honeycfa

Ironman Nutrition has traditionally followed a conservative policy of expensing most costs. However, the new CFO is an advocate of capitalization. During a meeting with company executives he explains that compared to expensing, capitalization is least likely to result in:

A) lower debt to equity ratio.

B) greater initial return on assets.

C) higher net cash flows.

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There is no difference in net cash flow. However, a firm that capitalizes classifies the expenditure as investing (not operations) cash flow from operations will be higher and cash flow from investing will be lower.

The other statements are correct. Capitalizing firms have higher asset and equity levels (due to the booking of the asset and the higher net income.)

honeycfa

A firm that capitalizes rather than expensing costs will have:

A) lower cash flows from investing.

B) lower cash flows from operations.

C) lower profitability in the earlier years.

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A firm that capitalizes costs classifies them as an investing cash flow rather than an operating cash flow. Investing cash flows will be lower and cash flow from operations will be higher when costs are capitalized.

honeycfa

Train, Inc.’s cash flow from operations (CFO) in 2004 was $14 million. Train paid $8 million cash to acquire a franchise at the beginning of 2004 that was expensed in 2004. If Train had elected to amortize the cost of the franchise over eight years, 2004 cash flow from operations (CFO) would have been:

A) unchanged.

B) $21 million.

C) $22 million.

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If Train decided to amortize the franchise cost, it would be capitalized and $1 million each year would be treated as a reduction in cash flow from investing (CFI). None of the cash expended would flow though CFO, and all of the $8 million would be added back to CFO.

honeycfa

Which of the following statements regarding capitalizing versus expensing costs is least accurate?

A) Capitalization results in higher profitability initially.

B) Cash flow from investing is higher with expensing than with capitalization.

C) Total cash flow is higher with capitalization than expensing.

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Total cash flow is higher with capitalization than expensing is least accurate because total cash flow would be the same under both methods, not considering tax implications.

honeycfa

 

Selected information from Willingham Corp.’s financial statements for the year ended December 31 included the following (in $ millions):

Accounts Payable	12
Long-term Debt	32
Common Stock	10
Retained Earnings	16
Total Liabilities and Equity	70

During the year, Willingham paid $14 million cash to purchase a franchise and fully expensed the franchise cost.  If the company had elected to amortize the franchise cost over 7 years instead of expensing it, Willingham’s total asset-to-equity ratio would be closest to:

A) 3.15.

B) 2.16.

C) 1.84.

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Given that total assets must equal total liabilities and equity, Willingham’s total asset-to-equity ratio was 70 / (10 + 16) = 2.69. If the franchise cost were amortized, retained earnings would be $12 million higher ($14 million cost less 14 / 7 = $2 million of amortization). The total asset-to-equity ratio would decrease to (70 + 12) / (10 + 16 + 12) = 2.16.

honeycfa

Income statement information for Quick Corp. for the years ended December 31, 20X0 and 20X1 was as follows (in $ millions):

	20X0	20X1
Sales	30,000,000	32,000,000
Cost of Goods Sold	(16,000,000)	(17,000,000)
Gross Profit	14,000,000	15,000,000
Amortization of Franchise	(1,500,000)	(1,500,000)
Other Expenses	(7,000,000)	(7,000,000)
Net Income	5,500,000	6,500,000

Quick acquired a franchise in 20X0 for $15,000,000 and elected to amortize the cost over 10 years. Ignoring taxes, if Quick had expensed the franchise cost in 20X0 instead of amortizing it, net income for 20X0 and 20X1 would be:

20X0

20X1

A) -$9,500,000   $8,000,000

B) -$8,000,000   $6,500,000

C) -$8,000,000   $8,000,000

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If the franchise cost were expensed, amortization would be eliminated and franchise expense would be fully taken in 20X0. 20X0 net income would be $5,500,000 + 1,500,000 - $15,000,000= -$8,000,000, and 20X1 net income would be $6,500,000 + $1,500,000= $8,000,000.

shxjm

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shxjm

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