Question

Consider the following 2017 information for your company, which began operations on January 1, 2017. (So it did not exist in 2016, and therefore had no balance sheet.)

- Number of units sold in 2017: 1,000

- Price per unit: $1,000

- Cost of goods sold for each unit: 65% of the price

- Other expenses (except depreciation): $50,000

- On January 1, the company bought $500,000 of fixed assets. You assume these assets will last 5 years

and have no salvage value (i.e., after 5 years you will need to scrap them and will not be able to sell

them for any money). You will depreciate these assets linearly over the five years.

- On January 1, the company received $200,000 as investment from its shareholders.

- On January 1, the company borrowed $400,000 from the bank at a rate of 5.0%. At the end of the

year, the company will pay the interest due on that amount only. (In other words, it will not pay

down the loan, since this is not an amortizing loan.)

- The tax rate is 20% and the company will pay its taxes at the end of the year.

- The company paid the owners $25,000 in dividends at the end of the year.

Using the above information, answer the questions below.

a. Create an income statement for the company. Remember to consider interest expense and depreciation. (5 points)

b. Calculate the operating cash flow (EBIT – Tax + Depreciation). (2 points)

c. Calculate the cash flow to creditors/debt. (2 points)

d. Calculate the cash flow to stockholders/equity. (2 points)

e. Calculate the cash flow from assets (CFFA). (2 points)

f. Can you calculate the changes in net working capital? If so, how much was it? (1 point)

g. How would the income statement change if the fixed assets were depreciated over 10 years instead of 5 years? Explain/calculate. (3 points)

h. If the fixed assets were depreciated over 10 years instead of 5 years as discussed in question 7 above, how would it affect the operating cash flow of the company? Explain/calculate. (3 points)

Answer 1

The income statement is as below:

Note the following:

(i). Sales revenue = 1000 units sold at $1000 each hence 1000 * 1000 = 1000000

(ii). Cost of good sold is given as 65% of sales price

(iii). Depreciation is given as straight line for 5 years with no salvage value hence (500000/5) = $ 100000 per year.

(iv). The shareholder investment and borrowing do not impact P&L; the annual interest cost at 5% has been accounted for

(v). Dividend is distributed after taxes and all other expenses, hence shown accordingly

b. operating cash flows = EBIT - Tax + Depreciation = 200000-36000+100000 = $ 264,000

c. Cash flow to creditors will be = Interest paid - net new borrowings; since this is the first year of operations, all the borrowings are net new borrowing. Thus cash flow to creditors = 20000 - 400000 = - $ 380,000

d. Cash flow to equity stock holders = Dividend paid - new equity issued = 25000 - 200000 = - $ 175,000

e. Cash flow from Assets = Operating cash flow - capital spending - change in net working capital

Operating cash flow we have from above at $264000 and capital spending is given as $ 500000 but we do not have net working capital number. Hence we will use another formula which states that cash flow from assets is sum of cash flow to creditors and cash flow to equity stockholders. Hence

cash flow from assets = -380000 - 175000 = - $ 555,000

f. From above we can estimate the change in net working capital = cash flow from assets - operating cash flow - capital spending hence change in net working capital = -555000 - 264000 - (-500000) = - $ 209000

g. If the fixed assets were depreciated for 10 year period then on straight line basis the annual depreciation will decrease from $100000 to $ 50000 only and P&L will look like below:

As we see the Profit after tax has increased by (50000 * (1-20%)) - 20% is the tax rate.

h. Operating cash flows = EBIT + Depreciation - Taxes = 250000 + 50000 - 46000 = $ 254000

hence we see that the operating cash flows have decreased by $ 10000 (which is the increase in the taxes) due the above change.