Question

15) Suppose that a company is deciding between raising debt (with interest and principal repayments) and raising equity, and management wants to understand the financial impact of both alternatives.

Which of the following statements CORRECTLY describe the immediate impact and the impact after one year?

a) *Immediately* after the company raises debt, Net Income on the Income Statement would be lower, Cash on the Balance Sheet would be lower, and Cash Flow from Financing would be higher.

b) *Immediately* after the company issues equity, Net Income would be unaffected, Cash on the Balance Sheet would increase, and the Equity side of the Balance Sheet would increase.

c) One year after the company raises debt, Net Income would be lower due to interest, and the Net Change in Cash on the CFS would be lower due to debt principal repayments.

d) One year after the company raises equity, Net Income would be unchanged, Cash on the Balance Sheet would be higher, and the Equity side of the Balance Sheet would remain higher.

19) You are analyzing the Net Income and Cash balances of a company over the past three years (shown below). You find that Net Income is increasing, but Cash is decreasing. What are possible explanations for this trend?

ENDING CASH BALANCE:    Year 1: 250    Year 2: 200    Year 3: 150     

ANNUAL NET INCOME:               Year 1: 50            Year 2: 100          Year 3: 150

a) In Years 2 and 3, the company made large capital expenditures.

b) The company has high working capital requirements (such as purchasing inventory in advance of selling products).

c) The company has a large debt balance that requires high annual principal repayments.

d) None of the above – this scenario could never happen in real life.

Answer 1

Ans 15.

Immediately after debt or equity is raised , there will be no immediate effect, The effect of higher interest expense or higher sales and net income from equity infusion will be there during the next periods , so we can understand theeffects after a year.

When debt is raised , cash flow will be higher as we are getting the fund, not paying the interest and principal immediately . When equity is issued , equity side of balance sheet will be higher and cash will also be higher due to the inflow from stock issued.

Considering all aspects , statement ' b) *Immediately* after the company issues equity, Net Income would be unaffected, Cash on the Balance Sheet would increase, and the Equity side of the Balance Sheet would increase.' --looks correct.

One year after debt is issued , the net income may go down as interest has to be paid , the cash flow will be reduced as principal on debt to be repaid .

One year after equity issue, the net income should raise as new investment will increase income without any finance cost, the cash flow from operations should be high due to higher net income , there will be some dividend payout , but still the equity side will be higher due to increase in retained earning.

Considering all aspects , statemnt 'c) One year after the company raises debt, Net Income would be lower due to interest, and the Net Change in Cash on the CFS would be lower due to debt principal repayments'--looks correct.

Ans 19.

When the cash flow of a company decreases though the net income increases , it is most probable that additional cash generated from net income is being invested in additional Capital expenditure for future earning or to meet the additonal working capital reuirement coming from increasing sales or paying off debt balances as the company wants to reduce the debt burden.

So options a,b,c all three are correct in this case.