Answers to Worksheet 1

Professor James Sefton

j.sefton@imperial.ac.uk

Imperial College Business School 1

 CapEx and Depreciation
Question 1 a)
The cash flow statement provides an accurate picture of depreciation
expense.

Investing $75 in Year 1 and in Year 2 in capital assets generates a yearly

depreciation expense of $25 for 3 years, so the cash flows and expenses
are:

Time Yr1 Yr2 Yr3 Yr4

Capital Expense $75 $75

Depreciation of Yr 1 Expense $25 $25 $25

Depreciation of Yr 2 Expense $25 $25 $25

Total Depreciation Expense $25 $50 $50 $25

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 CapEx and Depreciation
Question 1 a)
The completed Income Statement of Imperial Machines.

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 CapEx and Depreciation
Question 1 b)
The completed Income Statement of Imperial Machines.

$80 $80

-$15 - $15
$0 $0 $0 $0 $0 $0
-$15 - $15 $60 $60

-$15 -$20 $55 $55 $55 $55

$0 $0 $22 $22
-$15 -$20 $33 $33

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 CapEx and Depreciation
Question 1 c)
In Case 1 Imperial Machines paid $74 in taxes, whereas
in Case 2 it paid $88.
Capitalising the CapEx spend in the accounts
1. Smoothed Net Income
2. But bought forward the tax payments (in practise
losses can be carried across years for tax purposes,
so notional sums paid are identical).

Capital Expenses are expenses that generate benefits

over multiple period. Due to difficulties in assessing the
capital value of R&D spend it is more often treated as an
operating expense.
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 Working Capital
Question 2 a)
Receivables and Payables convert income (or
earnings) to cash flows

Cash In + Receivables = Sales

Cash Out + Payables = Cost of Goods
1Q1 1Q2 1Q3 1Q4 2Q1
Reported Accounts 0 75 75 300 0
Payable
Changes in 0 75 0 225 -300
Accounts Payable
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 Working Capital
Question 2 a)
The impact of delaying payments to suppliers implies the
cash flows are received earlier than earnings but the total
does not change.
1Q1 1Q2 1Q3 1Q4 2Q1
Net Income 0 25 25 100 0
Changes in Operating working Capital
Accounts Receivable 0 0 0 0 0
Inventories 0 0 0 0 0
Accounts Payable 0 75 0 225 -300
Net Cash from Operations 0 100 25 325 -300

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 Working Capital
Question 2 c)
Notice that the sign convention of the cash flow statement
is that Net Cash is the sum of the items above.

1Q1 1Q2 1Q3 1Q4 2Q1

Net Income 0 25 25 100 0
Changes in Operating working Capital
Accounts Receivable 0 -20 -30 -50 100
Inventories 0 -30 -30 50 10
Accounts Payable 0 75 0 225 -300
Net Cash from Operations 0 50 -35 325 -190

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 Deferred Taxes
Question 3 a)
The completed Tax Statement of Imperial Machines.

$75 $75 $0 $0 $0 $0
-$15 - $15 $60 $60

-$15 -$20 $55 $55 $55 $55

-$6 - $8 $22 $22
Corporate Tax Payments Due $0
-$15 $0
-$20 $8
$33 $22
$33 $22 $22

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 Deferred Taxes
Question 3 b)
the deferred tax account is recorded in the statements.
The deferred tax liability accounts for the difference between reported
and accrued.

Reported Corporate Income Tax $14 $2 $2 $12 $22 $22

Accrued Corporate Tax in Tax -$6 - $8 $22 $22 $22 $22
Difference between reported and accrued tax $20 $10 -$20 -$10 $0 $0
Deferred Tax Liability $20 $30 $10 $0 $0 $0

And the deferred tax asset accounts for the carry forward of tax credits
Corporate tax credits $6 $8 -$14 $0 $0 $0
Deferred Tax Asset $6 $14 $0 $0 $0 $0
 Deferred Taxes
Question 3 b)
The deferred tax asset and liability then enable the reconciliation of net
income with the cash flow from operation in the cash flow account.

Net Income $21 $3 $3 $18 $33 $33

+ Depreciation $25 $50 $50 $25 $0 $0
- Change in Deferred Tax Asset -$6 -$8 $14 $0 $0 $0
+ Change in Deferred Tax Liability $20 $10 -$20 -$10 $0 $0

Cash flow from Operations $60 $55 $47 $33 $33 $33
 Deferred Taxes
Question 3 b)
The reporting standards allow for the Deferred Tax Asset and Liability to
be netted off if the tax asset and liability were accrued by the same
business entity with the same tax authority. In this case

Deferred Tax Liability $20 $30 $10 $0 $0 $0

- Deferred Tax Asset -$6 -$14 $0 $0 $0 $0

Deferred Tax Liability (Net) $14 $16 $10 $0 $0 $0

And there would be this single line for the net tax liabilities in the
balance sheet.
 Deferred Taxes
Q3 b) additional note on book entries
The Book entries are for Year 1:

Year 1: Tax Loss 15

40% Tax credit 6 Debit Credit

Deferred Tax Asset 6
P&L Tax 6

P&L Tax 20
A/C Depreciation 25 Deferred Tax Liability 20
Tax Depreciation 75
1. To classify as a tax asset must assume will
Difference 50
be physically collected in the next year
DT Liability @40% 20 2. Can be netted on balance sheet if accrued
by the same business and with the same
tax authority.
 Putting it all together
Question 4 a)
Using the direct approach, the cash flow statement is
Operating Activities 1st Quarter 2nd Quarter
Revenue 40000
Wages -10000 -10000
Rent -12000
Interest -4000 -4000
Cash Flow From Operations (CFO) -26000 26000
Investing Activities
Capital Expenditure (Truck) -100000
Cash Flow from Investing (CFI) -100000 0
Financing Activities
Sale (+) or Purchase (-) of Stock 50000
Increases in Borrowing 80000
Cash Flow form Financing (CFF) 130000 0
Change in Cash Balances 4000 26000
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 Putting it all together
Question 4 b)
The income statement records the business done
Window cleaner wages included in COGS
Depreciation charge is Cost / Expected Life = 100,000/ 20 = 5000
Rental Charge is Total Cost / Rental Period = 12,000 / 12 = 1000

1st Quarter 2nd Quart. 1st Quarter 2nd Quarter

Revenue 40000 40000 Revenue 40000 40000
Depreciation -5000 -5000 COGS -5000 -5000
Rent -1000 -1000 Depreciation -5000 -5000
Wages -10000 -10000 SGA -6000 -6000
Operating Profit 24000 24000 Operating Profit 24000 24000
Interest Expense -4000 -4000 Interest Expense -4000 -4000
Net Income 20000 20000 Net Income 20000 20000

Imperial College Business School Rearranged in standard format 15

 Putting it all together
Question 4 c)
The balance Sheet records the accounting value of the firm

1. Cash balances from Assets 1st Quarter 2nd Quarter

the cash flows Cash 4000 30000
2. Receivables Receivables 40000 40000
reconciles revenues Prepaid expenses (Rent) 11000 10000
with cash paid Long Term Assets (Truck) 95000 90000
3. Prepaid expenses Total Assets 150000 170000
reconciles costs with Liabilites
cash flows. Debt 80000 80000
Shareholder's Equity
4. Equipment (truck)
Share Capital 50000 50000
recorded as cost
Retained Earnings 20000 40000
minus accumulated
depreciation. Shareholders Equity +
Liabilities 150000 170000
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 Putting it all together
Question 4 e)
The indirect approach to the cash flow statement
Operating Activities 1st Quarter 2nd Quarter
1. Add back Net Income 20000 20000
depreciation (non- Depreciation 5000 5000
cash expense). Change in Receivables -40000 0
2. Subtract change in Change in prepaid expenses -11000 1000
receivables Changes in Payables
Cash Flow From Operations (CFO) -26000 26000
3. Subtract change in Investing Activities -100000 0
pre-paid expenses Capital Expenditure -100000 0
4. Add back change in Cash Flow from Investing (CFI) -100000 0
payables. Financing Activities
Sale (+) or Purchase (-) of Stock 50000 0
Increases in Borrowing 80000 0
Cash Flow form Financing (CFF) 130000 0
Change in Cash Balances 4000 26000

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 Free Cash Flows
Question 5
Calculating the Free Cash Flow of Tanaka Enterprise

2012 2011 2010

Operating Income (EBIT) 120 85 75
-Corporate Taxes 34 20 16
+ Changes in Deferred Taxes 4 16 -
+ Depreciation 25 23 20
- Changes in Receivables 2 3 -
- Changes in Inventories 7 3 -
+Changes in Payables -1 1 -
Capital Expenditure 0 30 200
=Free Cash Flow 105 69 -
 Free Cash Flows
Question 5
For later: we should calculate FCF as 100% equity financed

Tax rates are 40% so tax shield = 0.4 * 35 = 14

2012 2011 2010

Free Cash Flow (current) 105 69 -
- Interest Tax Shield 14 14 14
=Free Cash Flow (100% Equity) 91 55 -