30. Net Income vs. Free Cash Flow Calculation

Watson Oil recently reported (in millions) $8,250 of sales, $5,750 of operating costs other than depreciation, and $800 of depreciation. The company had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital. By how much did the firm's net income exceed its free cash flow? Do not round the intermediate calculations.

a. $717

b. $646

c. $633

d. $601

e. $808

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25. Operations and Cash Flows

Which of the following statements is CORRECT?

a. To estimate the net cash provided by operations, depreciation must be subtracted from net income because it is a non-cash charge that has been added to revenue.

b. The current cash flow from existing assets is highly relevant to investors. However, since the value of the firm depends primarily upon its growth opportunities, accounting net income projections from those opportunities are the only relevant future flows with which investors are concerned.

c. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to discourage the use of debt financing by corporations.

d. If Congress changed depreciation allowances so that companies had to report higher depreciation levels for tax purposes in 2015, this would lower their free cash flows for 2015.

e. Two metrics that are used to measure a company's financial performance are net income and free cash flow. Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on free cash flows as they do on net income.