ECON 4400

Chapter 2: End-of-Chapter Questions 1-10, 13, 15-17, and 19

Note: Questions are the same in the 7th, 8th and 9th editions of the book
All end-of-chapter questions are great and I encourage you to work through them if you want extra
practice.

2.1. To find shareholders’ equity, we must construct a balance sheet as follows:

Balance Sheet
Current assets $5,300 Current liabilities $3,900
Net fixed assets 26,000 Long-term debt 14,200
Shareholders’ equity ..??....
Total assets $31,300 Total liabilities & equity $31,300

We know that total liabilities and shareholders’ equity must equal total assets of $31,300. We also know that
total liabilities & shareholders’ equity is equal to current liabilities plus long-term debt plus shareholders’
equity, so shareholders’ equity is:

Shareholders’ equity = $31,300 –$14,200 – $3,900 = $13,200

Net Working Capital = Current Assets – Current Liabilities = $5,300 – $3,900 = $1,400

2.2 The income statement for the company is:

Income Statement
Sales $493,000
Costs 210,000
Depreciation 35,000
EBIT $248,000
Interest 19,000
EBT $229,000
Taxes 80,150
Net income $148,850

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 = $148,850 – $50,000
Addition to retained earnings = $98,850

2.3 To find the book value of current assets, we use:

Net Working Capital = Current Assets – Current Liabilities.

Rearranging to solve for current assets, we get:

Current Assets = Net Working Capital + Current Liabilities

Answers to End–of–Chapter Problems 2-1

 Current Assets = $800,000 + $2,100,000 = $2,900,000

The market value of current assets and net fixed assets is given, so:

Book value Current Assets = $2,900,000 Market value Current Assets = $2,800,000
Book value Net Fixed Assets = $5,000,000 Market value Net Fixed Assets = $6,300,000
Book value assets = $7,900,000 Market value assets = $9,100,000

2.4 To calculate Operating cash flow, we first need the income statement:

Income Statement
Sales $18,700
Costs 10,300
Depreciation 1,900
EBIT $6,500
Interest 1,250
Taxable income $5,250
Taxes 2,100
Net income $3,150

Operating cash flow = EBIT + Depreciation – Taxes

Operating cash flow = $6,500 + $1,900 – $2,100
Operating cash flow = $6,300

2.5 Net capital spending = Net Fixed Assetsend – Net Fixed Assetsbeg + Depreciation
Net capital spending = $1,730,000 – $1,650,000 + $284,000
Net capital spending = $364,000

2.6 The long-term debt account will increase by $35 million, the amount of the new long-term debt issue. Since the
company sold 10 million new shares of stock with a $1 par value, the common stock account will increase by $10
million. The capital surplus account will increase by $48 million, the value of the new common shares sold above
its par value. Since the company had a net income of $9 million, and paid $2 million in dividends, the addition to
retained earnings was $7 million, which will increase the accumulated retained earnings account. So, the new long-
term debt and stockholders’ equity portion of the balance sheet will be:

Long-term debt $ 100,000,000

Total long-term debt $100,000,000

Shareholders equity
Preferred shares $ 4,000,000
Common shares ($1 par value) 25,000,000
Accumulated retained earnings 142,000,000
Capital surplus 93,000,000
Total equity $264,000,000

Total Liabilities & Equity $ 364,000,000

Answers to End–of–Chapter Problems 2-2

2.7 Cash flow to creditors = Interest paid – Net new borrowing
Cash flow to creditors = $127,000 – (Long-term debtend – Long-term debtbeg)
Cash flow to creditors = $127,000 – ($1,520,000 – $1,450,000)
Cash flow to creditors = $127,000 – $70,000
Cash flow to creditors = $57,000

2.8 Cash flow to stockholders = Dividends paid – Net new equity

Cash flow to stockholders = $275,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)]
Cash flow to stockholders = $275,000 – [($525,000 + $3,700,000) – ($490,000 + $3,400,000)]
Cash flow to stockholders = $275,000 – ($4,225,000 – $3,890,000)
Cash flow to stockholders = –$60,000

Note, APIS is the additional paid-in surplus.

2.9 Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
= $57,000 – $60,000
= – $3,000

Cash flow from assets = Operating cash flow – Change in Net Working Capital
– Net capital spending
–$3,000 = Operating cash flow – (–$87,000) – $945,000

Operating cash flow = –$3,000 – $87,000 + $945,000

Operating cash flow = $855,000

2.10 a. The accounting statement of cash flows explains the change in cash during the year. The accounting
statement of cash flows will be:

Statement of cash flows

Operations
Net income $95
Depreciation 90
Changes in other current assets (5)
Accounts payable 10
Total cash flow from operations $190

Investing activities
Acquisition of fixed assets $(110)
Total cash flow from investing
activities $(110)

Financing activities
Proceeds of long-term debt $5
Dividends (75)

Answers to End–of–Chapter Problems 2-3

 Total cash flow from financing
activities $(70)

Change in cash (on balance sheet) $10

b. Change in NWC= NWCend – NWCbeg

= (CAend – CLend) – (CAbeg – CLbeg)
= [($65 + $170) – $125] – [($55 + $165) – $115)
= $110 – $105
= $5
c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the capital
spending. So, calculating each of these, we find:

Operating cash flow

Net income $95
Depreciation 90
Operating cash flow $185

Note that we can calculate operating cash flow in this manner since there are no taxes.

Capital spending
Ending fixed assets $390
Beginning fixed assets (370)
Depreciation 90
Capital spending $110

Now we can calculate the cash flow generated by the firm’s assets, which is:

Cash flow from assets

Operating cash flow $185
Capital spending (110)
Change in NWC (5)
Cash flow from assets $70

Answers to End–of–Chapter Problems 2-4

2.13 To find the operating cash flow, we first calculate net income.

Income Statement
Sales $167,000
Costs 91,000
Depreciation 8,000
Other expenses 5,400
EBIT $62,600
Interest 11,000
Taxable income $51,600
Taxes 18,060
Net income $33,540

Dividends $9,500
Additions to RE $24,040

a. Operating cash flow = EBIT + Depreciation – Taxes

Operating cash flow = $62,600 + $8,000 – $18,060
Operating cash flow = $52,540

b. Cash flow to Creditors = Interest – Net new long-term debt

Cash flow to Creditors = $11,000 – (–$7,100)
Cash flow to Creditors = $18,100

Note that the net new long-term debt is negative because the company repaid part of its long-term debt.

c. Cash flow to stockholders = Dividends – Net new equity

Cash flow to stockholders = $9,500 – $7,250
Cash flow to stockholders = $2,250

d. We know that Cash flow from assets = Cash flow to creditors + Cash flow to stockholders, so:

Cash flow from assets = $18,100 + $2,250 = $20,350

Cash flow from assets is also equal to Operating cash flow – Net capital spending – Change in NWC.

We already know operating cash flow. Net capital spending is equal to:

Net capital spending = Increase in Net fixed assets + Depreciation

Net capital spending = $22,400 + $8,000
Net capital spending = $30,400

Now we can use:

Cash flow from assets = Operating cash flow – Net capital spending – Change in NWC
$20,350 = $52,540 – $30,400 – Change in NWC.

Answers to End–of–Chapter Problems 2-5

 Solving for the change in NWC gives $1,790, meaning the company increased its NWC by $1,790.

2.15 The balance sheet for the company looks like this:

Balance Sheet
Cash $274,500 Accounts payable $697,500
Accounts receivable 207,000 Notes payable 217,500
Inventory 445,500 Current liabilities $915,000
Current assets $927,000 Long-term debt 2,325,000
Total liabilities $3,240,000
Tangible net fixed assets 4,393,000
Intangible net fixed assets 860,000 Common shares ??
Accumulated ret. earnings 2,940,000
Total assets $6,180,000 Total liabilities. & equity $6,180,000

Total liabilities and equity is:

Total liabilities & equity = Total debt + Common shares + Accumulated retained earnings

Solving for this equation for equity gives us:

Common shares = $6,180,000 – $3,240,000 – $2,940,000

Common shares= $0

2.17 a. Income Statement

Sales $630,000
COGS 470,000
A&S expenses 95,000
Depreciation 140,000
EBIT $(75,000)
Interest 70,000
Taxable income $(145,000)
Taxes (35%) 0
Net income $(145,000)

b. OCF = EBIT + Depreciation – Taxes

OCF = $(75,000) + $140,000 – 0
OCF = $65,000

c. Net income was negative because of the tax deductibility of depreciation and interest expense. However,
the actual cash flow from operations was positive because depreciation is a non-cash expense and interest
is a financing expense, not an operating expense.
So:

Net new LTD = Interest – Cash flow to creditors

Net new LTD = $70,000 – $31,000
Net new LTD = $39,000

Answers to End–of–Chapter Problems 2-6

2.19 a. The income statement is:

Income Statement
Sales $19,900
Cost of good sold 14,200
Depreciation 2,700
EBIT $3,000
Interest 670
Taxable income $2,330
Taxes 932
Net income $1,398

b. OCF = EBIT + Depreciation – Taxes

OCF = $3,000 + $2,700 – $932
OCF = $4,768

c. Change in NWC = NWCend – NWCbeg

= (CAend – CLend) – (CAbeg – CLbeg)
= ($5,135 – $2,535) – ($4,420 – $2,470)
= $2,600 – 1,950
= $650

Net capital spending = NFAend – NFAbeg + Depreciation

= $16,770 – $15,340 + $2,700
= $4,130

CFA = OCF – Change in NWC – Net capital spending

= $4,768 – $650 – $4,130
= –$12

The cash flow from assets can be positive or negative, since it represents whether the firm raised funds or
distributed funds on a net basis. In this problem, even though net income and OCF are positive, the firm
invested heavily in both fixed assets and net working capital; it had to raise a net $12 in funds from its
stockholders and creditors to make these investments.

d. Cash flow to creditors = Interest – Net new LTD

= $670 – 0
= $670

Answers to End–of–Chapter Problems 2-7

 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors
= –$12 – $670
= –$682

We can also calculate the cash flow to stockholders as:

Cash flow to stockholders = Dividends – Net new equity

Solving for net new equity, we get:

Net new equity = $650 – (–$682)

= $1,332

The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from
operations. The firm invested $650 in new net working capital and $4,130 in new fixed assets. The firm
had to raise $12 from its stakeholders to support this new investment. It accomplished this by raising
$1,332 in the form of new equity. After paying out $650 of this in the form of dividends to shareholders
and $670 in the form of interest to creditors, $12 was left to meet the firm’s cash flow needs for
investment.

Answers to End–of–Chapter Problems 2-8