A242-742 - F 2020 - HWQ-2-Solution

docx

School

University of Pennsylvania *

*We aren’t endorsed by this school

Course

242

Subject

Accounting

Date

Jan 9, 2024

Type

docx

Pages

Uploaded by MateTeamTiger43

1 Name ACCOUNTING 242/742 Homework / Quiz 1 Fall 2020 Instructions  Please print or type your name in the space provided above.  You have two hours from the time you download the Quiz to return your answers via Gradescope on Canvas. Be sure to budget enough time to scan your answers into a pdf file and complete the upload before the two-hour time limit expires.  This Quiz is open book and open notes. You are welcome to use information from non-class sources as well (i.e. look things up on the internet)  You are not allowed to contact other people (or Siri or Alexa!)  Sign the HONOR CODE statement at the bottom of the page and return this page with your answers.  Show your work to receive partial credit. If you feel you need to make an assumption to answer a question, state that assumption with your answer.  Note than not all of the information presented in the problems is necessarily relevant!  Upload your answers in the form of a pdf file via Gradescope in Canvas by the end of the time limit.  Also separately send me a copy of your answers (lambertr@wharton.upenn.edu) Maximum Points Points Scored Question 1 - What Does Operating Mean? 5 Question 2 - Interest Cost 6 Question 3 - PPE 14 Question 4 – Compare Free Cash Flow 10 Question 5 – Calculate Free Cash Flow 12 Question 6 – Revenue Recognition 10 TOTAL 57 The Wharton School Honor Code applies to this exam. In particular, you may not talk about the exam with other people. By signing below, you agree to abide by the Honor Code. Signature

2 1. (5 pts) How are the terms “operations” or “operating” used differently on the cash flow statement versus how they’re used on the income statement and how we used them when we decomposed and re-formulated the balance sheet? That is, how are items classified differently on the statements? I’m not looking for a long, detailed list of specific differences, but a higher-level discussion. The term operations or operating generally has a more narrow definition on the cash flow statement than on the other two statements. On the balance sheet and income statement, we classified things as “Operating” vs “Financial.” But the cash flow statement uses three categories: Operating, Investing and Financing. There are also some other classification differences across the statements. Some of the things in the Operating category of Income and the Balance Sheet are in the Investing section, not the Operating section of the Cash Flow statement. For example, Long term assets like PPE are considered operating assets, and the expenses associated with them (like depreciation and amortization) are considered part of operating income. But Operating Cash Flow excludes these things – they are in the Investing Section. (This is why Cash From Operations is not a measure of profitability – it omits relevant costs). Cash flows from financial assets are mixed across the operating and Investing sections of the cash flow statement. Interest cost is in the operating section, not the financial section. (Note that the Financing Section of the Cash Flow Statement only contains flows associated with the right hand side of the balance sheet – financial liabilities and shareholders’ equity. It does not mix flows from / to financial assets with ones associated with financial liabilities – there is no section on the cash flow statement comparable to Net Financial Assets on the balance sheet or Net Financial Income. The Operating section of the Cash Flow statement includes interest expense, which should be properly classified in the financing section.) (Note that R&D is in the Operating section of the CF statement, but it is also considered an operating expense on the income statement. To the extent it appears on the balance sheet, it is considered an Operating Asset.) Note that Free Cash Flow (appropriately defined) is more analogous to the (Net) Operating Assets on the balance sheet and Net Operating Income from the income statement. In fact, one definition of Free Cash Flow is Net Operating Income – Change in Net Operating Assets.

3 2. (6 pts) The cost of interest appears in the Operating Section of the Cash Flow Statement under GAAP. Many analysts feel this is not where it belongs. Suppose a firm has  $9,000 of Interest Expense  $8,000 of Cash Paid for Interest  A Tax Rate of 20% (4 pts) What adjustment would you make to Cash From Operations to better reflect the proper placement of interest? (Give me a magnitude and a direction; e.g., I would adjust CFO downwards by $1). Since it’s the CASH flow statement, we need to adjust the CASH PAID for interest out of the Operating section. This would increase Cash from Operations by (1-.2) x 8,000 = $6,400 (2 pts) To what section (if any) of the cash flow statement would you move the cost of interest? We’d move it to the Financing Section. (where it would be matched with principal paid on interest, as well as inflows and outflows to shareholders).

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

4 3. (14 pts) The following transactions occurred related to a company’s Net Property, Plant, and Equipment account (Net means it’s the Original Cost net of Accumulated Depreciation)  Purchased New PPE for $50,000 in cash  Acquired New PPE by issuing $20,000 in bonds directly to the manufacturer  Sold PPE for $40,000 in cash and recorded an $8,000 gain on sale  Recognized Depreciation Expense of $5,000  Ignore taxes Using just these items, construct the cash flow statement for the year. In particular, what would appear in the following line items / sections of the cash flow statement: Cash From Operations (4 pts) : Impact on Net Income: (NOTE THAT INCOME IS THE STARTING POINT FOR CASH FROM OPS) Depreciation Expense (5,000) Gain on Sale 8,000 3,000 Adjustments (if any - show the sign and what it’s related to): Addback Depreciation +5,000 Subtract: Gain on Sale (8,000) Total Adjustments (3,000) Total Impact on Cash From Operations 0 Cash from Investing Section (6 pts) : Additions: Purchase of PPE (50,000) (note that the purchase by issuing bonds does not appear) Subtractions: Sales of PPE 40,000 Total Impact on Cash From Investing (10,000) There would also be a note disclosing that there was a NONCASH INVESTING AND FINANCING ACTIVITY in which we bought $20,000 of PPE by issuing bonds. (4 pts) Overall, by how much did the Net PPE account go up (or down) on the balance sheet during the year? Change in PPE = Purchases for Cash + Purchases by Issuing Bonds – Deprec Expense – Net Book Value of PPE Sold The Net book Value of PPE Sold = Proceeds Received – Gain on Sale = 40,000 – 8,000 = 32,000 Change in PPE = 50,000 + 20,000 – 5,000 – 32,000 = +33,000. PPE went up by 33,000 on the balance sheet

5 4. (10 pts) Firms A and B start out with similar sizes. Neither firm has any debt. Below are the Cash Flow Statements for the two firms for the next three years: Firm A Firm B Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Cash from Operations 100 120 140 1000 1200 1400 Cash from Investing -100 -120 -140 -1000 -1200 -1400 Cash from Financing 0 0 0 0 0 0 Change in Cash 0 0 0 0 0 0  (3 pts) Calculate Free Cash Flow for each firm for each year. FCF = 0 for each firm for each year. (if we had more information about the investments, we might classify some as discretionary investments, which would likely make FCF positive)  (3 pts) Which firm is performing better over this period of time? Explain your reasoning. According to FCF, they did the same. But FCF is not very useful as an indicator in this case because everything generated by the firm was re-invested. This is why it’s useful to look at the components of the calculation of FCF. Both firms start with the same size. Firm B is generating a higher Return in the form of more cash from operations, but re-investing this larger amount back into the firm (and then generating more cash the next period). B is growing faster than A (in absolute terms) Note that the Cash Invested in a period is generally not what generated the Operating Cash Flow for that period (although it may have contributed somewhat). Instead the Operating Cash Flow was largely generated from prior period’s investing cash outflows. The Investing Outflows this period are designed to replace the deterioration of the asset base and provide for future growth potential.  (4 pts) Are the Net Income numbers for these firms likely to be positive or negative during these years? Explain. (There are many things that could be discussed here about how income differs from cash flow, including operating cash flows and free cash flows). Two of the big differences are how they treat CAPEX and the effect of changes in working capital. Net Income re-arranges the cash flows. In particular, Net income will depreciate CAPEX from the past to match it against the inflows generated this period. Both firms seem to be growing, the operating inflows this period are greater than the investing outflows from the past. This suggests that Net Income will be likely by positive. Also, growing firms tend to be re-investing in working capital. This reduces CFO relative to Net Income. Given that CFO is positive, this would also suggest Net Income is positive.

6 5. (12 pts) Refer to the Cash Flow Statement below. Do not worry about Interest Cost in this problem. Cash From Operations Net Income $ 90,0 Adjustments (total) $ (10,0 Cash From Operations $ 80,0 Cash From Investing Sale of Mkt Securities $ 65,0 Purchase of Mkt Securities $ (15,0 Purchases of PPE $ (60,0 Acquisitions (net of cash acquired) $ (120,0 Cash From Investing $ (130,0 Cash From Financing Net from Shareholders $ (45,0 Net From Others $ 85,0  (3 pts) Calculate Free Cash Flow (to all), defined as the amount Paid Out to Investors. The Financing Section of the Cash Flow statement lists the amount (paid out) or received from investors – overall the firm received 40,000 from investors FCF = - 40,000 We could also get this as CFO + CFI – Change in Cash Note that the overall change in cash is -10,000 So FCF = 80,000 – 130,000 – (-10,000) = -40,000  (4 pts) Calculate Free Cash Flow (to all), where only CAPEX is considered to be a required investment; all other investments are considered discretionary. All cash is considered a financial asset. FCF = Cash From Operations – CAPEX = 80,000 – 60,000 = +20,000 Note that our biggest activity was an acquisition and that this measure of FCF does not include the acquisition. If we leave it out of the calculation of FCF (and instead view it as USE of FCF), we should make sure we’re factoring in the profitability of this acquisition (what it will generate for us relative to its cost) somewhere in our valuation analysis.

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

7  (5 pts) For your second Free Cash Flow Measure, what did the firm do with its free cash flow that it generated (or where did the free cash flow it consumed come from)? Be as specific as possible. Make sure you account for everything! Free Cash Flow was: 80,000 – 60,000 = + 20,000 What did we do with this? We combined it with Cash from selling securities: 65,000 – 15,000 = 50,000 Cash from Investors: 85,000 – 45,000 = 40,000 Drawing down the cash balance 10,000 To pay cash for an acquisition that cost 120,000

8 6. (10 pts) Suppose that on January 1 st of Year 1, a customer loans $200,000 to a manufacturer at 8% interest for two years. During that period of time, the manufacturer builds a product for that customer. The two parties agree that at the end of the two years (say on January 1 st of Year 3), the customer will forgive the loan in exchange for the manufacturer delivering the product. The product is, in fact, delivered on the agreed upon date.  (3 pts) When does the manufacturer recognize revenue? (give me a date or dates). Explain your reasoning. Not until it is delivered. This would be on Jan 1 of Year 3.  (4 pts) How much revenue does the manufacturer recognize? (give me a dollar amount for the date or dates you listed in the prior answer) Assuming no “interest” was actually paid out (including in year 2). The balance of the loan would be 200,000 x 1.08 = 216,000 after one year and 216,000 x 1.08 = 233,280 after two years  (3 pts) In what section of the manufacturer’s cash flow statement does the $200,000 received in Year 1 appear? Explain. Because the loan contract and the sale are related, the $200,000 would not be considered a financing inflow. Instead it would classified as an operating inflow. On the balance sheet this would be considered Deferred Revenue (or an Advance from Customers) as opposed to a Note Payable.