The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.
A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to personal liabilities in the event of bankruptcy than are investors in a typical partnership.
An advantage of the corporate form of organization is that corporations are generally less highly regulated than proprietorships and partnerships.
Some partners in a partnership may have different rights, privileges, and responsibilities than other partners.
It is generally harder to transfer one's ownership interest in a partnership than in a corporation.
One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business.
If a corporation elects to be taxed as an S corporation, then it can avoid the corporate tax. However, its stockholders will have to pay personal taxes on the firm's net income.
If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses.
It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required.
The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation.
One disadvantage of forming a corporation rather than a partnership is that this makes it more difficult for the firm's investors to transfer their ownership interests.
Organizing as a corporation makes it easier for the firm to raise capital. This is because corporations' stockholders are not subject to personal liabilities if the firm goes bankrupt and also because it is easier to transfer shares of stock than partnership interests.
In order to maximize its shareholders' value, a firm's management must attempt to maximize the expected EPS.
In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price on a specific target date.
In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price in the long run, or the stock's "intrinsic value".
If management operates in a manner designed to maximize the firm's expected profits for the current year, this will also maximize the stockholders' wealth as of the current year.
There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to banks and to stockholders. It is illegal to provide such information to banks, but it is not illegal to provide it to stockholders because they are the owners of the firm, not outsiders.
A stock's market price would equal its intrinsic value if all investors had all the information that is available about the stock. In this case the stock's market price would equal its intrinsic value.
If a stock's market price is above its intrinsic value, then the stock can be thought of as being undervalued, and it would be a good buy.
If a stock's intrinsic value is greater than its market price, then the stock is overvalued and should be sold.
For a stock to be in equilibrium as the book defines it, its market price should exceed its intrinsic value.
The term "marginal investor" means an investor who is active in the market and would tend to buy a stock if its price fell and sell it if it rose, barring any new information coming out about the stock.
If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby increase profits above the correct profits because he or she was told to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted.
If someone deliberately understates costs and thereby increases profits, then this can cause the price of the stock to rise above its intrinsic value. The stock price will probably fall in the future. Also, those who participated in the fraud can be prosecuted, and the firm itself can be penalized.
Managers always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible. However, there can be conflicts between stockholders and bondholders.
A hostile takeover is said to occur when another corporation or group of investors gains voting control over a firm and replaces the old managers. If the old managers were managing the firm inefficiently, then hostile takeovers can improve the economy. However, hostile takeovers are controversial, and legislative actions have been taken to make them more difficult to undertake.
If a firm's board of directors wants to maximize value for its stockholders in general (as opposed to some specific stockholders), it should design an executive compensation system whose goal is to maximize the stock's intrinsic value rather than the stock's current market price.
Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?
a. Corporations generally face fewer regulations.
b. Less of a corporation's income is generally subject to federal taxes.
c. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.
d. Corporate investors are exposed to unlimited liability.
e. Corporations generally find it easier to raise large amounts of capital.
The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to
a. Maximize its expected total corporate income.
b. Maximize its expected EPS.
c. Minimize the chances of losses.
d. Maximize the stock price per share over the long run, which is the stock's intrinsic value.
e. Maximize the stock price on a specific target date.
Which of the following actions would be most likely to reduce conflicts of interest between stockholders and bondholders?
a. If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby artificially increase profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted.
b. There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders because they are the owners of the firm.
c. The bankruptcy of Enron Corporation, and the fraud committed by some of its officers, was much discussed, but it did not lead to any important changes in business practices.
d. If someone deliberately understates costs and thereby causes reported profits to increase, then this can cause the price of the stock to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted.
e. Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business.
Which of the following statements would most people in business agree with?
a. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation.
b. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees.
c. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees.
d. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior.
e. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Which of the following actions would be most likely to reduce conflicts between stockholders and bondholders?
a. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders).
b. Compensating managers with more stock options and less cash income.
c. The passage of laws that make it harder for hostile takeovers to succeed.
d. A government regulation that banned the use of convertible bonds.
e. The firm begins to use only long-term debt, e.g., debt that matures in 30 years or more, rather than debt that matures in less than one year.
Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?
a. Pay managers large cash salaries and give them no stock options.
b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.
c. Beef up the restrictive covenants in the firm's debt agreements.
d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm's stock.
e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.
Which of the following actions would be likely to reduce conflicts of interest between stockholders and managers?
a. Congress passes a law that severely restricts hostile takeovers.
b. A firm's compensation system is changed so that managers receive larger cash salaries but fewer long-term options to buy stock.
c. The company changes the way executive stock options are handled, with all options vesting after 2 years rather than having 20% of the options awarded vest every 2 years over a 10-year period.
d. The company's outside auditing firm is given a lucrative year-by-year consulting contract with the company.
e. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash.
Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?
a. Decrease the use of restrictive covenants in bond agreements.
b. Take actions that reduce the possibility of a hostile takeover.
c. Elect a board of directors that allows managers greater freedom of action.
d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.
e. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock.
Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders?
a. The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced.
b. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover.
c. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%.
d. The firm's founder, who is also president and chairman of the board, sells 90% of her shares.
e. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval.
A financial intermediary is a corporation that takes funds from investors and then provides those funds to those who need capital. A bank that takes in demand deposits and then uses that money to make long-term mortgage loans is one example of a financial intermediary.
The NYSE is defined as a "spot" market purely and simply because it has a physical location. The Nasdaq, on the other hand, is not a spot market because it has no one central location.
The NYSE is defined as a "primary" market because it is one of the largest and most important stock markets in the world.
Primary markets are large and important, while secondary markets are smaller and less important.
Private markets are those like the NYSE, where transactions are handled by members of the organization, while public markets are those like the Nasdaq, where anyone can make transactions.
A share of common stock is not a derivative, but an option to buy the stock is a derivative because the value of the option is derived from the value of the stock.
Financial institutions are more diversified today than they were in the past, when federal laws kept investment banking houses, commercial banks, insurance companies, and so on quite separate. Today the larger financial corporations offer a variety of services, ranging from checking accounts, to insurance, to underwriting securities, to stock brokerages.
Hedge funds are somewhat similar to mutual funds. The primary differences are that hedge funds are less highly regulated, have more flexibility regarding what they can buy, and restrict their investors to wealthy, sophisticated individuals and institutions.
Investment banking houses today often have divisions that engage in traditional investment banking and other divisions that engage in regular commercial banking.
Trades on the NYSE are generally completed by having a brokerage firm acting as a "dealer" buy securities and adding them to its inventory or selling from its inventory. The Nasdaq, on the other hand, operates as an auction market, where buyers offer to buy, and sellers to sell, and the price is negotiated on the floor of the exchange.
The "over-the-counter" market received its name years ago because brokerage firms would hold inventories of stocks and then sell them by literally passing them over the counter to the buyer.
If you decide to buy 100 shares of Google, you would probably do so by calling your broker and asking him or her to execute the trade for you. This would be defined as a secondary market transaction, not a primary market transaction.
The term IPO stands for "individual purchase order", as when an individual (as opposed to an institution) places an order to buy a stock.
The term "Dutch auction" in a new stock offering refers to a situation where each potential bidder indicates the price they are willing to pay and how many shares they will buy at that price. The highest price that permits the company to sell all the shares it wants to sell is determined--it is the "market clearing price," and all bidders who specified that price or higher are allowed to buy their shares at the market clearing price.
When a corporation's shares are owned by a few individuals who are associated with the firm's management, we say that the stock is closely held.
A publicly owned corporation is a company whose shares are held by the investing public, which may include other corporations as well as institutional investors.
If you wanted to know what rate of return stocks have provided in the past, you could examine data on the Dow Jones Industrial Index, the S&P 500 Index, or the Nasdaq Index.
The annual rate of return on any given stock can be found as the stock's dividend for the year plus the change in the stock's price during the year, divided by its beginning-of-year price.
The annual rate of return on any given stock can be found as the stock's dividend for the year plus the change in the stock's price during the year, divided by its beginning-of-year price. If you obtain such data on a large portfolio of stocks, like those in the S&P 500, find the rate of return on each stock, and then average those returns, this would give you an idea of stock market returns for the year in question.
Each stock's rate of return in a given year consists of a dividend yield (which might be zero) plus a capital gains yield (which could be positive, negative, or zero). Such returns are calculated for all the stocks in the S&P 500. A weighted average of those returns, using each stock's total market value, is then calculated, and that average return is often used as an indicator of the "return on the market."
Each stock's rate of return in a given year consists of a dividend yield (which might be zero) plus a capital gains yield (which could be positive, negative, or zero). Such returns are calculated for all the stocks in the S&P 500. A simple average of those returns is then calculated, and that average is called "the return on the S&P Index," and it is often used as an indicator of the "return on the market."
You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?
a. This is an example of a direct transfer of capital.
b. This is an example of a primary market transaction.
c. This is an example of an exchange of physical assets.
d. This is an example of a money market transaction.
e. This is an example of a derivative market transaction.
Which of the following is a primary market transaction?
a. You sell 200 shares of IBM stock on the NYSE through your broker.
b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.
c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.
d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.
e. IBM sells 2,000,000 shares of treasury stock to its employees when they exercise options that were granted in prior years.
Which of the following is an example of a capital market instrument?
a. Commercial paper.
b. Preferred stock.
c. U.S. Treasury bills.
d. Banker's acceptances.
e. Money market mutual funds.
Money markets are markets for
a. Foreign currencies.
b. Consumer automobile loans.
c. Common stocks.
d. Long-term bonds.
e. Short-term debt securities such as Treasury bills and commercial paper.
You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:
a. A money market transaction.
b. A primary market transaction.
c. A secondary market transaction.
d. A futures market transaction.
e. An over-the-counter market transaction.
e. It is possible for a firm to go public and yet not raise any additional new capital for the firm itself.
The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and statement of stockholders' equity.
The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows.
Companies typically provide four basic financial statements: the fixed income statement, the current income statement, the balance sheet, and the cash flow statement.
Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the amounts at which the assets are carried on the books.
The amount shown on the December 31, 2009 balance sheet as "retained earnings" is equal to the firm's net income for 2009 minus any dividends it paid.
The income statement shows the difference between a firm's income and its costs--i.e., its profits--during a specified period of time. However, not all reported income comes in the form of cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period.
If we were describing the income statement and the balance sheet, it would be correct to say that the income statement is more like a video while the balance sheet is more like a snapshot.
Consider the following balance sheet, for Games Inc. Because Games has $800,000 of retained earnings, we know that the company would be able to pay cash to buy an asset with a cost of $200,000.
Cash $ 50,000 Accounts payable $ 100,000
Inventory 200,000 Accruals 100,000
Accounts receivable 250,000 Total CL $ 200,000
Total CA $ 500,000 Debt 200,000
Net fixed assets $ 900,000 Common stock 200,000
Retained earnings 800,000
Total assets $1,400,000 Total L & E $1,400,000
Typically, the statement of stockholders' equity starts with retained earnings at the beginning of the year, adds net income, subtracts dividends paid, and ends up with retained earnings at the end of the year. Over time, a profitable company will have earnings in excess of the dividends it pays out, and the series of annual retained earnings will result in a substantial amount of retained earnings as shown on the balance sheet.
Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations.
The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows a business is able to provide to its investors is its free cash flow. This is the reason that FCF is so important in finance.
If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow.
The fact that 70% of the interest income received by corporations is excluded from its taxable income encourages firms to finance with more debt than they would in the absence of this tax law provision.
Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm's taxes.
The balance sheet measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time.
Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm either sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors.
The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called "the bottom line."
The statement of cash flows has four main sections, one each for operating, investing, and financing activities, and one that shows a summary of the cash and cash equivalents at the end of the year.
An increase in accounts payable represents an increase in net cash provided by operating activities just like borrowing money from a bank. An increase in accounts payable has an effect similar to taking out a new bank loan. However, these two items show up in different sections of the statement of cash flows.
An increase in accounts receivable represents an increase in net cash provided by operating activities because receivables will produce cash when they are collected.
The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section is "Net Income." Then, also in the first section, we show some items that represent increases or decreases to cash, and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt.
To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue.
Two metrics that are used to measure a company's financial performance are net income and cash flow. Accountants emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on cash flows as they do on net income.
Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. If the firm has sufficient retained earnings, it can purchase assets and pay for them with cash from retained earnings.
The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the stockholders' claim against the firm's existing assets. Put another way retained earnings are stockholders' reinvested earnings.
In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and changes in net working capital.
Free cash flow is the amount of cash that if withdrawn would harm the firm's ability to operate and to produce future cash flows.
If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant.
Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations.
Because the U.S. tax system is a progressive tax system, a taxpayer's marginal and average tax rates are the same.
The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions.
The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects specific changes in accounts over that period of time.
Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment.
Which of the following items is NOT normally considered to be a current asset?
a. Accounts receivable.
e. Short-term, highly-liquid, marketable securities.
Which of the following items cannot be found on a firm's balance sheet under current liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.
A loss incurred by a corporation
a. Must be carried forward unless the company has had 2 loss years in a row.
b. Can be carried back 2 years, then carried forward up to 20 years following the loss.
c. Can be carried back 5 years and forward 3 years.
d. Cannot be used to reduce taxes in other years except with special permission from the IRS.
e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.
Below are the 2007 and 2008 year-end balance sheets for Tran Enterprises:
Assets: 2008 2007
Cash $ 200,000 $ 170,000
Accounts receivable 864,000 700,000
Inventories 2,000,000 1,400,000
Total current assets $3,064,000 $2,270,000
Net fixed assets 6,000,000 5,600,000
Total assets $9,064,000 $7,870,000
Liabilities and equity:
Accounts payable $1,400,000 $1,090,000
Notes payable 1,600,000 1,800,000
Total current liabilities $3,000,000 $2,890,000
Long-term debt 2,400,000 2,400,000
Common stock 3,000,000 2,000,000
Retained earnings 664,000 580,000
Total common equity $3,664,000 $2,580,000
Total liabilities and equity $9,064,000 $7,870,000
The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year, non-callable, long-term debt in 2007. As of the end of 2008, none of the principal on this debt had been repaid. Assume that the company's sales in 2007 and 2008 were the same. Which of the following statements must be CORRECT?
a. The firm increased its short-term bank debt in 2008.
b. The firm issued long-term debt in 2008.
c. The firm issued new common stock in 2008.
d. The firm repurchased some common stock in 2008.
e. The firm had negative net income in 2008.
Below is the common equity section (in millions) of Timeless Technology's last two year-end balance sheets:
Common stock $2,000 $1,000
Retained earnings 2,000 2,340
Total common equity $4,000 $3,340
The firm has never paid a dividend to its common stockholders. Which of the following statements is CORRECT?
a. The company's net income in 2008 was higher than in 2007.
b. The firm issued common stock in 2008.
c. The market price of the firm's stock doubled in 2008.
d. The firm had positive net income in both 2007 and 2008, but its net income in 2008 was lower than it was in 2007.
e. The company has more equity than debt on its balance sheet.
Which of the following factors could explain why Michigan Energy's cash balance increased even though it had a negative cash flow last year?
a. The company sold a new issue of bonds.
b. The company made a large investment in new plant and equipment.
c. The company paid a large dividend.
d. The company had high depreciation expenses.
e. The company repurchased 20% of its common stock.
Analysts who follow Howe Industries recently noted that, relative to the previous year, the company's net cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?
a. The company cut its dividend.
b. The company made large investments in fixed assets.
c. The company sold a division and received cash in return.
d. The company issued new common stock.
e. The company issued new long-term debt.
Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash provided from operations declined. Which of the following could explain this performance?
a. The company's dividend payment to common stockholders declined.
b. The company's expenditures on fixed assets declined.
c. The company's cost of goods sold increased.
d. The company's depreciation expense declined.
e. The company's interest expense increased.
Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation?
a. The company had a sharp increase in its inventories.
b. The company had a sharp increase in its accrued liabilities.
c. The company sold a new issue of common stock.
d. The company made a large capital investment early in the year.
e. The company had a sharp increase in depreciation expenses.
Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes.
a. Companies' after-tax operating profits would decline.
b. Companies' physical stocks of fixed assets would increase.
c. Companies' cash flows would increase.
d. Companies' cash positions would decline.
e. Companies' reported net incomes would decline.
Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate. Prior to the new provision, BBI's net income was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BBI's financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.
a. The provision will reduce the company's cash flow.
b. The provision will increase the company's tax payments.
c. The provision will increase the firm's operating income (EBIT).
d. The provision will increase the company's net income.
e. Net fixed assets on the balance sheet will decrease.
The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.
a. Nantell's taxable income will be lower.
b. Nantell's operating income (EBIT) will increase.
c. Nantell's cash position will improve (increase).
d. Nantell's reported net income for the year will be lower.
e. Nantell's tax liability for the year will be lower.
Assume that Besley Golf Equipment commenced operations on January 1, 2008, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December 2008 management realized that the assets would last for only 10 years. The firm's accountants plan to report the 2008 financial statements based on this new information. How would the new depreciation assumption affect the company's financial statements?
a. The firm's reported net fixed assets would increase.
b. The firm's EBIT would increase.
c. The firm's reported 2008 earnings per share would increase.
d. The firm's cash position in 2008 and 2009 would increase.
e. The provision will increase the company's tax payments.
A start-up firm is making an initial investment in new plant and equipment. Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change?
a. The firm's operating income (EBIT) would increase.
b. The firm's taxable income would increase.
c. The firm's cash flow would increase.
d. The firm's tax payments would increase.
e. The firm's reported net income would increase.
The CFO of Daves Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?
a. The company's taxable income would fall.
b. The company's interest expense would remain constant.
c. The company would have less common equity than before.
d. The company's net income would increase.
e. The company would have to pay less taxes.
Last year Besset Company's operations provided a negative cash flow, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company's financial statements were prepared under generally accepted accounting principles (GAAP)?
a. The company repurchased some of its common stock.
b. The company dramatically increased its capital expenditures.
c. The company retired a large amount of its long-term debt.
d. The company sold some of its fixed assets.
e. The company had high depreciation expenses.