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Modern Finance Key Essay

4031 words - 17 pages

CHAPTER 2
FINANCIAL STATEMENTS AND CASH FLOW

Answers to Concepts Review and Critical Thinking Questions

1. True. Every asset can be converted to cash at some price. However, when we are referring to a liquid asset, the added assumption that the asset can be quickly converted to cash at or near market value is important.

2. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to ...view middle of the document...

6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative.

7. It’s probably not a good sign for an established company to have negative cash flow from operations, but it would be fairly ordinary for a start-up, so it depends.

8. For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if the company becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased.

9. If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest and principal, its cash flow to creditors will be negative.

10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives.
Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.

Basic

1. To find owners’ equity, we must construct a balance sheet as follows:

Balance Sheet
CA $ 5,700 CL $ 4,400
NFA 27,000 LTD 12,900
OE ??
TA $32,700 TL & OE $32,700

We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $32,700. We also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so owner’s equity is:

OE = $32,700 –12,900 – 4,400 = $15,400

NWC = CA – CL = $5,700 – 4,400 = $1,300

2. The income statement for the company is:

Income Statement
Sales $387,000
Costs 175,000
Depreciation 40,000
EBIT $172,000
Interest 21,000
EBT $151,000
Taxes 52,850
Net income $ 98,150


One equation for net income is:

Net income = Dividends + Addition to retained earnings

Rearranging, we get:

Addition to retained earnings = Net income – Dividends
Addition to retained earnings = $98,150 – 30,000
Addition to retained earnings = $68,150

3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get:

CA =...

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