Chapter 2, Problem 21QP

a)

Summary Introduction

To calculate: The net income for the year 2014.

Introduction:

Cash flow refers to the difference between the cash that comes into the business and the cash that goes out of the business. The following are the different types of cash flows in a corporation:

• Cash flow from assets:

  It refers to the difference between the revenues from the sale of assets and the money invested in purchasing the assets.

• Cash flow to creditors:

  It refers to the interest paid to the creditors minus the net fresh debt borrowed by the company.

• Cash flow to stockholders:

  It refers to the dividend paid to the shareholders of the company minus the fresh equity raised by the company.

Answer to Problem 21QP

The net income of the company for 2014 is $2,402.

Explanation of Solution

Given information:

Company T has sales of $23,730, cost of goods sold of $16,780, depreciation expense of $2,840, interest expenses of $414, dividend of $616 for the year 2014. At the starting, the company has net fixed assets of $16,560, current assets of $2,940, and current liabilities of $2,592. At the year end, the company has net fixed assets of $18,840, current assets of $3,528, current liabilities of $2,484 and tax at the rate of 35%.

Compute the net income of Company T:

Income statement
Particulars	Amount ($)	Amount ($)
Net sales		$23,730
Less:
Costs	$16,780
Depreciation	$2,840	$19,620
Earnings before interest and taxes		$4,110
Less: Interest paid		$414
Taxable income		$3,696
Less: Taxes ($3696×35%)		$1,294
Net income		$2,402

Hence, the net income is $2,402.

b)

Summary Introduction

To calculate: The operating cash flow for 2014.

Answer to Problem 21QP

The operating cash flow of Company T is $5,656.

Explanation of Solution

Given information:

The earnings before interest and taxes are $4,110 and the taxes are $1,294 (Refer Part (a) of the Answer).

Compute the operating cash flow:

Operating cash flow
Particulars	Amount ($)
Earnings before interest and taxes	$4,110
Add: Depreciation	$2,840
	$6,950
Less: Taxes	$1,294
Operating cash flow	$5,656

Hence, the operating cash flow is $5,656.

c)

Summary Introduction

To calculate: The cash flow from assets for 2014 and the possibility of having negative cash flow from assets

Answer to Problem 21QP

The cash flow from assets is −$160.

Explanation of Solution

Given information:

At the starting of the year, the company has net fixed assets of $16,560, current assets of $2,940, and current liabilities of $2,592. At the year end, the company has net fixed assets of $18,840, current assets of $3,528, current liabilities of $2,484 and tax at the rate of 35%. Depreciation expense of $2,840

Formulae:

The formula to calculate the ending net working capital:

$\text{Ending net working capital}=\text{Ending current assets}-\text{Ending current liabilities}$

The formula to calculate the beginning net working capital:

$\text{Beginning net working capital}=\text{Beginning current assets}-\text{Beginning current liabilities}$

The formula to calculate the changes in net working capital:

$\text{Change in net working capital}=\left(\begin{array}{l}\text{Ending net working capital}-\\ \text{Beginning net working capital}\end{array}\right)$

The formula to calculate the cash flow from the assets:

$\text{Cash flow from assets}=\left(\begin{array}{l}\text{Operating}\\ \text{cash flow}\end{array}\right)-\left(\begin{array}{l}\text{Change in net}\\ \text{working capital}\end{array}\right)-\left(\begin{array}{l}\text{Net capital}\\ \text{spending}\end{array}\right)$

Compute the ending net working capital:

$\begin{array}{c}\text{Ending net working capital}=\text{Ending current assets}-\text{Ending current liabilities}\\ =\$3,528-\$2,484\\ =\$1,044\end{array}$

Hence, the ending net working capital is $1,044.

Compute the beginning net working capital:

$\begin{array}{c}\text{Beginning net working capital}=\text{Beginning current assets}-\text{Beginning current liabilities}\\ =\$2,940-\$2,592\\ =\$348\end{array}$

Hence, the beginning net working capital is $348.

Compute the change in net working capital:

$\begin{array}{c}\text{Change in net working capital}=\left(\begin{array}{l}\text{Ending net working capital}-\\ \text{Beginning net working capital}\end{array}\right)\\ =\$1,044-\$348\\ =\$696\end{array}$

Hence, the change in net working capital is $696.

Compute the net capital spending:

Net capital spending
Particulars	Amount ($)
Ending net fixed assets	$18,840
Less: Beginning net fixed assets	$16,560
	$2,280
Add: Depreciation	$2,840
Net capital spending	$5,120

Hence, the net capital spending is $5,120.

Compute the cash flow from assets:

The operating cash flow is$5,656(Refer Part (b) of the Answer). The change in net working capital is $696 and the net capital spending is$5,120.

$\begin{array}{c}\text{Cash flow from assets}=\left(\begin{array}{l}\text{Operating}\\ \text{cash flow}\end{array}\right)-\left(\begin{array}{l}\text{Change in net}\\ \text{working capital}\end{array}\right)-\left(\begin{array}{l}\text{Net capital}\\ \text{spending}\end{array}\right)\\ =\$5,656-\$696-\$5,120\\ =-\$160\end{array}$

Hence, the cash flow from assets is −$160.

Determine whether the company can have negative cash flow from assets:

The cash flow from assets can be negative. A negative cash flow from assets means that the company borrowed funds to invest in fixed assets. In the given situation, the operating cash flow is positive. However, the cash flow from assets is negative because the company raised additional capital to invest in fixed assets.

d)

Summary Introduction

To calculate: The cash flow to the creditors and the cash flow to stockholders

Answer to Problem 21QP

The cash flow to creditors is $414 and the cash flow to stockholders is −$574.

Explanation of Solution

Given information:

Company T has interest expenses of $414. There were no debt borrowings in the current year. The cash flow from assets is −$160.

Formulae:

The formula to calculate the cash flow to creditors:

$\text{Cash flow to creditors}=\text{Interest paid}-\text{Net new borrowing}$

The formula to calculate the cash flow to stock holders:

$\text{Cash flow to stockholders}=\text{Cash flow from assets}-\text{Cash flow to creditors}$

The formula to calculate the cash flow to stockholders:

$\text{Cash flow to stockholders}=\text{Dividends paid}-\text{Net new equity raised}$

Compute the cash flow to creditors:

$\begin{array}{c}\text{Cash flow to creditors}=\text{Interest paid}-\text{Net new borrowing}\\ =\$414-\$0\\ =\$414\end{array}$

Hence, the cash flow to creditors is $414.

Compute the cash flow to stockholders:

$\begin{array}{c}\text{Cash flow to stockholders}=\text{Cash flow from assets}-\text{Cash flow to creditors}\\ =-\$160-\$414\\ =-\$574\end{array}$

Hence, the cash flow to stockholders is −$574.

Compute the new equity issued:

$\begin{array}{c}\text{Cash flow to stockholders}=\text{Dividends paid}-\text{Net new equity raised}\\ -\$574=\$616-\text{Net new equity raised}\\ -\text{\$1,190}=-\text{Net new equity raised}\\ \text{Net new equity raised}=\$1,190\end{array}$

Hence, the new equity raised is $1,190.

Final interpretation of the answers in all parts of the Answer:

The operating cash flow and the net income of the company for the year 2014 is positive.

The company had to invest $696 in working capital. It also invested $5,120 for buying new fixed assets. To meet the investment needs, the company raised $1,190 in new equity and the cash flow to stockholders is −$574. It paid $616 as dividend, and interest of $414.

After paying dividends and interest, the company had $160 to meet the investment needs.