Chapter 2
Financial Statements, Cash Flow, and Taxes
ANSWERS TO END-OF-CHAPTER QUESTIONS



2-1 a. The annual report is a report issued annually by a corporation to its stockholders. It contains basic financial statements, as well as management’s opinion of the past year’s operations and the firm’s future prospects. A firm’s balance sheet is a statement of the firm’s financial position at a specific point in time. It specifically lists the firm’s assets on the left-hand side of the balance sheet, while the right-hand side shows its liabilities and equity, or the claims against these assets. An income statement is a statement summarizing the firm’s revenues and expenses over an accounting period. Net sales are shown at the top of each statement, after which various costs, including income taxes, are subtracted to obtain the net income available to common stockholders. The bottom of the statement reports earnings and dividends per share.

b. Common Stockholders’ Equity (Net Worth) is the capital supplied by common stockholders--capital stock, paid-in capital, retained earnings, and, occasionally, certain reserves. Paid-in capital is the difference between the stock’s par value and what stockholders paid when they bought newly issued shares. Retained earnings is the portion of the firm’s earnings that have been saved rather than paid out as dividends.

c. The statement of retained earnings shows how much of the firm’s earnings were retained in the business rather than paid out in dividends. Note that retained earnings represents a claim against assets, not assets per se. Firms retain earnings primarily to expand the business, not to accumulate cash in a bank account. The statement of cash flows reports the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period.

d. Depreciation is a non-cash charge against tangible assets, such as buildings or machines. It is taken for the purpose of showing an asset’s estimated dollar cost of the capital equipment used up in the production process. Amortization is a non-cash charge against intangible assets, such as goodwill. EBITDA is earnings before interest, taxes, depreciation, and amortization.

e. Operating current assets are the current assets used to support operations, such as cash, accounts receivable, and inventory. It does not include short-term investments. Operating current liabilities are the current liabilities that are a natural consequence of the firm’s operations, such as accounts payable and accruals. It does not include notes payable or any other short-term debt that charges interest. Net operating working capital is operating current minus operating current liabilities. Operating capital is sum of net operating working capital and operating long-term assets, such as net plant and equipment. Operating capital also is equal to the net amount of capital raised from investors. This is the amount of interest-bearing debt plus preferred stock plus common equity minus short-term investments.

f. Accounting profit is a firm’s net income as reported on its income statement. Net cash flow, as opposed to accounting net income, is the sum of net income plus non-cash adjustments. Operating cash is defined as the difference between sales revenues and cash operating expenses, after taxes on operating income. NOPAT, net operating profit after taxes, is the amount of profit a company would generate if it had no debt and no financial assets. Free cash flow is the cash flow actually available for distribution to investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations.

g. Market value added is the difference between the market value of the firm (i.e., the sum of the market value of common equity, the market value of debt, and the market value of preferred stock) and the book value of the firm’s common equity, debt, and preferred stock. If the book values of debt and preferred stock are equal to their market values, then MVA is also equal to the difference between the market value of equity and the amount of equity capital that investors supplied. Economic value added represents the residual income that remains after the cost of all capital, including equity capital, has been deducted.

h. A progressive tax means the higher one’s income, the larger the percentage paid in taxes. Taxable income is defined as gross income less a set of exemptions and deductions which are spelled out in the instructions to the tax forms individuals must file.

i. Marginal tax rate is defined as the tax rate on the last unit of income. Average tax rate is calculated by taking the total amount of tax paid divided by taxable income.

j. Bracket creep is a situation that occurs when progressive tax rates combine with inflation to cause a greater portion of each taxpayer’s real income to be paid as taxes.

k. Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less) than its purchase price.

l. Ordinary corporate operating losses can be carried backward for 2 years or forward for 20 years to offset taxable income in a given year.

m. Improper accumulation is the retention of earnings by a business for the purpose of enabling stockholders to avoid personal income taxes on dividends.

n. An S corporation is a small corporation which, under Subchapter S of the Internal Revenue Code, elects to be taxed as a proprietorship or a partnership yet retains limited liability and other benefits of the corporate form of organization.

2-2 The four financial statements contained in most annual reports are the balance sheet, income statement, statement of retained earnings, and statement of cash flows.

2-3 No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the firm’s assets.

2-4 The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 2001. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2001. The income statement, on the other hand, reports on the firm’s operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2001, would represent the firm’s sales over the period from January 1, 2001, through December 31, 2001, not just sales for December 31, 2001.

2-5 The emphasis in accounting is on the determination of accounting income, or net income, while the emphasis in finance is on net cash flow. Net cash flow is the actual net cash that a firm generates during some specified period. The value of an asset (or firm) is determined by the cash flows generated. Cash is necessary to purchase assets to continue operations and to pay dividends. Thus, financial managers should strive to maximize cash flows available to investors over the long run.
Although companies with relatively high accounting profits generally have a relatively high cash flow, the relationship is not precise. A business’s net cash flow generally differs from net income because some of the expenses and revenues listed on the income statement are not paid out or received in cash during the year. The relationship between net cash flow and net income can be expressed as:

Net cash flow = Net income + Non-cash charges - Non-cash revenues.

The primary example of non-cash charges is depreciation. This item reduces net income but is not paid out in cash, so we add it back to net income when calculating net cash flow. Likewise, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash flow. Typically, though, deprecia-tion represents the largest non-cash item, and other items generally net to zero. Therefore, unless otherwise indicated, we will assume that non-cash items other than depreciation sum to zero. Given this assumption, net cash flow is equal to net income plus depreciation.

2-6 Operating cash flow arises from normal, ongoing operations, whereas net cash flow reflects both operating and financing decisions. Thus, operating cash flow is defined as the difference between sales revenues and operating expenses paid, after taxes on operating income. Operating cash flow can be calculated as follows:

Operating cash flow = Operating income (1 - T) + Depreciation.

Note that net cash flow also can be calculated as follows:

Net cash flow = Operating cash flow - (Interest charges)(1 - T).

2-7 Accountants translate physical quantities into numbers when they construct the financial statements. The numbers shown on balance sheets generally represent historical costs. When examining a set of financial statements, one should keep in mind the physical reality that lies behind the numbers, and the fact that the translation from physical assets to numbers is far from precise.

2-8 Investors (both debt and equity investors) use financial statements to make intelligent decisions about what firms to invest in, managers need financial statements to operate their businesses, and taxing authorities need them to assess taxes.

2-9 Operating capital is the amount of interest bearing debt, preferred stock, and common equity used to acquire the company’s net operating assets. Without this capital a firm cannot exist, as there is no source of funds with which to finance operations.

2-10 NOPAT is the amount of net income a company would generate if it had no debt and held no financial assets. NOPAT is a better measure of the performance of a company’s operations because debt lowers income. In order to get a true reflection of a company’s operating performance, one would want to take out debt to get a clearer picture of the situation.

2-11 Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations. It is the most important measure of cash flows because it shows the exact amount available to all investors.

2-12 There are two principal ways that the tax code discourages corporations from paying high dividends to their shareholders. First, since corporations pay dividends out of earnings that have already been taxed, there is double taxation of corporate income--income is first taxed at the corporate rate, and when what is left is paid out as dividends, it is taxed again at the personal rate. Second, since capital gains are taxed only when they are received, the tax laws favor retention of earnings for an investor who doesn’t need current income. In addition, capital gains are taxed at a maximum rate of 28 percent, so for taxpayers in the high tax brackets the tax law again favors retention of earnings.

2-13 Double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received.

2-14 If the business were organized as a partnership or a proprietorship, its income could be taken out by the owners without being subject to double taxation. Also, if you expected to have losses for a few years while the company was getting started, if you were not incorporated, and if you had outside income, the business losses could be used to offset your other income and reduce your total tax bill. These factors would lead you to not incorporate the business. An alternative would be to organize as an S Corporation, if requirements are met.

2-15 Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in Chapters 10 and 15.

2-16 The appropriate tax rate depends on the owner’s situation. If the owner has substantial other income, then the major concern would be the business’s marginal contribution to taxes, so the marginal tax rate would be more relevant. Conversely, if there were no outside income, the average tax rate would be more relevant.



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 $6,000,000
Interest 1,000,000
EBT $5,000,000
Taxes (40%) 2,000,000
NI $3,000,000

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 Taxable Income = $97,000. Federal taxes = ?
Taxes = $6,577.5 + ($97,000 - $43,850)0.28
= $6,577.5 + ($53,150)0.28
= $21,459.5.


2-5 Corporate bond yields 8%. Municipal bond yields 6%.




2-6 Income $365,000
Less Interest deduction (50,000)
Plus: Dividends receiveda 4,500
Taxable income $319,500

aFor a corporation, 70% 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 $319,500
Taxes (107,855)
Plus Non-taxable dividends receivedb 10,500
Net income $222,145

bNon-taxable dividends are calculated as $15,000 x 0.7 = $10,500.

The company’s marginal tax rate is 39 percent. The company’s average tax rate is $107,855/$319,500 = 33.76%.


2-7 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.


2-8 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.


2-9 Compare the after-tax returns of the two investments:

Corporate bond = 0.09(1 - 0.36) = 0.0576 = 5.76%.

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


2-10 EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%
NI = ?; NCF = ?; OCF = ?


First, determine net income by setting up an income statement:

EBIT $750,000
Interest 0
EBT $750,000
Taxes (40%) 300,000
NI $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% equity financed.


2-11 Statements b, c, and d will all decrease the amount of cash on a company’s balance sheet, while statement a will increase cash through the sale of common stock. This is a source of cash through financing activities.


2-12 a. Because we’re interested in net cash flow available to common stockholders, we exclude common dividends paid.

CF01 = NI available to common stockholders + Depreciation
= $364 + $220 = $584.

The net cash flow number is larger than net income by the current year’s depreciation expense, which is a noncash charge.

b. Balance of RE, December 31, 2000 $1,302
Add: NI, 2001 364
Less: Div. paid to common stockholders (146)
Balance of RE, December 31, 2001 $1,520

c. $1,520 million.

d. Cash + equivalents = $15 million.

e. Total current liabilities = $620 million.


2-13 a. Income Statement
Sales revenues $12,000,000
Costs except
depreciation 9,000,000
Depreciation 1,500,000
EBT $ 1,500,000
Taxes (40%) 600,000
Net income $ 900,000
Add back depreciation 1,500,000
Net cash flow $ 2,400,000

b. If depreciation doubled, taxable income would fall to zero and taxes would be zero. Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000. Menendez would save $600,000 in taxes, thus increasing its cash flow:

DCF = T(DDepreciation) = 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 firm’s performance depend on net income, a decline in net income could certainly hurt both the firm’s 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 firm’s ability to pay dividends and to repay loans would have improved.


2-14 This involves setting up the income statement and working from the bottom up.

Sales Revenues* $2,500,000
Cost of Goods Sold (60%) 1,500,000 2,500,000 H 0.6
Depreciation 500,000 (Given)
Total Operating Costs $2,000,000
EBIT $ 500,000 EBIT = EBT + Interest
Interest 100,000 (Given)
EBT $ 400,000 EBT =
Taxes (40%) 160,000
NI $ 240,000 (Given)

* Sales Revenues - COGS - Deprec. = EBIT
Sales Revenues - 0.6(Revenues) - $500,000 = $500,000
0.4 Revenues = $1,000,000
Revenues = $2,500,000.

2-15 a. NOPAT = EBIT(1 - Tax rate)
= $150,000,000(0.6)
= $90,000,000.

b. NOWC00 = Operating CA – operating CL
= $360,000,000 - ($90,000,000 + $60,000,000)
= $210,000,000.

NOWC01 = $372,000,000 - $180,000,000 = $192,000,000.

c. Operating capital00 =
= $250,000,000 + $210,000,000
= $460,000,000.

Operating capital01 = $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 2001 can most likely be attributed to a large increase in free cash flow from 2000 to 2001, since FCF represents the amount of cash available to be paid out to stockholders after the company has made all investments in fixed assets and working capital necessary to sustain the business.


2-16 Prior Years 1999 2000
Profit earned $150,000 $150,000
Carry-back credit 150,000 150,000
Adjusted profit $ 0 $ 0
Tax previously
paid (40%) 60,000 60,000
Tax refund: Taxes
previously paid $ 60,000 $ 60,000

Total check from U.S. Treasury = $60,000 + $60,000 = $120,000.

Future Years 2002 2003 2004 2005 2006
Estimated
profit $150,000 $150,000 $150,000 $150,000 $150,000
Carry-forward
credit 150,000 150,000 50,000 0 0
Adjusted
profit $ 0 $ 0 $100,000 $150,000 $150,000
Tax (at 40%) 0 $ 0 $ 40,000 $ 60,000 $ 60,000


2-17 2002 tax = $0, since the firm had a loss. The $95,000,000 loss will be used to offset future income.

2003 tax = $0; $70,000,000 income offset by $70,000,000 of 2002 loss.

2004 taxable income is reduced by remaining $25,000,000 of 2002 loss, so 2004 taxable income = $55,000,000 - $25,000,000 = $30,000,000, and 2004 tax = (0.40)($30,000,000) = $12,000,000.

2005 tax = $80,000,000 x 0.4 = $32,000,000.

2006 tax = $0; $110,000,000 of loss can be carried back to offset income from 2004 and 2005, 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.

2-18 a. 2002 2003 2004
Taxes as a corporation:
Income before salary & taxes $70,000 $95,000 $110,000
Less salary (52,000) (52,000) (52,000)
Taxable income, corporate $18,000 $43,000 $ 58,000
Total corporate tax $ 2,700 $ 6,450 $ 9,500

Salary $52,000 $52,000 $ 52,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Taxable personal income $32,200 $32,200 $32,200
Total personal tax $ 4,830 $ 4,830 $ 4,830
Combined corp. & personal tax $ 7,530 $11,280 $ 14,330

Taxes as a proprietorship:
Total income $70,000.0 $95,000.0 $110,000.0
Less exemptions & deductions (19,800.0) (19,800.0) (19,800.0)
Taxable personal income $50,200.0 $75,200.0 $ 90,200.0
Total proprietorship tax $ 8,355.5 $15,355.5 $ 19,555.5

Advantage to corporation $ 825.5 $ 4,075.5 $ 5,225.5

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.

Note: Problem 2-21 in the Spreadsheet Problems section deals with Visscher paying dividends, using a spreadsheet model. The model is on the website, and a printed copy of the solution is shown in this manual.



2-19 a. Calculation of gross income:
1998
Salary $ 82,000
Dividend Income 12,000
Interest Income (corp. bonds only) 5,000
ST capital gains 1,000
Gross Income
(excluding LT capital gains) $100,000

LT capital gains** $ 13,000
**Applicable tax rate = 20%.

Calculation of taxable income:

Gross income $100,000
Exemption (2,800)
Deductions (4,900)
Taxable income
(excluding LT capital gains) $ 92,300
Personal tax $ 22,682

Tax = $14,3818.50 + ($92,300 - $63,550)(0.31) + $13,000(0.20)
= $14,138.50 + $8,912.50 + $2,600 = $25,894.00.

b. Marginal tax rate = 31%.

Average tax rate = $25,894.00/$105,300* = 24.6%. One could argue that the average rate is really lower, because the base should consider the deductions and exemptions.

*Includes $13,000 long-term capital gain; ($92,300 + $13,000 = $105,300).

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). Now solve for T:

6 = 8 - 8T
8T = 2
T = 2/8 = 25%.

At a tax rate less than 25%, Mary would be better off holding 8% taxable bonds, but at a tax rate over 25%, 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.

SOLUTION TO SPREADSHEET PROBLEMS
2-20 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM (in the file Solution for Ch 02-20 Build a Model.xls) and on the instructor’s side of the Harcourt College Publishers’ web site, http://www.harcourtcollege.com/finance/theory10e.

2-21 a. An increase in the dividend payout ratio (DPR) would subject some income to double taxation if Visscher incorporates. Notice that in 2002 and 2004 incorporation is a slight disadvantage.

Tax liability with 50 percent dividend payout ratio:

Taxes as a corporation: 2002 2003 2004

Income before salary & taxes $70,000 $95,000 $110,000
Less salary (52,000) (52,000) (52,000)
Taxable income, corporate $18,000 $43,000 $ 58,000

Total corporate tax $ 2,700 $ 6,450 $ 9,500

Salary $52,000 $52,000 $ 52,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Plus taxable div. received 7,650 18,275 24,250
Taxable personal income $39,850 $50,475 $ 56,450

Total personal tax 5,978 8,433 10,106
Combined corp. & personal tax $ 8,678 $14,883 $ 19,606

Taxes as a proprietorship:

Total income $70,000 $95,000 $110,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Taxable personal income $50,200 $75,200 $ 90,200

Total proprietorship tax $ 8,356 $15,356 $ 19,556

Advantage to corporation $ (322) 473 $ (50)

At a 100 percent DPR, all of the after-corporate tax earnings are subject to personal taxes. In this situation, incorporating would be a disadvantage in all three years.


Tax liability with 100 percent dividend payout ratio:

Taxes as a corporation: 2002 2003 2004

Income before salary & taxes $70,000 $95,000 $110,000
Less salary (52,000) (52,000) (52,000)
Taxable income, corporate $18,000 $43,000 $ 58,000

Total corporate tax 2,700 6,450 9,500

Salary $52,000 $52,000 $ 52,000
Less exemptions & deductions (19,600) (19,600) (19,600)
Plus taxable div. received 15,300 36,550 48,500
Taxable personal income $47,500 $68,750 $ 80,700

Total personal tax 7,600 13,550 16,896
Combined corp. & personal tax $10,300 $20,000 $ 26,396

Taxes as a proprietorship:

Total income $70,000 $95,000 $110,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Taxable personal income $50,200 $75,200 $ 90,200

Total proprietorship tax $ 8,356 $15,356 $ 19,556

Advantage to corporation ($ 1,944) ($ 4,644) ($ 6,840)

The dividend policy decision would affect Visscher’s decision as to whether to incorporate or not. Note also that if Visscher needs the extra money, she should increase her salary, thus avoiding double taxation of dividends. For example, Visscher’s 2002 total tax as a corporation with a salary of $52,000 and $7,650 in dividends = $8,678. However, Visscher’s 2002 total tax as a corporation with salary of $59,650 and no dividends = $7,530.

b. If business income doubles, and Visscher pays no dividends and incorporates, her taxable corporate income increases as well as her corporate tax; however, her personal tax liability would remain the same. If Visscher operates as a proprietorship and business income doubles, her taxable personal income would increase, thus, increasing her proprietorship tax. Thus, it would be to Visscher’s advantage to incorporate. However, if Visscher paid dividends of more than 36 percent, it would no longer be an advantage to incorporate for any year.


Tax liability if business income increases by 100 percent (no dividends):

Taxes as a corporation: 2002 2003 2004

Income before salary & taxes $140,000 $190,000 $220,000
Less salary (52,000) (52,000) (52,000)
Taxable income, corporate $ 88,000 $138,000 $168,000

Total corporate tax 18,170 37,070 48,770

Salary $ 52,000 $ 52,000 $ 52,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Plus taxable div. received 0 0 0
Taxable personal income $ 32,200 $ 32,200 $ 32,200

Total personal tax 4,830 4,830 4,830

Combined corp. & personal tax $ 23,000 $ 41,900 $ 53,600

Taxes as a proprietorship:

Total income $140,000 $190,000 $220,000
Less exemptions & deductions (19,800) (19,800) (19,800)
Taxable personal income $120,200 $170,200 $200,200

Total proprietorship tax $ 28,383 $ 44,321 $ 55,121

Advantage to corporation $ 5,383 $ 2,421 $ 1,521


CYBERPROBLEM


2-22 The detailed solution for the cyberproblem is available on the instructor’s side of the Harcourt College Publishers’ web site: http://www.harcourtcollege.com/finance/theory10e.



MINI CASE



DONNA JAMISON, A 1997 GRADUATE OF THE UNIVERSITY OF TENNESSEE WITH FOUR YEARS OF BANKING EXPERIENCE, WAS RECENTLY BROUGHT IN AS ASSISTANT TO THE CHAIRMAN OF THE BOARD OF COMPUTRON INDUSTRIES, A MANUFACTURER OF ELECTRONIC CALCULATORS.
THE COMPANY DOUBLED ITS PLANT CAPACITY, OPENED NEW SALES OFFICES OUTSIDE ITS HOME TERRITORY, AND LAUNCHED AN EXPENSIVE ADVERTISING CAMPAIGN. COMPUTRON’S RESULTS WERE NOT SATISFACTORY, TO PUT IT MILDLY. ITS BOARD OF DIRECTORS, WHICH CONSISTED OF ITS PRESIDENT AND VICE-PRESIDENT 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 WAS COMPLAINING ABOUT THE DETERIORATING SITUATION AND THREATENING TO CUT OFF CREDIT. AS A RESULT, AL WATKINS, COMPUTRON’S PRESIDENT, WAS INFORMED THAT CHANGES WOULD HAVE TO BE MADE, AND QUICKLY, OR HE WOULD BE FIRED. ALSO, AT THE BOARD’S INSISTENCE DONNA JAMISON WAS BROUGHT IN AND GIVEN THE JOB OF ASSISTANT TO FRED CAMPO, A RETIRED BANKER WHO WAS COMPUTRON’S 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 JAMISON’S HELP.
JAMISON BEGAN BY GATHERING FINANCIAL STATEMENTS AND OTHER DATA. ASSUME THAT YOU ARE JAMISON’S ASSISTANT, AND YOU MUST HELP HER ANSWER THE FOLLOWING QUESTIONS FOR CAMPO. (NOTE: 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!)



BALANCE SHEETS

2001 2000___
ASSETS
CASH $ 7,282 $ 9,000
SHORT-TERM INVESTMENTS 0 48,600
ACCOUNTS RECEIVABLE 632,160 351,200
INVENTORIES 1,287,360 715,200
TOTAL CURRENT ASSETS $1,926,802 $1,124,000

GROSS FIXED ASSETS 1,202,950 491,000
LESS ACCUMULATED DEPRECIATION 263,160 146,200
NET FIXED ASSETS $ 939,790 $ 344,800
TOTAL ASSETS $2,866,592 $1,468,800

LIABILITIES AND EQUITY
ACCOUNTS PAYABLE $ 524,160 $ 145,600
NOTES PAYABLE 720,000 200,000
ACCRUALS 489,600 136,000
TOTAL CURRENT LIABILITIES $1,733,760 $ 481,600
LONG-TERM DEBT 1,000,000 323,432
COMMON STOCK (100,000 SHARES) 460,000 460,000
RETAINED EARNINGS (327,168) 203,768
TOTAL EQUITY $ 132,832 $ 663,768
TOTAL LIABILITIES AND EQUITY $2,866,592 $1,468,800

INCOME STATEMENTS

2001 2000
SALES $5,834,400 $3,432,000
COST OF GOODS SOLD 5,728,000 2,864,000
OTHER EXPENSES 680,000 340,000
DEPRECIATION 116,960 18,900
TOTAL OPERATING COSTS $6,524,960 $3,222,900
EBIT ($ 690,560) $ 209,100
INTEREST EXPENSE 176,000 62,500
EBT ($ 866,560) $ 146,600
TAXES (40%) (346,624) 58,640
NET INCOME ($ 519,936) $ 87,960


EPS ($5.199) $0.880
DPS $0.110 $0.220
BOOK VALUE PER SHARE $1.328 $6.638
STOCK PRICE $2.25 $8.50
SHARES OUTSTANDING 100,000 100,000
TAX RATE 40.00% 40.00%
LEASE PAYMENTS $40,000 $40,000
SINKING FUND PAYMENTS 0 0

STATEMENT OF RETAINED EARNINGS, 2001

BALANCE OF RETAINED EARNINGS, 12/31/00 $203,768
ADD: NET INCOME, 2001 (519,936)
LESS: DIVIDENDS PAID (11,000)
BALANCE OF RETAINED EARNINGS, 12/31/00 ($327,168)


STATEMENT OF CASH FLOWS, 2001

OPERATING ACTIVITIES
NET INCOME ($ 519,936)
ADJUSTMENTS:
NON-CASH ADJUSTMENTS:
DEPRECIATION 116,960
CHANGES IN WORKING CAPITAL:
CHANGE IN ACCOUNTS RECEIVABLE: (280,960)
CHANGE IN INVENTORIES (572,160)
CHANGE IN ACCOUNTS PAYABLE 378,560
CHANGE IN ACCRUALS 353,600
NET CASH PROVIDED BY OPERATING ACTIVITIES ($ 523,936)

LONG-TERM INVESTING ACTIVITIES
CASH USED TO ACQUIRE FIXED ASSETS ($ 711,950)

FINANCING ACTIVITIES
CHANGE IN SHORT-TERM INVESTMENTS $ 48,600
CHANGE IN NOTES PAYABLE 520,000
CHANGE IN LONG-TERM DEBT 676,568
PAYMENT OF CASH DIVIDENDS (11,000)
NET CASH PROVIDED BY FINANCING ACTIVITIES $1,234,168
SUM: NET CHANGE IN CASH ($ 1,718)
PLUS: CASH AT BEGINNING OF YEAR 9,000
CASH AT END OF YEAR $ 7,282


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: SALES INCREASED BY $2,402,400.

NOPAT 01 = EBIT (1 - TAX RATE)
= (-$690,560)(0.6) = -$414,336.

NOPAT 00 = $209,100(0.6) = $125,460.

NOWC 01 =
= ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600)
= $913,042.

NOWC 00 = $9,000 + $351,200 + $715,200) - ($145,600 + $136,000)
= $793,800.

OC 01 = NET OPERATING WORKING CAPITAL + NET PLANT AND EQUIPMENT
= $913,042 + $939,790 = $1,852,832.

OC 00 = $793,800 + $344,800 = $1,138,600.

NI 01 - NI 97 = (-$519,936) - $87,960 = -$607,896.

NOPAT DECREASED BY $539,796.
NET OPERATING WORKING CAPITAL INCREASED BY $119,242.
CAPITAL INCREASED SUBSTANTIALLY FROM 2000 TO 2001.
THERE WAS A HUGE DROP IN NET INCOME IN 2001.


B. WHAT EFFECT DID THE EXPANSION HAVE ON NET CASH FLOW, OPERATING CASH FLOW, AND FREE CASH FLOW?

ANSWER: NCF01 = NI + DEP = ($519,936) + $116,960 = ($402,976).

NCF01 = $87,960 + $18,900 = $106,860.


OCF01 = EBIT(1 - T) + DEP = (-$690,560)(0.6) + $116,960
= ($297,376).

OCF00 = ($209,100)(0.6) + $18,900 = $144,360.

FCF01 = NOPAT - NET INVESTMENT IN OPERATING CAPITAL
= (-$414,336) - ($1,852,832 - $1,138,600)
= (-$414,336) - $714,232 = -$1,128,568.

BOTH NCF AND OCF ARE NEGATIVE IN 2001, BUT THEY WERE POSITIVE IN 2000.
FREE CASH FLOW WAS -$1,128,568 IN 2001.


C. JAMISON ALSO HAS ASKED YOU TO ESTIMATE COMPUTRON’S EVA. SHE ESTIMATES THAT THE AFTER-TAX COST OF CAPITAL WAS 11% IN 2000 AND 13% IN 2001.

ANSWER: EVA01 = EBIT(1 - T) - AFTER-TAX COST OF CAPITAL
= (-$690,560)(0.6) - ($1,852,832)(0.13)
= (-$655,204).

EVA00 = EBIT(1 - T) - AFTER-TAX COST OF CAPITAL
= ($209,100)(0.6) - ($1,138,600)(0.11)
= $214.

IN 2000, EVA WAS SLIGHTLY POSITIVE; HOWEVER IN 2001 EVA WAS SIGNIFICANTLY NEGATIVE.


D. LOOKING AT COMPUTRON’S STOCK PRICE TODAY, WOULD YOU CONCLUDE THAT THE EXPANSION INCREASED OR DECREASED MVA?

ANSWER: DURING THE LAST YEAR, STOCK PRICE HAS DECREASED BY OVER 73 PERCENT, THUS ONE WOULD CONCLUDE THAT THE EXPANSION HAS DECREASED MVA.


E. COMPUTRON PURCHASES MATERIALS ON 30-DAY TERMS, MEANING THAT IT IS SUPPOSED TO PAY FOR PURCHASES WITHIN 30 DAYS OF RECEIPT. JUDGING FROM ITS 2001 BALANCE SHEET, DO YOU THINK COMPUTRON PAYS SUPPLIERS ON TIME? EXPLAIN. IF NOT, WHAT PROBLEMS MIGHT THIS LEAD TO?
ANSWER: COMPUTRON PROBABLY DOES NOT PAY ITS SUPPLIERS ON TIME JUDGING FROM THE FACT THAT ITS ACCOUNTS PAYABLES BALANCE INCREASED BY 260 PERCENT FROM THE PAST YEAR, WHILE SALES INCREASED BY ONLY 70 PERCENT. COMPANY RECORDS WOULD SHOW IF THEY PAID SUPPLIERS ON TIME.
BY NOT PAYING SUPPLIERS ON TIME, COMPUTRON IS STRAINING ITS RELATIONSHIP WITH THEM. IF COMPUTRON CONTINUES TO BE LATE, EVENTUALLY SUPPLIERS WILL CUT THE COMPANY OFF AND PUT IT INTO BANKRUPTCY.


F. COMPUTRON SPENDS MONEY FOR LABOR, MATERIALS, AND FIXED ASSETS (DEPRECIATION) TO MAKE PRODUCTS, AND STILL MORE MONEY TO SELL THOSE PRODUCTS. THEN, IT MAKES SALES WHICH RESULT IN RECEIVABLES, WHICH EVENTUALLY RESULT IN CASH INFLOWS. DOES IT APPEAR THAT COMPUTRON’S SALES PRICE EXCEEDS ITS COSTS PER UNIT SOLD? HOW DOES THIS AFFECT THE CASH BALANCE?

ANSWER: IT DOES NOT APPEAR THAT COMPUTRON’S 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 COMPUTRON’S SALES MANAGER TOLD THE SALES STAFF TO START OFFERING 60-DAY CREDIT TERMS RATHER THAN THE 30-DAY TERMS NOW BEING OFFERED. COMPUTRON’S COMPETITORS REACT BY OFFERING SIMILAR TERMS, SO SALES REMAIN CONSTANT. WHAT EFFECT WOULD THIS HAVE ON THE CASH ACCOUNT? HOW WOULD THE CASH ACCOUNT BE AFFECTED IF SALES DOUBLED AS A RESULT OF THE CREDIT POLICY CHANGE?

ANSWER: BY EXTENDING THE SALES CREDIT TERMS, IT WOULD TAKE LONGER FOR COMPUTRON 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. ACCOUNTS RECEIVABLE WOULD RISE AND CASH WOULD DECLINE. MUCH LATER, WHEN COLLECTIONS INCREASED CASH WOULD RISE. COMPUTRON 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 COMPUTRON 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 COMPUTRON COULD NOT BE EXPECTED TO INCREASE ITS SALES WITHOUT A CORRESPONDING INCREASE IN INVENTORY AND OTHER ASSETS. (SEE QUESTION G.)


J. DID COMPUTRON 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 COMPANY’S FINANCIAL STRENGTH?

ANSWER: COMPUTRON FINANCED ITS EXPANSION WITH EXTERNAL CAPITAL RATHER THAN INTERNALLY GENERATED FUNDS. IN PARTICULAR, COMPUTRON ISSUED LONG-TERM DEBT RATHER THAN COMMON STOCK, WHICH REDUCED ITS FINANCIAL STRENGTH.


K. REFER TO THE INCOME STATEMENTS AND THE STATEMENT OF CASH FLOWS. SUPPOSE COMPUTRON BROKE EVEN IN 2001 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 WHICH REQUIRED IT TO RAISE EXTERNAL CAPITAL?

ANSWER: EVEN IF COMPUTRON HAD BROKEN EVEN IN 1998, THE FIRM WOULD HAVE HAD TO FINANCE AN INCREASE IN ASSETS.


L. IF COMPUTRON 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 COMPANY’S 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: 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. BECAUSE DEPRECIATION EXPENSE WOULD INCREASE, NET INCOME WOULD DECLINE. FINALLY, THE FIRM’S CASH POSITION WOULD INCREASE, BECAUSE ITS TAX 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: 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.
IF RESEARCH AND DEVELOPMENT IS CAPITALIZED, THIS REDUCES THE CURRENT EXPENSE WHICH INCREASES NET INCOME AND TAXES. THIS CAUSES 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 COST UNTIL PEOPLE RETIRE.


N. COMPUTRON’S 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: THE POSITIVE STOCK PRICE DOES NOT INDICATE THAT SOME INVESTORS ARE IRRATIONAL. RATHER, THE POSITIVE STOCK PRICE MEANS THAT PEOPLE EXPECT THINGS TO GET BETTER IN THE FUTURE.


O. COMPUTRON FOLLOWED THE STANDARD PRACTICE OF PAYING DIVIDENDS ON A QUARTERLY BASIS. IT PAID A DIVIDEND DURING THE FIRST TWO QUARTERS OF 2001, 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: THE DIVIDEND CUT WAS A "SIGNAL" THAT MANAGEMENT THINKS OPERATIONS ARE IN TROUBLE. STOCK VALUES DEPEND ON FUTURE PROFITS AND DIVIDENDS. THE DIVIDEND CUT LOWERED EXPECTATIONS FOR FUTURE PROFITS WHICH 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.
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 COMPUTRON BORROW FROM ITS BANK DURING 2001? HOW MUCH ADDITIONAL CREDIT DID ITS SUPPLIERS EXTEND? ITS EMPLOYEES AND THE TAXING AUTHORITIES?

ANSWER: 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. BY LOOKING IN THE SECTION TITLED "FINANCING ACTIVITIES," WE SEE THAT THE FIRM’S NOTES PAYABLE INCREASED BY $520,000--THIS IS HOW MUCH IT BORROWED FROM THE BANK. ALSO, ITS SHORT-TERM INVESTMENTS DECREASED BY $48,600, WHICH MEANS COMPUTRON RAISED CASH BY SELLING SHORT-TERM INVESTMENTS. BY LOOKING IN THE "OPERATING ACTIVITIES" SECTION UNDER "ADDITIONS," WE SEE THAT THE FIRM’S 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 FIRM’S ACCRUALS INCREASED BY $353,600--ACCRUALS WOULD INCLUDE ACCRUED TAXES.


R. IF YOU WERE COMPUTRON’S BANKER, OR THE CREDIT MANAGER OF ONE OF ITS SUPPLIERS, WOULD YOU BE WORRIED ABOUT YOUR JOB? IF YOU WERE A CURRENT COMPUTRON 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 BANK AND SUPPLIERS COULD SUFFER LOSSES. FOR EMPLOYEES, RETIREES, AND 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 2001 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 BEEN LESS THAN $346,624, WHAT WOULD HAVE HAPPENED? WOULD THIS HAVE AFFECTED THE STATEMENT OF CASH FLOWS AND THE ENDING CASH BALANCE?

ANSWER: FOR THE FIRM TO ACTUALLY OBTAIN THIS TAX CREDIT, IT WOULD HAVE HAD TO PAY $346,624 IN TAXES DURING THE LAST TWO YEARS. IF THE FIRM’S 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.).

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. IT’S 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 WILL NEED TO COMPLETE YOUR RETURN. COMPUTRON PAID YOU A SALARY OF $45,000, AND YOU RECEIVED $3,000 IN DIVIDENDS FROM COMMON STOCK THAT YOU OWN. YOU ARE SINGLE, SO YOUR PERSONAL EXEMPTION IS $2,800, AND YOUR ITEMIZED DEDUCTIONS ARE $4,550.

1. ON THE BASIS OF THE INFORMATION ABOVE AND THE 2000 INDIVIDUAL TAX RATE SCHEDULE, WHAT IS YOUR TAX LIABILITY?

ANSWER: CALCULATION OF TAXABLE INCOME:

SALARY $45,000
DIVIDENDS 3,000
PERSONAL EXEMPTION (2,800)
DEDUCTIONS (4,550)
TAXABLE INCOME $40,650

TAX LIABILITY = $3,862.5 + ($40,650 - $26,250)0.28 = $7,969.5.


T. 2. WHAT ARE YOUR MARGINAL AND AVERAGE TAX RATES?

ANSWER: MARGINAL TAX RATE IS 28 PERCENT; AVERAGE TAX RATE = $7,969.5/$40,650 = 19.6%.


U. ASSUME THAT A CORPORATION HAS $100,000 OF TAXABLE INCOME FROM OPERATIONS PLUS $5,000 OF INTEREST INCOME AND $10,000 OF DIVIDEND INCOME. WHAT IS THE COMPANY’S TAX LIABILITY?

ANSWER: CALCULATION OF THE COMPANY’S TAX 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. WHICH ONE SHOULD YOU CHOOSE AND WHY? AT WHAT MARGINAL TAX RATE WOULD YOU BE INDIFFERENT TO THE CHOICE BETWEEN CALIFORNIA AND EXXON BONDS?

ANSWER: AFTER-TAX RETURN INCOME AT T = 28%:

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%.

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%.