FINA 4300 Ch. 1 – Flashcards

It means that the company's operating activities consumed cash. A combination of two things can cause this: operating losses, and increases in accounts receivable and inventories. Operating losses can obviously be dangerous. Rising receivables and inventories need not be dangerous provided they are growing in step with sales, and provided the company is able to finance the cash shortfalls. Rising receivables and inventories relative to sales suggest slackening management control of important operating assets, a potential danger.

This means that the company's investing activities consumed cash, that the company purchased more property, plant, equipment, or marketable securities than it disposed of during the year. For most growing, stable companies, cash flows from investing activities are negative as firms build production capacity and replace used equipment. Positive cash flows from investing activities can signal problems, suggesting the firm has no attractive investment opportunities or that it might be liquidating productive assets due to financial difficulties.

Negative cash flows from financing activities means that the firm is paying out more money to investors (in the form of debt principal repayment, interest payments, dividends and share repurchases) that it is raising from investors. Usually, negative cash flows from financing activities are associated with mature companies generating more than enough cash from operations to fund future activities. It is not necessarily bad news. Conversely, early-stage firms, rapidly growing firms, and those in financial distress typically have positive cash flows from financing activities.

Management is either dumb or thinks its board is. Earning $100 million on a $3 billion equity investment is a return of less than 4 percent, a figure well below any reasonable cost of equity. As a board member, I would vote to cut management's compensation, not raise it. I would also criticize them sharply for apparently attempting to deceive the board.

False Shareholders' equity is on the liabilities side of the balance sheet. It represents owners' claims on company assets. Or said differently, the money contributed by owners and supplemented by retained profits has already been spent to acquire company assets.

False Book value of equity is simply the "plug" number that makes the book value of assets equal the sum of the book value of liabilities and the book value of equity. If the book value of liabilities is greater that the book value of assets, then (by definition) book value of equity must be negative. This does not automatically spell bankruptcy. Bankruptcy occurs when a firm cannot pay its bills in a timely manner and creditors force it to seek, or it voluntarily seeks court protection.

False Earnings are allocated to either dividends or retained earnings after net income is calculated. Increasing the dividend will reduce retained earnings, but will not affect net income.

True By comparing a balance sheet from the beginning of 2014 (year-end 2013) with a balance sheet from the end of 2014, it is possible to construct a sources and uses statement for 2014.

False Goodwill arises when one firm acquires another at a price above its book value. For example, if one firm acquires another for $10 million in cash but the target has a book value of only $8 million, the accountants record a $10 million reduction in the acquirer's cash, and $8 million increase in assets, and a $2 million increase in goodwill to balance the accounts.

False It's just the reverse. As an asset account decreases, cash is made available for other uses. Thus, decreases in assets are sources of cash, In order to decrease a liability account, the firm must use cash to lower the liability. Thus, decreases in liability accounts are uses of cash.

Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000.

Net plant and equipment rises $80 million; Cash falls $32 million; Bank debt rises $48 million.

Net plant and equipment rises $60 million; cash falls $60 million.

Cash falls $40,000; Accounts payable falls $40,000.

Cash falls $240,000; Owner's equity falls by $240,000 (via an increase in Treasury stock).

Cash rises $80,000; Inventory falls; Accrued taxes, Owners' equity, and possibly other cost categories rise such that the algebraic sum equals $80,000.

Accounts receivable rise $120,000. Other categories change as described in part f.

Cash falls $50,000. Owner's equity falls by $50,000 (via Retained Earnings).

Because the accountants primary goal is to measure earnings, not cash generated. She sees earnings as a fundamental indicator of viability, not cash generation. A more balanced perspective is that over the long run successful companies must be both profitable and have cash in the bank to pay their bills when due. This means that you should pay attention to both earnings and cash flows.

R&E Supplies, Inc. Sources and Uses Statement 2008 - 2011 ($000). Sources of cash: Decrease in cash and securities $259 Increase in accounts payable 2,205 Increase in current portion long-term debt 40 Increase in accrued wages 13 Increase in retained earnings 537 Total $3,054 Uses of cash: Increase in accounts receivable $1,543 Increase in inventories 1,148 Increase in prepaid expenses 4 Increase in net fixed assets 159 Decrease in long-term debt 200 Total $3,054

1. R&E is making extensive use of trade credit to finance a buildup in current assets. The increase in accounts payable equals almost three fourths of total sources of cash. Increasing accounts receivable and inventories account for almost 90 percent of the uses of cash. 2. External long-term debt financing is a use of cash for R&E, meaning that it is repaying its loans. A restructuring involving less reliance on accounts payable and more bank debt appears appropriate.

The General Secretary has confused accounting profits with economic profits. Earning $300 million on a $7.5 billion equity investment is a return of only 4%. This is poor performance and is too low for the company to continue attracting new investment necessary for growth. The company is certainly not covering its cost of equity.

Accounting income will be the value of the parcels sold, less their original purchase price. So if all parcels are sold, the income is 5x$16 million + 5x$8 million -$100 million = $20 million. Economic income will be the increase in the market value of the land, whether sold or not, over the period. At the end of the first year, this will be $20 million. Answers to each part of the question appear below. Accounting Income Economic Income $20 million $20 million

Accounting Income Economic Income 0 $20 million

Accounting Income Economic Income -$10 million $20 million

Accounting Income Economic Income $30 million $20 million

Too many companies have tried this. If the market value of a piece of land falls, the owner loses whether he sells or not. The market price of the land fell because people thought the future income stream to the owners was worth less. Continuing to hold the property, forces the owner to accept the lower income. Whether the loss is recognized or not might affect accounting earnings, but has nothing to do with reality.

Acadia, Inc. generated $480,000 of cash during the year. The $500,000 net income ignores the fact accounts receivable rose $150,000, a use of cash. It also treats $130,000 depreciation as an expense, whereas its is a non-cash charge. The $25,000 increase in market value of assets adds to the market value of the business, but is not a cash flow. Here are the figures: Accounting Income $500,000 Depreciation (a non-cash charge) +$130,000 Increase in accounts receivable -$150,000 ------------- Cash Generated $480,000

The accounting profits from Jonathan's brewery are expected to be $40,000. These accounting profits do not include the implicit cost of the entrepreneur's time. Jonathan's time is worth at least $62,000, the current income he will have to forego to manage the brewery. When these implicit opportunity costs are included net income falls to: $230,000 - $190,000 - $62,000 = -$22,000 This new venture will reduce Jonathan's income not increase it.

In 2014, company sales were $782 million, but accounts receivable rose $30 million, meaning the company received only $752 million in cash. (This ignores possible changes in bad debt reserves.) Letting bop stand for beggining of period, and eop for end of period, the relevant equation is: AR pop = AR eop +Sales - Collections Collections = Sales - Change in AR $752 million = $782 million - $30 million

During 2014 the company sold $502 million of merchandise at cost, but finished goods inventory fell $10 million, indicating that the company produced only $492 million of merchandise. The equation is: Inventory eop = Inventory bop + Production - Cost of Sales Production = Cost of Sales + Change in Inventory $492 Million = $502 million - $10 million

Net fixed assets rose $78 million, depreciation reduced net fixed assets $61 million, so capital expenditures must have been $139 million (ignoring asset sales or write-offs). Net fixed assets eop = Net fixed assets bop + Capital Exp Capital Exp = Change in net fixed assets + Depreciation $139 million = $78 million + $61 million

There are two way to derive cash flow from operations. If there were no financing cash flows for the year, then changes in the year end cash balance must be due to cash flows from operations and investing activities. The capital expenditures of $139 million represent the investing cash flows of the firm. Thus, we can us ethe change in the cahs balance from 2013 to 2014 ($49 million) and the cash flows form investing ot obtain cash flow from operations. Change in cash balance = CF from ops + CF from investing + CF from financing $49 million = CF form ops + (-$139 million)+ 0 CF from ops = $49 + 139 = $188 million or CF from ops = Net income - increase in AR + decrease in inventory + increase in AP + Depreciation CF from ops = 142 - 30 + 10 + 5 + 61 = $188 million

Company A B C Year end cash $150 million $30 million $120 million

It appears that company C retired more debt than it issued, repurchased more stock than it issued, or some combination of the two.

I'd prefer to own company A. A appears to be a growing company as evidenced by the sizable net cash used in investing activities, and its negative net cash flow from operations may well be due to increasing accounts receivable and inventories that naturally accompany sales growth. Company B appears not to be growing, so its negative net cash flows from operations are probably due to losses or to increasing receivables and inventories relative to sales, a trend denoting poor management of current assets.

I don't think there is necessarily any cause for concern. It appears company C is a mature, slow-growth company that is returning its unneeded operating cash flows to investors in the form of debt repayment, share repurchase, dividends, or some combination of these. This is a perfectly viable strategy in the absence of attractive investment opportunities.

Stock price per share = $25 million/800,000 shares - $31.25 per share. Book value per share = $15 million/800,000 =$18.75 per share

Telluride Mining will pay $31.25 per share for the 160,000 shares it repurchases. This reduces the book value of equity by $5,000,000. Assuming all else remains the same, the new book value will be $10,000,000.

Since nothing else has changed, investors do not change their perceptions of the firms, and there are not taxes or transaction costs, the market value should fall by exactly the amount of the cash paid in the transaction. The new market value should be $20,000,000. Another way to think about he question is to note the repurchase of the share will reduce cash by $5,000,000 or increase liabilities by the same amount if they finance the repurchase with debt. Either way the firm is worth $5,000,000 less to owners after the repurchase,or $20,000,000. With 640,000 shares outstanding after the repurchase, the price per share remain $31.25 ($20,000,000/640,000).

Shares outstanding increase 10%. or 80,000 shares. At $31.25 per share, Telluride would raise $2,500,000. Assuming all else remains the same, the new book value of equity will be $17,500,000 ($15 million + $2,500,000).

Due to the same reasoning as in par (c), the market value should rise by $2,500,000. In essence the sale raises company cash by $2,500,000, increasing the value of the firm by just this amount. The new market value should be $27,500,000. The price per share should remain $31.25 ($27,500,000/880,000 shares).