Answer:

The indirect method starts with net income and then adjusts it for non-cash items and changes in
balance sheet accounts to arrive at the net cash flow from operating activities.
Here is the calculation:
1)Add back depreciation expense because it is a non-cash expense.($99,000 +$12,000)
2) Add the decrease in accounts receivable. ($111,000 + $13,000)
3)Deduct the decrease in account payable decrease. ($124,000-$3500)
4)Deduct the increase in inventory. ($120,500-$9000)
5)Add the increase in income tax payable ($111,500+$1500)
The net cash flow from operating activities using the indirect method is $113,000.

Answer:
Here is the calculation:
1) Accounts Receivable Change = Accounts Receivable (2020) - Accounts Receivable (2019) =
$45,000 - $35,000 = $10,000 (Increase)
2) Inventory Change = Inventory (2020) - Inventory (2019) = $55,000 - $49,000 = $6,000
(Increase)
3) Prepaid Rent Change = Prepaid Rent (2020) - Prepaid Rent (2019) = $6,000 - $7,000 = -$1,000
(Decrease)
4) Accounts Payable Change = Accounts Payable (2020) - Accounts Payable (2019) = $25,000 -
$20000 = $5000 (Increase)
5) Income Tax Payable Change = Income Tax Payable (2020) - Income Tax Payable (2019) =
$4,000 - $6,000 = -$2,000 (Decrease)

Net income = $40,000

Add back: Depreciation expense: $9000.
Subtract Gain on Sale of Investments: $11,000
Subtract Inventory Increase: $6,000
 Add Prepaid Rent Decrease: $1,000
Add Accounts Payable Increase: $5,000
Subtract Income Tax Payable Decrease: $2,000
Subtract Accounts receivable increase: $10,000
Net cash flow from operating activities = $26,000

Q3-2 (a) Explain how an increase in financial leverage can increase a company's ROE. (b) Given the
potentially positive relation between financial leverage and ROE, why don't we see companies
with 100%financial leverage (entirely nonowner financed)?
a)
An increase in financial leverage can increase a company's Return on Equity (ROE) due to the
financial leverage effect. ROE is a measure of a company's profitability and efficiency in generating
returns for its shareholders' equity. Financial leverage refers to the use of debt or borrowed funds to
finance a portion of a company's assets. When a company increases its financial leverage, it typically
does so by taking on more debt.
Here's how an increase in financial leverage can boost ROE:
1. Magnification of Returns: When a company borrows funds (usually through issuing bonds or
taking out loans), it can use those funds to invest in income-generating assets or projects. If
the return on these investments is higher than the cost of debt (interest expense), the
company benefits from a magnified return on equity. This is because the return generated on
the invested capital is spread over a smaller base of shareholders' equity (as a result of the
increased debt), which increases the ROE.
2. Fixed Interest Costs: Debt comes with a fixed interest cost, meaning that the company must
make regular interest payments to its creditors regardless of its overall profitability. If the
company's investments generate returns that exceed the interest rate on its debt, the excess
returns contribute to higher net income. As a result, the ROE increases because the interest
expense is relatively fixed, while the income generated from the debt-funded investments
can fluctuate with economic conditions.
3. Tax Shield: Interest expenses are tax-deductible in many jurisdictions. When a company has
higher levels of debt, it can benefit from a tax shield because it can deduct the interest
payments from its taxable income. Lower taxable income leads to lower income tax
payments, which increases the after-tax profits available to shareholders. This tax advantage
further boosts ROE.
However, it's important to note that while increased financial leverage can enhance ROE, it also
comes with risks and also achieves an increase in return on equity, the return on investment must be
greater than the cost of debt.

b)
While there is a potentially positive relationship between financial leverage and Return on Equity
(ROE), it's important to understand that there are practical limits and risks associated with increasing
financial leverage to extremely high levels, such as achieving 100% financial leverage (entirely non-
owner financed). Here are several reasons why companies don't typically operate with 100%
financial leverage such as financial instability, higher borrowing costs, loss of operating flexibility, and
investor concerns. Maintaining a balanced capital structure with a mix of equity and debt helps
manage these risks while optimizing Return on Equity (ROE).

Q3-4. When might a reduction in operating expenses as a percentage of sales denote a short-term
gain at the
cost of long-term performance?

Ans :
A reduction in operating expenses as a percentage of sales may indicate a short-term gain at the
expense of long-term performance when it involves cutting essential investments in areas like
research and development, employee training, quality control, or customer experience, which can
erode innovation, competitiveness, and sustainability over time.

Q3-8 )Describe what is meant by the " tax shield."

Answer:
The "tax shield" refers to the reduction in a company's taxable income, and consequently, its income
tax liability, due to allowable deductions and tax credits. This reduction in taxes paid provides a
financial benefit to the company, acting as a shield against the full burden of taxation. In essence, the
tax shield helps lower a company's overall tax expenses, freeing up more cash flow for other
purposes, such as reinvestment, debt reduction, or distribution to shareholders.
Common examples of tax shields include deductible expenses like interest on debt, depreciation of
assets, and certain operating expenses. Interest expense is a particularly significant tax shield
because the interest paid on debt is typically tax-deductible, which reduces a company's taxable
income and, in turn, its tax liability.
By using tax shields strategically, companies can optimize their tax planning, reduce their effective tax
rate, and increase their after-tax profits, thus enhancing overall financial performance. However, it's
essential to comply with tax laws and regulations to ensure the legitimacy and sustainability of these
tax-saving strategies.

E1-38
Answer:

a) Yes.

b) The company was more profitable in 2017 as reflected by a profitability ratio of 51% in 2017
vs. 23% in 2018.

c) The productivity of the company in 2018 has increased marginally to 31.8% from 29.9% in
the previous year. Hence, it is a positive development.

d) ROA = Net Income / Average Assets

= Net Income/ Sales * Sales / Average Assets

ROA (2018) = 0.233*0.318 = 0.074094 (7.4%)

ROA (2017) = 0.512*0.299 = 0.153088 (15.3%)

e) 1. The company’s profitability weakened significantly, leading to decline in RoA.

P1 -43

Answer:

a) ROE: Net Income / Avg. Equity

Avg Equity (2018) =(72,496+77,869)/2 =75,182

Avg Equity (2017) =(77,869+77,798)/2 =77,833

ROE (2018) = 6,670 / 75,182 = 8.88%

ROE (2017) = 9,862 / 77,833= 12.67%

b) ROA: NI / Avg Assets

Avg Assets (2018) = (219,295 + 204,522) / 2 = 211,909

Avg Assets (2017) = (204,522 + 198,825) / 2 = 201,674

ROA (2018) = 6,670 / 211,909 = 3.14%

ROA (2017) = 9,862/201,674 = 4.89%

c) Profit Margin = Net Income / Sales

Profit Margin (2018) =6670 / 510,329 = 1.30%
Profit Margin (2017) =9,862/495,761 = 1.98%

d) Asset Turnover = Net Sales / Avg Assets

Asset Turnover (2018) =510,329/211,909 = 2.41 times
Asset Turnover (2017) = 495761/201674 = 2.46 times

e) 1. The company’s profitability weakened considerably in 2018 leading to decline in ROA (ROA
= Profit Margin * Asset Turnover)
E3-30

Answer

a) ROE (2018) = Net Income attributable to 3M / Avg. Equity attributable to 3M shareholders

= 5,349 / [(9796+11563)/2]
=50%

b) Profit margin = Net Income / Sales

= 5349/32,765
= 16.32%

Asset Turnover = Sales / Avg. Total Assets

= 32,765/ {(36,500+37,987)/2}
= 0.88 times

Financial Leverage = Avg Asset / Avg Equity

Avg Asset = (36,500+37,987)/2 = 37243.5

Avg Equity =(9796+11563)/2 = 10679.5

Financial Leverage = 3.49 times

c) ROA = PM * AT
= .1632 *0.88
= 14.36%

d) Adjusted ROA = (Net Income + Net Interest expense (1-tax rate)) / Avg. Total Asset
= (5349+207*(0.78))/37243
= 14.79%
E3-36

Answer

a) ROE (2018) = Net Income / Avg Equity

= 502.1/ 2901.5
= 17.3%
ROE (2017) = 535.8 /2319.8
=23.1%

b) FMC reports non-GAAP measures of net income. Because they believe that this measure
provides useful information about their operating results to investors. They also believe that
excluding the effect of certain charges allows management and investors to compare more
easily the financial performance of their underlying businesses from period to period.
 Non-GAAP measures are more popular than ever. Most companies use non GAAP measure
of net income for the same reason as FMC, to show investors management's perspective on
their core activities, typically by removing nonrecurring costs and other amounts that they
feel aren't representative of ongoing results, such as major strategic restructurings.
c) Net income change
= (Net income for 2018 - Net income for 2017) / Net income for 2017
= ($502.1 - $535.8) / $535.8
= -33.7 / $535.8
= - 6%
Non-GAAP earnings change
=(non-GAAP income 2018-non-GAAP income for 2017)/non-GAAP income for 2017
= ($854.7 - $368.3) / $368.3
= 132%
Non-GAAP number accurately captures FMC’s earning trends. Yes, I do agree with FMC’s
claim about usefulness of non-GAAP number. It shows better image of the corporation to
investors.
d) ROE using non-GAAP measures:
ROE (2018) = 854.7 / 2901.5
= 29.4%
ROE (2017) = 368.3 /2319.8
=15.8%
Yes, the two returns are materially different. Investors would rely on non-GAAP because the
return of equity from non-GAAP is more than the return of equity from GAAP.
P3-45.
Compute the DuPont Disaggregation of ROE. Refer to the balance sheets and income statement
below for Facebook Inc.
Answer

a) ROE = Net Income / Avg Shareholders’ Equity

 Avg Equity = (84,127+74,347)/2 = 79,237 ----- a)

ROE = 22,112/79,237 = 27.90%

b) ROE = ROA * Financial Leverage

= Net Income / Avg Total Assets * Avg Total Assets / Avg Equity

 Avg Total Assets = (97,334+84,524)/2 = 90,929 -------b)

= (22,112/90,929) * (90,929/79,237)

= 24.32% * 1.14 times

= 27.90%

c) Profitability = Net Income / Sales

= 22,112/ 55,838
= 39.60%

Productivity = Sales/Avg Total Asset

= 55,838/90,929
= 61.41%

ROA = Profit Margin * Productivity

= 39.60%* 61.41%
= 24.32%

d) Asset Turnover = Sales / Avg Total Assets

= 55,838 / 90,929
= 61.41%

Financial Leverage = Avg total Asset / Avg Equity

= 90,929/79,237
= 1.15 times

ROE = PM * AT * FL
= 39.60% * 61.41% * 1.14 times
=27.96%