FINA200 Summer 2011, Section CB Case 1 - Covering Chapters 1 - 4
SUGGESTED SOLUTION
Question 1 (30 marks) Sibby Duchaine and Michael Costa Cash Flow Statement for the Year Just Ended Net Income Michael’s net salary1 Sibby's net salary2 Total net income $47,405 22,400 $69,805

Fixed Expenses Mortgage ($1,590 x 12) Property taxes Michael's car loan3 Car insurance and license Michael's transit pass ($80 x 12) Total fixed expenses Variable Expenses Home-related4 Groceries ($600 x 12) Recreation ($90 x 12) Personal care ($150 x 12) Sibby's car expenses ($250 x 12) Michael's gas ($100 x 12) Cuban holiday Clothes Miscellaneous Total variable expenses Net Cash Flow Notes $ 9,200 7,200 1,080 1,800 3,000 1,200 4,200 3,500 5,500 (36,680) ($3,270) $19,080 3,850 8,505 4,000 960 (36,395)

1

1. $65,000(1 + 0.05)4(1 - 0.4) = $47,405 2. $32,000(1 - 0.3) = $22,400 3. [($45,000)(1.12875) - $15,000] PV, 60 N, 7/12 = I, CPT PMT = -$708.76 x 12 = $8,505 4. Included under variable as many of these expenses vary with usage. Marking scheme: Footnote 1 - 3 marks, Footnote 2 - 2 marks; Footnote 3 - 2 marks; Footnote 4 - 5 marks; 6 marks for components of fixed expenses; 10 marks for components of variable expenses; 2 marks for net cash flow.

Question 2 (30 marks) Debt Ratio $298,125 ÷ $112,5751 = 2.65

Where net worth = Total assets - Total liabilities = ($4,700 + $56,000 + $350,000) - ($2,000 + $296,125) = $410,700 - $298,125 = $112,575 This ratio is extremely high, but not unusual for a young couple who have recently purchased a home and are starting out in their careers. Notice that their debt is largely mortgage debt.

Current Ratio

$4,700 ÷ $2,000 = 2.35

The couple has more than twice the level of liquid assets as current liabilities.

Liquidity Ratio

$4,700 ÷ [($36,395 + $36,680) ÷ 12] = 0.77

This ratio is extremely poor. The couple could not even cover 1 month of total expenses with their liquid assets.

Debt Payments Ratio

$8,505 ÷ $69,805 = 0.122

This ratio is well below the norm of 20%. The couple has very little consumer debt. -$5,051 ÷ [($65,000)(1.05)4 + $32,000] = -4.6%

Savings ratio

2

Remember that the RRSP and TFSA contributions that Michael made last year were not additional savings, merely transfers of existing investments. Therefore, at first glance it appears that the couple made no discretionary savings. However, we do not know if part of the deductions at source made by CAE represent contributions to some type of pension plan. Nevertheless, the couple does not appear to place a priority on savings, especially as they are running a cash flow deficit. Marking scheme: 4 marks per calculation; 2 marks per explanation.

Question 3 (40 marks - 10 marks each) Part A) A tax deduction reduces the amount of taxable income. A tax credit reduces the amount of the taxes owed. Tax Deduction A $1,000 tax deduction reduces taxable income by $1,000. This $1,000 reduction in taxable income would reduce Michael's overall tax burden by $1,000 x 0.26 = $260. 26% is assumed to be Michael's marginal tax rate given a salary of $65,000 x 1.054 = $79,008 and the absence of any apparent income tax deductions. This would result in taxable income of $79,008 and a marginal tax bracket (in 2009 and 2010) of 26% for federal purposes. resulting in taxable income of a similar amount. Michael's taxable Tax Credit A $1,000 amount would be converted into a tax credit of $1,000 x 0.15 = $150. This $150 would be subtracted directly from the taxes Michael owes. A tax deduction would be more beneficial to Michael as long as his marginal tax bracket (26% in this case) exceeds the conversion rate for tax credits (15%). Marking scheme: 6 marks for tax deduction; 4 marks for tax credit.

3

Part B) Michael would have qualified for the following 2009 federal tax credits: Amount Basic Personal Employment Quebec Pension Plan1 Employment Insurance1 Public Transit Pass2 Notes: 1. In view of his high salary, Michael would be