Chapter 3 Finance 1

The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and statement of stockholders’ equity. True
The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm’s future earnings and dividends, and the riskiness of those cash flows. True
Companies typically provide four basic financial statements: the fixed income statement, the current income statement, the balance sheet, and the cash flow statement. False
On the balance sheet, total assets must always equal the sum of total liabilities and equity. True
Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the amounts at which the assets are carried on the books. True
The amount shown on the December 31, 2015, balance sheet as “retained earnings” is equal to the firm’s net income for 2015 minus any dividends it paid. False
The income statement shows the difference between a The income statement shows the difference between a firm’s income and its costs–i.e., its profits–during a specified period of time. However, not all reported income comes in the form of cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may be a substantial difference between a firm’s reported profits and its actual cash flow for the same period. True
If we were describing the income statement and the balance sheet, it would be correct to say that the income statement is more like a video while the balance sheet is more like a snapshot. True
EBIT stands for earnings before interest and taxes, and it is often called “operating income.” True
EBITDA stands for earnings before interest, taxes, debt, and assets False
Typically, the statement of stockholders’ equity starts with total stockholders’ equity at the beginning of the year, adds net income, subtracts dividends paid, and ends up with total stockholders’ equity at the end of the year. Over time, a profitable company will have earnings in excess of the dividends it pays out, and will result in a substantial amount of retained earnings shown on the balance sheet True
The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows a business is able to provide to its investors is its free cash flow. This is the reason that FCF is so important in finance. True
Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations. True
If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow. False
The fact that 70% of the interest income received by corporations is excluded from its taxable income encourages firms to finance with more debt than they would in the absence of this tax law provision. False
Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm’s taxes False
The balance sheet measures the flow of funds into and out of various accounts over time, while the income statement measures the firm’s financial position at a point in time. False
Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors. False
Net operating working capital is equal to current assets minus the difference between current liabilities and notes payable. This definition assumes that the firm has no “excess” cash. True
The next-to-last line on the income statement shows the firm’s earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called “the bottom line.” False
The statement of cash flows has four main sections, one each for operating, investing, and financing activities, and one that shows a summary of the cash and cash equivalents at the end of the year. True
An increase in accounts receivable represents an increase in net cash provided by operating activities because receivables will produce cash when they are collected. False
An increase in accounts payable represents an increase in net cash provided by operating activities just like borrowing money from a bank. An increase in accounts payable has an effect similar to taking out a new bank loan. However, these two items show up in different sections of the statement of cash flows to reflect the difference between operating and financing activities. True
To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue in the net income calculation. True
The first major section of a typical statement of cash flows is “Operating Activities,” and the first entry in this section is “Net Income.” Then, also in the first section, we show some items that represent increases or decreases to cash, and the last entry is called “Net Cash Provided by Operating Activities.” This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt. False
Two metrics that are used to measure a company’s financial performance are net income and cash flow. Accountants emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on cash flows as they do on net income. True
Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. If the firm has sufficient retained earnings, it can purchase assets and pay for them with cash from retained earnings. False
The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the stockholders’ claims against the firm’s existing assets. Put another way retained earnings are stockholders’ reinvested earnings. True
In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and changes in net operating working capital. True
Free cash flow is the amount of cash that if withdrawn would harm the firm’s ability to operate and to produce future cash flows False
If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant. False
Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. True
Because the U.S. tax system is a progressive tax system, a taxpayer’s marginal and average tax rates are the same. False
The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions. True
The time dimension is important in financial statement analysis. The balance sheet shows the firm’s financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects specific changes in accounts over that period of time. True
. Which of the following statements is CORRECT? The balance sheet gives us a picture of the firm’s financial position at a point in time
Which of the following statements is CORRECT? The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm’s future earnings and dividends, and the riskiness of those cash flows.
. Which of the following statements is CORRECT? The assets section of a typical company’s balance sheet begins with cash, then lists the assets in the order in which they will probably be converted to cash, with the longest lived assets listed last.
Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet? The company issues new common stock.
Which of the following items is NOT normally considered to be a current asset? Bonds.
Which of the following items cannot be found on a firm’s balance sheet under current liabilities? Cost of goods sold.
Which of the following statements is CORRECT? The income statement for a given year is designed to give us an idea of how much the firm earned during that year.
. On its 12/31/14 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same amount was shown the following year. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? Dividends could have been paid in 2014, but they would have had to equal the earnings for the year.
Which of the following statements is CORRECT? If a firm is more profitable than average, we would normally expect to see its stock price exceed its book value per share
Which of the following statements is CORRECT? Operating income is derived from the firm’s regular core business. Operating income is calculated as Revenues less Operating costs. Operating costs do not include interest or taxes.
Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets: 2014 2013Common stock $2,000 $1,000Retained earnings 2,000 2,340Total common equity $4,000 $3,340The firm has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? The firm issued common stock in 2014.
. Which of the following factors could explain why Michigan Energy’s cash balance increased even though it had a negative cash flow last year? The company sold a new issue of bonds.
Analysts who follow Howe Industries recently noted that, relative to the previous year, the company’s net cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation? The company made large investments in fixed assets.
Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash provided from operations declined. Which of the following could explain this performance? The company’s depreciation expense declined.
Which of the following statements is CORRECT? The statement of cash flows shows how much the firm’s cash, the total of currency, bank deposits, and short-term liquid securities (or cash equivalents), increased or decreased during a given year.
Which of the following statements is CORRECT? In the statement of cash flows, a decrease in accounts payable is subtracted from net income in the operating activities section.
Which of the following statements is CORRECT? One way to increase EVA is to generate the same level of operating income but with less total invested capital.
Which of the following statements is CORRECT? EVA stands for economic value added, and it is defined as follows:EVA = NOPAT − (Total invested capital)(AT cost of capital %)
Which of the following statements is CORRECT? Free cash flow (FCF) is defined as follows:FCF = EBIT(1 − T) + Depreciation − Capital expenditures required to sustain operations − Required changes in net operating working capital.
Which of the following statements is most correct? Corporations are allowed to exclude 70% of their dividend income from corporate taxes
A loss incurred by a corporation Can be carried back 2 years, then carried forward up to 20 years following the loss.
Which of the following statements is CORRECT? Interest paid to an individual is counted as income for federal tax purposes and taxed at the individual’s regular tax rate, which in 2014 could go up to 39.6%, but qualified dividends received were taxed at a maximum tax rate of 15% for individuals earning less than $400,000 and married taxpayers filing jointly earning less than $450,000.
Which of the following statements is CORRECT? Small corporations that qualify under the Tax Code can elect not to pay corporate taxes, but then each stockholder must report his or her pro rata shares of the firm’s income as personal income and pay taxes on that income.
Which of the following statements is most correct? 70% of the dividends received by corporations is excluded from taxable income
Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? The company sold a new issue of common stock.
Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes Companies’ cash positions would decline.
. Assume that Congress recently passed a provision that will enable Bev’s Beverages Inc. (BBI) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate. Prior to the new provision, BBI’s net income was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BBI’s financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. Net fixed assets on the balance sheet will decrease
The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. Nantell’s operating income (EBIT) will increase
Assume that Besley Golf Equipment commenced operations on January 1, 2014, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December 2014 management realized that the assets would last for only 10 years. The firm’s accountants plan to report the 2014 financial statements based on this new information. How would the new depreciation assumption affect the company’s financial statements? The firm’s cash position in 2014 and 2015 would increase
A start-up firm is making an initial investment in new plant and equipment. Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change? The firm’s cash flow would increase.
Which of the following statements is CORRECT? If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year’s balance.
For managerial purposes, i.e., making decisions regarding the firm’s operations, the standard financial statements as prepared by accountants under generally accepted accounting principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm’s operations. Related to these modifications, which of the following statements is CORRECT? The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, the firm’s value is based on its future cash flows. After all, future cash flows tells us how much the firm can distribute to its investors.
Which of the following statements is CORRECT? A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments.
Last year Besset Company’s operations provided a negative cash flow, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company’s financial statements were prepared under generally accepted accounting principles (GAAP)? The company sold some of its fixed assets.
The CFO of Daves Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur? The company’s net income would increase.
Which of the following statements is CORRECT? The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm’s future earnings and dividends, and the riskiness of those cash flows.
Which of the following statements is CORRECT? In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and the change in net operating working capital. Free cash flow is the amount of cash that could be withdrawn without harming the firm’s ability to operate and to produce future cash flows.
Which of the following statements is CORRECT? Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations.
Which of the following statements is CORRECT? Two metrics that are used to measure a company’s financial performance are net income and free cash flow. Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on free cash flows as they do on net income.

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