Practical Financial Management, 8th Edition Solution Manual

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1CHAPTER 1FOUNDATIONSFOCUSChapter 1 is designed to provide an overview of finance. The emphasis is on breadth, lightly touching anumber of topics without going into a great deal of detail. The chapter provides a foundation on whichto base the more advanced work of later chapters.TEACHING OBJECTIVESStudents should gain an understanding of the following concepts:1. the basic nature of financial assets (securities) and the organization and operation of financialmarkets;2. the role and responsibility of financial management in corporations;3. the relationships between finance and accounting and between finance and economics, along with theimportance of cash flow in finance;4. thefinancialimplications of the proprietorship and corporate forms of business organizationincluding the true role of limited liability;5. the need for a top level managerial goal and why maximizing shareholder wealth works;6. stakeholder groups and conflicts of interest especially between management and stockholders.OUTLINEI.AN OVERVIEW OF FINANCEA.Financial AssetsDistinguish financial assets from real assets and establish the basis of their value in future cashflows.B.Financial MarketsDefine financial markets as networks within which financial assets are traded. Describe thepurpose of markets as transferring funds from investors to companies.C.Raising MoneyCorporations raise money in financial markets tofinanceprojects.D.Financial ManagementThe role of financial management within companies including Treasury and Control functionsand the responsibilities associated with each.E.The Price of Securities-A Link Between the Firm and the MarketThe market price of securities provides a link between the activities of management and theplayers in financial markets.II. FINANCE AND ACCOUNTINGThe relationship between finance and accounting conceptually and in the typical organization.A.The Importance of Cash FlowCash is king in finance. How that perception differs from the accounting viewpoint.B.The Language of FinanceFinancial people need to know at least a little accounting because it's the system in whichbusinesses "keep score."

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Chapter 12III. FINANCIAL THEORY-THE RELATIONSHIP WITH ECONOMICSA. Financial theory distinguished from everyday practice.B. The roots of financial theory in economics.IV. FORMS OF BUSINESS ORGANIZATION AND THEIR FINANCIAL IMPACTThe forms of business organization from the perspective of an entrepreneur starting and thenexpanding a business.A.The Proprietorship FormEasy to start, taxed just once. However, raising money for expansion is tough because no onewants to lend to new small businesses.B. The Corporate FormDouble taxation, but now the business can sell stock, which can give investors an incentive toput money into a new small business.C. The Truth About Limited LiabilityLimited liability works for an absentee equity investor, but rarely does small business ownersmuch good because of personal guarantees and liability for negligence.D.Limited Liability Companies (LLCs) andS-Type Corporations andThe best of both worlds for small businesses, from the people who gave you the tax system.V. THE GOALS OF MANAGEMENTMaximizing shareholder wealth. Distinguished from maximizing profits.A.Stakeholders andConflicts of InterestCorporate constituencies and how their interests can be different.B.Conflicts of Interest-An IllustrationEmployees vs. Stockholders-A gym on the factory site. Management referees.VI. MANAGEMENT, A PRIVILEGED STAKEHOLDER GROUP,A.The Agency ProblemThe special status of management and the opportunity to take advantage of it.VII. CREDITORS VS STOCKHOLDERS-A FINANCIALLY IMPORTANT CONFLICT OFINTERESTThe losses from risky ventures may be shared by debt and equity investors, but the rewardsaccrue to the stockholders.VIII. CONCEPT CONNEDTIONSA text feature provided throughout the book that relates end of chapter problems to in chapterexamples making studying easier and more efficient.IX. SECURITIES ANALYSIS AND THOMSON ONE–BUSINESS SCHOOL EDITIONAn introduction to the Thomson financial data base provided with the book for use to analyzingcompanies.QUESTIONS1.Separate the following list of assets into real assets and financial assets. What are thedistinguishing characteristics of each type of asset?Delivery TruckFactory BuildingCorporate BondInventory

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Foundations3Corporate StockLandNote ReceivableComputerANSWER:Real Assets: Delivery Truck, Factory Building, Inventory, Land, ComputerFinancial Assets: Corporate Bond, Corporate Stock, Note ReceivableReal assets are objects that provide some use or service. Financial assets are pieces of paperorelectronic filesthat provide a claim to future cash flows.2.What is the primary factor that determines the price of securities? Can you think of anotherfactor that might significantly affect how investors value the first factor?ANSWER:Financial assets, or securities, derive their value from the expected cash flows that comefrom owning them. Hence the primary determinant of price is what investors expect those cash flows tobe. The second factor is risk. Some securities are volatile, and people understand that the cash flowscoming from them may turn out to be a great deal more or less than originally expected. These riskysecurities have less value than more stable issues with the same expected cash flows.3.Discuss the differences, similarities, and ties between finance and accounting.ANSWER:Finance and accounting both deal with the firm's money. All records are stated in terms ofthe accounting system, so financial people have to be conversant with accounting. In finance, theemphasis is on cash flow, while accounting is more concerned with giving an overall portrayal of thefirm's condition. Accounting is generally part of the finance department, but people commonly think oftreasury functions as "finance" and separate from accounting.4.Discuss the relationship between finance and economics.ANSWER:Financial theory grew out of the application of economic methods to financial markets andthe problems of businesses. Financial theory is therefore sometimes called Financial Economics. Thetechniques of analysis used by theorists in finance are essentially the same as those used in economicsand tend to be very mathematical.5.How does the activity of investors in financial markets affect the decisions of executives within thefirm?ANSWER:The primary goal of management is to maximize shareholder wealth, which is taken to beequivalent to maximizing the price of the firm's stock. Senior corporate executives are therefore graded(and compensated) largely on the price performance of their companies' stock. That means theyevaluate the impact of most decisions on investors in terms of how the decision will affect the price ofsecurities. For example, an action that's likely to make the company more risky will be considered verycarefully because it might cause investors to lose interest in the stock, which would lower its price.6.What are the significant financial advantages and disadvantages of the sole proprietorship/partnership form in comparison with the corporate form?ANSWER:The proprietorship form is easy to start and is taxed only once. However, it is difficult fora proprietorship to raise money since it must do so by borrowing. The corporate form is harder to start,and suffers from double taxation. However, it allows the sale of stock to raise money, which is muchmore attractive than debt to potential investors in new small businesses.

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Chapter 147.Is limited liability a meaningful concept? Whyor why not?And if so, for whom?ANSWER:Limited liability is most meaningful to investors who own stock in firms they don't operate.To people who operate their own businesses the rule is of minimal value. With respect to loans, this isbecause banks demand personal guarantees from the owners of small firms to which they lend money.With respect to lawsuits it is because individuals within companies can be sued for damages they causealong with the companies.8.What conflict(s) of interest can you imagine arising between members of the community in which acompany operates and some other stakeholders? (Hint: Think about pollution.)ANSWER:It's generally cheaper to pollute than not to pollute; i.e., cleaning up industrial waste isexpensive. That means profits are lower and shareholders are poorer if a company doesn't pollute. Thepeople who live in the community, however, are better off if it doesn't foul the local environment. Thiscreates a conflict between the community and shareholders.9.Is the agency problem an ethical issue or an economic issue?ANSWER:It's both. It's an ethical issue because management may appropriate resources for their ownbenefit that rightly belong to stockholders. It's an economic issue because the resources so divertedmake companies less efficient.10.Compare and contrast the terms “stockholder” and “stakeholder.”ANSWER:A stockholder owns part of a company and is entitled to income in the form of dividends.Stockholders also elect directors who run the company. Stakeholders are groups of people who have aninterest in how the firm is run. These include stockholders, employees, management, creditors andcustomers among others. Each group is interested in the firm’s operation and profitability for its ownreasons. All stockholders are stakeholders, but all stakeholders aren’t stockholders.BUSINESS ANALYSIS1.Diversified companies are made up of divisions, each of which is a separate business. Largecompanies have divisions spread over the entire country. In such companiesmosttreasury functions arecentralized, whereasmostaccounting functions are carried out in the individual divisions.The cash management function controls the collection of revenues and the disbursement of fundsfrom various bank accounts. It makes sure that the company never runs out of cash by monitoringoutflows and having lines of bank credit ready in case temporary shortages occur. Today's bankingsystem is linked electronically so that cash can be transferred around the country immediately.The credit and collection function decides whether a particular customer canbuy the firm’s productson credit. After the sale, it is responsible for following up to ensure that the bill is paid. Customers areoften reluctant to pay because of problems and misunderstandings with sales or service departments.If you were designing the finance department of a diversified company, would you centralize thesefunctions or locate them in the remote divisions? Why? Address each function separately.ANSWER:The cash management function should be centralized so that efficient use can be made ofthe firm's total available cash. Divisions can collect from customers and pay their bills using centralizedaccounts without worrying about the details of banking relationships and how much cash is available atany time. In other words, nothing is gained by having divisional financial executives replicate the effortof administering the banking relationship.

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Foundations5Credit and collection is a completely different matter. It requires input from customers andcoordination with other departments in the company—like marketing, production, and engineering.Those functions are located at the division level as is the customer contact. Therefore, it makes sense tohave a credit and collection department in every division.2.The company president is reviewing the performance and budget of the marketing department withthe vice president of marketing. Should that be a one-on-one meeting or should the CFO be present?Why? If you feel the CFO should be there, what should be his or her role in the meeting?ANSWER:The CFO should be present and act in an advisory role to the president. The budget is afinancial representation of the physical activity planned for the next period. The translation betweenactivities and dollars often takes some financial expertise that the CFO should provide. He or sheshould also be sure the budget reflects a plan that is likely to achieve the firm's goals which tend to bestated largely in financial terms. Many presidents look to their CFOs to ask most of the questions inbudget reviews. When this happens the CFO has to be cautious not to offend the Vice President ofMarketing who is generally a peer.PROBLEMSAccounting Records and Cash Flow–Example 1.1, Page81.Sussman Industries purchased a drilling machine for $50,000 and paid cash. Sussman expectsto use the machine for 10 years after which it will have no value. It will be depreciated straight-lineover the ten years. Assume a marginal tax rate of 40% What are the cash flows associated with themachinea. At the time of the purchase?b. In each of the following ten years?SOLUTION:a. At the time of the purchase, Sussman simply has a cash outflow of $50,000 reflecting the payment forthe machine. There are no tax implications for this exchange of cash for another asset.b. In each of the next 10 years, Sussman will recognize ($50,000 /10 years =) $5,000 of depreciationexpense. As a result, taxable income will be $5,000 lower each year, and the firm will pay($5,000x.40=) $2,000 less tax which is in effect a cash inflow of that amount. (Notice that the total aftertax cash cost of the machine over its ten year life is $30,000 rather than $50,000.)Tax Consequences of Business Form-Example1.2, Page122. Harvey Redmondis planning a new business that he expects will grow into a large company within afew years. Harvey’s lawyer has advised him that large companies are usually C-type corporationsbecause of stock market considerations, so he’s considering that form now to avoid reorganizing lateron. However, he’s also concerned about the after tax income he’ll be able to take out of the businessduring the first few years.Harvey thinks his business will have pretax earnings (after paying his salary) of about $150,000per year for the first three years. Does it make sense for him to operate as a proprietorship for threeyears and then reorganize into a C-type at an estimated cost of $80,000 or to choose the C-type now atessentially no additional cost? Assume a simplified tax system in which the corporate rate is 34% andHarvey’s personal tax rate is 28% on all income including dividends.Ignore the fact that the cash flows occur at different times and the possibility of using an S-typecorporation or an LLCfor the first three years.

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Chapter 16SOLUTION:C-typeProprietorPretax earnings$150,000$150,000Less:Corporate tax (34%)51,000—___Earnings/dividend$99,000$150,000Less:Personal tax (28%)27,72042,000Net$ 71,280$108,000The tax savings due to using the proprietor form is estimated at $36,720 per year for three years totaling$110,160. That’s considerably more than $80,000, so starting off as a proprietorship makes goodfinancial sense.3.Jill Meier is the sole owner of Meier Corp., which provides her only source of income. Jill hasalways paid herself entirely by drawing dividends from her corporation. A friend suggested that as longas she is earning about what she would have to pay someone else to run the business, she might bebetter off paying herself a salary instead of dividends, because she would avoid the problem of doubletaxation. If Jill’s company earns $120,000 all of which she will pay to herself, how much will she takehome under each method. Assume a corporate tax rate of 30%,anda personal tax rate of 25%on bothsalary and dividend income.SOLUTION:DividendsSalaryIncome before payment to Jill$120.0$120.0Salary120.0Earnings before tax$120.0$ 0.0Corporate tax (30%)36.0$ 0.0Earnings after corporate tax (paid as dividend)$ 84.0$ 0.0Tax onpersonal income(25%)$ 21.0$30.0Payment (salary or dividend) minus taxes$63.0$90.0

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7Chapter 2FINANCIAL BACKGROUND: A REVIEW OF ACCOUNTING,FINANCIAL STATEMENTS, AND TAXESFOCUSMost students have been exposed to accounting and taxes in prerequisite courses, but many don't recallthe material well enough to tackle finance effectively. Chapter 2 provides a concise review of what theyneed to know in one convenient place. The material is presented in relatively non-numerical formalthough some computation is unavoidable.PEDAGOGYYou may not want to spend much class time lecturing on accounting and tax material. An hour isgenerally enough to hit the highlights. Assigning the chapter as background reading followed by a quizgets students warmed up and focused on financial concepts in preparation for the things to come.TEACHING OBJECTIVES1. To reacquaint students with basic accounting concepts and procedures which they may haveforgotten.2. To develop an understanding of federal tax fundamentals, and the ability to calculate simpletaxes.OUTLINEI.ACCOUNTING SYSTEMS AND FINANCIAL STATEMENTSA. The Nature of Financial StatementsHow accounting ideas such as "income" are different from everyday use of similar terms.B. The Accounting SystemA brief treatment of basic ideas including the double entry concept, accounting periods,closing the books, and stocks and flows.II.THE INCOME STATEMENTA line by line treatment of income, cost, and expense items along with subtotals such asGross Margin and EBIT.III.THE BALANCE SHEETA. PresentationFormat, the balance sheet identity, liquidity.B. AssetsA brief description of the treatment of each asset item along with the risks it presents. E.g.,overstatement of receivables.C. LiabilitiesAn intuitive description of the nature of current liabilities, especially accruals.D. EquityThe three equity accounts are explained along with the relationship between income,dividends, new stock sales and equity.IV.THE TAX ENVIRONMENTA. Taxing Authorities and Tax BasesWho can tax us, based on what.

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Chapter 28B. Income Taxes-The Total Effective Income Tax RateState tax is deductible from federal tax.C. Progressive Tax Systems, Marginal and Average RatesDefinitions, the current progressive system, the importance of the marginal rate forinvestment decisions.D.Ordinary Income andCapital Gains/LossesThe nature of capital gains and losses, why the way they're taxed is important to investment,and the current status.V.INCOME TAX CALCULATIONSA. Personal TaxesBasic rules of exempt income, deductions andpersonal exemptions. Taxpayer classesand the tax tables. Examples: Choosing between corporate and municipal bonds.B. Corporate TaxesDefining taxable income, the corporate rate structure,the system favors debt financing,dividend exemptions between corporations, carry backs/forwards.QUESTIONS1.Why does a financial professional working outside accounting need a knowledge of accountingprinciples and methods?ANSWERFinancial records are kept within accounting systems and results are formulated inaccounting reports. Therefore, to understand transactions and the results of operations, one has to haveat least a fundamental understanding of accounting principles.2.Discuss the purpose of an accounting system and financial statements in terms of the way thesystem represents a business.ANSWERAccounting is designed to provide a "picture" of operations in numerical terms. It does thatwith devices like depreciation which matches the cost of an asset with its service life regardless of thecash flows associated with its acquisition. The portrayal is conceptual in that it attempts to give abroader picture of the condition of a business than the immediate availability of funds.3.Why is EBIT an important line item in the income statement? What does EBIT show us?ANSWEREarnings before interest and taxes (EBIT) is the lowest line on the income statement thatisn't affected by the firm's method of financing (the relative amounts of debt and equity used). It isimportant because it allows an evaluation of physical business operations separate from the influence offinancing decisions. It is therefore often called operating income.4.What is meant by liquidity in financial statements?ANSWERIn financial statements liquidity implies the ease with which assets can be converted intocash without substantial loss.With respect to liabilities it is related to the immediacy with which theyrequire cash.5.What are the common misstatements of balance sheet figures and why do they present a problem?ANSWERReceivables are often overstated in that they contain uncollectible accounts. Inventories areoverstated when items are carried at values that exceed what they're actually worth. Less frequently,

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Financial Background: A Review of Accounting, Financial Statements, and Taxes9payables omit legitimate liabilities of the company. Such misstatements represent a firm as being worthmore than it actually is. That deceives investors and others interested in dealing with the company.6.Do the definitions of current assets and current liabilities suggest a quick way of looking at thefirm's ability to meet its financial obligations (pay its bills) over the near term? (Hint: Think in terms ofratios.)ANSWERCurrent assets represent things that are expected to become cash within a year (inflows),while current liabilities require cash within a year (outflows). Being able to pay the bills means theinflows have to exceed the outflows in the short run. This suggests forming the ratio of current assets tocurrent liabilities (called the current ratio). If that ratio exceeds 1.0, the firm should be able to pay itsbills in the next year.7.How are capital and working capital different?ANSWERCapital refers to the money used to start businesses and acquire long-lived assets. Workingcapital refers to the money used to support day to day operations. We can therefore think of the two asdiffering with respect to time. Capital is long term and working capital is short term.8.What is leverage and how does it work? What is the main concern about using it?ANSWERLeverage refers to using borrowed (someone else's) money to support a business rather thanthe owner's own equity. Leverage can enhance financial results if the business earns more with theborrowed money than the interest cost of borrowing it. In that case leverage multiplies good financialresults into better ones. The concern about using borrowed money is that interest has to be paid whetherresults are good or not. When a business earns less using borrowed money than the cost of borrowing it,leverage multiplies poor results into very poor results.9.Define the term tax base and discuss common bases. What government units tax on each? Whatare these taxes commonly called?ANSWERA tax base is the item or activity on which a tax is levied. The common bases are income,wealth, and consumption. Income taxes simply require the payment of a percentage of income to thegovernment in every period, usually a year. Income is taxed by the federal government, most states, anda few cities (e.g. New York City). A wealth tax charges the owner of property a percentage of its valueeach year. The most common wealth tax is levied on real estate by cities and counties. A consumptiontax charges users a percentage of the cost of products they consume. The most common consumptiontax is a sales tax usually levied by states, counties, and cities. The federal government's consumptiontaxes are called excise taxes.10.What is the total effective tax rate?ANSWERThe total effective tax rate is the combination of state and federal income tax rates. It is lessthan the sum of the two rates, because state tax is deductible from income for federal tax purposes.11.What is taxable income for an individual? How does it differ from taxable income for acorporation?ANSWERTaxable income for an individual is income less exempt or excluded items, less deductionsand less personal exemptions. Taxable income for a corporation is revenue less excluded items lessbusiness costs and expenses. Personal exemptions don't exist for corporations.

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Chapter 21012.What tax rate is important for investment decisions? Why?ANSWERThe marginal tax rate is the rate on the next (or last) dollar of income. It is important forinvestment decisions, because investments are generally made with "extra" income available afternecessary expenses have been taken care of. Thus investment income is generally taxed at thetaxpayer's marginal rate.13.Why is the tax treatment of capital gains an important financial issue?ANSWERIncome on investments is usually received at least in part in the form of capital gains.Therefore, if the tax system treats capital gains favorably, investing becomes relatively more attractive.Since investing is the essence of finance, capital gains taxation plays a pivotal role in financial matters.14.Is the corporate tax schedule progressive? Why or why not?ANSWERYes and no! Lower rates are charged on lower incomes so the system is progressive in thatmost basic sense.However, the benefits of the early lower rates are taken back through rate surchargesas income increases. That creates a rate structure that increases and then decreases which is contrary tothe normal notion of a progressive system.15.What are the tax implications of financing with debt versus equity? If financing with debt is better,why doesn't everyone finance almost entirely with debt?ANSWERFinancing with debt is cheaper than with equity because of the tax deductibility of interest.However, debt adds risk to businesses, so lenders tend to limit the amounts of capital they're willing tosupply to companies. Those limits make it virtually impossible to finance entirely with debt.16.Why are dividends paid from one corporation to another partially tax exempt?ANSWERFully taxing dividends paid by one corporation to another results in triple (and more)taxation of earnings which is more severe than the government's intent.17.Explain the reasoning behind tax loss carry backs and carry forwards.ANSWERIf business losses could not offset profits in previous or subsequent periods, the tax systemviewed over a period of years would tax companies with temporary losses at rates in excess of onehundred percent of profits. This clearly doesn't make sense, so the inter-year allocation of losses isallowed.

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Financial Background: A Review of Accounting, Financial Statements, and Taxes11PROBLEMSWriting Off a Large Uncollectable Receivable-Example2-1,Page321.Canaday Ltd.has the following receivables balances ($M)Gross Accounts Receivable$175Bad Debt Reserve(3)Net Accounts Receivable$172Two years ago a customer was approved for an unusually large credit sale of $7M over theobjections of the credit and collections department. Shortly after the sale the customer’s business beganto deteriorate due to an unexpected recession. To date it has paid only $2Magainst the order despite thefact that it has consumed all of the material purchased. The collections department has workeddiligently to collect the remaining $5M without success. The customer filed for bankruptcy thismorning with essentially no assets to pay a large number of creditors. Evaluate the financial statementimpact of the bankruptcy on Canaday.Assume Canaday’s product cost is 40% of revenueand the baddebt reserve of $3M will be fully reestablished.Solution:Grossreceivablesmust be reducedby $5M.Using the entire reserve has the followingimmediate effecton the balance sheet:Gross Accounts Receivable$170Bad Debt Reserve0Net Accounts Receivable$170This year’s income statementearnings before taxare reduced by another ($5M–3M =) $2Min baddebt expense. If the reserve is to be reinstatedfairlyquickly,another $3M profit reduction will beneeded.The pretax profit on the uncollected portion of the sale two years ago was$5M x .6 = $3MThe pretax loss due to the write off this year will be the full $5M.Selling a Fixed Asset-Example2-2,Page362. The Johnson Company bought a truck costing $24,000 two and a half years ago. The truck'sestimated life was four years at the time of purchase. It was accounted for using straight linedepreciation with zero salvage value. The truck was sold yesterday for $19,000. What taxable gainmust be reported on the sale of the truck?SOLUTION:Yearly depreciation on the truck is$24,000 / 4 = $6,000and depreciation for 2.5 years is$6,0002.5 = $15,000Therefore the truck's Net Book Value at the time of sale is$24,000$15,000 = $9,000This is the accounting cost of the sale, Thetaxable gainon the saleis:Sales price$19,000Cost9,000Gain$10,000

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Chapter 2123.If the Johnson Company of Problem2is subject to a marginal tax rate of 34%, what is the cash flowassociated with the sale of the used truck?SOLUTION:Johnson will pay tax on the $10,000 profit on the sale at 34%.$10,000.34 = $3,400.Cash flow is the sale proceeds of $19,000 less the tax paid.$19,000$3,400 = $15,600.Note: The truck’s cost in the profit calculation in Problem2is its net book value on Johnson’s books.Although that figure is subtracted from the price received for the truck to calculate accounting profit, nocash was expended at the time of sale associated with that cost. Hence cash flow is just revenue minustax.4. Heald and Swenson Inc purchased a drill press for $850,000 one year and nine months ago. The assethas a six year life and has been depreciated according to the following accelerated schedule.Year123456% of cost55%20%10%5%5%5%The press was just sold for $475,000. The firm’s marginal tax rate is 35% Calculate Heald andSwenson’s taxable profit and cash flow on the sale. Assume depreciation is spread evenly within eachyear.SOLUTION:First bring depreciation up to date as of the time of sale. Fifty five percent of the asset’scost will have been recognized as depreciation in the first year. In the second year9/12 x 20% = 15%will have been taken. This leaves a net book value of (100-55-15=) 30% of original cost at the time ofthe sale.NBV = $850,000 x .30 = $255,000This is the asset’s cost for accounting and tax purposes, andSales price$475,000Cost($255,000)Gain$220,000Tax on the gain at 35% will be$220,000.35 = $77,000,and cash flow is sale proceeds less tax.Cash flow = $475,000$77,000 = $398,000.Problems 5 through 13 are numerical exercises intended to develop familiarity withfinancial statements without actually going through debit and credit accounting entries.They don’t follow specific examples in the text, but most provide guidance in the form ofhints or instructions.5. Fred Gowen opened Gowen Retail Sales as a sole proprietorship and recorded the followingtransactions during his first month in business:(1)Purchased $50,000 of fixed assets, putting 10% down and borrowing the remainder.(2)Sold 1,000 units of product at an average price of $45 each. Half of the sales were oncredit, none of which had been collected as of the end of the month.(3)Recorded cost of goods sold of $21,000 related to the above sales(4)Purchased $30,000 worth of inventory and paid cash.

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Financial Background: A Review of Accounting, Financial Statements, and Taxes13(5)Incurred other expenses (including the interest from the loan) of $5,000, all of which werepaid in cash.(6)Fred’s tax rate is 40%. (Taxes will be paid in a subsequent period.)a.What will the business report as net income for its first month of business?(Hint: Write out anincome statement and enter revenue, cost, and expense, then calculate tax and net income.)b.List the flows of cash in and out of the business during the month. Show inflows as positivesand outflows as negatives (using parentheses). Sum to arrive at a “Net Cash Flow” figure.c.Should Fred pay more attention to net income or cash flow? Why?SOLUTION:a.Net IncomeSales$45,000(1000 units @ $45)Cost of Goods Sold21,000Gross Margin24,000Other Expense5,000(Includes Interest Expense)EBT19,000Taxes7,600($19,000 x 40%)Net Income11,400b.Cash FlowsPurchase of Assets($50,000)Proceeds from Loan45,000(90% of the asset purchase price)Cash from Sales22,500(One half of the sales)Purchase of Inventory( 30,000)Other Expenses(5,000)Net Cash Flow($17,500)c.Fred has to pay attention to both net income and cash flow. Net Income is important because itis an indication of the long term profitability of the business. It matches the revenues andexpenses for the period and will help him understand whether he can sell his products at a profitin the long run. However, cash flow is equally important, because if a business can’t generatepositive cash flows, it is destined to fail. It is not uncommon for a business to have negativecash flows early in its existence, even if it’s showing a positive net income. That’s one reasonfor doing a statement of cash flowslike the onewe’ll study in Chapter 3.6.McFadden Corp. reports the following balances on theirDecember31, 20X2 Balance Sheet:($000)Accounts Payable60Accounts Receivable120Accumulated Depreciation350Fixed Assets (Net)900Inventory150Long Term Debt400Paid in Excess160Retained Earnings380Total Assets1,240Total Liabilities500(long term debt + current liabilities)All of the remaining accounts are listed below. Calculate the balance in each.

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Chapter 214AccrualsCashCommon StockFixed Assets (Gross)Total Current AssetsTotal Current LiabilitiesTotal EquitySOLUTION:Assets ($000)Liabilities & Equity ($000)Cash$70Account Payable$60Accounts Receivable120Accruals40Inventory150Total Current Liabilities100Total Current Assets340Long Term Debt400Fixed Assets (Gross)1,250Accumulated Depreciation(350)Common Stock200Fixed Assets (Net)900Paid In Excess160Retained Earnings380Total Assets$1,240Total Equity740Total Liabilities & Equity$1,2407.Consider the Current Asset accounts (Cash, Accounts Receivable and Inventory) individuallyand as a group. What impact will the following transactions have on each account and currentassets in total (Increase, Decrease, No Change)?(Hint: Each transaction has two sides that areequal in amount but opposite in sign. Consider whether the sides offset within current assets orone side is recorded somewhere else.)a.The purchase of a fixed asset for cashb.The purchase of a fixed asset on creditc.The purchase of inventory for cashd.The purchase of inventory on credite.Customer payment of an account receivablef.Writing off a customer’s bad debt (assumebad debt reserve > write off)g.The sale of a fixed asset for cashh.The sale of inventory (at a profit) for cashi.The sale of inventory (at a loss) for cashj.The sale of inventory (at a profit) on creditSOLUTION:CashAccounts ReceivableInventoryTotal Current Assetsa.DecreaseNCNCDecreaseb.NCNCNCNCc.DecreaseNCIncreaseNCd.NCNCIncreaseIncreasee.IncreaseDecreaseNCNCf.NCNCNCNCg.IncreaseNCNCIncreaseh.IncreaseNCDecreaseIncrease

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Financial Background: A Review of Accounting, Financial Statements, and Taxes15i.IncreaseNCDecreaseDecreasej.NCIncreaseDecreaseIncrease8.OnJanuary1,20X2, Miller Corp. purchased a milling machine for $400,000. It will bedepreciated on a straight line basis over 20 years. OnJanuary1,20X3, Miller purchased aheavy duty lathe for $250,000 which will be depreciated on a straight line basis over 40 years.a. Compute Miller’s depreciation expense for 20X2, 20X3 and 20X4.b. Prepare the Fixed Asset portion of the balance sheet (for these two fixed assets) asof the end of 20X2, 20X3 and 20X4.(Hint: Subtract accumulated depreciation ineach year from total original cost. See page XX)SOLUTION:a. Depreciation ExpenseDepreciation on the milling machine:$400,000/20 years = $20,000/yearDepreciation on the lathe$250,000/40 years = $ 6,250/yearX3X4X5MM20,00020,00020,000Lathe6,2506,250Depreciation20,00026,25026,250Accum Depr20,00046,25072,500b.Fixed Assets (Gross)$400,000$650,000$650,000Accumulated Depreciation20,00046,25072,500Fixed Assets (Net)$380,000$603,750$577,5009.Becher Industries has three suppliers for its raw materials for manufacturing. The firmpurchases $180 million per year from Johnson Corp. and normally takes 30 days to pay thesebills. Belcher also purchases $150 million per year from Jensen, Inc. and normally pays Jensenin 45 days. Belcher’s third supplier, Docking Distributors, offers 2/10, n. 30 terms. Bechertakes advantage of the discount on the $90 million per year that it typically purchases fromDocking. Calculate Becher’s expected Accounts Payable balance. (Use a 360-day year foryour calculations.For example calculate Johnson’s account as $180M x 30/360.)SOLUTION:These problems assume that purchases are made evenly across the year. Therefore, at any pointin time, Becher will have 30/360ths of its annual purchases from Johnson in its accountsreceivable balance; 45/360ths of its annual purchases from Jensen in its accounts receivablebalance and 10/360ths (excluding any adjustment for treatment of the discount) of its annualpurchases from Docking in its account receivable balance. Therefore, we would expect thebalance to be:$180,000,000 x 30/360 =$15,000,000$150,000,000 x 45/360 =$18,750,000$ 90,000,000 x 10/360 =$ 2,500,000Total Accounts Receivable$36,250,00010.Belvedere Inc. has an annual payroll of $52 million. The firm pays employees every two weeks onFriday afternoon. Last month, the books were closed on the Tuesday after payday. How much is thepayroll accrual at the end of the month?(See pageXX.)

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