Essay Questions Chapter 1

Essay Questions ? Chapter 1

1. Meese Paper Distributors, Inc. has before-tax earnings of $1,900,000. Calculate the amount of the total tax liability.

Answer:

Meese Paper Distributors

Tax Liability

0.15 $50,000

$ 7,500

0.25 $25,000

6,250

0.34 $25,000

8,500

0.39 ($335,000 ? $100,000)

91,650

0.34 (1,900,000 ? $335,000)

$532,100

Total tax liability

$646,000

Level of Difficulty: 3 Learning Goal: 6 Topic: Business Taxes

2. During 2002, a firm has sold 5 assets described below. Calculate the tax liability on the assets. The firm pays a 40 percent tax rate on ordinary income.

Asset 1 2 3 4 5

Purchase Price $10,000 $50,000 $37,500 $ 3,000 $15,000

Sale Price $12,000 $40,000 $50,000 $ 3,500 $12,000

Answer:

Asset 1 2 3 4 5

Tax Liability $ 2,000(0.40)

-- $12,500(0.40) $ 500(0.40)

--

$ 800

$5,000 $ 200

Level of Difficulty: 3 Learning Goal: 6 Topic: Business Taxes

Chapter 1 The Role and Environment of Managerial Finance 2

3. Consider two firms, Go Debt corporation and No Debt corporation. Both firms are expected to have earnings before interest and taxes of $100,000 during the coming year. In addition, Go Debt is expected to incur $40,000 in interest expenses as a result of its borrowings whereas No Debt will incur no interest expense because it does not use debt financing. However, No Debt will have to pay stockholders $40,000 in dividend income. Both firms are in the 40 percent tax bracket. Calculate the Earnings after tax for both firms. Which firm has the higher after-tax earnings? Which firm appears to have the higher cash flow? How do you account for the difference?

Answer:

Earnings before interest and taxes Less: Interest expense Earnings before taxes Less: Taxes (40%) Earnings after taxes Less: Dividends paid

Go Debt $100,000

40,000 $ 60,000

24,000 $ 36,000

0

No Debt $100,000

0 $100,000

40,000 $ 60,000

40,000

Go Debt has lower earnings after taxes compared to No Debt. However, from a cash outflow perspective, Go Debt paid out a total of only $64,000 ($40,000 in interest expenses plus $24,000 in taxes) while No debt paid out a total of $80.000 ($40,000 in taxes and $40,000 in dividends). The difference between the two is $16,000 which is exactly the difference in taxes paid between the two firms ($24,000 compared to $40,000). This difference results from the fact that interest expense is a tax deductible expense.

Level of Difficulty: 4 Learning Goal: 6 Topic: Business Taxes

Essay Questions ? Chapter 2

1. Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at the year end. Interest expenses for the year were $10,000. The firm expects to distribute $100,000 in dividends. Calculate the earnings after taxes for the firm assuming a 40 percent tax on ordinary income.

Answer:

Earnings before interest and taxes Less: Interest Earnings before taxes Less: Taxes (40%) Earnings after taxes

$500,000 10,000

$490,000 196,000

$294,000

Level of Difficulty: 2 Learning Goal: 1 Topic: Income Statement

Chapter 1 The Role and Environment of Managerial Finance 3

2. At the end of 2005, the Long Life Light Bulb Company announced it had produced a gross profit of $1 million. The company has also established that over the course of this year it has incurred $345,000 in operating expenses and $125,000 in interest expenses. The company is subject to a 30 percent tax rate and has declared $57,000 total preferred stock dividends.

(a) How much is the earnings available for common stockholders? (b) Compute the increased retained earnings for 2005 if the company were to declare a $4.25

common stock dividend. The company has 15,000 shares of common stock outstanding.

Answers:

(a) Gross Profits Less: Operating expenses Operating Profits Less: Interest Net Profits before taxes Less: Taxes (30%) Net Profits After Taxes Less: Preferred Stock Dividend Earnings Available for Common Stock

(b) Earnings Available for Common Stock Dividend (4.25)(15,000 shares) Increased Retained Earnings

$1,000,000 (345,000) $ 655,000 (125,000) $ 530,000 (159,000) $ 371,000 (57,000) $ 314,000

$ 314,000 (63,750)

$ 250,250

Level of Difficulty: 3 Learning Goal: 1 Topic: Income Statement

3. Reliable Auto Parts has 5,000 shares of common stock outstanding. The company also has the following amounts in revenue and expense accounts.

Sales revenue General and administrative expense Interest expense Depreciation expense Preferred stock dividends Selling expense Cost of goods sold

$ 85,000 7,500 3,500 5,000 500 4,000 50,000

Calculate

(a) gross profits. (b) operating profits. (c) net profits before taxes. (d) net profits after taxes (assume a 40 percent tax rate). (e) cash flow from operations. (f) earnings available to common stockholders. (g) earnings per share.

Chapter 1 The Role and Environment of Managerial Finance 4

Answers:

(a) Sales revenue ? cost of goods sold Gross profits

(b) Gross profits ? operating expenses Selling expense General & adm. expense Depreciation expense

Operating profits (c) Operating profits

? interest expense Net profits before taxes (d) Net profits before taxes ? taxes (40%) Net profits after taxes (e) Net profits after taxes

depreciation expense Cash flow from operations (f) Net profits after taxes ? preferred dividends earnings available for C.S. (g) Earnings available for C.S. ______________________ = # of common shares outstanding

Level of Difficulty: 3 Learning Goal: 1 Topic: Income Statement

4,000 7,500 5,000

$85,000 ?50,000 $35,000 $35,000

$16,500 $18,500 $18,500

?3,500 $15,000 $15,000

?6,000 $9,000 $9,000

5,000 $14,000

$9,000 ?500

$8,500 $8,500

$1.70/share 5,000

Chapter 1 The Role and Environment of Managerial Finance 5

4. Colonial Furniture's net profits before taxes for 2002 totaled $354,000. The company's total retained earnings were $338,000 for 2004 year end and $389,000 for 2005 year end. Colonial is subject to a 26 percent tax rate. How large was the cash dividend declared by Colonial Furniture in 2005?

Answer:

Net Profits Before Taxes Less: Taxes (26%) Net Profits After Taxes Retained Earnings (2004) Net Profits After Taxes (2005) Dividends -----------------------------Retained Earnings (2005) Dividends $210,960

$354,000 92,040

$261,960 $338,000

261,960 X

-----------$389,000

Level of Difficulty: 3 Learning Goal: 1 Topic: Statement of Retained Earnings

5. On December 31, 2004, the Bradshaw Corporation had $485,000 as an ending balance for its retained earnings account. During 2005, the corporation declared a $3.50/share dividend to its stockholders. The Bradshaw Corporation has 35,000 shares of common stock outstanding. When the books were closed for 2005 year end, the corporation had a final retained earnings balance of $565,000. What was the net profit earned by Bradshaw Corporation during 2005?

Answer:

Dividends ($3.50/share)(35,000 shares) Retained Earnings (2004) Net Profits After Taxes (2005) Dividends -----------------------------Retained Earnings (2005) Net Profits After Taxes $202,500

$122,500 $485,000

X 122,500 ----------$565,000

Level of Difficulty: 3 Learning Goal: 1 Topic: Statement of Retained Earnings

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