Chapter 3 Financial Statements, Cash Flow, and Taxes 77Financial statements are based on generally accepted accounting principles (GAAP) and
are audited by CPA firms. Therefore, do investors need to worry about the validity of
those statements? Explain your answer.
What is free cash flow? If you were an investor, why might you be more interested in free
cash flow than net income?
Would it be possible for a company to report negative free cash flow and still be highly val-
ued by investors; that is, could a negative free cash flow ever be a good thing in the eyes
of investors? Explain your answer.
What is meant by the following statement: Our tax rates are progressive.
What does double taxation of corporate income mean? Could income ever be subject to triple
taxation? Explain your answer.
How does the deductibility of interest and dividends by the paying corporation affect the
choice of financing (that is, the use of debt versus equity)?INCOME STATEMENT Little Books Inc. recently reported $3 million of net income. Its
EBIT was $6 million, and its tax rate was 40%. What was its interest expense? [Hint: Write
out the headings for an income statement and fill in the known values. Then divide $3
million of net income by (1 " T)! 0.6 to find the pretax income. The difference between
EBIT and taxable income must be the interest expense. Use this same procedure to com-
plete similar problems.]
INCOME STATEMENT Pearson Brothers recently reported an EBITDA of $7.5 million and
net income of $1.8 million. It had $2.0 million of interest expense, and its corporate tax rate
was 40%. What was its charge for depreciation and amortization?
STATEMENT OF STOCKHOLDERS’ EQUITY In its most recent financial statements,
Newhouse Inc. reported $50 million of net income and $810 million of retained
earnings. The previous retained earnings were $780 million. How much in dividends
were paid to shareholders during the year? Assume that all dividends declared were
actually paid.
BALANCE SHEET Which of the following actions are most likely to directly increase cash
as shown on a firm’s balance sheet? Explain and state the assumptions that underlie your
answer.
a. It issues $2 million of new common stock.
b. It buys new plant and equipment at a cost of $3 million.
c. It reports a large loss for the year.
d. It increases the dividends paid on its common stock.STATEMENT OF STOCKHOLDERS’ EQUITY Computer World Inc. paid out $22.5 million in
total common dividends and reported $278.9 million of retained earnings at year-end. The
prior year’s retained earnings were $212.3 million. What was the net income? Assume that
all dividends declared were actually paid.
STATEMENT OF CASH FLOWS W.C. Cycling had $55,000 in cash at year-end 2007 and
$25,000 in cash at year-end 2008. Cash flow from long-term investing activities totaled
–$250,000, and cash flow from financing activities totaled #$170,000.
a. What was the cash flow from operating activities?
b. If accruals increased by $25,000, receivables and inventories increased by $100,000,
and depreciation and amortization totaled $10,000, what was the firm’s net
income?FREE CASH FLOW Bailey Corporation’s financial statements (dollars and shares are in
millions) are provided here.3-53-5
3-63-6
3-73-7
3-83-8
3-93-9
3-103-10
PROBLEMPROBLEMSS
Easy 3-13-1
Problems 1–3
Easy
Problems 1–3
3-23-2
3-33-3
Intermediate 3-43-4
Problems 4–7
Intermediate
Problems 4–7