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Chapter 13: Problem 13

A firm had net income last year of 1.2 million dollars . Its depreciation expenses were 5 million dollars , and its total cash flow was \(\$ 1.2\) million. What happened to net working capital during the year?

Short Answer

Expert verified
The net working capital of the firm increased by $5 million during the year.

Step by step solution

01

Given parameters

Net income for the year = $1.2 million, Depreciation expenses = $5 million, Total cash flow = $1.2 million.
02

Understand the formula for Net Working Capital

The change in Net Working Capital can be derived from: Total Cash Flow = Net Income + Depreciation expenses - Change in Net Working Capital.
03

Substitute the values into the equation

Substitute the given values into the equation: $1.2M = $1.2M + $5M - Change in Net Working Capital.
04

Solve for Change in Net Working Capital

By solving the above equation, you get: Change in Net Working Capital = $5M.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Cash Flow Analysis
Cash flow analysis is a vital aspect of understanding a company's financial health. It helps in tracking the flow of cash in and out of a business over a specific period. This analysis provides insights into the liquidity position, allowing companies to make important financial decisions.
Cash flows are categorized in three main areas:
  • Operating Activities: These include the core business operations, such as selling goods or providing services.
  • Investing Activities: This covers the purchase or sale of assets like equipment or investments.
  • Financing Activities: Involves cash movements resulting from borrowing or issuing stock.
In the exercise, total cash flow of $1.2 million indicates the net movement of cash in the company. By comparing this flow with net income and other financial metrics, you can infer changes in working capital and how effectively a company manages its cash resources.
Depreciation Expenses
Depreciation expenses, although non-cash in nature, have a significant impact on a company's financial statements. Understanding its role is essential in financial analysis. Depreciation represents the reduction in value of tangible assets over time due to wear and tear, such as machinery or buildings.
Here's why depreciation is important:
  • It spreads the cost of an asset over its useful life, thus allocating portions of the asset's cost to various fiscal periods.
  • This expense impacts the net income since it is deducted before taxes are calculated, hence reducing taxable income.
  • In cash flow analysis, depreciation is added back to net income, as it does not affect actual cash flows.
In our exercise, the $5 million in depreciation expenses was a non-cash charge that increased the cash flow without impacting the cash on hand, creating room for potential cash savings.
Net Income
Net income, often referred to as the "bottom line," is a key indicator of a company's profitability. It reflects the total profit of a company after all expenses, including taxes and depreciation, have been deducted from total revenues.
To better grasp net income:
  • Revenue: Total income generated from sales or services before any deductions.
  • Expenses: Operational costs, salaries, and other expenditures related to earning revenues.
  • Taxation and Interest: Reductions applied to pre-tax income.
In the example provided, the company had a net income of $1.2 million, showing profitability after accounting for all expenses, including taxes and depreciation. It's a crucial figure for assessing a company's ability to generate earnings compared to its expenses, providing a clear picture of financial performance in relation to cash flow analysis and changes in net working capital.

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Most popular questions from this chapter

Tubby Toys estimates that its new line of rubber ducks will generate sales of \$7 million, operating costs of \(\$ 4\) million, and a depreciation expense of \(\$ 1\) million. If the tax rate is 40 percent, what is the firm's operating cash flow? Show that you get the same answer using all three methods to calculate operating cash flow.

A house painting business had revenues of \(\$ 16,000 dollars and expenses of \)\$ 9,000 dollars . There were no depreciation expenses. However, the business reported the following changes in various components of working capital:$$\begin{array}{lcr} & \text { Beginning } & \text { End } \\\\\hline \text { Accounts receivable } & \mathrm{S} 1,200 & \mathrm{S} 4,500 \\\\\text { Accounts payable } & 600 & 200 \\\\\hline\end{array}.$$ Calculate net cash flow for the business for this period.

Laurel's Lawn Care, Ltd., has a new mower line that can generate revenues of 120,000 dollars per year. Direct production costs are 40,000 dollars and the fixed costs of maintaining the lawn mower factory are \(\$ 15,000\) a year. The factory originally cost \(\$ 1\) million and is being depreciated for tax purposes over 25 years using straight-line depreciation. Calculate the operating cash flows of the project if the firm's tax bracket is 35 percent.

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of 6 million dollars . The equipment will be depreciated straight line over 5 years to a value of zero, but in fact it can be sold after 5 years for 500,000 dollars .The firm believes that working capital at each date must be maintained at a level of 10 percent of next year's forecast sales. The firm estimates production costs equal to 1.50 dollars per trap and believes that the traps can be sold for 4 dollars each. Sales forecasts are given in the following table. The project will come to an end in 5 years, when the trap becomes technologically obsolete. The firm's tax bracket is 35 percent, and the required rate of return on the project is 12 percent. What is project NPV?$$\begin{array}{lccccccc} \text { Year: } & 0 & 1 & 2 & 3 & 4 & 5 & \text { Thereafter } \\ \hline \text { Sales (millions of traps) } & 0 & .5 & .6 & 1.0 & 1.0 & .6 & 0 \\\\\hline\end{array}$$

Depreciation and Project Value. Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can purchase the washer for 6,000 dollars and sell its old washer for 2,000 dollars . The new washer will last for 6 years and save \(\$ 1,500\) a year in expenses. The opportunity cost of capital is 15 percent, and the firm's tax rate is 40 percent.a. If the firm uses straight-line depreciation to an assumed salvage value of zero over a 6 year life, what are the cash flows of the project in Years \(0-6 ?\) The new washer will in fact have zero salvage value after 6 years, and the old washer is fully depreciated. b. What is project NPV? c. What will NPV be if the firm uses MACRS depreciation with a 5-year tax life?
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