Chapter 2 Questions Foundations of Financial Management

1) Discuss some financial variables that affect the price-earnings ratio

Influence by earnings and by share price changes
Debt-equity
Dividend payment policy
Sales growth
Quality of management
Risk assessment

2) What is the difference between book value per share of common stock and market value per share? Why does this disparity occur?

Book value is the net worth assigned to common stock divided by the number of common shares outstanding. This is the value from the balance sheet of the net owners equity less preferred stock obligations.
The market value of the shares is the value the share is traded at. It can also be considered as the earnings per share multiplied by the P/E ratio.
There can be a big difference between the 2 numbers based on expected future earnings and even expected future capital growth.

3) Explain how depreciation generates actual cash flows for the company

Depreciation is a non-cash deduction in net-income and should be added back to net income to increase cash balance and for calculating cash flow statement.
Depreciation decreases net income as mentioned above. With lower net income, income tax will be lower thus saving a cash outflow.

4) What is the difference between accumulated depreciation and Depreciation expense and how are they related?

Accumulated Depreciation is a contra account in the Balance sheet and is used to record the effect of depreciation on the value of assets in the BS. Each Accumulated depreciation account has a respective Asset class to which the accumulated depreciation can be closed out in the event of an asset sale or write down.
Depreciation expense is an expense account which affects the profits. This is often used to reduce taxation expense by reducing taxable income.
Each time depreciation expense is recorded a corresponding entry is made in the respective accumulated depreciation account so there is a one to one mapping of accounts. This ensures that depreciation is recorded in both the Income statement and the balance sheet.

5) How is the income statement related to the balance sheet?

The Net Income in the income statement (Earnings available to common stockholders after taxes and preferred stock dividends) should be the same number as the earnings available to common stockholders in the balance sheet. This number is added to retained earnings and reflects the change in the owner’s interest in the firm. In short the profit or loss number from the income statement reflects the change in owners equity in the balance sheet.

6) How might inflation restrict the usefulness of the balance sheet as normally presented?

All assets and liabilities are recorded in the balance sheet at their historical cost. I.e. the cost to the firm at the time that they were acquired. For assets that depreciate it is possible to make a regular adjustment using the depreciation accounts mentioned above. But for other assets it is difficult (given the general requirement for prudence and the tendency for conservatism) to revalue assets at current market values. This requires some kind of offset and may affect the Income statement which is a little scary from a truth point of view.

7) Why does a statement of Cash Flows provide useful information that goes beyond the income statement and the balance sheet data.

As the accrual method is used for the Balance sheet and Income statement (allowing for the matching of revenues and expenses) this records income and expenses when income is earned and when an expense is made. This may be very much out of step with the cash situation. With the use of Accounts Receivable there may even be a big difference between revenue and the cash that is eventually received. Also depreciation can make a company show a loss even when they have a cash surplus.

8) What are the three sections of a cash flow statement and under which heading would payment of a cash dividend be shown?

Cash flows from Operating Activities
Cash flows from Investing Activities
Cash flows from Financing Activities

This is where payment of cash dividends appears. This is a financing activity.

9) What is free cash flow? Why is it important for leveraged buyouts?

This is equal to

the cash flow from operating activities
less the Capital Expenditures (maintains productive capacity)
less dividends

This balance is available for special financial activities e.g. leveraged buyouts where a firm borrows money to buy it’s won stock and go private. The free cash flow must be sufficient to pay back the loan of the leveraged buyout.

10) Why is the interest expense said to cost the firm less than the actual expense while dividends cost it 100% of the outlay?

Interest is a tax deductable expense. This lowers the taxable income and thus reduces the tax expense. The interest expense is thus offset buy a savings in tax expense at the prevail rate. Dividends on the other hand are paid out of after tax income and are not tax deductible. They have no affect on the amount of tax paid and thus must be paid for 100%.

Problems

1) Income Statement for Rodham Hair Care Company

Sales	470000
Cost of goods Sold	140000
Gross Profit	330000
Selling and Administrative expense	60000
Depreciation Expense	70000
Operating Profit (EBIT)	200000
Interest Expense	40000
Earnings before Taxes (EBT)	160000
Taxes	45000
Earnings after Taxes (EAT)	115000

2) The Reid Book Company Income statement Jan 1 to Dec 31 1996

Sales	84500
Cost of goods Sold	58500
Gross Profit	26000
Selling and Administrative expense	2000
Depreciation Expense	6000
Operating Profit (EBIT)	18000
Interest Expense	3500
Earnings before Taxes (EBT)	14500
Taxes	2900
Earnings after Taxes (EAT)	11600

3) Lemon Auto Wholesalers Income Statement Jan 1 to Dec 31 1996

Sales	700000
Cost of goods Sold	490000
Gross Profit	210000
Selling and Administrative expense	84000
Depreciation Expense	10000
Operating Profit (EBIT)	116000
Interest Expense	8000
Earnings before Taxes (EBT)	108000
Taxes	32400
Earnings after Taxes (EAT)	75600

After hiring the efficiency expert some revised earnings

Sales	750000
Cost of goods Sold	495000
Gross Profit	255000
Selling and Administrative expense	105000
Depreciation Expense	10000
Operating Profit (EBIT)	140000
Interest Expense	15000
Earnings before Taxes (EBT)	125000
Taxes	37500
Earnings after Taxes (EAT)	87500

The profitability is increased by 11900.

4) Classify as current or non-current

Current	Non-Current
Accounts Payable	Plant and Equipment
Accounts Receivable	Bonds payable
Accrued Wages Payable	Common Stock
Prepaid Expenses	Retained Earnings
Inventory	Capital in excess of par
Marketable Securities	Preferred Stock

5) Arranging income statement Items in the proper order

Sales

Cost of Goods Sold

Gross Profit

Selling and Administrative Expense

Depreciation Expense

Operating Profit

Interest Expense

Earnings Before Taxes (EBT)

Taxes

Earnings after Taxes (EAT)

Preferred Stock Dividends

Earnings Available to common stockholders

Shares outstanding

Earnings Per share.

6) Identify whether each of the following items increases or decreases cash flow

Increases cash flow	Decreases cash flow
Increase in notes payable	Increase in Accounts Receivable
Decrease in prepaid Expenses	Increase in inventory
Depreciation expense	Increase in investments
Increase in accrued expenses	Decrease in Accounts Payable
	Dividend payment

7) Okra Snack Delights Income Statement and Retained Earnings Earnings Per share.

Operating Profit (EBIT)	210000
Interest Expense	30000
Earnings before Taxes (EBT)	180000
Taxes	59300
Earnings after Taxes (EAT)	120700
Preferred Stock Dividends	24700
Earnings Available to common stockholders	96000
Shares outstanding	16000
Earnings per share	6.00
Dividends paid	36000
Common dividends per share	2.25
Increase in retained earnings	60000

8) Thermo Dynamics Earnings per share etc.

Retained earnings Dec 31 1996	400000
*Earnings available to common stockholders 1997*	*75000*
Cash dividends paid 1997	25000
Retained Earnings Balance Dec 31 1997	450000
Common stock outstanding	20000
*Earnings per share*	*3.75*

9) Cataloguing from Balance sheet and income statement.

Key: Balance sheet BS, Income Statement IS, Current Assets CA, Fixed Assets FA, Current Liabilities CL, Long Term Liabilities LL, Stockholders Equity SE

Balance sheet or Income statement	Category for BS	Item
BS	SE	Retained Earnings
IS		Income tax expense
BS	CA	Accounts Receivable
BS	SE	Common Stock
BS	SE	Capital in Excess of par value
BS	LL	Bonds Payable, maturity 2005
BS	CL	Notes payable (6 months)
IS		Net Income
IS		Selling and administrative Expenses
BS	CA	Inventories
BS	CL	Accrued Expenses
BS	CA	Cash
BS	FA	Plant and Equipment
IS		Sales
IS		Operating Expenses
BS	CA	Marketable Securities
BS	CL	Accounts Payable
IS		Interest Expense
BS	CL	Income tax payable

10) Jupiter Corporation and Saturn Corporation Cash flows

Jupiter Corporation	Saturn Corporation
700000	700000	Gross Profit
240000	40000	Depreciation Expense
160000	160000	Selling and Admin Expenses
300000	500000	Taxable income
120000	200000	Tax paid
180000	300000	Earnings after tax
*420000*	*340000*	*Add back depreciation to give cash flow*

11) Proper Balance sheet presentation

Assets

Current Assets

Cash 10000

Marketable Securities 20000

Accounts Receivable 48000

Less Allowance for bad debts 6000

42000

Inventory 66000

Total Current Assets 138000

Other Assets:

Investments 20000

Fixed Assets

Plant and Equipment original cost 680000

Less Accumulated Depreciation 300000

Net Plant and equipment 380000

Total Assets 538000

Liabilities and Stockholder Equity

Current liabilities

Accounts Payable 35000

Notes Payable 33000

Total Current Liabilities 68000

Long Term liabilities

Bonds Payable 136000

Total liabilities 204000

Stockholders Equity

Preferred stock $50 par 1000 shares outstanding 50000

Common Stock $1 par 100000 shares outstanding 100000

Capital paid in excess of par (common stock) 88000

Retained earnings 96000

Total stockholders equity 334000

Total liabilities and stockholders equity 538000

12) Landers Nursery and Garden Stores. Computation of Book Value.

Total Assets

Current Assets 220000

Fixed Assets 170000

Total Assets 390000

Total Liabilities

Current liabilities 80000

Long term liabilities 140000

Total Liabilities 220000

Stockholders Equity 170000

Preferred stock obligation 40000

Net worth assigned to common 130000

Common shares outstanding 25000

Net worth or book value per share 5.2

13) Jennifer’s Apparel shop

a) book value (net worth) per share

Total Assets 800000

Total Liabilities

Current Liabilities 150000

Long term liabilities 120000

Total liabilities 270000

Stockholder’s equity 530000

Preferred stock obligation 65000

Net worth assigned to common 465000

Common shares outstanding 30000

Net worth or book value per share 15.5

b) Current price of stock

Earnings available to common stockholders 48000

P/E ratio per share 15:1

Earnings per share (48000/30000) 1.6

Value of each share (15 * 1.6) 24

c) Ratio of market value per share to book value per share

Market value per share / book value per share (24/1.5) 1.55

14) If in Jennifer’s shop the firm sells at 2 times the book value per share, what will the P/E ratio be? (to nearest whole number)

Shares outstanding 30000

Book value *2 per share (selling price) 31

Selling Price 930000

P/E (930000/48000) 19

15) Baxter corporation, construction of Income Statement from Balance Sheet.

Sales 220000

Cost of Goods sold 132000

Gross Profit 88000

Selling and Administration Expense 22000

Depreciation Expense 20000

Operating Income 46000

Interest expense 8000

Earnings before tax 38000

Taxes 7600

Earnings after tax 30400

Preferred stock dividends 2000

Earnings available to common stockholders 28400

Shares outstanding 10000

Earnings per share 2.84

Statement of retained earnings

Retained Earnings Balance Dec 31 1996 80000

Add Earnings available to common stockholders 28400

Deduct cash dividends declared and paid 8400

Retained Earnings Dec 31 1997 100000

Baxter Balance Sheet Dec 31 1996

Current Assets

Cash 10000

Accounts Receivable 16500

Inventory 27500

Prepaid Expenses 12000

Total Current Assets 66000

Fixed Assets

Plant and equipment (gross) 285000

Less Accumulated Depreciation 70000

Net Plant and Equipment 215000

Total Assets 281000

Liabilities

Accounts Payable 15000

Notes Payable 26000

Bonds Payable 40000

Total Liabilities 81000

Stockholder’s Equity

Common Stock 75000

Paid in Capital 25000

Retained Earnings 100000

Total stockholders capital 200000

Total liabilities and stockholders equity 281000

16) Statement of cash flows for Maris Corporation

Statement of Cash Flows for the year ending December 31 1997

Net Income (Earnings after Tax) 250000

Adjustments to determine cash flow from Operating Activities

Add Back Depreciation 230000

Increase Accounts Receivable (10000)

Increase in Inventory (30000)

Decrease in prepaid expenses 30000

Increase in Accounts Payable 250000

Decrease in Accrued Expenses (20000)

Total Adjustments 450000

Net Cash Flows from Operating Activities 700000

Cash Flows from Investing Activities

Decrease in Investments (Long term securities) 10000

Increase in Plant and Equipment (600000)

Net Cash Flows from Investing Activities (590000)

Cash Flows from Financing Activities

Increase in Bonds Payable 60000

Preferred Stock Dividends Paid (10000)

Common Stock Dividends Paid (140000)

Net Cash Flows from Financing Activities (90000)

Net Increase in Cash Flow 20000

17) Describe the general relationship between net income and net cash flows from operating activities of the firm.

The net income 250000 is quite a lot larger than the net cash flow 20000. The difference is due to a number of things (see cash flow statement above) the largest factor being the investment of 600000 in Plant and Equipment.

18) Has the Plant and Equipment been financed in a satisfactory way?

The major sources of funds have been operating activities, 250000 being from profit. This is good. However 250000 has also been raised by increases in Accounts payable (not so good as this is short term finance for a long term investment). The 230000 from depreciation would point to an investment in Plant however. The raise in bonds payable seems a reasonable way to finance the investment. The only concern I would have is with the increase in accounts payable.

19) Compute the book value for a common share for both 1996 and 1997 for the Maris Corparation.

	1996	1997
Total Assets	2360000	2750000
Total Liabilities	970000	1126000
Stockholder’s Equity	1390000	1624000
Preferred stock obligation	90000	90000
Net worth assigned to common	1300000	1534000
Common shares outstanding	150000	150000
Net worth or book value per share	8.67	10.23

20) If the market value of a share of common stock is 2.8 times the book value for 1997, what is the firm\s P/E ratio for 1997? (Round to the nearest whole number)

Book value per share 10.23

Market value per share 28.64

Earnings per share 1.6

P/E 17.90 = 18.