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# Chapter 2 - Financial Statements, Cash Flow, and Taxes

TRUE/FALSE

1. The annual report contains four basic financial statements: the income statement, the balance sheet,
the cash flow statement, and statement of stockholders' equity.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

2. The primary reason the annual report is important in finance is that it is used by investors when
they form expectations about the firm's future earnings and dividends, and the riskiness of those
cash flows.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

3. Companies typically provide four basic financial statements: the fixed income statement, the
current income statement, the balance sheet, and the cash flow statement.

## ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

4. On the balance sheet, total assets must always equal the sum of total liabilities plus equity.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

5. Assets other than cash are expected to produce cash over time, but the amount of cash they
eventually produce could be higher or lower than the amounts at which the assets are carried on the
books.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

6. The amount shown on the December 31, 2009 balance sheet as "retained earnings" is equal to the
firm's net income for 2009 minus any dividends it paid

## ANS: F PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
7. The income statement shows the difference between a firm's income and its costs--i.e., its
profits--during a specified period of time. However, not all reported income comes in the form of
cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may be
a substantial difference between a firm's reported profits and its actual cash flow for the same
period.

## ANS: T PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

8. If we were describing the income statement and the balance sheet, it would be correct to say that
the income statement is more like a video while the balance sheet is more like a snapshot.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

9. EBIT stands for earnings before interest and taxes, and it is often called "operating income."

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

10. EBITDA stands for earnings before interest, taxes, debt, and assets.

## ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

11. Consider the following balance sheet, for Games Inc. Because Games has \$800,000 of retained
earnings, we know that the company would be able to pay cash to buy an asset with a cost of
\$200,000.

## Cash \$50,000 Accounts payable \$100,000

Inventory \$200,000 Accruals \$100,000
Accounts receivable \$250,000 Total CL \$200,000
Total CA \$500,000 Debt \$200,000
Net fixed assets \$900,000 Common stock \$200,000
Retained earnings \$800,000
Total assets \$1,400,000 Total L & E \$1,400,000

ANS: F
Note that the firm has only \$50,000 of cash. It would have to either sell assets or borrow \$150,000
to pay cash for the new asset. That might not be possible.

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
12. Typically, the statement of stockholders' equity starts with retained earnings at the beginning of
the year, adds net income, subtracts dividends paid, and ends up with retained earnings at the end
of the year. Over time, a profitable company will have earnings in excess of the dividends it pays
out, and the series of annual retained earnings will result in a substantial amount of retained
earnings as shown on the balance sheet.

## ANS: T PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

13. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after
the company has made the investments in current and fixed assets that are necessary to sustain
ongoing operations.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

14. The value of any asset is the present value of the cash flows the asset is expected to provide. The
cash flows a business is able to provide to its investors is its free cash flow. This is the reason that
FCF is so important in finance.

## ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

15. If a firm is reporting its income in accordance with generally accepted accounting principles, then
its net income as reported on the income statement should be equal to its free cash flow.

ANS: F
There is no reason to think that net income would be equal to FCF. For example, a company that is
not growing might report zero net income yet have high FCF because of depreciation.

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

16. The fact that 70% of the interest income received by corporations is excluded from its taxable
income encourages firms to finance with more debt than they would in the absence of this tax law
provision.

## ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

17. Both interest and dividends paid by a corporation are deductible operating expenses, hence they
decrease the firm's taxes.

## ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

18. The balance sheet measures the flow of funds into and out of various accounts over time, while the
income statement measures the firm's financial position at a point in time.

## ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

19. Assume that two firms are both following generally accepted accounting principles. Both firms
commenced operations two years ago with \$1 million of identical fixed assets, and neither firm
either sold any of those assets or purchased any new fixed assets. The two firms would be required
to report the same amount of net fixed assets on their balance sheets as those statements are
presented to investors.

ANS: F
One firm might choose to use straight-line depreciation, the other an accelerated method, and this
would lead to differences in reported depreciation and therefore reported net fixed assets.

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

20. Net working capital is equal to current assets minus accounts payable and accruals.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

21. The next-to-last line on the income statement shows the firm's earnings, while the last line shows
the dividends the company paid. Therefore, the dividends are frequently called "the bottom line."

## ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

22. The statement of cash flows has four main sections, one each for operating, investing, and
financing activities, and one that shows a summary of the cash and cash equivalents at the end of
the year.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

23. An increase in accounts payable represents an increase in net cash provided by operating activities
just like borrowing money from a bank. An increase in accounts payable has an effect similar to
taking out a new bank loan. However, these two items show up in different sections of the
statement of cash flows.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

24. An increase in accounts receivable represents an increase in net cash provided by operating
activities because receivables will produce cash when they are collected.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

25. The first major section of a typical statement of cash flows is "Operating Activities," and the first
entry in this section is "Net Income." Then, also in the first section, we show some items that
represent increases or decreases to cash, and the last entry is called "Net Cash Provided by
Operating Activities." This number can be either positive or negative, but if it is negative, the firm
is almost certain to soon go bankrupt.

ANS: F
Rapidly growing firms often require additions to inventory and receivables that are larger than net
income, with the deficit being made up by borrowings and/or the sale of new stock.

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

26. To estimate the cash flow from operations, depreciation must be added back to net income because
it is a non-cash charge that has been deducted from revenue.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

27. Two metrics that are used to measure a company's financial performance are net income and cash
flow. Accountants emphasize net income as calculated in accordance with generally accepted
accounting principles. Finance people generally put at least as much weight on cash flows as they
do on net income.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

28. Its retained earnings is the actual cash that the firm has generated through operations less the cash
that has been paid out to stockholders as dividends. If the firm has sufficient retained earnings, it
can purchase assets and pay for them with cash from retained earnings.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.
29. The retained earnings account on the balance sheet does not represent cash. Rather, it represents
part of the stockholders' claim against the firm's existing assets. Put another way retained earnings
are stockholders' reinvested earnings.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

30. In finance, we are generally more interested in cash flows than in accounting profits. Free cash
flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital
expenditures and changes in net working capital.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

31. Free cash flow is the amount of cash that if withdrawn would harm the firm's ability to operate and
to produce future cash flows.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

32. If the tax laws were changed so that \$0.50 out of every \$1.00 of interest paid by a corporation was
allowed as a tax-deductible expense, this would probably encourage companies to use more debt
financing than they presently do, other things held constant.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

33. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are
not deductible. This treatment, other things held constant, tends to encourage the use of debt
financing by corporations.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

34. Because the U.S. tax system is a progressive tax system, a taxpayer's marginal and average tax
rates are the same.

## ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

35. The alternative minimum tax (AMT) was created by Congress to make it more difficult for
wealthy individuals to avoid paying taxes through the use of various deductions.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

36. The time dimension is important in financial statement analysis. The balance sheet shows the
firm's financial position at a given point in time, the income statement shows results over a period
of time, and the statement of cash flows reflects specific changes in accounts over that period of
time.

## ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

MULTIPLE CHOICE

## 1. Which of the following statements is CORRECT?

a. The four most important financial statements provided in the annual report are the balance
sheet, income statement, cash budget, and the statement of stockholders' equity.
b. The balance sheet gives us a picture of the firm’s financial position at a point in time.
c. The income statement gives us a picture of the firm’s financial position at a point in time.
d. The statement of cash flows tells us how much cash the firm must pay out in interest
during the year.
e. The statement of cash needs tells us how much cash the firm will require during some
future period, generally a month or a year.
ANS: B PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 2. Which of the following statements is CORRECT?

a. Assets other than cash are expected to produce cash over time, and the amounts of cash
they eventually produce should be exactly the same as the amounts at which the assets are
carried on the books.
b. The primary reason the annual report is important in finance is that it is used by investors
when they form expectations about the firm's future earnings and dividends, and the
riskiness of those cash flows.
c. The annual report is an internal document prepared by a firm's managers solely for the use
of its creditors/lenders.
d. The four most important financial statements provided in the annual report are the balance
sheet, income statement, cash budget, and statement of stockholders' equity.
e. Prior to the Enron scandal in the early 2000s, companies would put verbal information in
their annual reports, along with the financial statements. That verbal information was often
misleading, so today annual reports can contain only quantitative information--audited
financial statements.
ANS: B PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 3. Which of the following statements is CORRECT?

a. The balance sheet for a given year, say 2008, is designed to give us an idea of what
happened to the firm during that year.
b. The balance sheet for a given year, say 2008, tells us how much money the company
earned during that year.
c. The difference between the total assets reported on the balance sheet and the liabilities
reported on this statement tells us the current market value of the stockholders' equity,
assuming the statements are prepared in accordance with generally accepted accounting
principles (GAAP).
d. If a company's statements were prepared in accordance with generally accepted
accounting principles (GAAP), the market value of the stock equals the book value of the
stock as reported on the balance sheet.
e. The assets section of a typical industrial company’s balance sheet begins with cash, then
lists the assets in the order in which they will probably be converted to cash, with the
longest lived assets listed last.
ANS: E PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

4. Other things held constant, which of the following actions would increase the amount of cash on a
company’s balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment.
ANS: C PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 5. Which of the following items is NOT normally considered to be a current asset?

a. Accounts receivable.
b. Inventory.
c. Bonds.
d. Cash.
e. Short-term, highly-liquid, marketable securities.
ANS: C PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

6. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.
ANS: D PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
7. Which of the following statements is CORRECT?
a. The focal point of the income statement is the cash account, because that account cannot
be manipulated by “accounting tricks.”
b. The reported income of two otherwise identical firms cannot be manipulated by different
accounting procedures provided the firms follow generally accepted accounting principles
(GAAP).
c. The reported income of two otherwise identical firms must be identical if the firms are
publicly owned, provided they follow procedures that are permitted by the Securities and
Exchange Commission (SEC).
d. If a firm follows generally accepted accounting principles (GAAP), then its reported net
income will be identical to its reported cash flow.
e. The income statement for a given year, say 2008, is designed to give us an idea of how
much the firm earned during that year.
ANS: E PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 8. Which of the following statements is most correct?

a. Corporations are allowed to exclude 70% of their interest income from corporate taxes.
b. Corporations are allowed to exclude 70% of their dividend income from corporate taxes.
c. Individuals pay taxes on only 30% of the income realized from municipal bonds.
d. Individuals are allowed to exclude 70% of their interest income from their taxes.
e. Individuals are allowed to exclude 70% of their dividend income from their taxes.
ANS: B PTS: 1 DIF: EASY | MEDIUM
NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 9. A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row.
b. Can be carried back 2 years, then carried forward up to 20 years following the loss.
c. Can be carried back 5 years and forward 3 years.
d. Cannot be used to reduce taxes in other years except with special permission from the IRS.
e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the
firm.
ANS: B PTS: 1 DIF: EASY | MEDIUM
NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

10. Below are the 2007 and 2008 year-end balance sheets for Tran Enterprises:The firm has never paid
a dividend on its common stock, and it issued \$2,400,000 of 10-year, non-callable, long-term debt
in 2007. As of the end of 2008, none of the principal on this debt had been repaid. Assume that the
company’s sales in 2007 and 2008 were the same. Which of the following statements must be
CORRECT?

## Assets: 2008 2007

Cash \$ 200,000 \$ 170,000
Accounts receivable 864,000 700,000
Inventories 2,000,000 1,400,000
Total current assets \$3,064,000 \$2,270,000
Net fixed assets 6,000,000 5,600,000
Total assets \$9,064,000 \$7,870,000
Liabilities and equity:
Accounts payable \$1,400,000 \$1,090,000
Notes payable 1,600,000 1,800,000
Total current liabilities \$3,000,000 \$2,890,000
Long-term debt 2,400,000 2,400,000
Common stock 3,000,000 2,000,000
Retained earnings 664,000 580,000
Total common equity \$3,664,000 \$2,580,000
Total liabilities and equity \$9,064,000 \$7,870,000

## a. The firm increased its short-term bank debt in 2008.

b. The firm issued long-term debt in 2008.
c. The firm issued new common stock in 2008.
d. The firm repurchased some common stock in 2008.
e. The firm had negative net income in 2008.
ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

11. On its 12/31/08 balance sheet, Barnes Inc showed \$510 million of retained earnings, and exactly
that same amount was shown the following year. Assuming that no earnings restatements were
issued, which of the following statements is CORRECT?
a. If the company lost money in 2008, it must have paid dividends.
b. The company must have had zero net income in 2008.
c. The company must have paid out half of its 2008 earnings as dividends.
d. The company must have paid no dividends in 2008.
e. Dividends could have been paid in 2008, but they would have had to equal the earnings for
the year.
ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

12. Below is the common equity section (in millions) of Timeless Technology’s last two year-end
balance sheets: The firm has never paid a dividend to its common stockholders. Which of the
following statements is CORRECT?

2008 2007
Common stock 2,000 1,000
Retained earnings 2,000 2,340
Total common equity \$4,000 \$3,340

## a. The company’s net income in 2008 was higher than in 2007.

b. The firm issued common stock in 2008.
c. The market price of the firm's stock doubled in 2008.
d. The firm had positive net income in both 2007 and 2008, but its net income in 2008 was
lower than it was in 2007.
e. The company has more equity than debt on its balance sheet.
ANS: B PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 13. Which of the following statements is CORRECT?

a. Typically, a firm’s DPS should exceed its EPS.
b. Typically, a firm’s net income should exceed its EBIT.
c. If a firm is more profitable than average (e.g., Google), we would normally expect to see
its stock price exceed its book value per share.
d. If a firm is more profitable than most other firms, we would normally expect to see its
book value per share exceed its stock price, especially after several years of high inflation.
e. The more depreciation a firm has in a given year, the higher its EPS, other things held
constant.
ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 14. Which of the following statements is CORRECT?

a. The more depreciation a firm reports, the higher its tax bill, other things held constant.
b. People sometimes talk about the firm’s cash flow, which is shown as the lowest entry on
the income statement, hence it is often called "the bottom line.”
c. Depreciation reduces a firm’s cash balance, so an increase in depreciation would normally
lead to a reduction in the firm’s cash flow.
d. Operating income is derived from the firm's regular core business. Operating income is
calculated as Revenues less Operating costs. Operating costs do not include interest or
taxes.
e. Depreciation is not a cash charge, so it does not have an effect on a firm’s reported profits.
ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

15. Which of the following factors could explain why Michigan Energy's cash balance increased even
though it had a negative cash flow last year?
a. The company sold a new issue of bonds.
b. The company made a large investment in new plant and equipment.
c. The company paid a large dividend.
d. The company had high depreciation expenses.
e. The company repurchased 20% of its common stock.
ANS: A PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

16. Analysts who follow Howe Industries recently noted that, relative to the previous year, the
company’s net cash provided from operations increased, yet cash as reported on the balance sheet
decreased. Which of the following factors could explain this situation?
a. The company cut its dividend.
b. The company made large investments in fixed assets.
c. The company sold a division and received cash in return.
d. The company issued new common stock.
e. The company issued new long-term debt.
ANS: B PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

17. Austin Financial recently announced that its net income increased sharply from the previous year,
yet its net cash provided from operations declined. Which of the following could explain this
performance?
a. The company’s dividend payment to common stockholders declined.
b. The company’s expenditures on fixed assets declined.
c. The company’s cost of goods sold increased.
d. The company’s depreciation expense declined.
e. The company’s interest expense increased.
ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 18. Which of the following statements is CORRECT?

a. The statement of cash flows reflects cash flows from operations, but it does not reflect the
effects of buying or selling fixed assets.
b. The statement of cash flows shows where the firm’s cash is located; indeed, it provides a
listing of all banks and brokerage houses where cash is on deposit.
c. The statement of cash flows reflects cash flows from continuing operations, but it does not
reflect the effects of changes in working capital.
d. The statement of cash flows reflects cash flows from operations and from borrowings, but
it does not reflect cash obtained by selling new common stock.
e. The statement of cash flows shows how much the firm’s cash--the total of currency, bank
deposits, and short-term liquid securities (or cash equivalents)--increased or decreased
during a given year.
ANS: E PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 19. Which of the following statements is CORRECT?

a. In the statement of cash flows, a decrease in accounts receivable is subtracted from net
income in the operating activities section.
b. Dividends do not show up in the statement of cash flows because dividends are considered
to be a financing activity, not an operating activity.
c. In the statement of cash flows, a decrease in accounts payable is subtracted from net
income in the operating activities section.
d. In the statement of cash flows, depreciation is subtracted from net income in the operating
activities section.
e. In the statement of cash flows, a decrease in inventories is subtracted from net income in
the operating activities section.
ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 20. Which of the following statements is CORRECT?

a. Most rapidly growing companies have positive free cash flows because cash flows from
existing operations generally exceed fixed asset purchases and changes to net working
capital.
b. Changes in working capital have no effect on free cash flow.
c. Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 - T)
+ Depreciation
- Capital expenditures required to sustain operations
- Required changes in net working capital.
d. Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 - T) + Capital expenditures.
e. Managers should be less concerned with free cash flow than with accounting net income.
Accounting net income is the
ANS: C PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 21. Which of the following statements is CORRECT?

a. Since companies can deduct dividends paid but not interest paid, our tax system favors the
use of equity financing over debt financing, and this causes companies’ debt ratios to be
lower than they would be if interest and dividends were both deductible.
b. Interest paid to an individual is counted as income for federal tax purposes and taxed at the
individual’s regular tax rate, which in 2008 could go up to 35%, but dividends received
were taxed at a maximum rate of 15%.
c. The maximum federal tax rate on corporate income in 2008 was 50%.
d. Corporations obtain capital for use in their operations by borrowing and by raising equity
capital, either by selling new common stock or by retaining earnings. The cost of debt
capital is the interest paid on the debt, and the cost of the equity is the dividends paid on
the stock. Both of these costs are deductible from income when calculating income for tax
purposes.
e. The maximum federal tax rate on personal income in 2008 was 50%.
ANS: B PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 22. Which of the following statements is CORRECT?

a. The income of certain small corporations that qualify under the Tax Code is completely
exempt from corporate income taxes. Thus, the federal government receives no tax
revenue from these businesses, even though they report high accounting profits.
b. All businesses, regardless of their legal form of organization, are taxed under the Business
Tax Provisions of the Internal Revenue Code.
c. Small corporations that qualify under the Tax Code can elect not to pay corporate taxes,
but then each stockholder must report his or her pro rata shares of the firm’s income as
personal income and pay taxes on that income.
d. Congress recently changed the tax laws to make dividend income received by individuals
exempt from income taxes. Prior to the enactment of that law, corporate income was
subject to double taxation, where the firm was first taxed on the corporation's income and
stockholders were taxed again on this income when it was paid to them as dividends.
e. All corporations other than non-profits are subject to corporate income taxes, which are
15% for the lowest amounts of income and 38% for the highest amounts.
ANS: C PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 23. Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the amount of cash a
company has available to pay out as dividends to shareholders.
b. 70% of the interest received by corporations is excluded from taxable income.
c. 70% of the dividends received by corporations is excluded from taxable income.
d. Because taxes on long-term capital gains are not paid until the gain is realized, investors
must pay the top individual tax rate on that gain.
e. The corporate tax system favors equity financing, as dividends paid are deductible from
corporate taxes.
ANS: C PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

24. Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash
flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors
could explain this situation?
a. The company had a sharp increase in its inventories.
b. The company had a sharp increase in its accrued liabilities.
c. The company sold a new issue of common stock.
d. The company made a large capital investment early in the year.
e. The company had a sharp increase in depreciation expenses.
ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

25. Which of the following would be most likely to occur in the year after Congress, in an effort to
increase tax revenue, passed legislation that forced companies to depreciate equipment over longer
lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the
same depreciation method is used for tax and stockholder reporting purposes.
a. Companies’ after-tax operating profits would decline.
b. Companies’ physical stocks of fixed assets would increase.
c. Companies’ cash flows would increase.
d. Companies’ cash positions would decline.
e. Companies’ reported net incomes would decline.
ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

26. Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to
double its depreciation expense for the upcoming year but will have no effect on its sales revenue
or the tax rate. Prior to the new provision, BBI’s net income was forecasted to be \$4 million.
Which of the following best describes the impact of the new provision on BBI’s financial
statements versus the statements without the provision? Assume that the company uses the same
depreciation method for tax and stockholder reporting purposes.
a. The provision will reduce the company’s cash flow.
b. The provision will increase the company’s tax payments.
c. The provision will increase the firm's operating income (EBIT).
d. The provision will increase the company’s net income.
e. Net fixed assets on the balance sheet will decrease.
ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

27. The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm
planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed
a provision that requires the company to depreciate the equipment on a straight-line basis over 7
years. Other things held constant, which of the following will occur as a result of this
Congressional action? Assume that the company uses the same depreciation method for tax and
stockholder reporting purposes.
a. Nantell’s taxable income will be lower.
b. Nantell’s operating income (EBIT) will increase.
c. Nantell’s cash position will improve (increase).
d. Nantell’s reported net income for the year will be lower.
e. Nantell’s tax liability for the year will be lower.
ANS: B PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

28. Assume that Besley Golf Equipment commenced operations on January 1, 2008, and it was
granted permission to use the same depreciation calculations for shareholder reporting and income
tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December
2008 management realized that the assets would last for only 10 years. The firm's accountants plan
to report the 2008 financial statements based on this new information. How would the new
depreciation assumption affect the company’s financial statements?
a. The firm’s reported net fixed assets would increase.
b. The firm’s EBIT would increase.
c. The firm's reported 2008 earnings per share would increase.
d. The firm's cash position in 2008 and 2009 would increase.
e. The provision will increase the company's tax payments.
ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

29. A start-up firm is making an initial investment in new plant and equipment. Assume that currently
its equipment must be depreciated on a straight-line basis over 10 years, but Congress is
considering legislation that would require the firm to depreciate the equipment over 7 years. If the
legislation becomes law, which of the following would occur in the year following the change?
a. The firm’s operating income (EBIT) would increase.
b. The firm’s taxable income would increase.
c. The firm’s cash flow would increase.
d. The firm’s tax payments would increase.
e. The firm’s reported net income would increase.
ANS: C PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 30. Which of the following statements is CORRECT?

a. Dividends paid reduce the net income that is reported on a company’s income statement.
b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable
securities, this will cause a decline in its current assets as shown on the balance sheet.
c. If a company issues new long-term bonds to purchase fixed assets during the current year,
this will increase both its reported current assets and current liabilities at the end of the
year.
d. Accounts receivable are reported as a current liability on the balance sheet.
e. If a company pays more in dividends than it generates in net income, its retained earnings
as reported on the balance sheet will decline from the previous year's balance.
ANS: E PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

31. For managerial purposes, i.e., making decisions regarding the firm's operations, the standard
financial statements as prepared by accountants under generally accepted accounting principles
(GAAP) are often modified and used to create alternative data and metrics that provide a somewhat
different picture of a firm's operations. Related to these modifications, which of the following
statements is CORRECT?
a. The standard statements make adjustments to reflect the effects of inflation on asset
values, and these adjustments are normally carried into any adjustment that managers
make to the standard statements.
b. The standard statements focus on accounting income for the entire corporation, not cash
flows, and the two can be quite different during any given accounting period. However,
the firm's value is based on its future cash flows. After all, future cash flows tells us how
much the firm can distribute to its investors.
c. The standard statements provide useful information on the firm’s individual operating
units, but management needs more information on the firm’s overall operations than the
standard statements provide.
d. The standard statements focus on cash flows, but managers should be less concerned with
cash flows than with accounting income as defined by GAAP.
e. The best feature of standard statements is that, if they are prepared under GAAP, the data
are always consistent from firm to firm. Thus, under GAAP, there is no room for
accountants to “adjust” the results to make earnings look better.
ANS: B PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 32. Which of the following statements is CORRECT?

a. Since depreciation increases the firm's net cash provided by operating activities, the more
depreciation a company has, the larger its retained earnings will be, other things held
constant.
b. A firm can show a large amount of retained earnings on its balance sheet yet need to
borrow cash to make required payments.
c. Common equity includes common stock and retained earnings, less accumulated
depreciation.
d. The retained earnings account as reported on the balance sheet shows the amount of cash
that is available for paying dividends.
e. If a firm reports a loss on its income statement, then the retained earnings account as
shown on the balance sheet will be negative.
ANS: B PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

33. The CFO of Daves Industries plans to have the company issue \$300 million of new common stock
and use the proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume
that the company, which does not pay any dividends, takes this action, and that total assets,
operating income (EBIT), and its tax rate all remain constant. Which of the following would
occur?
a. The company’s taxable income would fall.
b. The company’s interest expense would remain constant.
c. The company would have less common equity than before.
d. The company’s net income would increase.
e. The company would have to pay less taxes.
ANS: D PTS: 1 DIF: MEDIUM | HARD
NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

34. Last year Besset Company’s operations provided a negative cash flow, yet the cash shown on its
balance sheet increased. Which of the following statements could explain the increase in cash,
assuming the company’s financial statements were prepared under generally accepted accounting
principles (GAAP)?
a. The company repurchased some of its common stock.
b. The company dramatically increased its capital expenditures.
c. The company retired a large amount of its long-term debt.
d. The company sold some of its fixed assets.
e. The company had high depreciation expenses.
ANS: D PTS: 1 DIF: HARD NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 35. Which of the following statements is CORRECT?

a. Assume that two firms are both following generally accepted accounting principles. Both
firms commenced operations two years ago with \$1 million of identical fixed assets, and
neither firm either sold any of those assets or purchased any new fixed assets. The two
firms would be required to report the same amount of net fixed assets on their balance
sheets as those statements are presented to investors.
b. Assets other than cash are expected to produce cash over time, and the amount of cash
they eventually produce must be the same as the amounts at which the assets are carried
on the books.
c. The income statement shows the difference between a firm's income and its costs--i.e., its
profits--during a specified period of time. However, all reported income comes in the form
of cash, and reported costs likewise are consistent with cash outlays. Therefore, there will
not be a substantial difference between a firm's reported profits and its actual cash flow for
the same period.
d. The primary reason the annual report is important in finance is that it is used by investors
when they form expectations about the firm's future earnings and dividends, and the
riskiness of those cash flows.
e. EPS stands for earnings per share, while DPS stands for dividends per share. We would
normally expect to see DPS exceed EPS.
ANS: D PTS: 1 DIF: HARD NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 36. Which of the following statements is CORRECT?

a. An increase in accounts receivable is added to net income in the operating activities
section because if accounts receivable increase, then when they are collected cash will
come into the firm.
b. In finance, we are generally more interested in cash flows than in accounting profits. Free
cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum
of capital expenditures and net working capital. Free cash flow is the amount of cash that
could be withdrawn without harming the firm's ability to operate and to produce future
cash flows.
c. The first major section of a typical statement of cash flows is "Operating Activities," and
the first entry in this section is "Net Income." Then, also in the first section, we show some
items that add to or subtract from cash, and the last entry is called "Net Cash Provided by
Operating Activities." This number can be either positive or negative, but if it is negative,
the firm is almost certain to soon go bankrupt.
d. The next-to-last line on the income statement shows the firm's earnings, while the last line
shows the dividends the company paid. Therefore, the dividends are frequently called "the
bottom line."
e. Most rapidly growing companies have positive free cash flows because cash flows from
existing operations will exceed fixed assets and working capital needed to support the
growth.
ANS: B PTS: 1 DIF: HARD NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 37. Which of the following statements is CORRECT?

a. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and
dividends after the company has made the investments in current and fixed assets that are
necessary to sustain ongoing operations.
b. After-tax operating income is calculated as EBIT(1 - T) + Depreciation.
c. Two firms with identical sales and operating costs but with different amounts of debt and
tax rates will have different operating incomes by definition.
d. If a firm is reporting its income in accordance with generally accepted accounting
principles, then its net income as reported on the income statement should be equal to its
free cash flow.
e. Retained earnings as reported on the balance sheet represent cash and, therefore, are
available to distribute to stockholders as dividends or any other required cash payments to
creditors and suppliers.
ANS: A PTS: 1 DIF: HARD NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

## 38. Which of the following statements is CORRECT?

a. The current cash flow from existing assets is highly relevant to investors. However, since
the value of the firm depends primarily upon its growth opportunities, accounting net
income projections from those opportunities are the only relevant future flows with which
investors are concerned.
b. Two metrics that are used to measure a company's financial performance are net income
and free cash flow. Accountants tend to emphasize net income as calculated in accordance
with generally accepted accounting principles. Finance people generally put at least as
much weight on free cash flows as they do on net income.
c. To estimate the net cash provided by operations, depreciation must be subtracted from net
income because it is a non-cash charge that has been added to revenue.
d. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends
paid are not deductible. This treatment, other things held constant, tends to discourage the
use of debt financing by corporations.
e. If Congress changed depreciation allowances so that companies had to report higher
depreciation levels for tax purposes in 2009, this would lower their free cash flows for
2009.
ANS: B PTS: 1 DIF: HARD NAT: Reflective thinking
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows.

39. Bauer Software's current balance sheet shows total common equity of \$5,125,000. The company
has 490,000 shares of stock outstanding, and they sell at a price of \$27.50 per share. By how much
do the firm's market and book values per share differ?
a. \$18.57
b. \$19.09
c. \$20.28
d. \$17.04
e. \$18.23
ANS: D
Shares outstanding 490,000
Price per share \$27.50
Total book common equity \$5,125,000
Book value per share = Total book equity/Number of shares \$10.46
Difference between book and market values \$17.04
PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

40. Brown Fashions Inc.'s December 31, 2008 balance sheet showed total common equity of
\$4,050,000 and 295,000 shares of stock outstanding. During 2008, the firm had \$450,000 of net
income, and it paid out \$100,000 as dividends. What was the book value per share at 12/31/08,
assuming no common stock was either issued or retired during 2008?
a. \$11.34
b. \$13.87
c. \$16.56
d. \$12.38
e. \$14.92
ANS: E
12/31/08 common equity \$4,050,000
2008 net income \$450,000
2008 dividends \$100,000
2008 addition to retained earnings \$350,000
12/31/08 common equity \$4,400,000
Shares outstanding 295,000
12/31/08 BVPS \$14.92

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

41. Prezas Company's balance sheet showed total current assets of \$2,750, all of which were required
in operations. Its current liabilities consisted of \$975 of accounts payable, \$600 of 6% short-term
notes payable to the bank, and \$250 of accrued wages and taxes. What was its net working capital?
a. \$1,525
b. \$1,357
c. \$1,601
d. \$1,464
e. \$1,190
ANS: A
Current assets \$2,750
Accounts payable \$975
Accrued wages and taxes \$250
Net working capital \$1,525
Note that NWC represents current assets less accounts payable and accruals.

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
42. Rao Construction recently reported \$23.50 million of sales, \$12.60 million of operating costs other
than depreciation, and \$3.00 million of depreciation. It had \$8.50 million of bonds outstanding that
carry a 7.0% interest rate, and its federal-plus-state income tax rate was 40%. What was Rao's
operating income, or EBIT, in millions?
a. \$6.56
b. \$6.95
c. \$8.22
d. \$7.90
e. \$5.93
ANS: D
Sales \$23.50
Operating costs excluding depreciation \$12.60
Depreciation \$3.00
Operating income (EBIT) \$7.90
Note that operating income is before interest and taxes.

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

43. Brown Office Supplies recently reported \$18,500 of sales, \$8,250 of operating costs other than
depreciation, and \$1,750 of depreciation. It had \$9,000 of bonds outstanding that carry a 7.0%
interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm's earnings
before taxes (EBT)?
a. \$5,981
b. \$7,398
c. \$7,870
d. \$5,903
e. \$6,217
ANS: C
Bonds \$9,000.00
Interest rate 7.00%
Sales \$18,500.00
Operating costs excluding depr'n \$8,250.00
Depreciation \$1,750.00
Operating income (EBIT) \$8,500.00
Interest charges -\$630.00
EBT = Taxable income \$7,870

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

44. Vasudevan Inc. recently reported operating income of \$5.95 million, depreciation of \$1.20 million,
and had a tax rate of 40%. The firm's expenditures on fixed assets and net working capital totaled
\$0.6 million. How much was its free cash flow, in millions?
a. \$4.13
b. \$4.38
c. \$4.17
d. \$3.63
e. \$3.59
ANS: C
FCF = EBIT(1 - T) + Deprec - (Capex + NWC)
EBIT \$5.95
Tax rate 40%
Depreciation \$1.20
Capex + NW \$0.60
FCF = \$4.17

## PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

45. Emery Mining Inc. recently reported \$167,500 of sales, \$75,500 of operating costs other than
depreciation, and \$10,200 of depreciation. The company had \$16,500 of outstanding bonds that
carry a 7.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the
firm's net income? The firm uses the same depreciation expense for tax and stockholder reporting
purposes.
a. \$44,533.57
b. \$50,296.74
c. \$64,442.70
d. \$57,107.76
e. \$52,392.44
ANS: E
Bonds \$16,500
Interest rate 7.25%
Tax rate 35%
Sales \$167,500
Operating costs excluding depr'n \$75,500
Depreciation \$10,200
Operating income (EBIT) \$81,800
Interest charges -\$1,196.25
Taxable income \$80,603.75
Taxes -\$28,211.31
Net income \$52,392.44

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
46. On 12/31/08, Hite Industries reported retained earnings of \$502,500 on its balance sheet, and it
reported that it had \$135,000 of net income during the year. On its previous balance sheet, at
12/31/07, the company had reported \$445,000 of retained earnings. No shares were repurchased
during 2008. How much in dividends did the firm pay during 2008?
a. \$78,275
b. \$89,125
c. \$83,700
d. \$96,100
e. \$77,500
ANS: E
12/31/08 RE \$502,500
12/31/07 RE \$445,000
Change in RE \$57,500
Net income for 2008 \$135,000
Dividends = Net income - Change \$77,500

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

47. During 2008, Bascom Bakery paid out \$33,525 of common dividends. It ended the year with
\$155,000 of retained earnings versus the prior year’s retained earnings of \$159,600. How much net
income did the firm earn during the year?
a. \$23,719
b. \$28,057
c. \$24,008
d. \$28,925
e. \$27,768
ANS: D
Net income = The change in retained earnings plus the dividends paid:
Current RE \$155,000
Previous RE = Current RE - increment \$159,600
Change in RE \$–4,600
Plus dividends paid \$33,525
Net income = \$28,925

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

48. Your corporation has the following cash flows: If the applicable income tax rate is 40% (federal
and state combined), and if 70% of dividends received are exempt from taxes, what is the
corporation's tax liability?

## Operating income \$250,000

Interest paid \$45,000
Dividends paid \$50,000

a. \$71,118
b. \$87,800
c. \$86,044
d. \$102,726
e. \$98,336
ANS: B
Operating income \$250,000
Interest paid \$45,000
Divdend exclusion % 70%
Dividends paid \$50,000
Tax rate (T) 40%
Taxable income = Oper. income + Interest received – Interest paid + Taxable dividends received
Taxable income = Oper. income + Interest received – Interest paid + dividends received
(1 – Div exclusion %)
Taxable income = \$219,500
Taxes paid = Taxable income Tax rate
Taxes paid = \$87,800

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

49. Your corporation has a marginal tax rate of 35% and has purchased preferred stock in another
company. The before-tax dividend yield on the preferred stock is 13%. What is the company's
after-tax return on the preferred, assuming a 70% dividend exclusion?
a. 10.12%
b. 10.94%
c. 10.82%
d. 11.64%
e. 11.98%
ANS: D
Preferred dividend rate 13.00%
Tax rate 35%
Dividend exclusion % 70%
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 11.64%

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

50. Lovell Co. purchased preferred stock in another company. The preferred stock’s before-tax yield
was 13.2%. The corporate tax rate is 40%. What is the after-tax return on the preferred stock,
assuming a 70% dividend exclusion?
a. 12.55%
b. 14.52%
c. 11.62%
d. 11.15%
e. 11.27%
ANS: C
Preferred dividend rate 13.20%
Tax rate 40%
Dividend exclusion % 70%
If a company buys preferred stock in another company, 70% of the dividends are excluded from
taxes. Therefore, the after-tax return will be:
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 11.62%

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

51. A company with a 39% tax rate buys preferred stock in another company. The preferred stock has
a before-tax yield of 9%. What is the preferred stock’s after-tax return?
a. 8.66%
b. 6.12%
c. 7.95%
d. 9.38%
e. 6.75%
ANS: C
Preferred dividend rate 9.00%
Tax rate 39%
Dividend exclusion % 70%
If a company buys preferred stock in another company, 70% of the dividends are excluded from
taxes. Therefore, the after-tax return will be:
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 7.95%

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

52. Van Dyke Corporation has a corporate tax rate equal to 36%. The company recently purchased
preferred stock in another company. The preferred stock has an 8% before-tax yield. What is Van
Dyke’s after-tax yield on the preferred stock?
a. 6.78%
b. 5.78%
c. 8.49%
d. 7.14%
e. 5.92%
ANS: D
Preferred dividend rate 8.00%
Tax rate 36%
Dividend exclusion % 70%
If a company buys preferred stock in another company, 70% of the dividends are excluded from
taxes. Therefore, the after-tax return will be:
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 7.14%

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

53. Granville Co. recently purchased several shares of Kalvaria Electronics’ preferred stock. The
preferred stock has a before-tax yield of 7.6%. If the company’s tax rate is 25%, what is Granville
Co.’s after-tax yield on the preferred stock?
a. 8.79%
b. 7.03%
c. 8.72%
d. 6.26%
e. 7.24%
ANS: B
Preferred dividend rate 7.60%
Tax rate 25%
Dividend exclusion % 70%
If a company buys preferred stock in another company, 70% of the dividends are excluded from
taxes. Therefore, the after-tax return will be:
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 7.03%

## PTS: 1 DIF: EASY | MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

54. Wu Systems has the following balance sheet. How much net working capital does the firm have?

## Cash \$ 100 Accounts payable \$ 200

Accounts receivable 650 Accruals 75
Inventory 550 Notes payable 625
Current assets \$ 1,300 Current liabilities \$ 900
Net fixed assets \$ 1,000 Long-term debt 600
Common equity 300
Retained earnings 500
Total assets \$ 2,300 Total liab. & equity \$ 2,300

a. \$1,025
b. \$1,138
c. \$1,179
d. \$933
e. \$1,169
ANS: A
Cash \$100 Accounts payable
\$200
Accounts receivable 650 Accruals
75
Inventory 550 Notes payable
625
Current assets Current liabilities \$1,300 \$ 900
Net fixed assets Long-term debt 1,000 600
Common equity 300
Retained earnings 500
Total assets \$ 2,300 Total liab. & equity \$2,300
Net working capital = Current assets - AP - Accruals
NWC = \$1,300.00 - \$275.00
NWC = \$1,025

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 55. increase by \$1.00 million. By how much will net income

Last year Almazan Software reported \$10.5 0 million of sales, \$6.25 million of operating costs other than depreciation, and \$1.3 0 million of depreciation . The company had \$5.00 million of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rat e was 35%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to

change as a result of the change in depreciation? The company uses the same depreciation
calculations for tax and stockholder reporting purposes.
a. -\$0.663
b. -\$0.709
c. -\$0.631
d. -\$0.65
e. -\$0.598
ANS: D
This problem can be worked very easily--just multiply the increase in
depreciation by (1-T) to get the decrease in net income:
Change in depreciation \$1.000
Tax rate 0.350
Reduction in net income -\$0.65

We can also get the answer a longer way, which explains things more clearly:
Old New Change
Bonds \$5.000 \$5.000 \$0.000
Interest rate 0.065 0.065 0.000
Tax rate 0.350 0.350 0.000
Sales \$10.500 \$10.500 \$0.000
Operating costs excluding depr'n \$6.250 \$6.250 \$0.000
Depreciation \$1.300 \$2.300 \$1.000
Operating income (EBIT) \$2.950 \$1.950 -\$1.000
Interest charges \$0.325 \$0.325 \$0.000
Taxable income \$2.625 \$1.625 -\$1.000
Taxes \$0.919 \$0.569 -\$0.350
Net income \$1.706 \$1.056 -\$0.65
PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

56. C. F. Le e Inc. has the following income statement. How much after -tax operating income does the firm have?

Sales \$3,100.00
Costs 1,850.00
Depreciation 192.00
EBIT \$1,058.00
Interest expense 285.00
EBT \$773.00
Taxes (35%) 270.55
Net income \$502.45

a. \$646.44
b. \$536.41
c. \$859.63
d. \$687.70
e. \$584.55
ANS: D
Sales \$3,100.00
Costs 1,850.00
Depreciation 192.00
EBIT \$1,058.00
Interest expense 285.00
EBT \$773.00
Taxes : rate = 35% 270.55
Net income \$502.45

EBIT \$1,058.00
Tax rate 35%
EBIT(1 - T) =\$687.70

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

57. Kwok Enterprises has the following income statement. How much after -tax operating income does the firm have?

Sales \$2,050
Costs 1,400
Depreciation 250
EBIT \$400
Interest expense 70
EBT \$330
Taxes (40%) 132
Net income \$198
a. \$240
b. \$262
c. \$247
d. \$228
e. \$185
ANS: A
Sales \$2,050
Costs 1,400
Depreciation 250
EBIT \$400
Interest expense 70
EBT \$330
Taxes 40% 132
Net income \$198

EBIT \$400
Tax rate 40%
EBIT(1 - T) =\$240

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

58. Hartzell Inc. had the following data for 2007, in millions: Net income = \$600; after -tax operating income [EBIT (1-T)] = \$700; and Total assets = \$2,000. Information for 2008 is as follows: Net income = \$825; after -tax operating income [EBIT (1 -T)] = \$1,125; and Total assets = \$2,500. How much free cash flow did the firm generate during 2008?

a. \$644
b. \$494
c. \$481
d. \$675
e. \$625
ANS: E
EBIT(1 - T) 2007 2008 Change = Net invest. in FA + NWC

## 2008 FCF = EBIT(1 - T) - Net investment in FA + NWC

2008 FCF = \$1,125 - \$500
2008 FCF = \$625

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

59. Shrives Publishing recently reported \$9,750 of sales, \$5,500 of operating costs other than depreciation, and \$1,2 50 of depreciation. The company had \$3,500 of bonds that carry a 6.25% interest rate , and its federal-plus-state income tax rate was 35%. During the year, the firm had expenditures on fixed assets and net working capital that tot aled \$1,550. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. What was its free cash flow?
a. \$1,716
b. \$1,469
c. \$1,271
d. \$1,650
e. \$1,683
ANS: D
Bonds \$3,500.00
Interest rate 6.25%
Tax rate 35.00%
Sales \$9,750.00
Operating costs excluding depreciation 5,500.00
Depreciation 1,250.00
Operating income (EBIT) \$3,000.00
Capex + NWC = \$1,550.00
Tax rate = 35%

## FCF = EBIT(1 - T) + Deprec . — ( Capex + NWC)

FCF = \$1,950.00 + \$1,250 — \$1,550
Free cash flow = \$1,650

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

60. Housto n Pumps recently reported \$220,000 of sales, \$140,500 of operating costs o ther than depreciation, and \$9,250 of depreciation. The company had \$35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thusgenerate future sales and cash flows, the firm was required to spend \$15,250 to buy new fixed assets and to invest \$6,850 in net workin g capital. What was the firm's free cash flow?

a. \$32,813
b. \$38,719
c. \$26,906
d. \$31,828
e. \$36,422
ANS: A
Tax rate 35%
Required addition to net working capital \$6,850
Required capital expenditures (fixed assets) \$15,250
Sales \$220,000
Operating costs excluding depr'n 140,500
Depreciation 9,250
Operating income (EBIT) \$70,250

## FCF = EBIT(1 - T) + Depr'n - CapEx - Net

WC
FCF = \$45,662.50 + \$9,250 -\$15,250 -\$6,850
FCF =\$32,813

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

61. Appalachian Airlines began operating in 2004. The company lost money the first year but has been profitable ever since. The company’s taxable income (EBT) for its first five years is list ed below. Each year the company’s corporate tax rate has been 40%. Assume that the company has taken full advantage of the Tax Code’s carry -back, carry -forward provisions and that the current provisions were applicable in 2004. How much did the company pay in taxes in 2 007?

## Year Taxable Income

2004 -\$4,500,000
2005 \$1,000,000
2006 \$2,000,000
2007 \$3,000,000
2008 \$5,000,000

a. \$576,000
b. \$600,000
c. \$684,000
d. \$582,000
e. \$636,000
ANS: B
Tax rate 40%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2004 -\$4,500,000 \$0 \$0 \$4,500,000
2005 \$1,000,000 \$1,000,000 \$0 \$3,500,000
2006 \$2,000,000 \$2,000,000 \$0 \$1,500,000
2007 \$3,000,000 \$1,500,000 \$1,500,000 \$0
2008 \$5,000,000 \$0 \$5,000,000 \$0

## 2007 Tax liability = EBT Tax rate

2007 Tax liability = \$600,000

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

62. Garner Grocers began operations in 2005. Garner has reported the following levels of taxable income (EBT) over the past several years. The corporate tax rate was 34% each year. Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisionswere applicable in 2005. What is the amount of taxes the company paid in 2008?

## Year Taxable Income

2005 -\$2,750,000
2006 \$200,000
2007 \$500,000
2008 \$2,800,000

a. \$295,800
b. \$272,850
c. \$288,150
d. \$255,000
e. \$201,450
ANS: D
Tax rate 34%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2005 -\$2,750,000 \$0 \$0 \$2,750,000
2006 \$200,000 \$200,000 \$0 \$2,550,000
2007 \$500,000 \$500,000 \$0 \$2,050,000
2008 \$2,800,000 \$2,050,000 \$750,000 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$255,000

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

63. A corporation recently purchased some preferred stock that has a before-tax yield of 5.25%. The company has a tax rate of 38%. What is the after-tax return on the preferred stock?

a. 3.49%
b. 4.65%
c. 4.98%
d. 4.74%
e. 4.60%
ANS: B
Preferred dividend rate 5.25%
Tax rate 38%
Dividend exclusion % 70%
After-tax dividend yield = Preferred dividend rate [1 – (1 – Div exclusion%)(T)]
After-tax dividend yield = 4.65%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

64. A corporate bond currently yields 8.3%. Municipal bonds with the same risk, maturity, and liquidity currently yield 5.5%. At what tax rate would investors be indifferent between the two bonds?

a. 33.73%
b. 28.34%
c. 25.98%
d. 42.17%
e. 29.01%
ANS: A
Bond yield 8.30%
Municipal bond yield 5.50%

## Municipal yield = After-tax bond yield

5.50% = 8.30% (1 – T)
0.6627 = (1 – T)
T = 33.73%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

65. A 7 -year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 28%. What interest ra te on a 7 -year corporate bond of equal risk would provide you with the same after-tax return?

a. 5.20%
b. 6.20%
c. 5.40%
d. 5.80%
e. 6.67%
ANS: E
Municipal bond yield 4.80%
Tax rate 28.00%

## Municipal yield = After-tax bond yield

4.80% = BT yield (1 – T)
4.80% = BT yield 72.00%
BT yield = 6.67%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

66. A bond issued by the State of Pennsylv ania provides a 7% yield. What yield on a Synthetic Chemica l Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 35% tax bracket?

a. 11.42%
b. 8.29%
c. 10.77%
d. 11.09%
e. 8.18%
ANS: C
Municipal bond yield 7.00%
Tax rate 35.00%

## Municipal yield = After-tax bond yield

7.00% = BT yield (1 – T)
7.00% = BT yield 65.00%
BT yield = 10.77%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

67. Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6%, and Carter’s marginal income tax rate is 22%, what yield on the Chicago municipal bonds would make Carter’s treasurer indifferent between the two?

a. 3.93%
b. 4.02%
c. 4.68%
d. 4.63%
e. 4.26%
ANS: C
Treasury bond yield 6.00%
Tax rate 22.00%

Remember that municipal bonds are tax exempt, so their BT yield = AT yield.
Municipal yield = AT bond yield
Municipal yield = BT bond yield (1 – T)
Municipal yield = 4.68%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

68. A 5 -year corporate bond yields 10.8%. A 5 -year municipal bond of equal risk yields 6.5%. Assume that the st ate tax rate is z ero. At what federal tax rate are you indif ferent between the two bonds?

a. 32.65%
b. 32.25%
c. 41.41%
d. 36.63%
e. 39.81%
ANS: E
BT Bond yield 10.80%
Municipal bond yield 6.50%
Remember that municipal bonds are tax exempt, so their BT yield = AT yield.
Municipal yield = After-tax bond yield
6.50% = 10.80% (1 – T)
0.6019 = (1 – T)
T = 39.81%

## PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

69. Allen Corporation can (1) build a new plant that should generate a before-tax return of 11%, or (2) invest the same funds in the preferred stock of Florida Power & Light (FPL), which should provide A llen with a before-tax return of 9%, all in the form of dividends. Assume that Allen ’s marginal tax rate is 25%, and that 70% of dividends received are excluded from taxable income. If the plant project is div is ible into smal l increments, and if the two investments are equally risky, what combination of these two possibilities wil l maximiz e Allen’s effect ive return on the money invested?

## a. All in FPL preferred stock.

b. 60% in FPL; 40% in the project.
c. All in the plant project.
d. 60% in the project; 40% in FPL.
e. 50% in each.
ANS: A
BT project return
11.00%
BT preferred return 9.00%
Tax rate 25.00%
Dividend exclusion % 70.00%

## After-tax return on project = BT project return (1 – T)

After-tax return on project =8.25%

## After-tax return on pref. = BT pref. return [1 – (1 – Div exclusion%)(T)]

After-tax return on pref. = 8.33%

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
70. Solarcell Corporation has \$20,000 that it plans to invest in marketable s ecurities. It is choosing between AT&T bonds that yield 11%, State of Florida m unicipal bonds that yield 8%, and AT&T preferred stock with a dividend yield of 9%. Solarcell’s cor porate tax rate is 19%, and 70% of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after -tax returns, which security should be selected? Answer by givin g the after-tax rate of return on the highest yielding security.

a. 8.91%
b. 7.75%
c. 10.42%
d. 9.36%
e. 8.38%
ANS: A
BT bond yield 11.00%
BT municipal bond yield 8.00%
BT preferred yield 9.00%
Tax rate 19.00%
Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return
AT municipal bond yield 8.00%

## AT bond yield = BT bond yield (1 – T)

AT bond yield = 8.91%

## AT preferred yield = BT pref. return [1 – (1 – Div exclusion%)(T)]

AT preferred yield = 8.49%
Highest AT yield = 8.91%

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

71. A corporation can earn 7.5 % if it invests in municipal bonds. The corporation can also earn 8.7% (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break -even corporate tax rate tha t makes the corporation indifferent between the two investments?

a. 44.14%
b. 34.94%
c. 45.06%
d. 45.98%
e. 53.79%
ANS: D
BT Preferred stock yield 8.70%
Municipal yield 7.50%
Dividend exclusion % 70.00%
Remember that municipal bonds are tax exempt, so their BT yield = AT yield.
Muni yield = After-tax preferred yield
7.50% = BT pref. return [1 – (1 – Div exclusion%)(T)]
7.50% = 8.70% [1 – 30.00% (T)]
86.21% = [1 – 30.00% (T)]
T = 45.98%

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
72. Mantle Corporation is consid ering two equally risky investments:

## ·         

·          

What is the breakeven corporate tax rate that makes the company indifferent between the two
investments?
a. 37.64%
b. 59.36%
c. 56.46%
d. 48.26%
e. 41.50%
ANS: D
BT Preferred stock yield 6.05%
Dividend exclusion % 70.00%
BT bond yield 10.00%
AT bond yield = After - tax preferred yield
BT bond yield (1 – T) = BT pref. return [1 – (1 - Div exclusion %)
10.00% (1 – T) = 6.05% [1 – 30.00% (T)]
3.95% = 8.19% (T)
T = 48.26%

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

73. West Corporation has \$50,000 that it plans to invest in marketable securit ies. The corporation is choosing between the follow ing three equally risky securities: Al achua County tax -free municipal bonds yielding 8.5 %; Exxon Mobil bonds yielding 10.5%; and GM preferred stock with a dividend yield of 9.25%. West’s corporate tax rate is 15%. What is the after -tax return on the best investment alternative? (Assume the company chooses on the basis of after -tax returns.)

a. 8.747%
b. 9.461%
c. 8.657%
d. 8.925%
e. 7.765%
ANS: D
BT municipal bond yield 8.50%
BT bond yield 10.50%
BT preferred yield 9.25%
Tax rate 15.00%
Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return
AT municipal bond yield 8.500%

## AT bond yield=BT bond yield (1 – T)

AT bond yield = 8.925%

## AT preferred yield = BT pref. return [1 – (1 – Div exclusion%)(T)]

AT preferred yield = 8.834%

## Highest AT yield = 8.925%

PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

74. Arvo Corporation is trying to choosebetween three alternat ive investments. The three se curities that the company is consider ing are as follows:

## · −       

·        
·         

         −     

a. 9.094%
b. 10.640%
c. 11.368%
d. 11.186%
e. 6.821%
ANS: A
BT municipal bond yield 8.80%
BT bond yield 11.75%
BT preferred yield 9.80%
Tax rate 24.00%
Dividend exclusion % 70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return
AT municipal bond yield 8.800%

## AT bond yield=BT bond yield (1 – T)

AT bond yield = 8.930%

## AT preferred yield = BT pref. return [1 – (1 – Div exclusion%)(T)]

AT preferred yield = 9.094%

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

75. Collins Co. began operations in 2005. The company lost money the first two years, but has been profitable ever since. The com pany’s taxable income (EBT) for its first four years are summarized below:

Year EBT
2005 -\$7,000,000
2006 -\$5,200,000
2007 \$4,200,000
2008 \$8,300,000

The corporate tax rate has remained at 34%. Assume that the company has taken full advantage of
the Tax Code’s carry-back, carry-forward provisions, and assume that the current provisions were
applicable in 2005. What is Collins’ tax liability for 2008?
a. \$114,240
b. \$118,320
c. \$103,020
d. \$88,740
e. \$102,000
ANS: E
Tax rate 34%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2005 -\$7,000,000 \$0 \$0 \$7,000,000
2006 -\$5,200,000 \$0 \$0 \$12,200,000
2007 \$4,200,000 \$4,200,000 \$0 \$8,000,000
2008 \$8,300,000 \$8,000,000 \$300,000 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$102,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

76. Salinger Software was founded in 2005. The company lost money each of its first three years, but was able to turn a profit in 2008. Salinger’s operating income (EBIT) for its first four years of oper ations is reported below.

Year EBIT
2005 -\$375,000,000
2006 -\$150,000,000
2007 -\$100,000,000
2008 \$700,000,000

The company has no debt, so operating income equals earnings before taxes. The corporate tax rate
has remained constant at 35%. Assume that the company took full advantage of the carry-back,
carry-forward provisions in the Tax Code, and assume that the current provisions were applicable
in 2005. How much tax did the company pay in 2008?
a. \$22,050,000
b. \$32,812,500
c. \$31,762,500
d. \$26,250,000
e. \$19,687,500
ANS: D
Tax rate 35%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2005 -\$375,000,000 \$0 \$0 \$375,000,000
2006 -\$150,000,000 \$0 \$0 \$525,000,000
2007 -\$100,000,000 \$0 \$0 \$625,000,000
2008 \$700,000,000 \$625,000,000 \$75,000,000 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$26,250,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

77. Bradshaw Beverages began operations in 2004. The table below contains the company’s taxable income during each year of its operations. Notice that the company lost money in each of its first three years. The corporate tax rate has been 40% each year.

## Year Taxable Income

2004 -\$300,000
2005 -\$500,000
2006 -\$200,000
2007 \$800,000
2008 \$1,000,000

Assume that the company has taken full advantage of the Tax Code’s carry-back, carry-forward
provisions, and assume that the current provisions were applicable in 2004. How much did the
company pay in taxes during 2008?
a. \$262,400
b. \$320,000
c. \$323,200
d. \$361,600
e. \$281,600
ANS: B
Tax rate 40%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2004 -\$300,000 \$0 \$0 \$300,000
2005 -\$500,000 \$0 \$0 \$800,000
2006 -\$200,000 \$0 \$0 \$1,000,000
2007 \$800,000 \$800,000 \$0 \$200,000
2008 \$1,000,000 \$200,000 \$800,000 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$320,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

78. Unionto wn Booksbegan operating in 2004. The company lost money its first three years of operations, but has had an operating profit during the past two years. The company’s operating income (EBIT) for its first five years was as follows:

Year EBIT
2004 -\$5,000,000
2005 -\$2,000,000
2006 -\$1,000,000
2007 \$1,200,000
2008 \$7,000,000
The company has no debt, and therefore, pays no interest expense. Its corporate tax rate has
remained at 34% during this 5-year period. What was Uniontown’s tax liability for 2008? (Assume
that the company has taken full advantage of the carry-back and carry-forward provisions, and
assume that the current provisions were applicable in 2004.)
a. \$85,000
b. \$77,520
c. \$65,960
d. \$68,000
e. \$78,200
ANS: D
Tax rate 34%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2004 -\$5,000,000 \$0 \$0 \$5,000,000
2005 -\$2,000,000 \$0 \$0 \$7,000,000
2006 -\$1,000,000 \$0 \$0 \$8,000,000
2007 \$1,200,000 \$1,200,000 \$0 \$6,800,000
2008 \$7,000,000 \$6,800,000 \$200,000 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$68,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

79. Mays Industries was established in 2003. Since its inception, the company has generated the following levels of taxable income (EBT):

## Year Taxable Income

2003 \$50,000
2004 \$40,000
2005 \$30,000
2006 \$20,000
2007 -\$92,500
2008 \$60,000

Assume that each year the company has faced a 40% income tax rate. Also, assume that the
company has taken full advantage of the Tax Code’s carry-back, carry-forward provisions, and
assume that the current provisions were applicable in 2003. What is the company’s tax liability for
2008?
a. \$5,810
b. \$6,790
c. \$7,000
d. \$7,420
e. \$5,740
ANS: C
Tax rate 40%
EBT After Unused
Carry-Forward Forward Carryable
Year Tax. Income Used Applied Amount
2003 \$50,000 \$0 \$50,000 \$0
2004 \$40,000 \$0 \$40,000 \$0
2005 \$30,000 \$0 \$30,000 \$0
2006 \$20,000 \$0 \$20,000 \$0
2007 -\$92,500 \$0 \$0 \$92,500
2008 \$60,000 \$92,500 \$17,500 \$0

## 2008 Tax liability = EBT Tax rate

2008 Tax liability = \$7,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## Taxable Income Tax on Base of Bracket Percentage on Excess above Base

Up to \$50,000 \$0 15%
\$50,000-\$75,000 7,500 25
\$75,000-\$100,000 13,750 34
\$100,000-\$335,000 22,250 39
\$335,000-\$10,000,000 113,900 34
\$10,000,000-\$15,000,000 3,400,000 35
\$15,000,000-\$18,333,333 5,150,000 38
Over \$18,333,333 6,416,667 35

Last year the company realized \$7,000,000 in operating income (EBIT). Its annual interest expense
is \$1,500,000. What was the company’s net income for the year?
a. \$3,303,300
b. \$3,630,000
c. \$4,174,500
d. \$3,230,700
e. \$3,085,500
ANS: B
Operating income \$7,000,000
Interest expense \$1,500,000

## Taxable income = Operating income – Interest expense

Taxable income = Operating income – Interest expense
Taxable income = \$5,500,000

## Taxable Income Tax on Base of Bracket Percentage on Excess above Base

\$0 \$0 15%
\$50,000 7,500 25%
\$75,000 13,750 34%
\$100,000 22,250 39%
\$335,000 113,900 34%
\$10,000,000 3,400,000 35%
\$15,000,000 5,150,000 38%
\$18,333,333 6,416,667 35%
Tax on base = \$113,900
Tax on excess base = \$1,756,100
Tax liability = \$1,870,000

## Net income = Taxable income – Taxes

Net income = \$3,630,000

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## Taxable Income Tax on Base of Bracket Percentage on Excess above

Base
Up to \$50,000 \$0 15%
\$50,000-\$75,000 7,500 25
\$75,000-\$100,000 13,750 34
\$100,000-\$335,000 22,250 39
\$335,000-\$10,000,000 113,900 34
\$10,000,000-\$15,000,000 3,400,000 35
\$15,000,000-\$18,333,333 5,150,000 38
Over \$18,333,333 6,416,667 35

Company Z has \$65,000 of taxable income from its operations, \$5,000 of interest income, and
\$30,000 of dividend income from preferred stock it holds in other corporations. What is Company
Z’s tax liability?
a. \$18,736
b. \$17,225
c. \$15,110
d. \$11,786
e. \$18,888
ANS: C
Taxable income \$65,000
Interest income \$5,000
Dividend income \$30,000
Dividend exclusion % 70%

Total taxable income = Taxable income + Interest income + Taxable dividend income
Total taxable income = Taxable income + Interest income + Dividend income
(1-Dividend exclusion %)
Total taxable income = \$79,000
TaxableIncome Tax on Base of Bracket % on Excess above Base
\$0 \$0 15%
\$50,000 7,500 25%
\$75,000 13,750 34%
\$100,000 22,250 39%
\$335,000 113,900 34%
\$10,000,000 3,400,000 35%
\$15,000,000 5,150,000 38%
\$18,333,333 6,416,667 35%

## Tax on base = \$13,750

Tax on excess base = \$1,360
Tax liability = \$15,110

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

82. Lintner Beverage Corp. reported the following information from their financial stat ements:

## Operating income (EBIT) = \$14,500,000

Interest payments on long-term debt = \$1,750,000
Dividend income = \$1,000,000

Calculate Lintner's total tax liability using the corporate tax schedule below:
Taxable Income Tax on Base of Bracket Percentage on Excess above Base
\$0-\$50,000 \$0 15%
\$50,000-\$75,000 7,500 25
\$75,000-\$100,000 13,750 34
\$100,000-\$335,000 22,250 39
\$335,000-\$10,000,000 113,900 34
\$10,000,000-\$15,000,000 3,400,000 35
\$15,000,000-\$18,333,333 5,150,000 38
Over \$18,333,333 6,416,667 35

a. \$4,512,175
b. \$5,048,275
c. \$4,378,150
d. \$3,886,725
e. \$4,467,500
ANS: E
Operating income \$14,500,000
Interest payments \$1,750,000
Dividend income \$1,000,000
Dividend exclusion % 70%

## Taxable income = Operating income – Interest payments + Taxable dividend income

Taxable income = Operating income – Interest payments + Dividend income
(1 – Dividend exclusion%)
Taxable income = \$13,050,000

## Taxable Income Tax on Base of Bracket % on Excess above Base

\$0 \$0 15%
\$50,000 7,500 25%
\$75,000 13,750 34%
\$100,000 22,250 39%
\$335,000 113,900 34%
\$10,000,000 3,400,000 35%
\$15,000,000 5,150,000 38%
\$18,333,333 6,416,667 35%

## Tax on base = \$3,400,000

Tax on excess base = \$1,067,500
Tax liability = \$4,467,500

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

83. Last year, M artyn Company had \$140,000 in taxable income from its operations, \$50,0 00 in interest income, and \$100,000 in div idend income. Using the corporate tax rate table given below, what was the company’s tax liability f or the year?

## Taxable Income Tax on Base of Bracket Percentage on Excess above Base

\$0-\$50,000 \$0 15%
\$50,000-\$75,000 7,500 25
\$75,000-\$100,000 13,750 34
\$100,000-\$335,000 22,250 39
\$335,000-\$10,000,000 113,900 34
\$10,000,000-\$15,000,000 3,400,000 35
\$15,000,000-\$18,333,333 5,150,000 38
Over \$18,333,333 6,416,667 35

a. \$69,050
b. \$75,265
c. \$64,907
d. \$70,431
e. \$80,098
ANS: A
Operating income \$140,000
Interest income \$50,000
Dividend income \$100,000
Dividend exclusion % 70%

## Taxable income = Operating income + Interest income + Taxable dividend income

Taxable income = Operating income + Interest income + Dividend income
(1 – Dividend exclusion%)
Taxable income = \$220,000

## Taxable Income Tax on Base of Bracket % on Excess above Base

\$0 \$0 15%
\$50,000 7,500 25%
\$75,000 13,750 34%
\$100,000 22,250 39%
\$335,000 113,900 34%
\$10,000,000 3,400,000 35%
\$15,000,000 5,150,000 38%
\$18,333,333 6,416,667 35%

## Tax on base = \$22,250

Tax on excess base = \$46,800
Tax liability = \$69,050

## PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

84. Griffey Communications recently realized \$110,000 in operating income. The company had interest income of \$25,000 and realized \$70,000 in dividend income. The company’s interest expense was \$40,000.Using the corporate tax schedule above, what is Griff ey’s tax liability?

## Taxable Income Tax on Base of Bracket Percentage on Excess above Base

Up to \$50,000 \$0 15%
\$50,000-\$75,000 7,500 25
\$75,000-\$100,000 13,750 34
\$100,000-\$335,000 22,250 39
\$335,000-\$10,000,000 113,900 34
\$10,000,000-\$15,000,000 3,400,000 35
\$15,000,000-\$18,333,333 5,150,000 38
Over \$18,333,333 6,416,667 35

a. \$28,775
b. \$23,362
c. \$28,490
d. \$29,345
e. \$30,199
ANS: C
Operating income \$110,000
Interest expense \$40,000
Interest income \$25,000
Dividend income \$70,000
Dividend exclusion % 70%

Taxable income = Operating income – Interest expense + Interest income + Taxable dividend
income
Taxable income = Operating income – Interest expense + Interest income + Dividend income
(1-Dividend exclusion %)
Total taxable income = \$116,000

## Taxable Income Tax on Base of Bracket % on Excess above Base

\$0 \$0 15%
\$50,000 7,500 25%
\$75,000 13,750 34%
\$100,000 22,250 39%
\$335,000 113,900 34%
\$10,000,000 3,400,000 35%
\$15,000,000 5,150,000 38%
\$18,333,333 6,416,667 35%

## Tax on base = \$22,250

Tax on excess base = \$6,240
Tax liability = \$28,490
PTS: 1 DIF: MEDIUM | HARD NAT: Analytic skills
LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.

## 85. depreciation, which is expected to increase by

Last year, Stewart-Stern Inc. reported \$11,250 of sales, \$4,500 of operating costs other than depreciation, and \$1,250 of depreciation. The comp any had \$3,500 of bondsoutstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During last year, the firm had expenditures on fixed assets and net working capital tha t tota led \$2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item,

\$1,350. By how much will the depreciation change cause (1) the firm's net income and (2) its free
cash flow to change? Note that the company uses the same depreciation for tax and stockholder
reporting purposes.

## Net Income Free Cash Flow

a. -\$877.50\$472.50
b. -\$1,044.23\$368.55
c. -\$1,070.55\$354.38
d. -\$693.23\$420.53
e. -\$658.13\$491.40
ANS: A
This problem can be worked very easily--just multiply the increase in depreciation by (1-T) to get the decrease in net income, and then subtract this value from the change in
depreciation to get the change in free cash flow:

## Change in depreciation \$1,350

Tax rate 35.00%
Reduction in net income = Change in Depr'n (1 - Tax rate) -\$877.50
Increase in free cash flow = Change in Depr'n - Reduction in NI \$472.50

We can also get the answer the long way, which explains things in more detail:
Old New Change
Bonds \$3,500 \$3,500 \$0.00
Interest rate 6.50% 6.50% 0.00
Tax rate 35% 35% 0.00
Capex + NWC \$2,000 \$2,000 \$0.00
Sales \$11,250 \$11,250 \$0.00
Operating costs excluding depreciation \$4,500 \$4,500 \$0.00
Depreciation \$1,250 \$2,600 \$1,350.00
Operating income (EBIT) \$5,500 \$4,150 -\$1,350.00
Interest charges \$228 \$228 \$0.00
Taxable income \$5,273 \$3,923 -\$1,350.00
Taxes \$1,845 \$1,373 -\$472.50
Net income \$3,427 \$2,550 -\$877.50
Free cash flow = EBIT(1 - T) + Deprec - [Capex + NWC] \$2,825 \$3,298 \$472.50
Check on FCF: - FCF = Change in depreciation Tax rate \$472.50

We like this problem because it illustrates that an increase in depreciation will decrease the firm's
net income yet increase its free cash flow, and cash is king.

## PTS: 1 DIF: HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.
86. Watson Oil recently reported (in millions) \$8,2 50 of sales, \$5,750 of operating costs other than depreciation, and \$1,500 of depreciation. The company had \$3,2 00 of outstanding bon ds that carry a 5% interest rate, and its federal-plus-state income tax ra te was 35%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to make \$1,250 of capital expenditures on new fixed assets and to invest \$300 in net working capital. By how much did the firm's net income exceed its free cash flow?
a. \$66
b. \$58
c. \$54
d. \$52
e. \$53
ANS: C
Bonds \$3,200
Interest rate 5%
Tax rate 35%
Required capital expenditures (fixed assets) \$1,250
Required addition to net working capital \$300
Sales \$8,250.00
Operating costs excluding depr'n 5,750.00
Depreciation 1500.00
Operating income (EBIT) \$1,000.00
Interest charges 160.00
Taxable income (EBT) \$840.00
Taxes 294.00
Net income \$546.00

## FCF = EBIT(1 - T) + Depr'n - CapEx - Net WC

FCF = \$650.00 + \$1500.00 -\$1,250 -\$300 = \$600.00
Difference between net income and FCF = \$54.00

## PTS: 1 DIF: HARD NAT: Analytic skills

LOC: Students will acquire knowledge of financial statements, financial analysis, financial
forecasting, and cash flows. | Students will understand and be able to articulate the goals of the
firm, the role of the finance function in the enterprise's organization, and as an analyst using public
information.