Chapter 2

Discussion Questions

2-1. Discuss some financial variables that affect the price-earnings ratio.

2-2. What is the difference between book value per share of common stock and
market value per share? Why does this disparity occur?

2-3. What is the difference between accumulated depreciation and depreciation

expense? How are they related?

2-4. How is the income statement related to the balance sheet?

2-5. Comment on why inflation may restrict the usefulness of the balance sheet as
normally presented.

2-6. Explain why the statement of cash flows provides useful information that goes
beyond income statement and balance sheet data.

2-7. What are the three primary sections of the statement of cash flows? In what
section would the payment of a cash dividend be shown?

2-8. Why is interest expense said to cost the firm substantially less than the actual
expense, while dividends cost it 100 percent of the outlay?

Problems

2-1. Rockwell Paper Company had earnings after taxes of $580,000 in the year 2012
with 400,000 shares outstanding. On January 1, 2013, the firm issued 35,000 new
shares. Because of the proceeds from these new shares and other operating
improvements, earnings after taxes increased by 25 percent.
 a. Compute earnings per share for the year 2012. ($1.45)
b. Compute earnings per share for the year 2013. ($1.67)

2-2. Given the following information, prepare, in good form, an income statement for
the Goodman Software, Inc.

Selling and administrative expense $ 50,000

Depreciation expense 80,000
Sales 400,000
Interest expense 30,000
Cost of goods sold 150,000
Taxes 18,550
(EAT= $71,450)

2-3. a. Kevin Bacon and Pork Company had sales of $240,000 and cost of goods sold of
$108,000. What is the gross profit margin (ratio of gross profit to sales)?
(55%)
b. If the average firm in the pork industry had a gross profit of 60 percent, how is
the firm doing? (U)

2-4. Prepare in good form an income statement for Virginia Slim Wear. Take your
calculations all the way to computing earnings per share.

Sales $600,000
Shares outstanding 100,000
Cost of goods sold 200,000
Interest expense 30,000
Selling and administrative expense 40,000
Depreciation expense 20,000
Preferred stock dividends 80,000
Taxes 100,000
(EPS= $1.30)

2-5. Lasar Technology, Inc. had sales of $500,000, cost of goods sold of $180,000,
selling and administrative expense of $70,000, and operating profit of $90,000.
What was the value of depreciation expense? Set this problem up as a partial
income statement, and determine depreciation expense as the plug figure.
(Depre. Exp.= $160,000)
2-6. The Reid Book Company sold 1,500 finance textbooks for $100 each to High
Tuition University in 2013. These books cost Reid $74 to produce. Reid spent
$4,000 (selling expense) to convince the university to buy its books. In addition,
Reid borrowed $50,000 on January 1, 2013, on which the company paid 10
percent interest. Both interest and principal of the loan were paid on December
31, 2013. Reid’s tax rate is 25 percent. Depreciation expense for the year was
$8,000.

Did Reid Book Company make a profit in 2013? Please verify with an income
statement presented in good form. (Profit or EAT= $16,500)

2-7. Carr Auto Wholesalers had sales of $900,000 in 2013 and their cost of goods sold
represented 65 percent of sales. Selling and administrative expenses were 9
percent of sales. Depreciation expense was $10,000 and interest expense for the
year was $8,000. The firm's tax rate is 30 percent.

a. Compute earnings after taxes. (EAT= $151,200)

b. Assume the firm hires Ms. Hood, an efficiency expert, as a consultant. She
suggests that by increasing selling and administrative expenses to 12 percent
of sales, sales can be increased to $1,000,000. The extra sales effort will also
reduce cost of goods sold to 60 percent of sales (there will be a larger makeup
in prices as a result of more aggressive selling). Depreciation expense will
remain at $10,000. However, more automobiles will have to be carried in
inventory to satisfy customers, and interest expense will go up to $15,000.
The firm's tax rate will remain at 30 percent. Compute revised earnings after
taxes based on Ms. Hood's suggestions for Carr Auto Wholesalers. Will her
ideas increase or decrease profitability? (EAT= $178,500)

2-8. Classify the following balance sheet items as current or noncurrent.

Retained earnings Bonds payable

Accounts payable Accrued wages payable
Prepaid expenses Accounts receivable
Plant and equipment Capital in excess of par
Inventory Preferred stock
Common stock Marketable securities
2-9. Arrange the following income statement items so they are in the proper order of
an income statement:

Taxes Earnings per share

Shares outstanding Earnings before taxes
Interest expense Cost of goods sold
Depreciation expense Earnings after taxes
Preferred stock dividends Earnings available to common
Operating profit stockholders
Sales Selling and administrative expenses
Gross profit

2-10. Identify whether each of the following items increases or decreases cash flow:

Increase in accounts receivable Decrease in prepaid expenses

Increase in notes payable Increase in inventory
Depreciation expense Dividend payment
Increase in investments Increase in accrued expenses
Decrease in accounts payable

2-11. Elite trailor parks has an operating profit of $200,000. Interest expense for the
year was $10,000; preferred dividends paid were $18,750; and common dividends
paid were $30,000. The tax was $61,250. The firm has 20,000 shares of common
stock outstanding.

a. Calculate the earnings per share and the common dividends per share for Elite
trailor parks. (EPS= $5.50; DPS=$1.50)
b. What was the increase in retained earnings for the year? (R/E= $80,000)

2-12. Johnson Alarm Systems had $800,000 of retained earnings on December 31,
2013. The company paid dividends of $60,000 in 2013 and had retained earnings
of $640,000 on December 31, 2012. How much did Johnson earn during 2013,
and what would earnings per share be if 50,000 shares of common stock were
outstanding? (Earnings= $220,000; EPS= $4.40)

2-13. Nova Electrics anticipated cash flow from operating activities of $6 million in
2013. It will need to spend $1.2 million on capital investments in order to remain
competitive within the industry. Common stock dividends are projected at $.4
million and preferred stock dividends at $.55 million.
 a. What is the firm's projected free cash flow for the year 2013? (FCF= $3.85M)
b. What does the concept of free cash flow represent? (U)

2-14. Fill in the blank spaces with categories 1 through 7 below:

1. Balance sheet (BS). 5. Current liabilities (CL).

2. Income statement (IS). 6. Long-term liabilities (LL).
3. Current assets (CA). 7. Stockholders' equity (SE).
4. Fixed assets (FA).

Indicate
Whether Item is
on Balance
Sheet (BS) or If on Balance
Income Sheet, Designate
Statement (IS) Which Category Item
______________ ______________ Accounts receivable
Retained earnings
Income tax expense
______________ ______________ Accrued expenses
______________ ______________ Cash
Selling and administrative expenses
Plant and equipment
______________ ______________ Operating expense
______________ ______________ Marketable securities
Interest expense
Sales
______________ ______________ Notes payable (6 months)
______________ ______________ Bonds payable, maturity 2001
Common stock
Depreciation expense
______________ ______________ Inventories
______________ ______________ Capital in excess of par value
Net income (earnings after taxes)
Income tax payable

2-15. The Rogers Corporation has a gross profit of $880,000 and $360,000 in
depreciation expense. The Evans Corporation also has $880,000 in gross profit,
with $60,000 in depreciation expense. Selling and administrative expense is
$120,000 for each company.

Given that the tax rate is 40 percent, compute the cash flow for both companies.
Explain the difference in cash flow between the two firms.
(CF of Rogers= $600,000; CF of Evans= $480,000)
2-16. Arrange the following items in proper balance sheet presentation.

Accumulated depreciation $200,000

Retained earnings 110,000
Cash 5,000
Bonds payable 142,000
Accounts receivable 38,000
Plant and equipment—original cost 720,000
Accounts payable 35,000
Allowance for bad debts 6,000
Common stock $1 par, 150,000 shares outstanding 150,000
Inventory 66,000
Preferred stock, $50 par, 1,000 shares outstanding 50,000
Marketable securities 15,000
Investments 20,000
Notes payable 83,000
Capital paid in excess of par (common stock) 88,000
Assets= $658,000 (CA=$118,000; Other A= $20,000; FA= $20,000)
L&E= $658,000 (L=$260,000; E= $398,000)

2-17. Horton Electronics has current assets of $320,000 and fixed assets of $640,000.
Current liabilities are $90,000 and long-term liabilities are $160,000. There is
$90,000 in preferred stock outstanding and the firm has issued 40,000 shares of
common stock. Compute book value (net worth) per share. (BVPS= $15.50)

2-18. The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and
long-term liabilities of $100,000. There is $40,000 in preferred stock outstanding;
20,000 shares of common stock have been issued

a. Compute book values (net worth) per share. ($10.50)

b. If there is $22,000 in earnings available to common stockholders and Holtzman’s
stock has a P/E of 18 times earnings per share, what is the current price of the
stock? (CP= $19.80)
c. What is the ratio of market value per share to book value per share? (1.89T)
2-19. For December 31, 2012, the balance sheet of the Gardner Corporation is as follows:

Current Assets Liabilities

Cash $ 15,000 Accounts payable $ 20,000
Accounts receivable 22,500 Notes payable 30,000
Inventory 37,500 Bonds payable 75,000
Prepaid expenses 18,000

Fixed Assets Stockholders' Equity

Plant and equipment (gross) $375,000 Common stock $112,500
Less: Accumulated Paid-in-capital 37,500
Depreciation 75,000 Retained earnings 118,000
Net plant and assets 300,000
Total liabilities and
Total assets $393,000 Stockholders' equity $393,000

Sales for 2013 were $330,000, with cost of goods sold was 60 percent of sales.
Selling and administrative expense was $33,000. Depreciation expense was 10
percent of plant and equipment (gross) at the beginning of the year. Interest expense
for the notes payable was 10 percent, while interest on bonds payable was 12
percent. These were based on December 31, 2012, balances. The tax rate averaged
20 percent.

Two thousand dollars in preferred stock dividend were paid, and $4,100 in dividends
were paid to common stockholders. There were 10,000 shares of common stock
outstanding.

During the year 2013, the cash balance and prepaid expenses balance were
unchanged. Accounts receivable and inventory increased by 20 percent. A new
machine was purchased on December 31, 2013, at a cost of $60,000.

Accounts payable increased by 30 percent. At year-end, December 31, 2013, notes

payable increased by $10,000 and bonds payable decreased by $15,000. The
common stock and paid-in capital in excess of par accounts did not change.

a. Prepare an income statement for 2013. (EPS= $3.76)

b. Prepare a statement of retained earnings for 2013. (RE= $151,500)
c. Prepare a balance sheet as of December 31, 2013. (Assets= $427,500)
2-20. Prepare a statement of cash flows for the Jeter Corporation. Follow the general
procedures indicated in chapter 2.
Crosby Corporation
Income Statement
For the Year Ended December 31, 2012
Sales $2,200,000
Cost of goods sold 1,300,000
Gross profits 900,000
Selling and administrative expense 420,000
Depreciation expense 150,000
Operating income 330,000
Interest expense 90,000
Earnings before taxes 240,000
Taxes 80,000
Earnings after taxes 160,000
Preferred stock dividends 10,000
Earnings available to common stockholders $ 150,000
Shares outstanding 120,000
Earnings per share $1.25

Statement of Retained Earnings

For the Year Ended December 31, 2012
Retained earnings, balance, January 1, 2012 $500,000
Add: Earnings available to common stockholders, 2012 150,000
Deduct: Cash dividends declared and paid in 2012 50,000
Retained earnings, balance, December 31, 2012 $600,000

Comparative Balance Sheets

For 2011 and 2012
Year-End Year-End
2011 2012
Assets
Current assets:
Cash $ 70,000 $ 100,000
Accounts receivable (net) 300,000 350,000
410,000 430,000
Inventory 50,000 30,000
830,000 910,000
Prepaid expenses 80,000 70,000
2,000,000 2,400,000
Total current assets 1,000,000 1,150,000
1,000,000 1,250,000
 Investments (long-term securities) $1,910,000 $2,230,000

Plant and equipment

Less: Accumulated depreciation

Net plant and equipment

Total assets

Liabilities and Stockholders’ Equity

Current liabilities:
Accounts payable $ 250,000 $ 440,000
400,000 400,000
Notes payable 70,000 50,000
720,000 890,000
Accrued expenses
70,000 120,000
Total current liabilities 790,000 1,010,000

Long-term liabilities: 90,000 90,000

Bonds payable, 2004 120,000 120,000
410,000 410,000
Total liabilities 500,000 600,000
1,120,000 1,220,000
Stockholders’ equity: $1,910,000 $2,230,000
Preferred stock, $100 par value (Net CF= $30,000)

Common stock, $1 par value

Capital paid in excess of par

Retained earnings

Total stockholders’ equity

Total liabilities and stockholders’ equity