Solutions Manual

CHAPTER 2
FINANCIAL STATEMENTS AND
CASH FLOW
Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are
included in this solutions manual, rounding may appear to have occurred. However, the final
answer for each problem is found without rounding during any step in the problem.

Basic

1. To find owners’ equity, we must construct a balance sheet as follows:

Balance Sheet
CA $ 5,700 CL $ 4,400
NFA 27,000 LTD 12,900
OE ??
TA $32,700 TL & OE $32,700

We know that total liabilities and owners’ equity (TL & OE) must equal total assets of
$32,700. We also know that TL & OE is equal to current liabilities plus long-term debt
plus owners’ equity, so owners’ equity is:

OE = $32,700 –12,900 – 4,400 = $15,400

NWC = CA – CL = $5,700 – 4,400 = $1,300

3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve
for current assets, we get:

CA = NWC + CL = $800,000 + 2,400,000 = $3,200,000

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The market value of current assets and net fixed assets is given, so:

Book value CA = $3,200,000 Market value CA = $2,600,000

Book value NFA = $5,200,000 Market value NFA = $6,500,000
Book value assets = $8,400,000 Market value assets = $9,100,000

5. To calculate OCF, we first need the income statement:

Income Statement
Sales $18,700
Costs 10,300
Depreciation 1,900
EBIT $6,500
Interest 1,250
Taxable income $5,250
Taxes 2,100
Net income $3,150

OCF = EBIT + Depreciation – Taxes

OCF = $6,500 + 1,900 – 2,100
OCF = $6,300

7. The long-term debt account will increase by $35 million, the amount of the new long-term
debt issue. Since the company sold 10 million new shares of stock with a $1 par value, the
common stock account will increase by $10 million. The capital surplus account will
increase by $48 million, the value of the new stock sold above its par value. Since the
company had a net income of $9 million, and paid $2 million in dividends, the addition to
retained earnings was $7 million, which will increase the accumulated retained earnings
account. So, the new long-term debt and stockholders’ equity portion of the balance sheet
will be:

Long-term debt $ 100,000,000

Total long-term debt $ 100,000,000

Shareholders’ equity
Preferred stock $ 4,000,000
Common stock ($1 par value) 25,000,000

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Accumulated retained earnings 142,000,000

Capital surplus 93,000,000
Total equity $ 264,000,000

Total Liabilities & Equity $ 364,000,000

9. Cash flow to stockholders = Dividends paid – Net new equity

Cash flow to stockholders = $275,000 – [(Commonend + APISend) – (Commonbeg +
APISbeg)]
Cash flow to stockholders = $275,000 – [($525,000 + 3,700,000) – ($490,000 +
3,400,000)]
Cash flow to stockholders = $275,000 – ($4,225,000 – 3,890,000)
Cash flow to stockholders = –$60,000

Note, APIS is the additional paid-in surplus.

Intermediate
11. a. The accounting statement of cash flows explains the change in cash during the year.
The accounting statement of cash flows will be:

Statement of cash flows

Operations
Net income $95
Depreciation 90
Changes in other current assets (5)
Change in accounts payable 10
Total cash flow from operations $190

Investing activities
Acquisition of fixed assets $(110)
Total cash flow from investing activities $(110)

Financing activities
Proceeds of long-term debt $5
Dividends (75)
Total cash flow from financing activities ($70)

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Change in cash (on balance sheet) $10

b. Change in NWC = NWCend – NWCbeg

= (CAend – CLend) – (CAbeg – CLbeg)
= [($65 + 170) – 125] – [($55 + 165) – 115)
= $110 – 105
= $5

c. To find the cash flow generated by the firm’s assets, we need the operating cash flow,
and the capital spending. So, calculating each of these, we find:

Operating cash flow

Net income $95
Depreciation 90
Operating cash flow $185

Note that we can calculate OCF in this manner since there are no taxes.

Capital spending
Ending fixed assets $390
Beginning fixed assets (370)
Depreciation 90
Capital spending $110

Now we can calculate the cash flow generated by the firm’s assets, which is:

Cash flow from assets

Operating cash flow $185
Capital spending (110)
Change in NWC (5)
Cash flow from assets $ 70

13. a. The interest expense for the company is the amount of debt times the interest rate on
the debt. So, the income statement for the company is:
Income Statement

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in whole or part.
Solutions Manual

Sales $1,060,000
Cost of goods sold 525,000
Selling costs 215,000
Depreciation 130,000
EBIT $190,000
Interest 56,000
Taxable income $134,000
Taxes 46,900
Net income $ 87,100

b. And the operating cash flow is:

OCF = EBIT + Depreciation – Taxes

OCF = $190,000 + 130,000 – 46,900
OCF = $273,100

15. The solution to this question works the income statement backwards. Starting at the
bottom:

Net income = Dividends + Addition to retained earnings

Net income = $1,570 + 4,900
Net income = $6,470

Now, looking at the income statement:

EBT – (EBT × Tax rate) = Net income

Recognize that EBT × tax rate is simply the calculation for taxes. Solving this for EBT
yields:

EBT = NI / (1– Tax rate)

EBT = $6,470 / (1 – .35)
EBT = $9,953.85

Now we can calculate:

EBIT = EBT + Interest

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Solutions Manual

EBIT = $9,953.85 + 1,840

EBIT = $11,793.85

The last step is to use:

EBIT = Sales – Costs – Depreciation

$11,793.85 = $41,000 – 26,400 – Depreciation
Depreciation = $2,806.15

17. a. Taxes Growth = 0.15($50,000) + 0.25($25,000) + 0.34($86,000 – 75,000) =

$17,490
Taxes Income = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000)
+ 0.34($8,600,000 – 335,000)
= $2,924,000

b. Each firm has a marginal tax rate of 34 percent on the next $10,000 of taxable income,
despite their different average tax rates, so both firms will pay an additional $3,400 in
taxes.

19. A firm can still pay out dividends if net income is negative; it just has to be sure there is
sufficient cash flow to make the dividend payments.

Change in NWC = Net capital spending = Net new equity = 0. (Given)

Cash flow from assets = OCF – Change in NWC – Net capital spending
Cash flow from assets = $65,000 – 0 – 0 = $65,000

Cash flow to stockholders = Dividends – Net new equity

Cash flow to stockholders = $34,000 – 0 = $34,000

Cash flow to creditors = Cash flow from assets – Cash flow to stockholders
Cash flow to creditors = $65,000 – 34,000
Cash flow to creditors = $31,000
Cash flow to creditors is also:

Cash flow to creditors = Interest – Net new LTD

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So:

Net new LTD = Interest – Cash flow to creditors

Net new LTD = $70,000 – 31,000
Net new LTD = $39,000

21. a. Total assets 2011 = $936 + 4,176 = $5,112

Total liabilities 2011 = $382 + 2,160 = $2,542
Owners’ equity 2011 = $5,112 – 2,542 = $2,570

Total assets 2012 = $1,015 + 4,896 = $5,911

Total liabilities 2012 = $416 + 2,477 = $2,893
Owners’ equity 2012 = $5,911 – 2,893 = $3,018

b. NWC 2011 = CA11 – CL11 = $936 – 382 = $554

NWC 2012 = CA12 – CL12 = $1,015 – 416 = $599
Change in NWC = NWC12 – NWC11 = $599 – 554 = $45

c. We can calculate net capital spending as:

Net capital spending = Net fixed assets 2012 – Net fixed assets 2011 + Depreciation
Net capital spending = $4,896 – 4,176 + 1,150
Net capital spending = $1,870

So, the company had a net capital spending cash flow of $1,870. We also know that
net capital spending is:

Net capital spending = Fixed assets bought – Fixed assets sold

$1,870 = $2,160 – Fixed assets sold
Fixed assets sold = $2,160 – 1,870
Fixed assets sold = $290

To calculate the cash flow from assets, we must first calculate the operating cash
flow. The operating cash flow is calculated as follows (you can also prepare a
traditional income statement):

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in whole or part.
Solutions Manual

EBIT = Sales – Costs – Depreciation

EBIT = $12,380 – 5,776 – 1,150
EBIT = $5,454

EBT = EBIT – Interest

EBT = $5,454 – 314
EBT = $5,140

Taxes = EBT  .40

Taxes = $5,140  .40
Taxes = $2,056

OCF = EBIT + Depreciation – Taxes

OCF = $5,454 + 1,150 – 2,056
OCF = $4,548

Cash flow from assets = OCF – Change in NWC – Net capital spending.
Cash flow from assets = $4,548 – 45 – 1,870
Cash flow from assets = $2,633

d. Net new borrowing = LTD12 – LTD11

Net new borrowing = $2,477 – 2,160
Net new borrowing = $317

Cash flow to creditors = Interest – Net new LTD

Cash flow to creditors = $314 – 317
Cash flow to creditors = –$3

Net new borrowing = $317 = Debt issued – Debt retired

Debt retired = $432 – 317
Debt retired = $115

23. OCF = EBIT + Depreciation – Taxes

OCF = $3,689 + 1,126 – 1,049.24
OCF = $3,765.76

Change in NWC = NWCend – NWCbeg = (CA – CL) end – (CA – CL) beg

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Solutions Manual

Change in NWC = ($21,268 – 4,931) – ($19,218 – 5,110)

Change in NWC = $2,229

Net capital spending = NFAend – NFAbeg + Depreciation

Net capital spending = $35,277 – 34,455 + 1,126
Net capital spending = $1,948

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in whole or part.
Solutions Manual

Cash flow from assets = OCF – Change in NWC – Net capital spending
Cash flow from assets = $3,765.76 – 2,229 – 1,948
Cash flow from assets = –$411.24

Cash flow to creditors = Interest – Net new LTD

Net new LTD = LTDend – LTDbeg
Cash flow to creditors = $603 – ($16,050 – 13,460)
Cash flow to creditors = –$1,987

Net new equity = Common stockend – Common stockbeg

Common stock + Retained earnings = Total owners’ equity
Net new equity = (OE – RE) end – (OE – RE) beg
Net new equity = OEend – OEbeg + REbeg – REend
REend = REbeg + Additions to RE
 Net new equity = OEend – OEbeg + REbeg – (REbeg + Additions to
RE)
= OEend – OEbeg – Additions to RE
Net new equity = $35,564 – 35,103 – 985.76 = –$524.76

Cash flow to stockholders = Dividends – Net new equity

Cash flow to stockholders = $1,051– (–$524.76)
Cash flow to stockholders = $1,575.76

As a check, cash flow from assets is –$411.24

Cash flow from assets = Cash flow from creditors + Cash flow to stockholders
Cash flow from assets = –$1,987 + 1,575.76
Cash flow from assets = –$411.24

Challenge

25. Net capital spending = NFAend – NFAbeg + Depreciation

= (NFAend – NFAbeg) + (Depreciation + ADbeg) – ADbeg
= (NFAend – NFAbeg)+ ADend – ADbeg
= (NFAend + ADend) – (NFAbeg + ADbeg) = FAend – FAbeg

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