Chapter 4

Chapter 4
Understanding the Statement of Cash Flows
Choice D is correct.
An increase in inventory indicates that more cash was spent on inventory than will be
recognized as cost of goods sold on the income statement. Since an increase in inventory
represents a use of cash for working capital (that is, a current asset), the reduction to cash
flow appears in the operating activities section of the cash flow statement.
Choice C is correct.
Dividends are a financing cash outflow. A is false despite the fact that preferred
securities often have some of the attributes of both equity and debt. B is incorrect
because payment of dividends represents an outflow of cash. D is incorrect because
payment of dividends, for either common or preferred stock, by a U.S. firm is treated as a
financing activity.
Choice A is correct.
A portion of Boche’s R&D has been capitalized (that is, accounted for as though it
creates a long-term asset) whereas all of Perck’s R&D has been expensed as a period
cost. Therefore, the impact of this difference in accounting rules must be adjusted before
comparing the operating cash flows of these firms. B is incorrect because IAS does not
require that R&D be financed in a particular way in order for the related expenditure to
be capitalized. Since A is correct and B is incorrect, C and D are both false.
Use of accelerated depreciation for tax purposes has enabled SSI to reduce its income
before tax. This results in lower tax expense and increased cash flow in the current year.
The amount of the tax saving equals the product of the difference in depreciation and
SSI’s tax rate. Thus,
Tax Saving = $5 million X 25% = $1.25 million
The tax saving increases SSI’s cash flow by $1.25 million.
CPLI’s operating cash flow is obtained by adjusting the net income for depreciation and
the given changes in its working capital accounts as follows:
Net Income
Add: Depreciation
Add: Decrease in Acct.Rec.
Add: Decrease in Inventory
Add: Increase in Acct. Payable
Cash Flow from Operating Activities:
In addition to reviewing the directional effect of specific changes in working capital on
operating cash flow, this problem illustrates how cash flow from operations can depart
dramatically from net income.
EBITDA is given as:
Less Depreciation & amortization:
Interest Expense
Plus: Deprec. & Amort
+100 million
(80) million
+20 million
(10) million
+10 million
(3) million
+7 million
+80 million
+87 million
Since the purchase of its own stock does not affect operating cash flow, the additional
information is not sufficient to explain the forecast of either negative net income or
negative cash flow from operating activities for HLHN.
b. One type of item that could help reconcile the apparent discrepancy between
EBITDA and Operating Cash flow is an increase in working capital (such as
inventory). This would reduce operating cash flow without affecting EBITDA or net
income. While increases in fixed assets (such as property, plant, and equipment) or
debt repayment would affect total cash flow without affecting net income, they would
not reduce operating cash flow.
The effect of a $50 million investment in its customer on each of the following
components of Firm A’s cash flow statement is as follows:
Effect on Cash From Operating Activities
Effect on Cash From Investing Activities
Effect on Cash From Financing Activities
($50 million)
Investments such as this one are classified as investing activities. There are no tax
implications at the time such investments are made, so Firm A’s tax rate is irrelevant.
The amount of the cash outflow from investing is $50 million.
The effect of these bonds on CFI’s net income is:
Interest Payment
Less Amortization of premium
Interest Expense
In contrast, the effect on cash is an outflow of $8 million.
The reduction of the interest expense for the amortization of bond premium is a noncash
item, which reflects the fact that part of the annual outflow of interest is merely a return
of capital to the investor. As a result, the calculation of the CFI’s cash flow by the
indirect method must include a reduction of $500,000 for the difference between the
actual cash outflow and the amount of interest expense that is incorporated in the firm’s
reported income.
To arrive at cash flow from operating activities, given net income, the following
adjustments are necessary:
Net Income
Add back Depreciation +
Add increase in A/P
+ 1,500,000
Add increase in Int/P
Add Loss on Stock
+ 1,000,000
Cash flow from Op.
The two adjustments to operating cash low needed to arrive at free cash flow to the firm
can be explained as follows. First, for the purpose of measuring free cash flow to the
firm, cash used to pay interest expense remains available. Note that this would not be the
case for free cash flow to equity. Since interest expense is deductible, however, its effect
on Net Income was equal to Interest Expense X (1-tax rate). Therefore, this same quantity
is added back to cash flow available to the firm. Under IAS, if interest expense had not
been deducted from operating cash flow this adjustment would not be necessary.
Next, an adjustment to operating cash flow is required for the firm’s ongoing investment
in fixed capital assets. While this amount has been deducted from total cash flow, in the
cash flow from investing section of the cash flow statement, it has not been included as
an outflow in operating cash flow. These ongoing, necessary expenditures must not be
included in any measure of “free cash flow”.
Since depreciation does not impact either EBITDA or operating cash flow, it can not
explain any discrepancy between the two measures. In contrast, a significant change in
working capital impacts operating cash flow but not EBITDA. Thus, a large increase in
working capital assets during a given year would consume cash and could account for a
discrepancy between the two measures. In such a case, operating cash flow might be less
than EBITDA.
Choice B is correct.
Net cash flow from operations = Cash collected from customers – Cash paid for salaries –
Cash paid to suppliers – Cash paid for interest to bondholders
= $150,000 - $60,000 - $40,000 - $20,000
= $30,000
Choice A is correct.
Operating interest received and Interest paid are both classified as operating cash flows
under U.S. GAAP. Under IAS alternative classifications are available.
Choice B is correct.
Increase NP – Retired long-term debt + Stock sold – Dividends Paid
= $800 - $796 + $300 - $864 = -$560