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6. Depreciation methods Firms can use various methods to calculate depreciation, and it is important for you to consider these different methods when evaluating firms. The impact of different depreciation methods is stronger for asset-intensive firms. Major factors that affect the depreciation of a fixed asset include the purchase cost, residual/salvage value, and estimated useful life of the asset. The purchase cost includes the asset's explicit cost plus necessary costs associated with setting up and operating the asset (such as shipping and installation). An asset's useful life is the benefit or amount of use the purchaser expects out of it. The residual, or salvage, value is the anticipated value of the asset at the end of its useful life. An asset's depreciable cost is its purchase cost minus its residual value. This figure is the amount of depreciation to be allocated over the asset's life, and after each year, the asset's depreciable basis declines. The useful life can be defined in several ways. In some cases, it is the length of time (in years) the asset is expected to last; in others, it could be the use received (in units produced, miles driven, hours operated, etc.). Straight-Line Depreciation Straight-line depreciation is the simplest depreciation method because it assumes assets lose value evenly throughout their lives. The annual depreciation rate is 100% divided by the useful life; for example, a five-year useful life asset has an annual depreciation rate of 100%/5 = 20%. The annual depreciation expense is the depreciation rate times the depreciable cost. A five-year asset purchased for $100,000 with an expected residual value of $10,000 has an annual depreciation expense of 0.2 x ($100,000 - $10,000) = ~ After each year, the depreciation expense reduces the depreciable basis (for example, after the first year, the depreciable basis is o Accelerated Depreciation Compared to straight-line depreciation, accelerated depreciation methods make the more reasonable assumption that an asset loses more of its value early in its life. Different methods of calculating accelerated depreciation exist, but the most common is the declining-balance method. The declining-balance method doubles the depreciation rate suggested by the straight-line method and multiplies this rate by the asset's remaining depreciable cost. The depreciable cost equals the purchase cost and is not adjusted by the residual value, though you cannot depreciate an asset below its residual value. For the asset described above, the first year's depreciation expense is 0.2 x 2 x $100,000 = $40,000, and the remaining depreciable basis is $100,000 - $40,000 = $60,000. Therefore, the second year's depreciation expense is * and the remaining depreciable basis is * Because you cannot depreciate an asset below its residual value, if a year's calculated depreciation expense makes the depreciable basis less than the residual value, you ignore the calculated value and make the result equal the residual value. Check Your Understanding A company has purchased a new machine for $7,500, and the machine is expected to have a residual value of $1,500 at the end of its six-year life. Calculate the machine's depreciation using the straight-line method: Depreciable cost = a Annual depreciation expense = ~ Calculate the machine's depreciation using the declining balance method: Depreciable cost = * Year 1 depreciation expense = oa Year 2 depreciation expense = ~ 9. Statement of cash flows The statement of cash flows demonstrates how the firm generates and uses cash through a variety of operating, investing, and financing activities. Operating activities reflect the cash generated in the course of the firm conducting its business. Investing activities refer to the firm's long-term investment in fixed assets (also known as "capital expenditures"), subsidiaries, and other investments. Financing activities include the sources of long-term capital (bonds, equity, and preferred stock). The cash flow statement seeks to reconcile the income statement, which shows earnings influenced by non-cash items, and the balance sheet, which has accounts that obscure the firm's actual cash activity. Check Your Understanding Characterize the following actions of a firm as financing, investing, or operating activities: Operating Investing Financing Scenario Activity Activity Activity Sells a tract of land it has held for years Increases its use of trade credit from suppliers Improves profit margin and increases net income Issues new shares of preferred stock Tightens its credit policy with its customers Buys back shares of common stock Buys new equipment and machinery Issues new notes payable 10. Common-size financial statements A main element of financial statement analysis is the use of common-size financial statements, also called "vertical analysis." A common-size balance sheet divides each account's value by the value of total assets, while a common-size income statement divides each entry by net sales revenue. Common-ssize balance sheets immediately show how a firm's assets, liabilities, and equity are distributed. Common-size income statements give a quick snapshot of how various expenses and types of income relate to sales revenue. The following common-size statements show that total liabilities are 51.2% of total assets, while long-term debt is 36.7% of total assets. In your finance course, you will learn the significance of these relationships. Complete the missing entries in the following common-size statements: Balance Sheet (Thousands of dollars) Cash $377 8.6% Accounts Payable $136 3.1% Accounts 710 % Notes Payable 240 % Receivable Inventories 1,150 26.2% Accrued Liabilities 260 5.9% Total Current $2,237 51.0% Total current Liabilities $636 % Assets Long-term debt $1,610 36.7% Total liabilities $2,246 51.2% Preferred stock 90 2.1% Common Stock 300 6.8% Retained earnings 1,751 39.9% Net fixed assets $2,150 49.0% Total common equity $2,141 48.8% Total assets $4,387 100.0% Total liabilities and equity $4,387 100.0% Income Statement (Thousands of dollars) Total Revenues $7,000 100.0% - Cost of goods sold $2,781 % - Operating expense $1,809 25.8% - Research & development expense $912 % - Depreciation and amortization expense $223 3.2% Operating Income (EBIT) $1,275 18.2% -Interest expense $190 2.7% Taxable Income $1,085 15.5% - Taxes $434 6.2% Net Income $651 9.3% - Preferred dividends $9 0.1% Net income available to shareholders $642 9.2% 1. Financial statement accounts The following table lists a variety of accounts commonly seen in financial statements. Identify whether each account appears on the balance sheet as an asset, liability, or equity account; or whether it appears on the income statement as a revenue or expense. Account Asset Liability Equity Revenue Expense Accounts Payable Property, plant, and equipment Inventories Long-term debt Cost of goods sold Retained earnings Research and development Prepaid expenses Common stock Accounts Receivable 2. Financial statement accounts Several types of balance sheet accounts are described below. Choose the correct account for each description. Money that customers owe the firm due to sales made on oa credit All of the firm's liabilities expected to be due in the next ~~ year Money the firm owes to its suppliers due to purchases made on credit A hybrid security that has characteristics of both debt and common equity r Includes trademarks, patents, and goodwill from previous acquisitions Which of the following statements accurately describes the balance sheet? Check al/ that apply. Shows asset, liability, and equity account values on a specific date Shows asset, liability, and equity account values over a period of time Shows operating performance on a specific date Allows the book value and market value of equity to be different Complete the following statement: Depreciation represents the loss in a fixed asset's value due to aging. 'appears on the income statement and represents the reduction in fixed assets' values over the previous accounting period. '' appears on the balance sheet and represents the cumulative value reduction in the firm's present fixed asset holdings since their acquisition. 3. Accounting transactions The following statements are financial transactions completed by Carver Industries. Identify which financial statement accounts are affected by the transactions. 1. Carver owes one of its suppliers $120,000 on account for past purchases. Carver sent this supplier $50,000 to pay down the account. will ~ by $50,000. will ~ by $50,000. 2. Carver has $200,000 of long-term bonds outstanding that pay investors 8% annual interest at the end of the year. Carver has just made this payment to bond investors. * will * by $16,000. * will * by $16,000. 3. Carver paid $1,500 to the utility company to cover this month's electric bill. * will * by $1,500. * will Y by $1,500. 4. Carver issued new long-term bonds at their par value of $300,000 to fund a new investment project. ~*~ will ~* by $300,000. ~*~ will * by $300,000. 5. Carver closed a large sale to a major customer for $200,000, though the inventory was only valued at $140,000 on the company's balance sheet. The customer paid $70,000 upfront and has agreed to pay the rest of the bill in the next month. ~ will ~ by $200,000. ~ will ~ by $70,000. ~ will * by $130,000. ~ will ~ by $140,000. ~*~ will * by $140,000. 4. Statement of cash flows Determine how the following scenarios affect the firm's cash position. Identify whether the scenario describes a financing, investing, or operating activity (as defined on the Statement of Cash Flows). Operating Investing Financing Scenario Activity Activity Activity Sell a tract of land it has held for years Pay preferred stock dividends Now, indicate which of the scenarios below are expected to increase a company's cash flow. Check all that apply. Issue shares of common stock Buy property for a future factory Increase inventory holdings Sell some old equipment Pay preferred stock dividends Ll 1 l J ' ~~ 5. Income statement The income statement for Travers & Co. is shown below. The firm currently has 31.0 million shares of common stock outstanding. However, an analyst has looked at the firm's outstanding warrants and options to determine the likelihood of them being exercised. The analyst has determined that the firm's adjusted number of common shares after the expected dilution is 34.5 million. INCOME STATEMENT (Millions of dollars) Total revenues $ 1,500 - Operating costs excluding depreciation 1,200 - Depreciation and amortization expense 50 Operating income (EBIT) $ 250 - Interest expense 25 Taxable income $ 225 - Taxes 78 Net income $ 147 - Preferred dividends : Net income available to common shareholders $ 147 Common dividends $ 81 Addition to retained earnings $ 66 Answer the following questions about Travers & Co.'s income statement. What is the firm's DPS for 2005? $2.61 $1.95 $2.03 $2.25 $1.79 What is the basic EPS? $3.20 $4.74 $3.83 $2.83 $4.43 What is the diluted EPS? $4.43 $3.83 $4.26 $2.91 $2.83 What is the firm's operating margin? $2.55 What is the firm's operating margin? 13.79% 7.42% 16.67% 12.39% 6.29% What is the firm's net profit margin? 9.80% 13.79% 7.72% 6.29% 12.39% 2. Percentage changes Brandi Inc.'s stock price at the end of each of the last 6 years is shown below. Calculate the stock return in years 1 through 5. Year End-of-yearStock Price Annual Stock Return 0 uth WN Be In Year 2, the stock price the previous year's price and the stock return $15.08 $17.18 $15.55 $19.97 $30.48 $36.49 qd) 4] 4) 4] 4 ~' from the previous year's price and the stock return ~' from the previous year's return. In Year 5, the stock price ~*~ from ~' from the previous year's return. What is the (arithmetic) average stock return for Brandi's stock over this five-year period? 21.25% 21.04% 20.66% 21.47% 21.14% What is the (geometric) average stock return for Brandi's stock over this five-year period? 19.72% 18.94% 19.53% 19.43% 19.33% 5. Weighted average Richie holds a stock portfolio of two stocks. The portfolio's return is the weighted average of the returns of the component stocks. Stock A had a return of 8.0% and Stock B had a return of 11.0%. If Stock A constitutes 40% of Richie's stock portfolio, what is the return on the portfolio? 11.0% 11.4% 9.8% 11.6% 11.8% Jordan has a three-stock portfolio. The returns of the three stocks are shown below: Stock Return x 8% Y 9% Zz 13% Stock X makes up 50% of Jordan's portfolio, and the portfolio has a return of 9.3%. How much of Jordan's portfolio consists of Stock Y? 10% 60% 40% 50% 30%