Chapter 2

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

2-1

NI = $3,000,000; EBIT = $6,000,000; T = 40%; I = ? Need to set up an income statement and work from the bottom up. EBIT Interest EBT Taxes (40%) NI $6,000,000 1,000,000 $5,000,000 2,000,000 $3,000,000

EBT =

$3,000,000 $3,000,000 = (1 T) 0.6

Interest = EBIT - EBT = $6,000,000 - $5,000,000 = $1,000,000.

2-2

NI = $3,100,000; DEP = $500,000 NCF = NI + DEP = $3,100,000 + $500,000 = $3,600,000.

2-3

Corporate yield = 9%; T = 36% AT yield = 9%(1 - T) = 9%(0.64) = 5.76%.

2-4

Married Taxes = = =

Taxable Income = $102,000; Federal taxes = ?; $ 6,457.50 + ($102,000 - $43,050)0.28 $ 6,457.50 + ($58,950)0.28 $22,963.50.

2-5

Corporate bond yields 8%; Municipal bond yields 6%. Yield on muni Equivalent pre - tax yield = on taxable bond (1 T) 6% 8% = (1 T) 0.08 0.08 T = 0.06 0.08 T = 0.02 T = 25%.

2-6

EBIT = $170,000; LT debt = $300,000; AT cost of debt = 6%; Equity = $500,000; Cost of equity = 15%; T = 40%; EVA = ? EVA = EBIT(1 - T) - AT dollar cost of capital

2-7

= $170,000(1 - 0.4) - [(0.06 $300,000) + (0.15 $500,000)] = $102,000 - [$18,000 + $75,000] = $9,000. Income $365,000 Less Interest deduction (50,000) Plus: Dividends receiveda 4,500 Taxable income $319,500
a

For a corporation, 70 percent of dividends received are excluded from taxes; therefore, taxable dividends are calculated as $15,000(1 - 0.70) = $4,500. Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 = $107,855. After-tax income: Taxable income Taxes Plus Non-taxable dividends receivedb Net income
b

$319,500 (107,855) 10,500 $222,145

Non-taxable dividends are calculated as $15,000 0.7 = $10,500. The companys average tax

The companys marginal tax rate is 39 percent. rate is $107,855/$319,500 = 33.76% 33.8%.

2-8

a. Tax = $3,400,000 + ($10,500,000 - $10,000,000)(0.35) = $3,575,000. b. Tax = $1,000,000(0.35) = $350,000. c. Tax = ($1,000,000)(0.30)(0.35) = $105,000.

2-9

A-T yield on FLA bond = 5%. A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%. Check: Invest $10,000 @ 7.5% = $750 interest. Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50. A-T rate of return = $487.50/$10,000 = 4.875%.

A-T yield on AT&T preferred stock: A-T yield = 6% - Taxes = 6% - (0.3)(6%)(0.35) = 6% - 0.63% = 5.37%. Therefore, invest in AT&T preferred stock. We could make this a harder problem by asking for the tax rate that would cause the company to prefer the Florida bond or the AT&T bond.

2-10

Compare the after-tax returns of the two investments: Corporate bond = 0.09(1 - 0.36) = 0.0576 = 5.76%.

Answers and Solutions: 2 - 2

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

Municipal bond = 0.07 = 7%; therefore, choose the municipal bond over the corporate bond.

2-11

EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40% NI = ?; NCF = ?; OCF = ? First, determine net income by setting up an income statement: EBIT Interest EBT Taxes (40%) NI $750,000 0 $750,000 300,000 $450,000

NCF = NI + DEP = $450,000 + $200,000 = $650,000. OCF = EBIT(1 - T) + DEP = $750,000(0.6) + $200,000 = $650,000. Note that NCF = OCF because the firm is 100 percent equity financed.

2-12

Statements b, c, and d will all decrease the amount of cash on a companys balance sheet, while Statement a will increase cash through the sale of common stock. This is a source of cash through financing activities.

2-13

a. Because were interested in net cash flow available stockholders, we exclude common dividends paid. CF00 = NI available to common stockholders + Depreciation = $364 + $220 = $584.

to

common

The net cash flow number is larger than net income by the current years depreciation expense, which is a noncash charge. b. Balance of RE, December 31, 1999 Add: NI, 2000 Less: Div. paid to common stockholders Balance of RE, December 31, 2000 c. $1,520 million. d. Cash + Marketable securities = $15 million. e. Total current liabilities = $620 million. $1,302 364 (146) $1,520

2-14

a. Sales revenues Costs except depreciation (75%) Depreciation EBT Taxes (40%) Net income Add back depreciation

Income Statement $12,000,000 9,000,000 1,500,000 $ 1,500,000 600,000 $ 900,000 1,500,000

Answers and Solutions: 2 - 4

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

Net cash flow b. If depreciation would be zero. flow would rise thus increasing

$ 2,400,000 doubled, taxable income would fall to zero and taxes Thus, net income would decrease to zero, but net cash to $3,000,000. Menendez would save $600,000 in taxes, its cash flow:

CF = T(Depreciation) = 0.4($1,500,000) = $600,000. c. If depreciation were halved, taxable income would rise to $2,250,000 and taxes to $900,000. Therefore, net income would rise to $1,350,000, but net cash flow would fall to $2,100,000. d. You should prefer to have higher depreciation charges and higher cash flows. Net cash flows are the funds that are available to the owners to withdraw from the firm and, therefore, cash flows should be more important to them than net income. e. In the situation where depreciation doubled, net income fell by 100 percent. Since many of the measures banks and investors use to appraise a firms performance depend on net income, a decline in net income could certainly hurt both the firms stock price and its ability to borrow. For example, earnings per share is a common number looked at by banks and investors, and it would have declined by 100 percent, even though the firms ability to pay dividends and to repay loans would have improved.

2-15

This involves setting up the income statement and working from the bottom up. Sales Revenue* Cost of Goods Sold (60%) Depreciation Total Operating Costs EBIT Interest EBT Taxes (40%) NI * $2,500,000 1,500,000 500,000 $2,000,000 $ 500,000 100,000 $ 400,000 160,000 $ 240,000 = = = =

2,500,000 0.6 (Given) EBIT = EBT + Interest (Given) $240,000 $240,000 = EBT = (1 T) 0.6 (Given) EBIT $500,000 $1,000,000 $2,500,000.

Sales Revenue - COGS - Deprec. Sales Revenue - 0.6(Revenue) - $500,000 0.4 Revenue Revenue

2-16

a. NOPAT = EBIT(1 - Tax rate) = $150,000,000(0.6) = $90,000,000. Net operating Non -interest charging b. working capital = Current assets - current liabilities 99

= $360,000,000 - ($90,000,000 + $60,000,000) = $210,000,000. Net operating working capital00 = $372,000,000 - $180,000,000 = $192,000,000. Net plant Net operating c. Operating capital99 = and equipment + working capital = $250,000,000 + $210,000,000 = $460,000,000. Operating capital00 = $300,000,000 + $192,000,000 = $492,000,000. d. FCF = NOPAT - Net investment in operating capital = $90,000,000 - ($492,000,000 - $460,000,000) = $58,000,000. e. The large increase in dividends for 2000 can most likely be attributed to a large increase in free cash flow from 1999 to 2000, since FCF represents the amount of cash available to be paid out to stockholders after the company has made all investments in fixed assets, new products, and working capital necessary to sustain the business.

2-17

Prior Years Profit earned Carry-back credit Adjusted profit Taxes previously paid (40%) Tax refund: Taxes previously paid

1998 $150,000 150,000 $ 0 60,000 $ 60,000

1999 $150,000 150,000 $ 0 60,000 $ 60,000

Total check from U. S. Treasury = $60,000 + $60,000 = $120,000. Future Years Estimated profit Carry-forward credit Adjusted profit Taxes (at 40%) 2001 $150,000 150,000 $ 0 0 $ $ 2002 $150,000 150,000 0 0 2003 $150,000 50,000 $100,000 $ 40,000 2004 $150,000 0 $150,000 $ 60,000 2005 $150,000 0 $150,000 $ 60,000

2-18

2001 tax = $0, since the firm had a loss. used to offset future income.

The $95,000,000 loss will be

2002 tax = $0; $70,000,000 income offset by $70,000,000 of 2001 loss.

Answers and Solutions: 2 - 6

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

2003 taxable income is reduced by remaining $25,000,000 of 2001 loss, so 2003 taxable income = $55,000,000 - $25,000,000 = $30,000,000, and 2003 tax = (0.40)($30,000,000) = $12,000,000. 2004 tax = $80,000,000 0.4 = $32,000,000. 2005 tax = $0; $110,000,000 of loss can be carried back to offset income from 2003 and 2004, reducing taxes in those years to $0. The firm will get a refund of $12,000,000 + $32,000,000 = $44,000,000 for taxes paid in those years. The remaining $40,000,000 loss can be carried forward.

2-19

a. Taxes as a corporation: Income before salary & taxes Less salary Taxable income, corporate Total corporate tax Salary Less exemptions & deductions Taxable personal income Total personal tax Combined corp. & personal tax Taxes as a proprietorship: Total income Less exemptions & deductions Taxable personal income Total proprietorship tax Advantage to corporation

2001 $70,000 (52,000) $18,000 $ 2,700 $52,000 (19,600) $32,400 $ 4,860 $ 7,560

2002 $95,000 (52,000) $43,000 $ 6,450 $52,000 (19,600) $32,400 $ 4,860 $11,310

2003 $110,000 (52,000) $ 58,000 $ 9,500 $ 52,000 (19,600) $32,400 $ 4,860 $ 14,360

$70,000 (19,600) $50,400 $ 8,516 $ 956

$95,000 (19,600) $75,400 $15,516 $ 4,206

$110,000 (19,600) $ 90,400 $ 19,716 $ 5,356

b. On the basis of these figures, Visscher should incorporate, since her expected tax liability is less each year as a corporation and since she plans to retain all income in excess of her salary in the business. However, if Visscher planned to withdraw earnings in the future, she would have to consider the effects of double taxation on dividends she would receive when she withdrew earnings. Of course, Visscher could avoid double taxation simply by raising her salary.

2-20

a. Calculation of gross income: Salary Dividend Income Interest Income (corp. bonds only) ST capital gains Gross Income (excluding LT capital gains) LT capital gains** **Applicable tax rate = 20%. 2000 $ 82,000 12,000 5,000 1,000 $100,000 13,000

Calculation of taxable income: Gross income Exemption Deductions Taxable income (excluding LT capital gains) Personal tax

$100,000 (2,750) (5,000) $ 92,250 $ 25,977

Tax = $14,138.50 + ($92,250 - $62,450)(0.31) + $13,000(0.20) = $14,138.50 + $9,238 + $2,600 = $25,976.50 $25,977. b. Marginal tax rate = 31%. Average tax rate = $25,977/$105,250* = 24.7%. One could argue that the average rate is really lower, because the base should consider the deductions and exemptions. *Includes $13,000 $105,250). c. After-tax returns: Disney = (0.08)($5,000) - (0.31)($5,000)(0.08) = $276. FLA = (0.06)($5,000) - 0 = $300. Viewed another way, the Disney bonds provide an after-tax yield of 8%(1 - T) = 8%(1 - 0.31) = 8%(0.69) = 5.52%. The Florida bonds provide an after-tax yield of 6 percent; hence they are better for her. d. 6% = 8%(1 - T). 6 = 8 - 8T 8T = 2 T = 2/8 = 25%. At a tax rate less than 25 percent, Mary would be better off holding 8 percent taxable bonds, but at a tax rate over 25 percent, she would be better off holding tax-exempt municipal bonds. Given our progressive tax rate system, it makes sense for wealthy people to hold tax-exempt bonds, but not for those with lower incomes and consequently lower tax rates. Now solve for T: long-term capital gain; ($92,250 + $13,000 =

Answers and Solutions: 2 - 8

Harcourt, Inc. items and derived items copyri ght 2000 by Harcourt, Inc.

SPREADSHEET PROBLEM

2-21

The detailed solution for the spreadsheet problem is available both on the instructors resource CD-ROM and on the instructors side of the Harcourt College Publishers web site, http://www.harcourtcollege.com/finance/ brigham.

CYBERPROBLEM

2-22

The detailed solution for the cyberproblem is available on the instructors side of the Harcourt College Publishers web site, http://www. harcourtcollege.com/finance/brigham.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.Computer/Internet Applications: 2 - 9

INTEGRATED CASE

DLeon Inc., Part I Section 1: Financial Statements

2-23 DONNA JAMISON, A 1995 GRADUATE OF THE UNIVERSITY OF FLORIDA WITH FOUR YEARS OF BANKING EXPERIENCE, WAS RECENTLY BROUGHT IN AS ASSISTANT TO THE CHAIRMAN OF THE BOARD OF DLEON INC., A SMALL FOOD PRODUCER THAT OPERATES IN NORTH FLORIDA AND WHOSE SPECIALTY IS HIGH-QUALITY PECAN AND OTHER NUT PRODUCTS SOLD IN THE SNACK-FOODS MARKET. DLEONS PRESIDENT, AL WATKINS, DECIDED IN 1999 TO UNDERTAKE A MAJOR EXPANSION AND TO GO NATIONAL IN COMPETITION WITH FRITO-LAY, EAGLE, AND OTHER MAJOR SNACKFOOD COMPANIES. WATKINS FELT THAT DLEONS PRODUCTS WERE OF A HIGHER QUALITY THAN THE COMPETITIONS, THAT THIS QUALITY DIFFERENTIAL WOULD ENABLE IT TO CHARGE A PREMIUM PRICE, AND THAT THE END RESULT WOULD BE GREATLY INCREASED SALES, PROFITS, AND STOCK PRICE. THE COMPANY DOUBLED ITS PLANT CAPACITY, OPENED NEW SALES OFFICES OUTSIDE ITS HOME TERRITORY, AND LAUNCHED AN EXPENSIVE ADVERTISING CAMPAIGN. DLEONS RESULTS WERE NOT SATISFACTORY, TO PUT IT MILDLY. ITS BOARD OF DIRECTORS, WHICH CONSISTED OF ITS PRESIDENT AND VICEPRESIDENT PLUS ITS MAJOR STOCKHOLDERS (WHO WERE ALL LOCAL BUSINESS PEOPLE), WAS MOST UPSET WHEN DIRECTORS LEARNED HOW THE EXPANSION WAS GOING. SUPPLIERS WERE BEING PAID LATE AND WERE UNHAPPY, AND THE BANK AS A RESULT, WATKINS WAS INFORMED THAT CHANGES WOULD WAS COMPLAINING ABOUT THE DETERIORATING SITUATION AND THREATENING TO CUT OFF CREDIT. HAVE TO BE MADE, AND QUICKLY, OR HE WOULD BE FIRED. ALSO, AT THE BOARDS INSISTENCE DONNA JAMISON WAS BROUGHT IN AND GIVEN THE JOB OF ASSISTANT TO FRED CAMPO, A RETIRED BANKER WHO WAS DLEONS CHAIRMAN AND LARGEST STOCKHOLDER. CAMPO AGREED TO GIVE UP A FEW OF HIS GOLFING DAYS AND TO HELP NURSE THE COMPANY BACK TO HEALTH, WITH JAMISONS HELP. JAMISON BEGAN BY GATHERING THE FINANCIAL STATEMENTS AND OTHER DATA GIVEN IN TABLES IC2-1, IC2-2, IC2-3, AND IC2-4. JAMISONS ASSISTANT, AND YOU MUST HELP HER QUESTIONS FOR CAMPO. (NOTE: ASSUME THAT YOU ARE THE FOLLOWING ANSWER

WE WILL CONTINUE WITH THIS CASE IN

CHAPTER 3, AND YOU WILL FEEL MORE COMFORTABLE WITH THE ANALYSIS THERE, BUT ANSWERING THESE QUESTIONS WILL HELP PREPARE YOU FOR CHAPTER 3. PROVIDE CLEAR EXPLANATIONS, NOT JUST YES OR NO ANSWERS!) Integrated Case: 2 - 10 Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

TABLE IC2-1. BALANCE SHEETS

2000 ASSETS CASH ACCOUNTS RECEIVABLE INVENTORIES TOTAL CURRENT ASSETS GROSS FIXED ASSETS LESS ACCUMULATED DEPRECIATION NET FIXED ASSETS TOTAL ASSETS LIABILITIES AND EQUITY ACCOUNTS PAYABLE NOTES PAYABLE ACCRUALS TOTAL CURRENT LIABILITIES LONG-TERM DEBT COMMON STOCK (100,000 SHARES) RETAINED EARNINGS TOTAL EQUITY TOTAL LIABILITIES AND EQUITY $ 7,282 632,160 1,287,360 $1,926,802 1,202,950 263,160 $ 939,790 $2,866,592 $ 1999 57,600 351,200 715,200 $1,124,000 491,000 146,200 $ 344,800 $1,468,800

524,160 720,000 489,600 $1,733,760 1,000,000 460,000 (327,168) $ 132,832 $2,866,592

145,600 200,000 136,000 $ 481,600 323,432 460,000 203,768 $ 663,768 $1,468,800

TABLE IC2-2. INCOME STATEMENTS

SALES COST OF GOODS SOLD OTHER EXPENSES DEPRECIATION TOTAL OPERATING COSTS EBIT INTEREST EXPENSE EBT TAXES (40%) NET INCOME EPS DPS BOOK VALUE PER SHARE STOCK PRICE SHARES OUTSTANDING TAX RATE LEASE PAYMENTS SINKING FUND PAYMENTS 2000 $5,834,400 5,728,000 680,000 116,960 $6,524,960 ($ 690,560) 176,000 ($ 866,560) (346,624) ($ 519,936) ($5.199) $0.110 $1.328 $2.25 100,000 40.00% 40,000 0 1999 $3,432,000 2,864,000 340,000 18,900 $3,222,900 $ 209,100 62,500 $ 146,600 58,640 $ 87,960 $0.880 $0.220 $6.638 $8.50 100,000 40.00% 40,000 0

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 11

TABLE IC2-3. STATEMENT OF RETAINED EARNINGS, 2000

BALANCE OF RETAINED EARNINGS, 12/31/99 ADD: NET INCOME, 2000 LESS: DIVIDENDS PAID BALANCE OF RETAINED EARNINGS, 12/31/00 $203,768 (519,936) (11,000) ($327,168)

TABLE IC2-4. STATEMENT OF CASH FLOWS, 2000

OPERATING ACTIVITIES NET INCOME ADDITIONS (SOURCES OF CASH) DEPRECIATION INCREASE IN ACCOUNTS PAYABLE INCREASE IN ACCRUALS SUBTRACTIONS (USES OF CASH) INCREASE IN ACCOUNTS RECEIVABLE INCREASE IN INVENTORIES NET CASH PROVIDED BY OPERATING ACTIVITIES LONG-TERM INVESTING ACTIVITIES CASH USED TO ACQUIRE FIXED ASSETS FINANCING ACTIVITIES INCREASE IN NOTES PAYABLE INCREASE IN LONG-TERM DEBT PAYMENT OF CASH DIVIDENDS NET CASH PROVIDED BY FINANCING ACTIVITIES SUM: NET DECREASE IN CASH PLUS: CASH AT BEGINNING OF YEAR CASH AT END OF YEAR ($ 519,936) 116,960 378,560 353,600 (280,960) (572,160) ($ 523,936)

($

711,950)

520,000 676,568 (11,000) $1,185,568 ($ 50,318) 57,600 $ 7,282

Integrated Case: 2 - 12

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

A.

WHAT EFFECT DID THE EXPANSION HAVE ON SALES, NET OPERATING PROFIT AFTER TAXES (NOPAT), NET OPERATING WORKING CAPITAL (NOWC), OPERATING CAPITAL, AND NET INCOME?

ANSWER:

[S2-1 THROUGH S2-9 PROVIDE BACKGROUND INFORMATION. THROUGH S2-13 HERE.] SALES INCREASED BY $2,402,400.

THEN SHOW S2-10

NOPAT00 = EBIT (1 - TAX RATE) = (-$690,560)(0.6) = ($414,336). NOPAT99 = $209,100(0.6) = $125,460. NOPAT = ($414,336) - $125,460 = ($539,796). NOPAT DECREASED BY $539,796. ACCOUNTS ACCOUNTS NOWC00 = CASH + + INVENTORIES PAYABLE + ACCRUALS RECEIVABLE = ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600) = $913,042. NOWC99 = ($57,600 + $351,200 + $715,200) - ($145,600 + $136,000) = $842,400. NOWC = $913,042 - $842,400 = $70,642. NET OPERATING WORKING CAPITAL INCREASED BY $70,642. OC00 = NET OPERATING WORKING CAPITAL + NET PLANT AND EQUIPMENT = $913,042 + $939,790 = $1,852,832. OC99 = $842,400 + $344,800 = $1,187,200. OC = $1,852,832 - $1,187,200 = $665,632. OPERATING CAPITAL INCREASED SUBSTANTIALLY BY $665,632 FROM 1999 TO 2000. NI00 - NI99 = ($519,936) - $87,960 = ($607,896). THERE WAS A HUGE DROP, -$607,896, IN NET INCOME DURING 2000.

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 13

B.

WHAT EFFECT DID THE COMPANY S EXPANSION HAVE ON ITS NET CASH FLOW, OPERATING CASH FLOW, AND FREE CASH FLOW?

ANSWER:

[SHOW S2-14 AND S2-15 HERE.] NCF00 = NI + DEP = ($519,936) + $116,960 = ($402,976). NCF99 = $87,960 + $18,900 = $106,860. OCF00 = EBIT(1 - T) + DEP = (-$690,560)(0.6) + $116,960 = ($297,376). OCF99 = ($209,100)(0.6) + $18,900 = $144,360. FCF00 = NOPAT - NET INVESTMENT IN OPERATING CAPITAL = (-$414,336) - ($1,852,832 - $1,187,200) = (-$414,336) - $665,632 = ($1,079,968). BOTH NCF AND OCF ARE NEGATIVE IN 2000, BUT THEY WERE POSITIVE IN 1999. FREE CASH FLOW WAS -$1,079,968 IN 2000.

C.

JAMISON ALSO HAS ASKED YOU TO ESTIMATE DLEONS EVA. THAT THE AFTER-TAX COST OF CAPITAL WAS 11 PERCENT

SHE ESTIMATES IN 1999 AND

13 PERCENT IN 2000. ANSWER: [SHOW S2-16 THROUGH S2-18 HERE.] EVA00 = EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL = (-$690,560)(0.6) - ($1,852,832)(0.13) = ($655,204). EVA99 = EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL = ($209,100)(0.6) - ($1,187,200)(0.11) = ($5,132). IN 1999, EVA WAS SLIGHTLY NEGATIVE; HOWEVER IN 2000 EVA WAS

SIGNIFICANTLY NEGATIVE.

Integrated Case: 2 - 14

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

D.

LOOKING AT DLEONS STOCK PRICE TODAY, WOULD YOU CONCLUDE THAT THE EXPANSION INCREASED OR DECREASED MVA?

ANSWER:

[SHOW S2-19 AND S2-20 HERE.] DECREASED BY OVER 73

DURING THE LAST YEAR, STOCK PRICE HAS THUS ONE WOULD CONCLUDE THAT THE

PERCENT,

EXPANSION HAS DECREASED MVA.

E.

DLEON PURCHASES MATERIALS ON 30-DAY TERMS, MEANING THAT IT IS SUPPOSED TO PAY FOR PURCHASES WITHIN 30 DAYS OF RECEIPT. JUDGING FROM ITS 2000 EXPLAIN.

BALANCE SHEET, DO YOU THINK DLEON PAYS SUPPLIERS ON TIME? IF NOT, WHAT PROBLEMS MIGHT THIS LEAD TO? ANSWER: [SHOW S2-21 HERE.]

DLEON PROBABLY DOES NOT PAY ITS SUPPLIERS ON TIME

JUDGING FROM THE FACT THAT ITS ACCOUNTS PAYABLES BALANCE INCREASED BY 260 PERCENT FROM THE P AST YEAR, WHILE SALES INCREASED BY ONLY 70 PERCENT. COMPANY RECORDS WOULD SHOW IF THEY PAID SUPPLIERS ON TIME. BY NOT PAYING SUPPLIERS ON TIME, DLEON IS STRAINING ITS RELATIONSHIP WITH THEM. IF DLEON CONTINUES TO BE LATE, EVENTUALLY SUPPLIERS WILL CUT THE COMPANY OFF AND PUT IT INTO BANKRUPTCY.

F.

DLEON

SPENDS

MONEY

FOR

LABOR,

MATERIALS,

AND

FIXED

ASSETS

(DEPRECIATION) TO MAKE PRODUCTS, AND STILL MORE MONEY TO SELL THOSE PRODUCTS. THEN, IT MAKES SALES THAT RESULT IN RECEIVABLES, WHICH EVENTUALLY RESULT IN CASH INFLOWS. DOES IT APPEAR THAT DLEONS SALES PRICE EXCEEDS ITS COSTS PER UNIT SOLD? HOW DOES THIS AFFECT THE CASH BALANCE? ANSWER: [SHOW S2-22 HERE.] IT DOES NOT APPEAR THE DLEONS SALES PRICE EXCEEDS

ITS COSTS PER UNIT SOLD AS INDICATED IN THE INCOME STATEMENT. THE COMPANY IS SPENDING MORE CASH THAN IT IS TAKING IN AND, AS A RESULT, THE CASH ACCOUNT BALANCE HAS DECREASED.

G.

SUPPOSE DLEONS SALES MANAGER TOLD THE SALES STAFF TO START OFFERING 60-DAY CREDIT TERMS RATHER THAN THE 30-DAY TERMS NOW BEING OFFERED. DLEONS COMPETITORS REACT BY OFFERING SIMILAR TERMS, SO SALES REMAIN CONSTANT. WHAT EFFECT WOULD THIS HAVE ON THE CASH ACCOUNT? HOW WOULD

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

Integrated Case: 2 - 15

THE CASH ACCOUNT BE AFFECTED IF SALES DOUBLED AS A RESULT OF THE CREDIT POLICY CHANGE? ANSWER: [SHOW S2-23 AND S2-24 HERE.] BY EXTENDING THE SALES CREDIT TERMS, IT

WOULD TAKE LONGER FOR DLEON TO RECEIVE ITS MONEY--ITS CASH ACCOUNT WOULD DECREASE AND ITS ACCOUNTS RECEIVABLE WOULD BUILD UP. BECAUSE COLLECTIONS WOULD SLOW, ACCOUNTS PAYABLE WOULD BUILD UP TOO. INVENTORY WOULD HAVE TO BE BUILT UP AND POSSIBLY FIXED ASSETS TOO BEFORE SALES COULD BE INCREASED. CASH WOULD DECLINE. RISE. ACCOUNTS RECEIVABLE WOULD RISE AND

MUCH LATER, WHEN COLLECTIONS INCREASED CASH WOULD

DLEON WOULD PROBABLY NEED TO BORROW OR SELL STOCK TO FINANCE

THE EXPANSION.

H.

CAN YOU IMAGINE A SITUATION IN WHICH THE SALES PRICE EXCEEDS THE COST OF PRODUCING AND SELLING A UNIT OF OUTPUT, YET A DRAMATIC INCREASE IN SALES VOLUME CAUSES THE CASH BALANCE TO DECLINE?

ANSWER:

THIS SITUATION IS LIKELY TO OCCUR AS SUGGESTED IN THE SECOND PART OF THE ANSWER TO QUESTION G.

I.

IN GENERAL, COULD A COMPANY LIKE DLEON INCREASE SALES WITHOUT A CORRESPONDING INCREASE IN INVENTORY AND OTHER ASSETS? WOULD THE ASSET

INCREASE OCCUR BEFORE THE INCREASE IN SALES, AND, IF SO, HOW WOULD THAT AFFECT THE CASH ACCOUNT AND THE STATEMENT OF CASH FLOWS? ANSWER: GENERALLY, A COMPANY LIKE DLEON COULD NOT BE EXPECTED TO INCREASE ITS SALES WITHOUT A CORRESPONDING INCREASE IN INVENTORY AND OTHER ASSETS. (SEE QUESTION G.)

J.

DID DLEON FINANCE ITS EXPANSION PROGRAM WITH INTERNALLY GENERATED FUNDS (ADDITIONS TO RETAINED EARNINGS PLUS DEPRECIATION) OR WITH

EXTERNAL CAPITAL? HOW DOES THE CHOICE OF FINANCING AFFECT THE COMPANYS FINANCIAL STRENGTH? ANSWER: [SHOW S2-25 HERE.] DLEON FINANCED ITS EXPANSION WITH EXTERNAL CAPITAL IN PARTICULAR, DLEON ISSUED

RATHER THAN INTERNALLY GENERATED FUNDS.

Integrated Case: 2 - 16

Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.

LONG-TERM DEBT RATHER THAN COMMON STOCK, WHICH REDUCED ITS FINANCIAL STRENGTH.

K.

REFER TO TABLES IC2-2 AND IC2-4.

SUPPOSE DLEON BROKE EVEN IN 2000 IN

THE SENSE THAT SALES REVENUES EQUALED TOTAL OPERATING COSTS PLUS INTEREST CHARGES. WOULD THE ASSET EXPANSION HAVE CAUSED THE COMPANY TO

EXPERIENCE A CASH SHORTAGE THAT REQUIRED IT TO RAISE EXTERNAL CAPITAL? ANSWER: [SHOW S2-26 HERE.] EVEN IF DLEON HAD BROKEN EVEN IN 2000, THE FIRM

WOULD HAVE HAD TO FINANCE AN INCREASE IN ASSETS.

L.

IF DLEON STARTED DEPRECIATING FIXED ASSETS OVER 7 YEARS RATHER THAN 10 YEARS, WOULD THAT AFFECT (1) THE PHYSICAL STOCK OF ASSETS, (2) THE BALANCE SHEET ACCOUNT FOR FIXED ASSETS, (3) THE COMPANYS REPORTED NET INCOME, AND (4) ITS CASH POSITION? ASSUME THE SAME DEPRECIATION METHOD

IS USED FOR STOCKHOLDER REPORTING AND FOR TAX CALCULATIONS, AND THE ACCOUNTING CHANGE HAS NO EFFECT ON ASSETS PHYSICAL LIVES.

ANSWER:

[SHOW S2-27 HERE.]

THIS WOULD HAVE NO EFFECT ON THE PHYSICAL STOCK OF

THE ASSETS; HOWEVER, THE BALANCE SHEET ACCOUNT FOR NET FIXED ASSETS WOULD DECLINE BECAUSE ACCUMULATED DEPRECIATION WOULD INCREASE DUE TO DEPRECIATING ASSETS OVER 7 YEARS VERSUS 10 YEARS. EXPENSE WOULD INCREASE, NET INCOME WOULD DECLINE. CASH POSITION WOULD INCREASE, BECAUSE ITS TAX BECAUSE DEPRECIATION FINALLY, THE FIRMS PAYMENTS WOULD BE

REDUCED.

M.

EXPLAIN HOW (1) INVENTORY VALUATION METHODS, (2) THE ACCOUNTING POLICY REGARDING EXPENSING VERSUS CAPITALIZING RESEARCH AND DEVELOPMENT, AND (3) THE POLICY WITH REGARD TO FUNDING FUTURE RETIREMENT PLAN COSTS (RETIREMENT PAY AND RETIREES HEALTH BENEFITS) COULD AFFECT THE

FINANCIAL STATEMENTS. ANSWER: [SHOW S2-28 HERE.] INVENTORY VALUATION METHODS, SUCH AS LIFO AND FIFO,

CAUSE COST OF GOODS SOLD TO BE HIGHER OR LOWER, WHICH THEN AFFECTS NET INCOME, TAXES, AND THE BALANCE SHEET INVENTORY FIGURE.

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Integrated Case: 2 - 17

IF RESEARCH AND DEVELOPMENT COSTS ARE CAPITALIZED, THEY REDUCE THE CURRENT EXPENSE THAT INCREASES NET INCOME AND TAXES. ASSETS TO APPEAR LARGER. WITH RESPECT TO RETIREMENT PLAN COSTS, A COMPANY CAN FUND THE RETIREMENT PLAN, WHICH MEANS PAY NOW FOR FUTURE COSTS, OR PUT OFF REPORTING THE COSTS UNTIL PEOPLE RETIRE. THIS CAUSES

N.

DLEONS STOCK SELLS FOR $2.25 PER SHARE EVEN THOUGH THE COMPANY HAD LARGE LOSSES. DOES THE POSITIVE STOCK PRICE INDICATE THAT SOME

INVESTORS ARE IRRATIONAL? ANSWER: [SHOW S2-29 HERE.] THE POSITIVE STOCK PRICE DOES NOT INDICATE THAT RATHER, THE POSITIVE STOCK PRICE MEANS

SOME INVESTORS ARE IRRATIONAL.

THAT PEOPLE EXPECT THINGS TO GET BETTER IN THE FUTURE.

O.

DLEON

FOLLOWED

THE

STANDARD

PRACTICE

OF

PAYING

DIVIDENDS

ON

QUARTERLY BASIS.

IT PAID A DIVIDEND DURING THE FIRST TWO QUARTERS OF

2000, THEN ELIMINATED THE DIVIDEND WHEN MANAGEMENT REALIZED THAT A LOSS WOULD BE INCURRED FOR THE YEAR. THE DIVIDEND WAS CUT BEFORE THE LOSSES

WERE ANNOUNCED, AND AT THAT POINT THE STOCK PRICE FELL FROM $8.50 TO $3.50. WHY WOULD AN $0.11, OR EVEN A $0.22, DIVIDEND REDUCTION LEAD TO A $5.00 STOCK PRICE REDUCTION?

ANSWER:

[SHOW S2-30 HERE.]

THE DIVIDEND CUT WAS A SIGNAL THAT MANAGEMENT STOCK VALUES DEPEND ON FUTURE

THINKS OPERATIONS ARE IN TROUBLE. PROFITS AND DIVIDENDS.

THE DIVIDEND CUT LOWERED EXPECTATIONS FOR

FUTURE PROFITS THAT CAUSED THE STOCK PRICE TO DECLINE.

P.

EXPLAIN HOW EARNINGS PER SHARE, DIVIDENDS PER SHARE, AND BOOK VALUE PER SHARE ARE CALCULATED, AND WHAT THEY MEAN. WHY DOES THE MARKET PRICE

PER SHARE NOT EQUAL THE BOOK VALUE PER SHARE? ANSWER: NET INCOME DIVIDED BY SHARES OUTSTANDING EQUALS EARNINGS PER SHARE. DIVIDENDS DIVIDED BY SHARES OUTSTANDING EQUALS DIVIDENDS PER SHARE, WHILE BOOK VALUE PER SHARE IS CALCULATED AS COMMON EQUITY DIVIDED BY SHARES OUTSTANDING.

Integrated Case: 2 - 18

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MARKET PRICE PER SHARE DOES NOT EQUAL BOOK VALUE PER SHARE.

THE

MARKET VALUE OF A STOCK REFLECTS FUTURE PROFITABILITY, WHILE BOOK VALUE PER SHARE REPRESENTS HISTORICAL COST.

Q.

HOW MUCH NEW MONEY DID DLEON BORROW FROM ITS BANK DURING 2000? MUCH ADDITIONAL CREDIT DID ITS SUPPLIERS EXTEND? TAXING AUTHORITIES?

HOW

ITS EMPLOYEES AND THE

ANSWER:

[SHOW S2-31 HERE.]

TO DETERMINE HOW MUCH MONEY THE COMPANY BORROWED

FROM THE BANK AND HOW MUCH CREDIT THE FIRM OBTAINED FROM ITS SUPPLIERS AND TAXING AUTHORITIES, ONE CAN EXAMINE THE STATEMENT OF CASH FLOWS AS SHOWN IN TABLE IC2-4. ACTIVITIES, WE SEE BY LOOKING IN THE SECTION TITLED FINANCING THAT THE FIRMS NOTES PAYABLE INCREASED BY

$520,000--THIS IS HOW MUCH IT BORROWED FROM THE BANK.

BY LOOKING IN

THE OPERATING ACTIVITIES SECTION UNDER ADDITIONS, WE SEE THAT THE FIRMS ACCOUNTS PAYABLE INCREASED BY $378,560--THIS IS THE AMOUNT OF CREDIT IT OBTAINED FROM SUPPLIERS. BY LOOKING IN THE OPERATING

ACTIVITIES SECTION UNDER ADDITIONS, WE SEE THAT THE FIRMS ACCRUALS INCREASED BY $353,600--ACCRUALS WOULD INCLUDE ACCRUED TAXES.

R.

IF YOU WERE DLEONS BANKER, OR THE CREDIT MANAGER OF ONE OF ITS SUPPLIERS, WOULD YOU BE WORRIED ABOUT YOUR JOB? IF YOU WERE A CURRENT

DLEON EMPLOYEE, A RETIREE, OR A STOCKHOLDER, SHOULD YOU BE CONCERNED? ANSWER: YES. IF THE STATEMENT OF CASH FLOWS IS EXAMINED, YOU CAN SEE THAT THE

NET CASH FLOW FROM OPERATIONS WAS A NEGATIVE $523,936--THE FIRM IS SPENDING MORE THAN IT IS TAKING IN. IF THE COMPANY GOES BANKRUPT, THE FOR EMPLOYEES, RETIREES, AND

BANK AND SUPPLIERS COULD SUFFER LOSSES.

STOCKHOLDERS, JOBS COULD BE LOST, RETIREE PENSIONS COULD BE CUT IF THE PLAN WERE NOT FULLY FUNDED, AND STOCKHOLDERS COULD LOSE THEIR

INVESTMENTS.

S.

THE 2000 INCOME STATEMENT SHOWS NEGATIVE TAXES, THAT IS, A TAX CREDIT. HOW MUCH TAXES WOULD THE COMPANY HAVE HAD TO PAY IN THE PAST TO ACTUALLY GET THIS CREDIT? IF TAXES PAID WITHIN THE LAST 2 YEARS HAD WOULD THIS HAVE

BEEN LESS THAN $346,624, WHAT WOULD HAVE HAPPENED?

AFFECTED THE STATEMENT OF CASH FLOWS AND THE ENDING CASH BALANCE?
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc. Integrated Case: 2 - 19

ANSWER:

[SHOW S2-32 HERE.]

FOR THE FIRM TO ACTUALLY OBTAIN THIS TAX CREDIT, IT IF

WOULD HAVE HAD TO PAY $346,624 IN TAXES DURING THE LAST TWO YEARS.

THE FIRMS TAX PAYMENTS DURING THE LAST TWO YEARS DID NOT ADD UP TO $346,624, IT WOULD NOT HAVE OBTAINED A FULL REFUND. RATHER, THE FIRM

WOULD HAVE HAD TO CARRY FORWARD THE AMOUNT OF ITS LOSS NOT CARRIED BACK IN ORDER TO REDUCE FUTURE TAXES, IF THE COMPANY BECOMES PROFITABLE. IF THE FIRM HAD NOT RECEIVED A FULL REFUND OF ITS TAXES, THE CASH DRAIN FROM OPERATIONS WOULD HAVE BEEN LARGER. THE FIRM WOULD HAVE HAD

TO MAKE THIS UP ELSEWHERE (BY BORROWING FROM THE BANK, ISSUING MORE BONDS, ETC.).

Section II: Taxes

T. WORKING WITH JAMISON HAS REQUIRED YOU TO PUT IN A LOT OF OVERTIME, SO YOU HAVE HAD VERY LITTLE TIME TO SPEND ON YOUR PRIVATE FINANCES. ITS

NOW APRIL 1, AND YOU HAVE ONLY TWO WEEKS LEFT TO FILE YOUR INCOME TAX RETURN. YOU HAVE MANAGED TO GET ALL THE INFORMATION TOGETHER THAT YOU D LEON PAID YOU A SALARY OF

WILL NEED TO COMPLETE YOUR RETURN.

$45,000, AND YOU RECEIVED $3,000 IN DIVIDENDS FROM COMMON STOCK THAT YOU OWN. YOU ARE SINGLE, SO YOUR PERSONAL EXEMPTION IS $2,750, AND

YOUR ITEMIZED DEDUCTIONS ARE $4,850. 1. ON THE BASIS OF THE INFORMATION ABOVE AND THE APRIL 2000 INDIVIDUAL TAX RATE SCHEDULE, WHAT IS YOUR TAX LIABILITY? ANSWER: [SHOW S2-33 THROUGH S2-37 HERE.] CALCULATION OF TAXABLE INCOME: SALARY DIVIDENDS PERSONAL EXEMPTION DEDUCTIONS TAXABLE INCOME $45,000 3,000 (2,750) (4,850) $40,400

TAX LIABILITY = $3,862.50 + ($40,400 - $25,750)(0.28) = $7,964.50 $7,965.

T.

2. WHAT ARE YOUR MARGINAL AND AVERAGE TAX RATES?

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Integrated Case: 2 - 20

ANSWER:

MARGINAL TAX RATE IS 28 PERCENT; AVERAGE TAX RATE = $7,965/$40,400 = 19.71% 19.7%.

U.

ASSUME

THAT

CORPORATION

HAS

$100,000

OF

TAXABLE

INCOME

FROM

OPERATIONS PLUS $5,000 OF INTEREST INCOME AND $10,000 OF DIVIDEND INCOME. ANSWER: WHAT IS THE COMPANYS TAX LIABILITY? CALCULATION OF THE COMPANYS TAX

[SHOW S2-38 THROUGH S2-40 HERE.] LIABILITY:

TAXABLE OPERATING INCOME $100,000 TAXABLE INTEREST INCOME 5,000 TAXABLE DIVIDEND INCOME (0.3 $10,000) 3,000 TOTAL TAXABLE INCOME $108,000 TAX = $22,250 + ($108,000 - $100,000)0.39 = $25,370. TAXABLE DIVIDEND INCOME = DIVIDENDS - EXCLUSION = $10,000 - 0.7($10,000) = $3,000.

V.

ASSUME THAT AFTER PAYING YOUR PERSONAL INCOME TAX AS CALCULATED IN PART T, YOU HAVE $5,000 TO INVEST. YOU HAVE NARROWED YOUR INVESTMENT

CHOICES DOWN TO CALIFORNIA BONDS WITH A YIELD OF 7 PERCENT OR EQUALLY RISKY EXXON BONDS WITH A YIELD OF 10 PERCENT. CHOOSE AND WHY? WHICH ONE SHOULD YOU

AT WHAT MARGINAL TAX RATE WOULD YOU BE INDIFFERENT TO

THE CHOICE BETWEEN CALIFORNIA AND EXXON BONDS? ANSWER: [SHOW S2-41 THROUGH S2-44 HERE.] EXXON = 0.10($5,000) - (0.10)($5,000)(0.28) = $360. CALIFORNIA = 0.07($5,000) - $0 = $350. ALTERNATIVELY, CALCULATE AFTER-TAX YIELDS: A-T YIELDEXXON = 10.0%(1 - T) = 10%(1 - 0.28) = 7.2%. A-T YIELDCALIF. = 7.0%.

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Integrated Case: 2 - 21

AT WHAT MARGINAL TAX RATE WOULD YOU BE INDIFFERENT? 7.0% = 10.0%(1 - T). SOLVE FOR T.

7.0% = 10.0% - 10.0%(T) 10.0%(T) = 3% T = 30%.

Integrated Case: 2 - 22

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