million. c. $1,600 million. d. Cash + Equivalents = $15 million. e. Total current liabilities = $620 million. 3-13 a. NOPAT05 = EBIT(1 T) = $150,000,000(0.6) = $90,000,000. b.  EMBED Equation.3  = Current assets  EMBED Equation.3  = $360,000,000 ($90,000,000 + $60,000,000) = $210,000,000.  EMBED Equation.3  ADVANCE \d3= $372,000,000 $180,000,000 = $192,000,000. c. Operating capital04 =  EMBED Equation.3  = $250,000,000 + $210,000,000 = $460,000,000. Operating capital05 = $300,000,000 + $192,000,000 = $492,000,000. d. FCF05 = NOPAT Net investment in operating capital = $90,000,000 ($492,000,000 $460,000,000) = $58,000,000. e. The large increase in dividends for 2005 can most likely be attributed to a large increase in free cash flow from 2004 to 2005, since FCF represents the amount of cash available to be paid out to stockholders after the company has made all investments in fixed assets, new products, and operating working capital necessary to sustain the business. 3-14 a. Sales revenues $12,000,000 Costs except deprec. and amort. (75%) 9,000,000 EBITDA $ 3,000,000 Depreciation and amortization 1,500,000 EBT $ 1,500,000 Taxes (40%) 600,000 Net income $ 900,000 Add back deprec. and amort. 1,500,000 Net cash flow $ 2,400,000 b. If depreciation and amortization doubled, taxable income would fall to zero and taxes would be zero. Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000. Menendez would save $600,000 in taxes, thus increasing its cash flow: (CF = T((Depreciation and amortization) = 0.4($1,500,000) = $600,000. c. If depreciation and amortization were halved, taxable income would rise to $2,250,000 and taxes to $900,000. Therefore, net income would rise to $1,350,000, but net cash flow would fall to $2,100,000. d. You should prefer to have higher depreciation and amortization charges and higher cash flows. Net cash flows are the funds that are available to the owners to withdraw from the firm and, therefore, cash flows should be more important to them than net income. e. In the situation where depreciation and amortization doubled, net income fell by 100%. Since many of the measures banks and investors use to appraise a firms performance depend on net income, a decline in net income could certainly hurt both the firms stock price and its ability to borrow. For example, earnings per share is a common number looked at by banks and investors, and it would have declined by 100%, even though the firms ability to pay dividends and to repay loans would have improved. Comprehensive/Spreadsheet Problem Note to Instructors: The solution to this problem is not provided to students at the back of their text. Instructors can access the Excel file on the textbooks Web site or the Instructors Resource CD. 3-15 a.  b.   c.  The difference in these two measures is notes payable. Notes payable is deducted from current assets to arrive at net working capital, while it is not deducted from current assets to calculate net operating working capital because notes payable is an interest-bearing current liability. d.   e. The firm's market value exceeds its book value by $14.895 million. This means that management has added this much to shareholder value over the company's history. It would have to be compared to the MVA of other companies before declaring the performance good, bad, or indifferent. f. An increase in the firm's dividend payout ratio would have no effect on its corporate taxes paid because dividends are paid with after-tax dollars. However, the company's shareholders would pay additional taxes on the additional dividends they would receive. As of 12/05, dividends are generally taxed at a maximum rate of 15 percent. Integrated Case 3-16 DLeon Inc., Part I Financial Statements and Taxes Donna Jamison, a 2000 graduate of the University of Florida with 4 years of banking experience, was recently brought in as assistant to the chairman of the board of DLeon Inc., a small food producer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the snack-foods market. DLeons president, Al Watkins, decided in 2004 to undertake a major expansion and to go national in competition with Frito-Lay, Eagle, and other major snack-food companies. Watkins felt that DLeons products were of a higher quality than the competitions; that this quality differential would enable it to charge a premium price; and that the end result would be greatly increased sales, profits, and stock price. The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. DLeons results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice-president plus its major stockholders (who were all local business people), was most upset when directors learned how the expansion was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Watkins was informed that changes would have to be made, and quickly, or he would be fired. Also, at the boards insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was DLeons chairman and largest stockholder. Campo agreed to give up a few of his golfing days and to help nurse the company back to health, with Jamisons help. Jamison began by gathering the financial statements and other data given in Tables IC 3-1, IC 3-2, IC 3-3, and IC 3-4. Assume that you are Jamisons assistant, and you must help her answer the following questions for Campo. (Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis there, but answering these questions will help prepare you for Chapter 4. Provide clear explanations, not just yes or no answers!) Table IC 3-1. Balance Sheets 2005 2004 Assets Cash $ 7,282 $ 57,600 Accounts receivable 632,160 351,200 Inventories 1,287,360 715,200 Total current assets $ 1,926,802 $ 1,124,000 Gross fixed assets 1,202,950 491,000 Less accumulated depreciation 263,160 146,200 Net fixed assets $ 939,790 $ 344,800 Total assets $ 2,866,592 $ 1,468,800 Liabilities and Equity Accounts payable $ 524,160 $ 145,600 Notes payable 636,808 200,000 Accruals 489,600 136,000 Total current liabilities $ 1,650,568 $ 481,600 Long-term debt 723,432 323,432 Common stock (100,000 shares) 460,000 460,000 Retained earnings 32,592 203,768 Total equity $ 492,592 $ 663,768 Total liabilities and equity $ 2,866,592 $ 1,468,800 Table IC 3-2. Income Statements 2005 2004 Sales $ 6,034,000 $ 3,432,000 Cost of goods sold 5,528,000 2,864,000 Other expenses 519,988 358,672 Total operating costs excluding depreciation and amortization $ 6,047,988 $ 3,222,672 EBITDA ($ 13,988) $ 209,328 Depreciation and amortization 116,960 18,900 EBIT ($ 130,948) $ 190,428 Interest expense 136,012 43,828 EBT ($ 266,960) $ 146,600 Taxes (40%) (106,784)a 58,640 Net income ($ 160,176) $ 87,960 EPS ($ 1.602) $ 0.880 DPS $ 0.110 $ 0.220 Book value per share $ 4.926 $ 6.638 Stock price $ 2.25 $ 8.50 Shares outstanding 100,000 100,000 Tax rate 40.00% 40.00% Lease payments 40,000 40,000 Sinking fund payments 0 0 Note: a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005. Table IC 3-3. Statement of Retained Earnings, 2005 Balance of retained earnings, 12/31/04 $ 203,768 Add: Net income, 2005 (160,176) Less: Dividends paid (11,000) Balance of retained earnings, 12/31/05 $ 32,592 Table IC 3-4. Statement of Cash Flows, 2005 Operating Activities Net income ($ 160,176) Additions (Sources of Cash) Depreciation and amortization 116,960 Increase in accounts payable 378,560 Increase in accruals 353,600 Subtractions (Uses of Cash) Increase in accounts receivable (280,960) Increase in inventories (572,160) Net cash provided by operating activities ($ 164,176) Long-Term Investing Activities Cash used to acquire fixed assets ($ 711,950) Financing Activities Increase in notes payable $ 436,808 Increase in long-term debt 400,000 Payment of cash dividends (11,000) Net cash provided by financing activities $ 825,808 Sum: net decrease in cash ($ 50,318) Plus: cash at beginning of year 57,600 Cash at end of year $ 7,282 A. What effect did the expansion have on sales, NOPAT, net operating working capital (NOWC), total operating capital, and net income? Answer: [S3-1 through S3-9 provide background information. Then show S310 through S3-14 here.] Sales increased by $2,602,000. NOPAT05 = EBIT(1 Tax rate) = (-$130,948)(0.6) = ($78,569). NOPAT04 = $190,428(0.6) = $114,257. (NOPAT = ($78,569) $114,257 = ($192,826). NOPAT decreased by $192,826. NOWC05 =  EMBED Equation.3   EMBED Equation.3  = ($7,282 + $632,160 + $1,287,360) ($524,160 + $489,600) = $913,042. NOWC04 = ($57,600 + $351,200 + $715,200) ($145,600 + $136,000) = $842,400. (NOWC = $913,042 $842,400 = $70,642. Net operating working capital increased by $70,642. OC05 =  EMBED Equation.3  +  EMBED Equation.3  = $913,042 + $939,790 = $1,852,832. OC04 = $842,400 + $344,800 = $1,187,200. (OC = $1,852,832 $1,187,200 = $665,632. Total operating capital increased substantially by $665,632 from 2004 to 2005. NI05 NI04 = ($160,176) $87,960 = ($248,136). There was a big drop, -$248,136, in net income during 2005. B. What effect did the companys expansion have on its net cash flow, operating cash flow, and free cash flow? Answer: [Show S3-15 and S3-16 here.] NCF05 = NI + Dep and amort = ($160,176) + $116,960 = ($43,216). NCF04 = $87,960 + $18,900 = $106,860. OCF05 = EBIT(1 T) + Dep and amort = (-$130,948)(0.6) + $116,960 = $38,391. OCF04 = ($190,428)(0.6) + $18,900 = $133,157. FCF05 = NOPAT Net investment in operating capital = (-$78,569) ($1,852,832 $1,187,200) = (-$78,569) $665,632 = ($744,201). NCF is negative in 2005, but it was positive in 2004. OCF is positive in 2005, but it decreased by over 70% from its 2004 level. Free cash flow was -$744,201 in 2005. C. Looking at DLeons stock price today, would you conclude that the expansion increased or decreased MVA? Answer: [Show S3-17 through S3-19 here.] During the last year, stock price has decreased by over 73%, thus one would conclude that the expansion has decreased MVA. D. DLeon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30 days of receipt. Judging from its 2005 balance sheet, do you think DLeon pays suppliers on time? Explain. If not, what problems might this lead to? Answer: [Show S3-20 here.] DLeon probably does not pay its suppliers on time judging from the fact that its accounts payables balance increased by 260% from the past year, while sales increased by only 76%. Company records would show if they paid suppliers on time. By not paying suppliers on time, DLeon is straining its relationship with them. If DLeon continues to be late, eventually suppliers will cut the company off and put it into bankruptcy. E. DLeon spends money for labor, materials, and fixed assets (depreciation) to make products, and still more money to sell those products. Then, it makes sales that result in receivables, which eventually result in cash inflows. Does it appear that DLeons sales price exceeds its costs per unit sold? How does this affect the cash balance? Answer: [Show S3-21 here.] It does not appear the DLeons sales price exceeds its costs per unit sold as indicated in the income statement. The company is spending more cash than it is taking in and, as a result, the cash account balance has decreased. F. Suppose DLeons sales manager told the sales staff to start offering 60-day credit terms rather than the 30-day terms now being offered. DLeons competitors react by offering similar terms, so sales remain constant. What effect would this have on the cash account? How would the cash account be affected if sales doubled as a result of the credit policy change? Answer: [Show S3-22 here.] By extending the sales credit terms, it would take longer for DLeon to receive its moneyits cash account would decrease and its accounts receivable would build up. Because collections would slow, accounts payable would build up too. Inventory would have to be built up and possibly fixed assets too before sales could be increased. Accounts receivable would rise and cash would decline. Much later, when collections increased cash would rise. DLeon would probably need to borrow or sell stock to finance the expansion. G. Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of output, yet a dramatic increase in sales volume causes the cash balance to decline? Answer: This situation is likely to occur as suggested in the second part of the answer to question F. H. Did DLeon finance its expansion program with internally generated funds (additions to retained earnings plus depreciation) or with external capital? How does the choice of financing affect the companys financial strength? Answer: [Show S3-23 here.] DLeon financed its expansion with external capital rather than internally generated funds. In particular, DLeon issued long-term debt rather than common stock, which reduced its financial strength and flexibility. I. Refer to Tables IC 3-2 and IC 3-4. Suppose DLeon broke even in 2005 in the sense that sales revenues equaled total operating costs plus interest charges. Would the asset expansion have caused the company to experience a cash shortage that required it to raise external capital? Answer: [Show S3-24 here.] Even if DLeon had broken even in 2005, the firm would have had to finance an increase in assets. J. If DLeon started depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the physical stock of assets, (2) the balance sheet account for fixed assets, (3) the companys reported net income, and (4) its cash position? Assume the same depreciation method is used for stockholder reporting and for tax calculations, and the accounting change has no effect on assets physical lives. Answer: [Show S3-25 here.] This would have no effect on the physical stock of the assets; however, the balance sheet account for net fixed assets would decline because accumulated depreciation would increase due to depreciating assets over 7 years versus 10 years. Because depreciation expense would increase, net income would decline. Finally, the firms cash position would increase, because its tax payments would be reduced. K. Explain how earnings per share, dividends per share, and book value per share are calculated, and what they mean. Why does the market price per share not equal the book value per share? Answer: Net income divided by shares outstanding equals earnings per share. Dividends divided by shares outstanding equals dividends per share, while book value per share is calculated as total common equity divided by shares outstanding. Market price per share does not equal book value per share. The market value of a stock reflects future profitability, while book value per share represents historical cost. L. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends received, (3) capital gains, and (4) tax loss carry-back and carry-forward. How might each of these items impact DLeons taxes? Answer: [Show S3-26 through S3-29 here.] For a business, interest paid is considered an expense and is paid out of pre-tax income. Therefore, interest paid is tax deductible for businesses. For individuals, interest paid is generally not tax deductible, with the notable exception being limited tax deductibility on home mortgage interest. Dividends paid by a business are paid out of after-tax income. Interest earned, whether by a business or individual, is taxable income and subject to standard income taxes, except for some state and local government debt interest. Dividends received are taxed at the capital gains rate for individuals, creating a double taxation of dividends (although by not as much as it could be if dividends were taxed as ordinary income). A portion of dividends received by corporations is tax excludable, in order to avoid triple taxation. Capital gains are defined as the profits from the sale of an asset not used in the normal course of business. For individuals, capital gains on assets are taxed as ordinary income if held for less than a year, and at the capital gains rate if held for more than a year. Corporations face somewhat different rules. Capital gains for corporations are taxed as ordinary income. Tax loss carry-back and carry-forward provisions allow businesses to use a loss in the current year to offset profits in prior years (2 years), and if losses havent been completely offset by past profits they can be carried forward to offset profits in the future (20 years). DLeon paid interest expense of $136,012 which was used to further lower its tax liability resulting in a tax credit of $106,784 for a net loss of -$160,176. However, because of the tax loss carry-back and carry-forward provision DLeon was able to obtain its full tax refund in 2005 (as the firm had sufficient taxable income in 2003 and 2004). 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