practical financial management chapter 2 solman

7/25/2019 Practical Financial Management Chapter 2 SolMan

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Financial Background: A Review of Accounting, Financial Statements, and Taxes

Chapter 2

FINANCIAL BACKGROUND: A REVIEW OF ACCOUNTING,

FINANCIAL STATEMENTS, AND TAXES

FOCUSMost students have been exosed to accounting and taxes in rere!uisite courses, but man" don#t recallthe material well enough to tackle finance effectivel"$ %hater & rovides a concise review of what the"need to know in one convenient lace$ The material is resented in relativel" non'numerical formalthough some comutation is unavoidable$

PEDAGOG

(ou ma" not want to send much class time lecturing on accounting and tax material$ An hour isgenerall" enough to hit the highlights$ Assigning the chater as background reading followed b" a !ui)gets students warmed u and focused on financial concets in rearation for the things to come$

TEAC!ING OB"ECTIVES

*$ To reac!uaint students with basic accounting concets and rocedures which the" ma" haveforgotten$ &$ To develo an understanding of federal tax fundamentals, and the abilit" to calculate simletaxes$

OUTLINE

+$ A%%-.T+./ S(ST0MS A.1 F+.A.%+A2 STAT0M0.TSA$ The .ature of Financial Statements

3ow accounting ideas such as 4income4 are different from ever"da" use of similar terms$B$ The Accounting S"stem

A brief treatment of basic ideas including the double entr" concet, accounting eriods,closing the books, and stocks and flows$

++$ T30 +.%M0 STAT0M0.TA line b" line treatment of income, cost, and exense items along with subtotals such as/ross Margin and 0B+T$

+++$ T30 BA2A.%0 S300TA$ 5resentation

Format, the balance sheet identit", li!uidit"$B$ Assets

A brief descrition of the treatment of each asset item along with the risks it resents$ 0$g$,overstatement of receivables$

%$ 2iabilitiesAn intuitive descrition of the nature of current liabilities, eseciall" accruals$

1$ 0!uit"The three e!uit" accounts are exlained along with the relationshi between income,dividends, new stock sales and e!uit"$

+6$ T30 TA7 0.6+R.M0.TA$ Taxing Authorities and Tax Bases

8ho can tax us, based on what$

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B$ +ncome Taxes ' The Total 0ffective +ncome Tax RateState tax is deductible from federal tax$

%$ 5rogressive Tax S"stems, Marginal and Average Rates1efinitions, the current rogressive s"stem, the imortance of the marginal rate forinvestment decisions$

1$ rdinar" +ncome and %aital /ains2osses

The nature of caital gains and losses, wh" the wa" the"#re taxed is imortant to investment,and the current status$

6$ +.%M0 TA7 %A2%-2AT+.SA$ 5ersonal Taxes

Basic rules of exemt income, deductions and ersonal exemtions$ Taxa"er classesand the tax tables$ 0xamles: %hoosing between cororate and municial bonds$

B$ %ororate Taxes1efining taxable income, the cororate rate structure, the s"stem favors debt financing,dividend exemtions between cororations, carr" backsforwards$

#UESTIONS

*$ 8h" does a financial rofessional working outside accounting need a knowledge of accountingrinciles and methods;

ANSWER Financial records are ket within accounting s"stems and results are formulated inaccounting reorts$ Therefore, to understand transactions and the results of oerations, one has to haveat least a fundamental understanding of accounting rinciles$

&$ 1iscuss the urose of an accounting s"stem and financial statements in terms of the wa" thes"stem reresents a business$

ANSWERAccounting is designed to rovide a 4icture4 of oerations in numerical terms$ +t does thatwith devices like dereciation which matches the cost of an asset with its service life regardless of thecash flows associated with its ac!uisition$ The ortra"al is concetual in that it attemts to give abroader icture of the condition of a business than the immediate availabilit" of funds$


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a"ables omit legitimate liabilities of the coman"$ Such misstatements reresent a firm as being worthmore than it actuall" is$ That deceives investors and others interested in dealing with the coman"$

$ 1o the definitions of current assets and current liabilities suggest a !uick wa" of looking at thefirm#s abilit" to meet its financial obligations =a" its bills> over the near term; =Hint: Think in terms ofratios$>

ANSWER %urrent assets reresent things that are exected to become cash within a "ear =inflows>,while current liabilities re!uire cash within a "ear =outflows>$ Being able to a" the bills means theinflows have to exceed the outflows in the short run$ This suggests forming the ratio of current assets tocurrent liabilities =called the current ratio>$ +f that ratio exceeds *$C, the firm should be able to a" itsbills in the next "ear$

9$ 3ow are caital and working caital different;

ANSWER %aital refers to the mone" used to start businesses and ac!uire long'lived assets$ 8orkingcaital refers to the mone" used to suort da" to da" oerations$ 8e can therefore think of the two asdiffering with resect to time$ %aital is long term and working caital is short term$

$ 8hat is leverage and how does it work; 8hat is the main concern about using it;

ANSWER2everage refers to using borrowed =someone else#s> mone" to suort a business rather thanthe owner#s own e!uit"$ 2everage can enhance financial results if the business earns more with theborrowed mone" than the interest cost of borrowing it$ +n that case leverage multilies good financialresults into better ones$ The concern about using borrowed mone" is that interest has to be aid whetherresults are good or not$ 8hen a business earns less using borrowed mone" than the cost of borrowing it,leverage multilies oor results into ver" oor results$

D$ 1efine the term tax base and discuss common bases$ 8hat government units tax on each; 8hatare these taxes commonl" called;

ANSWER A tax base is the item or activit" on which a tax is levied$ The common bases are income,wealth, and consumtion$ +ncome taxes siml" re!uire the a"ment of a ercentage of income to thegovernment in ever" eriod, usuall" a "ear$ +ncome is taxed b" the federal government, most states, anda few cities =e$g$ .ew (ork %it">$ A wealth tax charges the owner of roert" a ercentage of its valueeach "ear$ The most common wealth tax is levied on real estate b" cities and counties$ A consumtiontax charges users a ercentage of the cost of roducts the" consume$ The most common consumtiontax is a sales tax usuall" levied b" states, counties, and cities$ The federal government#s consumtiontaxes are called excise taxes$

*C$ 8hat is the total effective tax rate;

ANSWER The total effective tax rate is the combination of state and federal income tax rates$ +t is lessthan the sum of the two rates, because state tax is deductible from income for federal tax uroses$

**$ 8hat is taxable income for an individual; 3ow does it differ from taxable income for acororation;

ANSWER Taxable income for an individual is income less exemt or excluded items, less deductionsand less ersonal exemtions$ Taxable income for a cororation is revenue less excluded items lessbusiness costs and exenses$ 5ersonal exemtions don#t exist for cororations$

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*&$ 8hat tax rate is imortant for investment decisions; 8h";

ANSWER The marginal tax rate is the rate on the next =or last> dollar of income$ +t is imortant forinvestment decisions, because investments are generall" made with 4extra4 income available afternecessar" exenses have been taken care of$ Thus investment income is generall" taxed at thetaxa"er#s marginal rate$

*taxation of earnings which is more severe than the government#s intent$

*9$ 0xlain the reasoning behind tax loss carr" backs and carr" forwards$

ANSWER +f business losses could not offset rofits in revious or subse!uent eriods, the tax s"stemviewed over a eriod of "ears would tax comanies with temorar" losses at rates in excess of onehundred ercent of rofits$ This clearl" doesn#t make sense, so the inter'"ear allocation of losses isallowed$

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PROBLEMS

Wr$t$%& O'' a Lar&e U%()**e(ta+*e Re(e$a+*e - E.a/p*e 201, Pa&e 3*$ %anada" 2td$ has the following receivables balances =M>

/ross Accounts Receivable *9@

Bad 1ebt Reserve =.et Accounts Receivable *9&

Two "ears ago a customer was aroved for an unusuall" large credit sale of 9M over theobGections of the credit and collections deartment$ Shortl" after the sale the customerHs business beganto deteriorate due to an unexected recession$ To date it has aid onl" &M against the order desite thefact that it has consumed all of the material urchased$ The collections deartment has workeddiligentl" to collect the remaining @M without success$ The customer filed for bankrutc" thismorning with essentiall" no assets to a" a large number of creditors$ 0valuate the financial statementimact of the bankrutc" on %anada"$ Assume %anada"Hs roduct cost is ?CI of revenue and the baddebt reserve of


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=@> +ncurred other exenses =including the interest from the loan> of @,CCC, all of which wereaid in cash$=> FredHs tax rate is ?CI$ =Taxes will be aid in a subse!uent eriod$>

a$ 8hat will the business reort as net income for its first month of business; (Hint: Write out anincome statement and enter revenue, cost, and expense, then calculate tax and net income.)

b$ 2ist the flows of cash in and out of the business during the month$ Show inflows as ositivesand outflows as negatives =using arentheses>$ Sum to arrive at a .et %ash FlowN figure$c$ Should Fred a" more attention to net income or cash flow; 8h";

SOLUTION:

a$ .et +ncomeSales ?@,CCC =*CCC units O ?@>%ost of /oods Sold &*,CCC/ross Margin &?,CCCther 0xense @,CCC =+ncludes +nterest 0xense>0BT *D,CCCTaxes 9,CC =*D,CCC x ?CI>.et +ncome **,?CC

b$ %ash Flows5urchase of Assets =@C,CCC>5roceeds from 2oan ?@,CCC =DCI of the asset urchase rice>%ash from Sales &&,@CC =ne half of the sales>5urchase of +nventor" = ther 0xenses = @,CCC>.et %ash Flow =*9,@CC>

c$ Fred has to a" attention to both net income and cash flow$ .et +ncome is imortant because itis an indication of the long term rofitabilit" of the business$ +t matches the revenues andexenses for the eriod and will hel him understand whether he can sell his roducts at a rofitin the long run$ 3owever, cash flow is e!uall" imortant, because if a business canHt generateositive cash flows, it is destined to fail$ +t is not uncommon for a business to have negativecash flows earl" in its existence, even if itHs showing a ositive net income$ ThatHs one reasonfor doing a statement of cash flows weHll stud" in %hater


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Accruals%ash%ommon StockFixed Assets =/ross>Total %urrent AssetsTotal %urrent 2iabilities

Total 0!uit"

SOLUTION:

Assets =CCC> 2iabilities Q 0!uit" =CCC>%ash 9C Account 5a"able CAccounts Receivable *&C Accruals ?C+nventor" *@C Total %urrent 2iabilities *CC Total %urrent Assets


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i$ +ncrease .% 1ecrease 1ecreaseG$ .% +ncrease 1ecrease +ncrease

$ n Lanuar" *, &C7&, Miller %or$ urchased a milling machine for ?CC,CCC$ +t will bedereciated on a straight line basis over &C "ears$ n Lanuar" *, &C7 ?CC,CCC @C,CCC @C,CCCAccumulated 1ereciation &C,CCC ?,&@C 9&,@CCFixed Assets =.et>


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SOLUTION: Two da"s of the a" eriod belong in the month Gust closed, so the accrual is &@ of oneweek#s a"roll:

&@ *,CCC,CCC K ?CC,CCC$

**$ Sanderson Metals +nc$ accrues four liabilit" items: a"roll, emlo"ee vacation that has been earnedbut not used, roert" taxes, and inventor" that arrives at its factor" dock before an invoice is received

from the vendor$5a"roll: Sanderson a"s its emlo"ees ever" other Frida" for work erformed throughthat da"$ The annual a"roll is ?9 million$

5roert" tax: The firm a"s the local government of vacation each "ear,which is earned at a rate of =*@U*& K> *$&@ da"s er month worked$ .o vacation can be carriedover "ear end, but an emlo"ee can take the current "earHs vacation before it is actuall" earned$There are &@C work da"s each "ear$ The vacation accrual reflects that a" for vacation da"searned but not used is a liabilit" of the coman"$

+nventor": The accounting deartment uses vendor =sulier> invoices combined withreceiving documents to enter new inventor" on the coman"Hs books$ 3owever, inventor" oftenarrives a few da"s before the associated invoice is received$ The aroximate value of materialin this received but unbilled status is accrued to reflect that the coman" is in ossession of thegoods and has a liabilit" to a" for them$

Sanderson is currentl" closing the books on Aril &C7$ The last da" of the month was sevenda"s after a a"da"$ Through the end of Aril emlo"ees had taken @9,CCC of aid vacation time$Five railroad carloads of steel arrived in the last week of Aril but invoices for onl" three of thoseshiments have been received$ An average carload shiment costs *C9,CCC$ All rior receits havebeen invoiced$ %alculate SandersonHs Aril month end accruals balance$

=3int: Some accruals, like a"roll and inventor", clear a few da"s after month end$ thers, likeroert" tax, build u steadil" until cleared at the end of a eriod like the count"Hs fiscal "ear$ Still

others, like vacation, are increased steadil" and are decreased when some activit" occurs, such as eolegoing on vacation$>

A roert" tax bill aid in arrears is due at the end of the eriod during which the liabilit" is incurred$The liabilit" for the bill, however, comes from owning the roert" as time asses$ 3ence, as eachmonth of the tax "ear goes b", the coman"Hs roert" tax liabilit" increases b" **& of the annual billuntil it is aid at the end of the fiscal "ear$A fiscal "ear is an organi)ationHs "ear for accounting uroses$ Man" comanies and most governmentunits use fiscal "ears that donHt coincide with calendar "ears$ SandersonHs books are ket on a calendar"ear$

SOLUTION: a$

5a"roll: 9 da"s is *$? weeks=*$? @&> V ?9,CCC,CCC K *,&@,


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Aril accrual "ear to date &Aril balance 5urchased inventor" on credit totaling @CC,CCC, Accruals increased b" *C,CCC during the month$=@> Additional cash a"ments were made for exenses incurred during the month oftotaling C,CCC$

%omute the change in 0lliottHs working caital for the month of Lanuar", &C7


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%hater &

n Lune

Total Assets *&,CCC

2iabilities

Accounts 5a"able &,CCC

Accruals

1ebt

0!uit" *&,CCC

*


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Total 2iabilit" Q 0!uit" *&,CCC

+.%M0 STAT0M0.T

Sales D,CCC

%ost

5a" for+nventor"

=>

Bu" Truck

=9>5a"

0mlo"ees? weeks

=>5a"

0mlo"ees2ast & da"s

BA2A.%0 S300T

Assets

%ash =&,CCC> =,CCC> =?,CCC>

Accounts Receivable

+nventor" Fixed Assets =net> ,CCC

Total Assets

2iabilities

Accounts 5a"able =&,CCC>

Accruals ?CC

1ebt

0!uit"

Total 2iabilit" and 0!uit"

+.%M0 STAT0M0.T

Sales

%ost

0xense ?,CCC ?CC

.et +ncome

=D>

Reclassif"verdraftas 2oan

=*C>Record

5rofit as .et+ncome Q

0!uit"

=**>

LuneStatements

BA2A.%0 S300TAssets

%ash @,CCC 'C'

Accounts Receivable D,CCC

+nventor" ?,CCC

Fixed Assets =net> ,CCC

Total Assets *D,CCC

2iabilities

*D


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Accounts 5a"able 'C'

Accruals ?CC

1ebt @,CCC @,CCC

0!uit" *,CC *4$t9 ?@ 1@

0arnings &C,CCC &C,CCC &C,CCC

+nterest =after tax> W D,CCC *@,CCC.et +ncome &C,CCC **,CCC @,CCC

1ebt W *@C,CCC *@C,CCC0!uit" &@C,CCC *CC,CCC *CC,CCCTotal caital &@C,CCC &@C,CCC &@C,CCCReturn I **I @I

.et +ncome0!uit" K &C&@C ***CC @*CC

c$ 2everage works both wa"s$ +t imroves R0 if the firmHs underl"ing return on caital is higher thanthe rate it a"s for borrowed mone"$ This is the case when the interest rate is I$ But if debt costs

more than the coman" earns with the borrowed mone", as in art b$, leverage makes R0 worse$

*@$ /atwick 2td$ has after tax rofits =net income> of @CC,CCC and no debt$ The owners have a million investment in the business$ +f the" borrow & million at *CI and use it to retire stock, how willthe return on their investment =e!uit"> change if earnings before interest and taxes remains the same;Assume a flat ?CI tax rate and that the loan reduces e!uit" dollar for dollar$ A business ownerHs returnon investment or e!uit" is R+KR0K.et +ncome0!uit"$

SOLUTION: /atwick#s original return on invested e!uit" is its after'tax earnings divided b" thee!uit":

&C


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@CC,CCC ,CCC,CCC K $


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Then:%ommon stock = ,CCC,CCC5aid in 0xcess =&M shrs O > *,CCC,CCC Total 0!uit" &?,CCC,CCC

At The E%5 O' The F$r6t ear

Add to common stock $@M shrs ? ar K &M

Add to 5aid in 0xcess $@M shrs *C K @M

Add retained earnings of &M *$&M K C$M

%ommon stock =&$@M shrs O ? ar> *C,CCC,CCC5aid in 0xcess &*,CCC,CCCRetained 0arnings CC,CCC Total 0!uit" and substitute from the roblem noticing that the %oolidge#s marginal tax rate is&I from Table &'?$

T0TR K Tf P Ts=* Tf>

K $& P $** =* $&>

K


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&*$ -se the following tax brackets for taxable income:

Bracket Tax RateC ' *C,CCC *@I*C,CCC ' @C,CCC &@I@C,CCC ' &@C,CCC &C,CCC=b> *&@,CCC=c> *,CCC,CCC

SOLUTION:

a$ =*C,CCC x $*@> P =*C,CCC x $&@> K ?,CCC&C,CCC K &C$CIb$ =*C,CCC x $*@> P =?C,CCC x $&@> P =9@$CCC x $ K


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The famil" made home mortgage a"ments that included interest of *,?C, and aidreal estate =roert"> tax of ?, x $&@ K **,*?C V $&@ K &,9@

Tax liabilit" *&,@&C

c$ Average tax rate K tax liabilit" taxable incomeK *&,@&C *,?CK *@$


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1eductions 3ome mortgage interest ,CCCReal estate tax *,?@CState income tax K $&@ x 9&,CCC K *,CCC$& x =*@,*CC J *?&,9CC> K $& x &&,?CC K ,&9&

Total


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Savings @,CC Brother 2ou : Biotech *C,CCC Real 0state =?,CCC> ,CCC

+ncome *@*,@C

.ext list deductions from income noticing that rincial rea"ment on the mortgage is not deductible$2ikewise the a"ment to Loan#s mother isn#t deductible$ Mortgage interest D,CCC Real 0state tax &,9@C State +ncome tax ,CC %haritable contributions *,@CC &C,C@C

Finall" calculate exemtions at x $&@ K ,*9@ *@,D*C

The tax on the caital gain is

,CCC $*@ K DCC

and the tax on the dividend is*@,CCC x $*@ K &,&@C

3ence, the total tax liabilit" is

*@,D*C P DCC P &,&@C K *D,CC

c$ The average tax rate is Gust the tax liabilit" divided b" taxable income:

+ncluding caital gains and dividends K *D,CC**,?CC K *$?I.ot including caital gains and dividends K *@,D*CD@,?CC K *$9I

d$ .otice that there are actuall" two marginal rates, one for ordinar" income =&@I> and one for long'term caital gains and dividends =*@I>$ 3ence the correct marginal rate for financial decisions woulddeend on the t"e of investment income under consideration$

&


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C)/par$%& Ta.a+*e a%5 Ta. E.e/pt Ret4r%6 = E.a/p*e 208, Pa&e 82

&$ 3arr" Swart) wants to invest in a bond and has narrowed his choices down to two issues$ The firstis offered b" Microsoft %or$ and a"s an interest rate of I$ The second otion is offered b" the cit"of Sringfield, Massachusetts, and offers a return of I$ 3arr" feels that the risk levels inherent in the

two bonds are similar$ The both mature in ten "ears$ 3arr" is single, has taxable income of *&@,CCC in&C*& and lives in a state that has no ersonal income tax$ 8hich bond should 3arr" choose;

S)*4t$)%: First consult the &C*& tax schedule for single individuals in Table &$? and observe that 3arr"is in the &I federal tax bracket$ The bracket rate is also his marginal tax rate which is relevant forinvestment decisions$

The Microsoft bond a"s I, but 3arr" will kee onl" @$9I after taxes calculated as followsI x =* ' $&> K I x $9& K @$9I

8hich is less than the Sringfield bondHs tax exemt return of I$ 3ence 3arr" is better off with themunicial bond$

&9$ 1ick 1owen is considering three investment oortunities:

=*> A ?$@I %it" of %hicago bond that is tax exemt at both the state and federal level$=&> A ?$9@I State of +llinois bond that is tax exemt at the federal level but taxable at the statelevel$= A $9I Mc1onaldHs bond that is taxable at both the state and federal level$ =Hint:-se theT0TR$>

+f the +llinois state tax rate is I and 1ickHs marginal federal tax rate is


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g$ *9,


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&C**


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Sales *C,9C,CCC %ost **C,?@C,CCC 0xenses @,@C,CCC

+n addition, it received both interest and dividends from the Bevins %or$, of which it owns


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b$ 1uncan and Angela are also considering getting married, but have considerabl" lower incomes$1uncan Angela

Salar" @,?@C

practical financial management chapter 2 solman

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