Chapter 3 Selected Solutions Essay

Chapter 3 Selected Solutions

12. a.,b. Note: Because depreciation expense is already included in various costs it is not reported as separate line in the calculation of earnings before interest and taxes (EBIT) or calculation of net earnings (which is also called net income)
Sales $10,000 Cost of sales (6,500) General and admin expenses ( 1,000) EBIT 2,500 Interest expense (500) Taxable income 2,000 Taxes (35%) (700) Net earnings $ 1,300

c. Note: We are assuming that cash balance did not change, allowing us to use change in working capital as the change in non-cash working capital. Since net working capital increased, this was a use of cash to make the investment in net working capital.

Cash flow from operating activities starting from net earnings:
= net earnings + depreciation expense + cash flow from (used in) non-cash working capital
= 1,300 + 1,000 - 200 = $2,100

Cash flow from operating activities if start with profit before tax, taxable income:
= taxable income + depreciation expense + cash flow from (used in) non-cash working capital - taxes
= 2,000 + 1,000 - 200 - 700 = $2,100

d. Using Equation (3.3), cash flow from assets
= cash flow from operating activities + cash flow from (used in) investments
= 2,100 – 900 = $1,200

Note: Nothing in the problem indicated whether the interest expense should be considered an operating cash flow or a financing flow. With interest expense is treated as a financing flow, the cash flow values become:

Cash flow from operating activities (adjusted)
= net earnings + depreciation expense + interest expense + cash flow from (used in) non-cash working capital
= 1,300 + 1,000 + 500 - 200 = $2,600

Cash flow from assets (adjusted)
= cash flow from operating activities (adjusted) + cash flow from (used in) investments
= 2,600 – 900 = $1,700

13. Yes, both of these statements are true. Since cash flow from operations is determined by cash inflows and outflows, whereas profit before tax is determined by the accrual method of accounting, there is no reason why one cannot be negative when the other is positive. For example, if depreciation expenses are large, then negative profit before tax might correspond to positive cash flow because depreciation is treated as an expense in calculating profit before tax, but does not represent a cash outlay.

Conversely, if profit before tax is positive, but a large portion of sales are made on credit, cash flow can be negative since the credit sales are revenue, but they don’t yet generate cash. This is true for other types of working capital, such as inventory. Purchases of inventory do not show up on the income statement but use up cash. So it is possible for profit before tax to be positive but cash flow from operations to be negative when there is a large increase in net working capital. Look back to the tables under Profits vs. Cash Flow, and you will see that increases in trade receivables reduce cash provided by operations.

17. a. Note: assume depreciation equals CCA (capital cost allowance). Since CCA is the depreciation that can be deducted as an expense in the calculation of taxable corporate income.

Since the $8 million cost of sales includes the depreciation (CCA) of $2 million, the cost of sales excluding depreciation is $8 million - $2 million = $6 million.
So the calculation of the taxable income and net income can be done 2 ways: using Cost of sales including depreciation or using cost of sales not including depreciation. But these two methods give the same answers. Here are both possible calculations:

Including depreciation in Cost of Sales:
Sales $14.00 million
 Cost of Sales 8.00
 Interest expense 1.00
 Depreciation expense 0.00
Taxable income 5.00
 Taxes (35%) 1.75
Net income $3.25 million

Removing depreciation from Cost of Sales:

Sales $14.00 million
 Cost of Sales

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