Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 1 of 6 Questions and Problems Basic 3.1. Balance Sheet: Given the following information about the Elkridge Sporting Goods, Inc., construct a balance sheet for the period ending June 30, 2008. The firm had cash and marketable securities of $25,135, accounts receivables of $43,758, inventory of $167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and common stock of $150,000. How much retained earnings does the firm have? Solution: ASSETS Book Value LIABILITIES Book Value Cash 25,135$ Accounts Payables 67,855$ Accounts Receivables 43,758$ Notes Payables 36,454$ Inventories 167,112$ Total Current Assets 236,005$ Total Current Liabilities 104,309$ Net Fixed Assets 325,422$ Long Term Debt 223,125$ Other Assets 13,125$ Common Stock 150,000$ Retained Earnings 97,118$ TOTAL ASSETS 574,552$ TOTAL LIABILITIES & EQUITY 574,552$ 3.2. Inventory Accounting: Differentiate between FIFO and LIFO. Solution: FIFO (first in, first out) refers to the practice of firms, when making sales, assuming that the inventory that came in first (at a lower price) being sold first. LIFO (last in, last out) implies that a firm is selling the higher cost, newer inventory first, leaving the lower cost, older inventory on the balance sheet. 3.3. Inventory Accounting: Explain how the choice of FIFO versus LIFO can affect a firm?s balance sheet and income statement. Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 2 of 6 Solution: FIFO makes sense during times of rising prices because it allows the firm to eliminate the lower priced inventory fist resulting in higher profit margin. This allows the firm to leave higher valued inventory on the balance sheet. During inflationary times, a firm using LIFO would see a lower profit margin and lower values of inventory on the balance sheet. It is important for anyone analyzing firms using different accounting methods on inventory to recognize the impact on the bottom line (profit margin and net income) and on current assets. 3.4. Market Value Accounting: How does the use of market value accounting help managers? Solution: Market value accounting of both assets and liabilities allows managers to have a truer picture of their company?s financial condition and allows them to do a better job of estimating cash flows that the assets would generate. However, marking-to-market is not as easy as it sounds because of the difficulties involved in coming up with the correct market value of current assets and liabilities. 3.5. Working Capital: Laurel Electronics reported the following information at its annual meetings. The company had cash and marketable securities worth $1,235,455, accounts payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121, notes payable worth $1,151,663, and other current assets of $121,455. What is the company?s net working capital? Solution: Current assets = $1,235,455 + $3,488,121 + $7,121, 599 + 121,455 = $11,966,630 Current liabilities = $4,159,357 + $1,151,663 = $5,311,020 Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 3 of 6 Net working capital = $11,966,630 - $5,311,020 = $6,655,610 3.6. Working Capital: The financial information for Laurel Electronics referred to in problem 3.5 is all book value. Suppose marking-to-market reveals that the market value of the firm?s inventory is 20 percent below its book value and its receivables are 25 percent below its book value. The market value of its current liabilities is identical to the book value. What is firm?s net working capital using market values? What is the percent change in net working capital? Solution: Market value of inventory = $7,121,599 * 0.80 = $5,697,279 Market value of receivables = $3,488,121 * 0.75 = $2,616,091 Current assets = $1,235,455 + $2,616,091 + $5,697,279 + 121,455 = $9,670,280 Current liabilities = $4,159,357 + $1,151,663 = $5,311,020 Net working capital = $9,670,280 - $5,311,020 = $4,359,260 %5.34 610,656,6$ 610,656,6$260,359,4$ Change Percent ?= ? = 3.7. Income Statement: The Oakland Mills Company has disclosed the following financial information in its annual reports for the period ending March 31, 2009. It produced sales of $1.45 million, had cost of goods sold to the tune of $812,500, depreciation expenses of $175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35 percent. What is the company?s net income? Set up an income statement to answer the question. Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 4 of 6 Solution: Amount Revenues 1,450,000.00$ Costs 812,500.00$ EBITDA 637,500.00$ Depreciation 175,000.00$ EBIT 462,500.00$ Interest 89,575.00$ EBT 372,925.00$ Taxes (35%) 130,523.75$ NET INCOME 242,401.25$ 3.8. Cash Flow: Describe the organization of the statement of cash flows. Solution: The statement of cash flows identifies the cash inflows and cash outflows of the firms for a specified period. This allows one to estimate the net cash flows from operations. This financial statement is organized to report the cash flows resulting from the three basic activities in any firm ? operating, investing, and financing. See Exhibit 3.4 for an example. The cash flows from operations are the results of netting all revenues and expenses that result from the operating activities of the firm. Buying and selling of a firm?s assets lead to cash flows from investing activities. Cash flows from financing activities arise from the firm borrowing from its investors and/or making payments to its lenders and shareholders. 3.9. Cash Flows: During 2008 Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed assets acquisition by $109,455, and had marketable securities to the tune of $14,215 mature. What is the net cash used in investing activities? Solution: Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 5 of 6 Net property, equipment and other ass ($109,455.00) Net cas h used in inve sting ac tivities ($109,455.00) 3.10. Cash Flows: Caustic Chemicals identified the following cash flows during this year as significant in its meeting with analysts. It had repaid existing debt to the tune of $312,080, while raising additional debt capital of $650,000. It also repurchased stock in the open markets for a total of $45,250. What is the net cash provided by financing activities? Solution: FINANCING ACTIVITIES Loan Repayment ($312,080) Increase in Long-term Debt $650,000 Purchase of Treasury Stock ($45,250) Net cash provided by financing activities $292,670 3.11. Cash Flow: Identify and explain the noncash expenses that a firm may incur. Solution: A firm may have several items on its income statement that did not result in any cash outflow to the firm. The two largest are depreciation expenses and amortization expenses. Other non-cash expenses include deferred taxes, wages, and depletion charges which is similar to depreciation and used for natural resource assets. Pre-paid expenses also fit into this category as they represent expenses to the firm that are yet to be paid out. 3.12. Tax: Define average tax rate and marginal tax rate. Solution: Created by: Babu G. Baradwaj Instructor Manual Created on: July 8, 2009 Chapter 3 For: Kidwell & Parrino Principles of Financial Management Revised IM # 02 Page 6 of 6 The average tax rate is defined as the total taxes paid divided by taxable income. The marginal tax rate, meanwhile, represents the tax rate that is paid on the last dollar of income earned, or the rate that will be paid on the next dollar earned. 3.13. Tax: What is the relevant tax rate to use when making financial decisions? Explain why. Solution: Managers need to use the marginal tax rate for making financial decisions. This is because any additional cash flows that result from a firm?s new projects will be taxed at the marginal tax rate. Thus, this is the appropriate rate to use. 3.14. Tax: Manz Property Management Company announced that in the year ended June 30, 2008, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit 3.6. Solution: Earnings before tax = $1,478,936 Tax Rate Taxable Income Taxable Income TO Tax 15% $0 $50,000 7,500.00$ 25% $50,001 $75,000 6,250.00$ 34% $75,001 $100,000 8,500.00$ 39% $100,001 $335,000 91,650.00$ 34% $335,001 ########## ########## 35% $10,000,001 ########## -$ 38% $15,000,001 ########## -$ 35% > $18,333,333 -$ TOTAL TAXES ########## David S. Kidwell Chapter 3
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