Chapter 2

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

2-1

NI = $3,000,000; EBIT = $6,000,000; T = 40%; I = ?

Need to set up an income statement and work from the bottom up.
EBIT
Interest
EBT
Taxes (40%)
NI

$6,000,000
1,000,000
$5,000,000
2,000,000
$3,000,000

EBT =

$3,000,000
$3,000,000
=
(1 T)
0.6

Interest = EBIT - EBT = $6,000,000 - $5,000,000 = $1,000,000.

2-2

NI = $3,100,000; DEP = $500,000

NCF = NI + DEP = $3,100,000 + $500,000 = $3,600,000.

2-3

Corporate yield = 9%; T = 36%

AT yield = 9%(1 - T)
= 9%(0.64) = 5.76%.

2-4

Married
Taxes =
=
=

2-5

Corporate bond yields 8%; Municipal bond yields 6%.

Taxable Income = $102,000; Federal taxes = ?;

$ 6,457.50 + ($102,000 - $43,050)0.28
$ 6,457.50 + ($58,950)0.28
$22,963.50.

Yield on muni
Equivalent pre - tax yield
=
on taxable bond
(1 T)
6%
8% =
(1 T)
0.08 0.08 T = 0.06
0.08 T = 0.02
T = 25%.

2-6

EBIT = $170,000; LT debt = $300,000; AT cost of debt = 6%; Equity =

$500,000; Cost of equity = 15%; T = 40%; EVA = ?
EVA = EBIT(1 - T) - AT dollar cost of capital

= $170,000(1 - 0.4) - [(0.06 $300,000) + (0.15 $500,000)]

= $102,000 - [$18,000 + $75,000]
= $9,000.
Income
$365,000
Less Interest deduction
(50,000)
Plus: Dividends receiveda
4,500
Taxable income
$319,500

2-7

For a corporation, 70 percent of dividends received are excluded from

taxes; therefore, taxable dividends are calculated as $15,000(1 - 0.70) =
$4,500. Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 =
$107,855.
After-tax income:
Taxable income
Taxes
Plus Non-taxable dividends receivedb
Net income
b

Non-taxable dividends are calculated as $15,000 0.7 = $10,500.

The companys marginal tax rate is 39 percent.

rate is $107,855/$319,500 = 33.76% 33.8%.

2-8

$319,500
(107,855)
10,500
$222,145

The companys average tax

a. Tax = $3,400,000 + ($10,500,000 - $10,000,000)(0.35) = $3,575,000.

b. Tax = $1,000,000(0.35) = $350,000.
c. Tax = ($1,000,000)(0.30)(0.35) = $105,000.

2-9

A-T yield on FLA bond = 5%.

A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%.
Check:

Invest $10,000 @ 7.5% = $750 interest.

Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50.
A-T rate of return = $487.50/$10,000 = 4.875%.

A-T yield on AT&T preferred stock:

A-T yield = 6% - Taxes = 6% - (0.3)(6%)(0.35) = 6% - 0.63% = 5.37%.
Therefore, invest in AT&T preferred stock. We could make this a harder
problem by asking for the tax rate that would cause the company to prefer
the Florida bond or the AT&T bond.

2-10

Compare the after-tax returns of the two investments:

Corporate bond = 0.09(1 - 0.36) = 0.0576 = 5.76%.

Answers and Solutions: 2 - 2

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

Municipal bond = 0.07 = 7%; therefore, choose the municipal bond over the
corporate bond.

2-11

EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%

NI = ?; NCF = ?; OCF = ?
First, determine net income by setting up an income statement:
EBIT
Interest
EBT
Taxes (40%)
NI

$750,000
0
$750,000
300,000
$450,000

NCF = NI + DEP = $450,000 + $200,000 = $650,000.

OCF = EBIT(1 - T) + DEP = $750,000(0.6) + $200,000 = $650,000.
Note that NCF = OCF because the firm is 100 percent equity financed.

2-12

Statements b, c, and d will all decrease the amount of cash on a companys

balance sheet, while Statement a will increase cash through the sale of
common stock. This is a source of cash through financing activities.

2-13

a. Because were interested in net cash flow available

stockholders, we exclude common dividends paid.

to

common

CF00 = NI available to common stockholders + Depreciation

= $364 + $220 = $584.
The net cash flow number is larger than net income by the current
years depreciation expense, which is a noncash charge.
b. Balance of RE, December 31, 1999
Add: NI, 2000
Less: Div. paid to common stockholders
Balance of RE, December 31, 2000

$1,302
364
(146)
$1,520

c. $1,520 million.
d. Cash + Marketable securities = $15 million.
e. Total current liabilities = $620 million.

2-14

a.
Sales revenues
Costs except depreciation (75%)
Depreciation
EBT
Taxes (40%)
Net income
Add back depreciation

Answers and Solutions: 2 - 4

Income Statement
$12,000,000
9,000,000
1,500,000
$ 1,500,000
600,000
$
900,000
1,500,000

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

Net cash flow

b. If depreciation
would be zero.
flow would rise
thus increasing

$ 2,400,000
doubled, taxable income would fall to zero and taxes
Thus, net income would decrease to zero, but net cash
to $3,000,000. Menendez would save $600,000 in taxes,
its cash flow:

CF = T(Depreciation) = 0.4($1,500,000) = $600,000.

c. If depreciation 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 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 doubled, net income fell by 100
percent.
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 percent,
even though the firms ability to pay dividends and to repay loans
would have improved.

2-15

This involves setting up the income statement and working from the bottom
up.
Sales Revenue*
Cost of Goods Sold (60%)
Depreciation
Total Operating Costs
EBIT
Interest
EBT
Taxes (40%)
NI
*

2-16

$2,500,000
1,500,000
500,000
$2,000,000
$ 500,000
100,000
$ 400,000
160,000
$ 240,000

Sales Revenue - COGS - Deprec.

Sales Revenue - 0.6(Revenue) - $500,000
0.4 Revenue
Revenue

2,500,000 0.6
(Given)
EBIT = EBT + Interest
(Given) $240,000
$240,000
=
EBT =
(1 T)
0.6
(Given)
=
=
=
=

EBIT
$500,000
$1,000,000
$2,500,000.

a. NOPAT = EBIT(1 - Tax rate)

= $150,000,000(0.6)
= $90,000,000.
Net operating
Non -interest charging
b. working capital = Current assets - current liabilities
99

= $360,000,000 - ($90,000,000 + $60,000,000)

= $210,000,000.
Net operating
working capital00 = $372,000,000 - $180,000,000 = $192,000,000.
Net plant
Net operating
c. Operating capital99 = and equipment + working capital
= $250,000,000 + $210,000,000
= $460,000,000.
Operating capital00 = $300,000,000 + $192,000,000
= $492,000,000.
d. FCF = 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 2000 can most likely be attributed
to a large increase in free cash flow from 1999 to 2000, 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 working capital necessary to sustain the business.

2-17

Prior Years
Profit earned
Carry-back credit
Adjusted profit
Taxes previously paid (40%)
Tax refund: Taxes
previously paid

1998
$150,000
150,000
$
0
60,000

1999
$150,000
150,000
$
0
60,000

$ 60,000

$ 60,000

Total check from U. S. Treasury = $60,000 + $60,000 = $120,000.

Future Years
Estimated
profit
Carry-forward
credit
Adjusted
profit
Taxes (at 40%)

2-18

2001

2002

2003

2004

2005

$150,000

$150,000

$150,000

$150,000

$150,000

150,000

150,000

50,000

0
0

$100,000
$ 40,000

$150,000
$ 60,000

$150,000
$ 60,000

0
0

$
$

2001 tax = $0, since the firm had a loss.

used to offset future income.

The $95,000,000 loss will be

2002 tax = $0; $70,000,000 income offset by $70,000,000 of 2001 loss.

Answers and Solutions: 2 - 6

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

2003 taxable income is reduced by remaining $25,000,000 of 2001 loss, so

2003 taxable income = $55,000,000 - $25,000,000 = $30,000,000, and 2003
tax = (0.40)($30,000,000) = $12,000,000.
2004 tax = $80,000,000 0.4 = $32,000,000.
2005 tax = $0; $110,000,000 of loss can be carried back to offset income
from 2003 and 2004, reducing taxes in those years to $0. The firm will
get a refund of $12,000,000 + $32,000,000 = $44,000,000 for taxes paid in
those years. The remaining $40,000,000 loss can be carried forward.

2-19

a.

2001

2002

2003

Taxes as a corporation:
Income before salary & taxes
Less salary
Taxable income, corporate
Total corporate tax

$70,000
(52,000)
$18,000
$ 2,700

$95,000
(52,000)
$43,000
$ 6,450

$110,000
(52,000)
$ 58,000
$ 9,500

Salary
Less exemptions & deductions
Taxable personal income
Total personal tax
Combined corp. & personal tax

$52,000
(19,600)
$32,400
$ 4,860
$ 7,560

$52,000
(19,600)
$32,400
$ 4,860
$11,310

$ 52,000
(19,600)
$32,400
$ 4,860
$ 14,360

Taxes as a proprietorship:
Total income
Less exemptions & deductions
Taxable personal income
Total proprietorship tax

$70,000
(19,600)
$50,400
$ 8,516

$95,000
(19,600)
$75,400
$15,516

$110,000
(19,600)
$ 90,400
$ 19,716

Advantage to corporation

$ 4,206

956

5,356

b. On the basis of these figures, Visscher should incorporate, since her

expected tax liability is less each year as a corporation and since she
plans to retain all income in excess of her salary in the business.
However, if Visscher planned to withdraw earnings in the future, she
would have to consider the effects of double taxation on dividends she
would receive when she withdrew earnings. Of course, Visscher could
avoid double taxation simply by raising her salary.

2-20

a. Calculation of gross income:

Salary
Dividend Income
Interest Income (corp. bonds only)
ST capital gains
Gross Income
(excluding LT capital gains)
LT capital gains**
**Applicable tax rate = 20%.

2000
$ 82,000
12,000
5,000
1,000
$100,000
13,000

Calculation of taxable income:

Gross income
Exemption
Deductions
Taxable income
(excluding LT capital gains)
Personal tax

$100,000
(2,750)
(5,000)
$ 92,250
$ 25,977

Tax = $14,138.50 + ($92,250 - $62,450)(0.31) + $13,000(0.20)

= $14,138.50 + $9,238 + $2,600 = $25,976.50 $25,977.
b. Marginal tax rate = 31%.
Average tax rate = $25,977/$105,250* = 24.7%. One could argue that the
average rate is really lower, because the base should consider the
deductions and exemptions.
*Includes $13,000
$105,250).

long-term

capital

gain; ($92,250

$13,000

c. After-tax returns:
Disney = (0.08)($5,000) - (0.31)($5,000)(0.08) = $276.
FLA = (0.06)($5,000) - 0 = $300.
Viewed another way, the Disney bonds provide an after-tax yield of
8%(1 - T) = 8%(1 - 0.31) = 8%(0.69) = 5.52%.
The Florida bonds provide an after-tax yield of 6 percent; hence they
are better for her.
d. 6% = 8%(1 - T).

Now solve for T:

6 = 8 - 8T
8T = 2
T = 2/8 = 25%.
At a tax rate less than 25 percent, Mary would be better off holding 8
percent taxable bonds, but at a tax rate over 25 percent, she would be
better off holding tax-exempt municipal bonds. Given our progressive
tax rate system, it makes sense for wealthy people to hold tax-exempt
bonds, but not for those with lower incomes and consequently lower tax
rates.

Answers and Solutions: 2 - 8

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

SPREADSHEET PROBLEM

2-21

The detailed solution for the spreadsheet problem is available both on the
instructors resource CD-ROM and on the instructors side of the Harcourt
College Publishers web site, http://www.harcourtcollege.com/finance/
brigham.

CYBERPROBLEM

2-22

The detailed solution for the cyberproblem is available on the

instructors side of the Harcourt College Publishers web site,
http://www.
harcourtcollege.com/finance/brigham.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.Computer/Internet Applications: 2 - 9

INTEGRATED CASE

DLeon Inc., Part I

Section 1: Financial Statements
2-23

DONNA JAMISON, A 1995 GRADUATE OF THE UNIVERSITY OF FLORIDA WITH FOUR

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 1999 TO UNDERTAKE A MAJOR EXPANSION AND TO GO

NATIONAL IN COMPETITION WITH FRITO-LAY, EAGLE, AND OTHER MAJOR SNACKFOOD 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 VICEPRESIDENT 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 IC2-1, IC2-2, IC2-3, AND IC2-4.
JAMISONS

ASSISTANT,

QUESTIONS FOR CAMPO.

AND

YOU

(NOTE:

MUST

HELP

HER

ASSUME THAT YOU ARE

ANSWER

THE

FOLLOWING

WE WILL CONTINUE WITH THIS CASE IN

CHAPTER 3, AND YOU WILL FEEL MORE COMFORTABLE WITH THE ANALYSIS THERE,
BUT ANSWERING THESE QUESTIONS WILL HELP PREPARE YOU FOR CHAPTER 3.
PROVIDE CLEAR EXPLANATIONS, NOT JUST YES OR NO ANSWERS!)
Integrated Case: 2 - 10

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

TABLE IC2-1. BALANCE SHEETS

2000
ASSETS
CASH
ACCOUNTS RECEIVABLE
INVENTORIES
TOTAL CURRENT ASSETS
GROSS FIXED ASSETS
LESS ACCUMULATED DEPRECIATION
NET FIXED ASSETS
TOTAL ASSETS
LIABILITIES AND EQUITY
ACCOUNTS PAYABLE
NOTES PAYABLE
ACCRUALS
TOTAL CURRENT LIABILITIES
LONG-TERM DEBT
COMMON STOCK (100,000 SHARES)
RETAINED EARNINGS
TOTAL EQUITY
TOTAL LIABILITIES AND EQUITY

1999

7,282
632,160
1,287,360
$1,926,802

57,600
351,200
715,200
$1,124,000

1,202,950
263,160
$ 939,790
$2,866,592

491,000
146,200
$ 344,800
$1,468,800

524,160
720,000
489,600
$1,733,760
1,000,000
460,000
(327,168)
$ 132,832
$2,866,592

145,600
200,000
136,000
$ 481,600
323,432
460,000
203,768
$ 663,768
$1,468,800

TABLE IC2-2. INCOME STATEMENTS

SALES
COST OF GOODS SOLD
OTHER EXPENSES
DEPRECIATION
TOTAL OPERATING COSTS
EBIT
INTEREST EXPENSE
EBT
TAXES (40%)
NET INCOME
EPS
DPS
BOOK VALUE PER SHARE
STOCK PRICE
SHARES OUTSTANDING
TAX RATE
LEASE PAYMENTS
SINKING FUND PAYMENTS

2000
$5,834,400
5,728,000
680,000
116,960
$6,524,960
($ 690,560)
176,000
($ 866,560)
(346,624)
($ 519,936)

1999
$3,432,000
2,864,000
340,000
18,900
$3,222,900
$ 209,100
62,500
$ 146,600
58,640
$
87,960

($5.199)
$0.110
$1.328
$2.25
100,000
40.00%
40,000
0

$0.880
$0.220
$6.638
$8.50
100,000
40.00%
40,000
0

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 11

TABLE IC2-3. STATEMENT OF RETAINED EARNINGS, 2000

BALANCE OF RETAINED EARNINGS, 12/31/99
ADD: NET INCOME, 2000
LESS: DIVIDENDS PAID
BALANCE OF RETAINED EARNINGS, 12/31/00

$203,768
(519,936)
(11,000)
($327,168)

TABLE IC2-4. STATEMENT OF CASH FLOWS, 2000

OPERATING ACTIVITIES
NET INCOME
ADDITIONS (SOURCES OF CASH)
DEPRECIATION
INCREASE IN ACCOUNTS PAYABLE
INCREASE IN ACCRUALS
SUBTRACTIONS (USES OF CASH)
INCREASE IN ACCOUNTS RECEIVABLE
INCREASE IN INVENTORIES
NET CASH PROVIDED BY OPERATING ACTIVITIES
LONG-TERM INVESTING ACTIVITIES
CASH USED TO ACQUIRE FIXED ASSETS
FINANCING ACTIVITIES
INCREASE IN NOTES PAYABLE
INCREASE IN LONG-TERM DEBT
PAYMENT OF CASH DIVIDENDS
NET CASH PROVIDED BY FINANCING ACTIVITIES
SUM: NET DECREASE IN CASH
PLUS: CASH AT BEGINNING OF YEAR
CASH AT END OF YEAR

Integrated Case: 2 - 12

($

519,936)
116,960
378,560
353,600

(280,960)
(572,160)
($ 523,936)

($

711,950)

520,000
676,568
(11,000)
$1,185,568
($
50,318)
57,600
$
7,282

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

A.

WHAT EFFECT DID THE EXPANSION HAVE ON SALES, NET OPERATING PROFIT AFTER
TAXES (NOPAT), NET OPERATING WORKING CAPITAL (NOWC), OPERATING CAPITAL,
AND NET INCOME?

ANSWER:

[S2-1 THROUGH S2-9 PROVIDE BACKGROUND INFORMATION.

THROUGH S2-13 HERE.]

THEN SHOW S2-10

SALES INCREASED BY $2,402,400.

NOPAT00 = EBIT (1 - TAX RATE)

= (-$690,560)(0.6) = ($414,336).
NOPAT99 = $209,100(0.6) = $125,460.
NOPAT = ($414,336) - $125,460 = ($539,796).
NOPAT DECREASED BY $539,796.
ACCOUNTS
ACCOUNTS
NOWC00 = CASH +
+ INVENTORIES
+ ACCRUALS
RECEIVABLE

PAYABLE

= ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600)

= $913,042.
NOWC99 = ($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.
OC00 = NET OPERATING WORKING CAPITAL + NET PLANT AND EQUIPMENT
= $913,042 + $939,790 = $1,852,832.
OC99 = $842,400 + $344,800 = $1,187,200.
OC = $1,852,832 - $1,187,200 = $665,632.
OPERATING CAPITAL INCREASED SUBSTANTIALLY BY $665,632 FROM 1999 TO
2000.
NI00 - NI99 = ($519,936) - $87,960 = ($607,896).
THERE WAS A HUGE DROP, -$607,896, IN NET INCOME DURING 2000.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 13

B.

WHAT EFFECT DID THE COMPANY S EXPANSION HAVE ON ITS NET CASH FLOW,
OPERATING CASH FLOW, AND FREE CASH FLOW?

ANSWER:

[SHOW S2-14 AND S2-15 HERE.]

NCF00 = NI + DEP = ($519,936) + $116,960 = ($402,976).
NCF99 = $87,960 + $18,900 = $106,860.
OCF00 = EBIT(1 - T) + DEP = (-$690,560)(0.6) + $116,960
= ($297,376).
OCF99 = ($209,100)(0.6) + $18,900 = $144,360.
FCF00 = NOPAT - NET INVESTMENT IN OPERATING CAPITAL
= (-$414,336) - ($1,852,832 - $1,187,200)
= (-$414,336) - $665,632 = ($1,079,968).
BOTH NCF AND OCF ARE NEGATIVE IN 2000, BUT THEY WERE POSITIVE IN 1999.
FREE CASH FLOW WAS -$1,079,968 IN 2000.

C.

JAMISON ALSO HAS ASKED YOU TO ESTIMATE DLEONS EVA.

THAT

THE

AFTER-TAX

COST

OF

CAPITAL

WAS

11

PERCENT

SHE ESTIMATES
IN

1999

AND

13 PERCENT IN 2000.
ANSWER:

[SHOW S2-16 THROUGH S2-18 HERE.]

EVA00 = EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL
= (-$690,560)(0.6) - ($1,852,832)(0.13)
= ($655,204).
EVA99 = EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL
= ($209,100)(0.6) - ($1,187,200)(0.11)
= ($5,132).
IN

1999,

EVA

WAS

SLIGHTLY

NEGATIVE;

HOWEVER

IN

2000

EVA

WAS

SIGNIFICANTLY NEGATIVE.

Integrated Case: 2 - 14

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

D.

LOOKING AT DLEONS STOCK PRICE TODAY, WOULD YOU CONCLUDE THAT THE
EXPANSION INCREASED OR DECREASED MVA?

ANSWER:

[SHOW S2-19 AND S2-20 HERE.]

DECREASED

BY

OVER

73

DURING THE LAST YEAR, STOCK PRICE HAS

PERCENT,

THUS

ONE

WOULD

CONCLUDE

THAT

THE

EXPANSION HAS DECREASED MVA.

E.

DLEON PURCHASES MATERIALS ON 30-DAY TERMS, MEANING THAT IT IS SUPPOSED

TO PAY FOR PURCHASES WITHIN 30 DAYS OF RECEIPT.

JUDGING FROM ITS 2000

BALANCE SHEET, DO YOU THINK DLEON PAYS SUPPLIERS ON TIME?

EXPLAIN.

IF NOT, WHAT PROBLEMS MIGHT THIS LEAD TO?

ANSWER:

[SHOW S2-21 HERE.]

DLEON PROBABLY DOES NOT PAY ITS SUPPLIERS ON TIME

JUDGING FROM THE FACT THAT ITS ACCOUNTS PAYABLES BALANCE INCREASED BY
260 PERCENT FROM THE PAST YEAR, WHILE SALES INCREASED BY ONLY 70
PERCENT. 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.

F.

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 S2-22 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.

G.

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?

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

HOW WOULD

Integrated Case: 2 - 15

THE CASH ACCOUNT BE AFFECTED IF SALES DOUBLED AS A RESULT OF THE CREDIT

POLICY CHANGE?
ANSWER:

[SHOW S2-23 AND S2-24 HERE.]

BY EXTENDING THE SALES CREDIT TERMS, IT

WOULD TAKE LONGER FOR DLEON TO RECEIVE ITS MONEY--ITS 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.
CASH WOULD DECLINE.
RISE.

ACCOUNTS RECEIVABLE WOULD RISE AND

MUCH LATER, WHEN COLLECTIONS INCREASED CASH WOULD

DLEON WOULD PROBABLY NEED TO BORROW OR SELL STOCK TO FINANCE

THE EXPANSION.

H.

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 G.

I.

IN GENERAL, COULD A COMPANY LIKE DLEON INCREASE SALES WITHOUT A

CORRESPONDING INCREASE IN INVENTORY AND OTHER ASSETS?

WOULD THE ASSET

INCREASE OCCUR BEFORE THE INCREASE IN SALES, AND, IF SO, HOW WOULD THAT
AFFECT THE CASH ACCOUNT AND THE STATEMENT OF CASH FLOWS?
ANSWER:

GENERALLY, A COMPANY LIKE DLEON COULD NOT BE EXPECTED TO INCREASE ITS

SALES WITHOUT A CORRESPONDING INCREASE IN INVENTORY AND OTHER ASSETS.
(SEE QUESTION G.)

J.

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 S2-25 HERE.]

DLEON FINANCED ITS EXPANSION WITH EXTERNAL CAPITAL

RATHER THAN INTERNALLY GENERATED FUNDS.

Integrated Case: 2 - 16

IN PARTICULAR, DLEON ISSUED

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

LONG-TERM DEBT RATHER THAN COMMON STOCK, WHICH REDUCED ITS FINANCIAL
STRENGTH.

K.

REFER TO TABLES IC2-2 AND IC2-4.

SUPPOSE DLEON BROKE EVEN IN 2000 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 S2-26 HERE.]

EVEN IF DLEON HAD BROKEN EVEN IN 2000, THE FIRM

WOULD HAVE HAD TO FINANCE AN INCREASE IN ASSETS.

L.

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 S2-27 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

PAYMENTS

POSITION

WOULD

INCREASE,

BECAUSE

ITS

TAX

WOULD

BE

REDUCED.

M.

EXPLAIN HOW (1) INVENTORY VALUATION METHODS, (2) THE ACCOUNTING POLICY
REGARDING EXPENSING VERSUS CAPITALIZING RESEARCH AND DEVELOPMENT, AND
(3) THE POLICY WITH REGARD TO FUNDING FUTURE RETIREMENT PLAN COSTS
(RETIREMENT

PAY

AND

RETIREES

HEALTH

BENEFITS)

COULD

AFFECT

THE

FINANCIAL STATEMENTS.
ANSWER:

[SHOW S2-28 HERE.]

INVENTORY VALUATION METHODS, SUCH AS LIFO AND FIFO,

CAUSE COST OF GOODS SOLD TO BE HIGHER OR LOWER, WHICH THEN AFFECTS NET
INCOME, TAXES, AND THE BALANCE SHEET INVENTORY FIGURE.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 17

IF RESEARCH AND DEVELOPMENT COSTS ARE CAPITALIZED, THEY REDUCE THE

CURRENT EXPENSE THAT INCREASES NET INCOME AND TAXES.

THIS CAUSES

ASSETS TO APPEAR LARGER.

WITH RESPECT TO RETIREMENT PLAN COSTS, A COMPANY CAN FUND THE
RETIREMENT PLAN, WHICH MEANS PAY NOW FOR FUTURE COSTS, OR PUT OFF
REPORTING THE COSTS UNTIL PEOPLE RETIRE.

N.

DLEONS STOCK SELLS FOR $2.25 PER SHARE EVEN THOUGH THE COMPANY HAD
LARGE

LOSSES.

DOES

THE

POSITIVE

STOCK

PRICE

INDICATE

THAT

SOME

INVESTORS ARE IRRATIONAL?

ANSWER:

[SHOW S2-29 HERE.]

THE POSITIVE STOCK PRICE DOES NOT INDICATE THAT

SOME INVESTORS ARE IRRATIONAL.

RATHER, THE POSITIVE STOCK PRICE MEANS

THAT PEOPLE EXPECT THINGS TO GET BETTER IN THE FUTURE.

O.

DLEON

FOLLOWED

QUARTERLY BASIS.

THE

STANDARD

PRACTICE

OF

PAYING

DIVIDENDS

ON

IT PAID A DIVIDEND DURING THE FIRST TWO QUARTERS OF

2000, THEN ELIMINATED THE DIVIDEND WHEN MANAGEMENT REALIZED THAT A LOSS
WOULD BE INCURRED FOR THE YEAR.

THE DIVIDEND WAS CUT BEFORE THE LOSSES

WERE ANNOUNCED, AND AT THAT POINT THE STOCK PRICE FELL FROM $8.50 TO
$3.50. WHY WOULD AN $0.11, OR EVEN A $0.22, DIVIDEND REDUCTION LEAD TO
A $5.00 STOCK PRICE REDUCTION?

ANSWER:

[SHOW S2-30 HERE.]

THE DIVIDEND CUT WAS A SIGNAL THAT MANAGEMENT

THINKS OPERATIONS ARE IN TROUBLE.

PROFITS AND DIVIDENDS.

STOCK VALUES DEPEND ON FUTURE

THE DIVIDEND CUT LOWERED EXPECTATIONS FOR

FUTURE PROFITS THAT CAUSED THE STOCK PRICE TO DECLINE.

P.

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 COMMON EQUITY DIVIDED BY
SHARES OUTSTANDING.

Integrated Case: 2 - 18

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

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.

Q.

HOW MUCH NEW MONEY DID DLEON BORROW FROM ITS BANK DURING 2000?
MUCH ADDITIONAL CREDIT DID ITS SUPPLIERS EXTEND?

HOW

ITS EMPLOYEES AND THE

TAXING AUTHORITIES?
ANSWER:

[SHOW S2-31 HERE.]

TO DETERMINE HOW MUCH MONEY THE COMPANY BORROWED

FROM THE BANK AND HOW MUCH CREDIT THE FIRM OBTAINED FROM ITS SUPPLIERS
AND TAXING AUTHORITIES, ONE CAN EXAMINE THE STATEMENT OF CASH FLOWS AS
SHOWN IN TABLE IC2-4.
ACTIVITIES,

WE

SEE

BY LOOKING IN THE SECTION TITLED FINANCING

THAT

THE

FIRMS

NOTES

PAYABLE

$520,000--THIS IS HOW MUCH IT BORROWED FROM THE BANK.

INCREASED

BY

BY LOOKING IN

THE OPERATING ACTIVITIES SECTION UNDER ADDITIONS, WE SEE THAT THE

FIRMS ACCOUNTS PAYABLE INCREASED BY $378,560--THIS IS THE AMOUNT OF
CREDIT IT OBTAINED FROM SUPPLIERS.

BY LOOKING IN THE OPERATING

ACTIVITIES SECTION UNDER ADDITIONS, WE SEE THAT THE FIRMS ACCRUALS

INCREASED BY $353,600--ACCRUALS WOULD INCLUDE ACCRUED TAXES.

R.

IF YOU WERE DLEONS BANKER, OR THE CREDIT MANAGER OF ONE OF ITS

SUPPLIERS, WOULD YOU BE WORRIED ABOUT YOUR JOB?

IF YOU WERE A CURRENT

DLEON EMPLOYEE, A RETIREE, OR A STOCKHOLDER, SHOULD YOU BE CONCERNED?

ANSWER:

YES.

IF THE STATEMENT OF CASH FLOWS IS EXAMINED, YOU CAN SEE THAT THE

NET CASH FLOW FROM OPERATIONS WAS A NEGATIVE $523,936--THE FIRM IS

SPENDING MORE THAN IT IS TAKING IN.

IF THE COMPANY GOES BANKRUPT, THE

BANK AND SUPPLIERS COULD SUFFER LOSSES.

FOR EMPLOYEES, RETIREES, AND

STOCKHOLDERS, JOBS COULD BE LOST, RETIREE PENSIONS COULD BE CUT IF THE

PLAN

WERE

NOT

FULLY

FUNDED,

AND

STOCKHOLDERS

COULD

LOSE

THEIR

INVESTMENTS.

S.

THE 2000 INCOME STATEMENT SHOWS NEGATIVE TAXES, THAT IS, A TAX CREDIT.
HOW MUCH TAXES WOULD THE COMPANY HAVE HAD TO PAY IN THE PAST TO
ACTUALLY GET THIS CREDIT?

IF TAXES PAID WITHIN THE LAST 2 YEARS HAD

BEEN LESS THAN $346,624, WHAT WOULD HAVE HAPPENED?

WOULD THIS HAVE

AFFECTED THE STATEMENT OF CASH FLOWS AND THE ENDING CASH BALANCE?
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 19

ANSWER:

[SHOW S2-32 HERE.]

FOR THE FIRM TO ACTUALLY OBTAIN THIS TAX CREDIT, IT

WOULD HAVE HAD TO PAY $346,624 IN TAXES DURING THE LAST TWO YEARS.

IF

THE FIRMS TAX PAYMENTS DURING THE LAST TWO YEARS DID NOT ADD UP TO
$346,624, IT WOULD NOT HAVE OBTAINED A FULL REFUND.

RATHER, THE FIRM

WOULD HAVE HAD TO CARRY FORWARD THE AMOUNT OF ITS LOSS NOT CARRIED BACK
IN ORDER TO REDUCE FUTURE TAXES, IF THE COMPANY BECOMES PROFITABLE.
IF THE FIRM HAD NOT RECEIVED A FULL REFUND OF ITS TAXES, THE CASH
DRAIN FROM OPERATIONS WOULD HAVE BEEN LARGER.

THE FIRM WOULD HAVE HAD

TO MAKE THIS UP ELSEWHERE (BY BORROWING FROM THE BANK, ISSUING MORE
BONDS, ETC.).

Section II: Taxes

T.

WORKING WITH JAMISON HAS REQUIRED YOU TO PUT IN A LOT OF OVERTIME, SO

YOU HAVE HAD VERY LITTLE TIME TO SPEND ON YOUR PRIVATE FINANCES.

ITS

NOW APRIL 1, AND YOU HAVE ONLY TWO WEEKS LEFT TO FILE YOUR INCOME TAX
RETURN.

YOU HAVE MANAGED TO GET ALL THE INFORMATION TOGETHER THAT YOU

WILL NEED TO COMPLETE YOUR RETURN.

DLEON PAID YOU A SALARY OF

$45,000, AND YOU RECEIVED $3,000 IN DIVIDENDS FROM COMMON STOCK THAT
YOU OWN.

YOU ARE SINGLE, SO YOUR PERSONAL EXEMPTION IS $2,750, AND

YOUR ITEMIZED DEDUCTIONS ARE $4,850.

1. ON THE BASIS OF THE INFORMATION ABOVE AND THE APRIL 2000 INDIVIDUAL TAX
RATE SCHEDULE, WHAT IS YOUR TAX LIABILITY?
ANSWER:

[SHOW S2-33 THROUGH S2-37 HERE.]

CALCULATION OF TAXABLE INCOME:
SALARY
DIVIDENDS
PERSONAL EXEMPTION
DEDUCTIONS
TAXABLE INCOME

$45,000
3,000
(2,750)
(4,850)
$40,400

TAX LIABILITY = $3,862.50 + ($40,400 - $25,750)(0.28) = $7,964.50

$7,965.

T.

2. WHAT ARE YOUR MARGINAL AND AVERAGE TAX RATES?

Integrated Case: 2 - 20

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

ANSWER:

MARGINAL TAX RATE IS 28 PERCENT; AVERAGE TAX RATE = $7,965/$40,400 =

19.71% 19.7%.

U.

ASSUME

THAT

CORPORATION

HAS

$100,000

OF

TAXABLE

INCOME

FROM

OPERATIONS PLUS $5,000 OF INTEREST INCOME AND $10,000 OF DIVIDEND

INCOME.
ANSWER:

WHAT IS THE COMPANYS TAX LIABILITY?

[SHOW S2-38 THROUGH S2-40 HERE.]

CALCULATION OF THE COMPANYS TAX

LIABILITY:
TAXABLE OPERATING INCOME
$100,000
TAXABLE INTEREST INCOME
5,000
TAXABLE DIVIDEND INCOME (0.3 $10,000)
3,000
TOTAL TAXABLE INCOME
$108,000
TAX = $22,250 + ($108,000 - $100,000)0.39 = $25,370.
TAXABLE DIVIDEND INCOME = DIVIDENDS - EXCLUSION
= $10,000 - 0.7($10,000)
= $3,000.

V.

ASSUME THAT AFTER PAYING YOUR PERSONAL INCOME TAX AS CALCULATED IN

PART T, YOU HAVE $5,000 TO INVEST.

YOU HAVE NARROWED YOUR INVESTMENT

CHOICES DOWN TO CALIFORNIA BONDS WITH A YIELD OF 7 PERCENT OR EQUALLY

RISKY EXXON BONDS WITH A YIELD OF 10 PERCENT.
CHOOSE AND WHY?

WHICH ONE SHOULD YOU

AT WHAT MARGINAL TAX RATE WOULD YOU BE INDIFFERENT TO

THE CHOICE BETWEEN CALIFORNIA AND EXXON BONDS?

ANSWER:

[SHOW S2-41 THROUGH S2-44 HERE.]

EXXON = 0.10($5,000) - (0.10)($5,000)(0.28) = $360.
CALIFORNIA = 0.07($5,000) - $0 = $350.
ALTERNATIVELY, CALCULATE AFTER-TAX YIELDS:
A-T YIELDEXXON = 10.0%(1 - T) = 10%(1 - 0.28) = 7.2%.
A-T YIELDCALIF. = 7.0%.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 21

AT WHAT MARGINAL TAX RATE WOULD YOU BE INDIFFERENT?

7.0% = 10.0%(1 - T).

SOLVE FOR T.

7.0% = 10.0% - 10.0%(T)

10.0%(T) = 3%
T = 30%.

Integrated Case: 2 - 22

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.