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2-1
CHAPTER 2
Financial Statements, Cash Flow,
and Taxes
Balance sheet
Income statement
Statement of cash flows
Accounting income vs. cash flow
MVA and EVA
Personal taxes
Corporate taxes
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2-2
Balance Sheet: Assets
Cash
AR
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
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2000
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
1999
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
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2-3
Liabilities and Equity
2000
1999
Accts payable
524,160
145,600
Notes payable
720,000
200,000
Accruals
489,600
136,000
Total CL
481,600
1,733,760
Long-term debt
1,000,000
323,432
Common stock
460,000
460,000
Retained earnings (327,168) 203,768
Total equity
132,832
663,768
Total L&E
2,866,592 1,468,800
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2-4
Income Statement
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest exp.
EBT
Taxes (40%)
Net income
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2000
1999
5,834,400 3,432,000
5,728,000 2,864,000
680,000
340,000
(573,600)
228,000
116,960
18,900
(690,560)
209,100
176,000
62,500
(866,560)
146,600
(346,624)
58,640
(519,936)
87,960
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2-5
Other Data
2000
1999
No. of shares
100,000
100,000
EPS
($5.199)
$0.88
DPS
$0.110
$0.22
Stock price
$2.25
$8.50
Lease pmts
$40,000
$40,000
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2-6
Statement of Retained Earnings (2000)
Balance of retained
earnings, 12/31/99
Add: Net income, 2000
Less: Dividends paid
Balance of retained
earnings, 12/31/00
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$203,768
(519,936)
(11,000)
($327,168)
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2-7
Statement of Cash Flows (2000)
OPERATING ACTIVITIES
Net income
Add (Sources of cash):
Depreciation
Increase in A/P
Increase in accruals
Subtract (Uses of cash):
Increase in A/R
Increase in inventories
Net cash provided by ops.
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(519,936)
116,960
378,560
353,600
(280,960)
(572,160)
(523,936)
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2-8
L-T INVESTING ACTIVITIES
Investment in fixed assets
(711,950)
FINANCING ACTIVITIES
Increase in notes payable
Increase in long-term debt
Payment of cash dividends
Net cash from financing
520,000
676,568
(11,000)
1,185,568
NET CHANGE IN CASH
Plus: Cash at beginning of year
Cash at end of year
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(50,318)
57,600
7,282
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2-9
What can you conclude about
D’Leon’s financial condition from its
statement of CFs?
Net cash from operations = -$523,936,
mainly because of negative NI.
The firm borrowed $1,185,568 to meet
its cash requirements.
Even after borrowing, the cash account
fell by $50,318.
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2 - 10
Did the expansion create additional
net operating profit after taxes
(NOPAT)?
NOPAT = EBIT(1 – Tax rate)
NOPAT00 = -$690,560(1 – 0.4)
= -$690,560(0.6)
= -$414,336.
NOPAT99 = $125,460.
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2 - 11
What effect did the expansion have on
net operating working capital
(NOWC)?
NOWC =
Current
assets
Non-interest
–
bearing CL
NOWC00 = ($7,282 + $632,160 + $1,287,360)
– ($524,160 + $489,600)
= $913,042.
NOWC99 = $842,400.
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2 - 12
What effect did the expansion have on
capital used in operations?
Operating
capital = NOWC + Net fixed assets.
Operating
= $913,042 + $939,790
capital00
= $1,852,832.
Operating
= $1,187,200.
capital99
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2 - 13
What is your initial assessment of the
expansion’s effect on operations?
Sales
NOPAT
NOWC
Operating capital
Net Income
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2000
$5,834,400
($414,336)
$913,042
$1,852,832
($519,936)
1999
$3,432,000
$125,460
$842,400
$1,187,200
$87,960
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What effect did the company’s
expansion have on its net cash flow
and operating cash flow?
NCF00 = NI + DEP = ($519,936) + $116,960
= ($402,976).
NCF99 = $87,960 + $18,900 = $106,860.
OCF00 = NOPAT + DEP
= ($414,336) + $116,960
= ($297,376).
OCF99 = $125,460 + $18,900
= $144,360.
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2 - 15
What was the free cash flow (FCF)
for 2000?
FCF = NOPAT – Net capital investment
= -$414,336 – ($1,852,832 – $1,187,200)
= -$414,336 – $665,632
= -$1,079,968.
Is negative free cash flow always a bad
sign?
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2 - 16
Economic Value Added (EVA)
Operating Income
After-Tax
EVA =
–
After Tax
Capital Costs
Cost of
= Funds Available –
Capital Used
to Investors
=
NOPAT
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– After-Tax Cost
of Capital
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2 - 17
EVA Concepts
In order to generate positive EVA, a
firm has to more than just cover
operating costs. It must also provide
a return to those who have provided
the firm with capital.
EVA takes into account the total cost
of capital, which includes the cost of
equity.
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2 - 18
What is the company’s EVA?
Assume the firm’s after-tax cost of
capital was 11% in 1999
and 13% in 2000.
EVA00 = NOPAT – (A-T cost of capital)(Capital)
= -$414,336 – (0.13)($1,852,832)
= -$414,336 – $240,868
= -$655,204.
EVA99 = $125,460 – (0.11)($1,187,200)
= $125,460 – $130,592
= -$5,132.
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2 - 19
Would you conclude that
the expansion increased or
decreased MVA?
Market value Equity capital
MVA = of equity –
supplied
During the last year stock price has
decreased 73%, so market value of
equity has declined. Consequently,
MVA has declined.
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2 - 20
Leading Creators of Wealth in the U. S.
Market Value Added in 1999
Company
Microsoft
General Electric
Intel
Wal-Mart Stores
Coca-Cola
Merck
Pfizer
Cisco Systems
Lucent Technologies
Bristol-Myers Squibb
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Market Value Added
$328,257 million
$285,320 million
$166,902 million
$159,444 million
$157,536 million
$153,170 million
$148,245 million
$135,650 million
$127,265 million
$119,350 million
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2 - 21
Does D’Leon pay its suppliers on time?
Probably not.
A/P increased 260% over the past
year, while sales increased by only
70%.
If this continues, suppliers may cut
off D’Leon’s trade credit.
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2 - 22
Does it appear that D’Leon’s sales
price exceeds its cost per unit sold?
No, the negative NOPAT and
decline in cash position shows
that D’Leon is spending more on
its operations than it is taking in.
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2 - 23
What effect would each of these
actions have on D’Leon’s cash
account?
1. The company offers 60-day credit
terms. The improved terms are
matched by its competitors, so sales
remain constant.
A/R would 
Cash would 
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2 - 24
2. Sales double as a result of the
change in credit terms.
Short run: Inventory and fixed
assets to meet increased
sales. A/R , Cash . Company
may have to seek additional
financing.
Long-run: Collections increase
and the company’s cash
position would improve.
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2 - 25
How did D’Leon finance its expansion?
D’Leon financed its expansion with
external capital.
D’Leon issued long-term debt
which reduced its financial strength
and flexibility.
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2 - 26
Would D’Leon have required external
capital if they had broken even in
2000 (Net Income = 0)?
YES, the company would still have
to finance its increase in assets.
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2 - 27
What happens if D’Leon depreciates its
fixed assets over 7 years (as opposed
to the current 10 years)?
No effect on physical assets.
Fixed assets on balance sheet
would decline.
Net income would decline.
Tax payments would decline.
Cash position would improve.
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2 - 28
Other policies that affect
financial statements
Inventory valuation methods.
Capitalization of R&D expenses.
Policies for funding the company’s
retirement plan.
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2 - 29
Does the company’s positive stock
price ($2.25), in the face of large
losses, suggest that investors are
irrational?
NO, it means that investors
expect things to get better in
the future.
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2 - 30
Why did the stock fall after the
dividend was cut?
Management was “signaling” that
the firm’s operations were in trouble.
The dividend cut lowered
expectations for future cash flows,
which caused the stock price to
decline.
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2 - 31
What were some other sources of
financing for D’Leon in 2000?
Bank loans: Notes payable increased
by $520,000.
Credit from suppliers: A/P increased
by $378,560.
Employees: Accruals increased by
$353,600.
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2 - 32
D’Leon received a tax credit of
$346,624 in 2000.
 This suggests the company paid at least
$346,624 in taxes during the past 2 years.
 If D’Leon’s payments over the past 2 years
were less than $346,624 the firm would
have had to carry forward the amount of
its loss that was not carried back.
 If the firm did not receive a full refund its
cash position would be even worse.
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2 - 33
INCOME TAXES
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2 - 34
April 2000 Single Individual Tax Rates
Taxable Income
0 - 25,750
25,750 - 62,450
62,450 - 130,250
130,250 - 283,150
Over 283,150
Tax on Base
Rate*
0
3,862.50
14,138.50
35,156.50
90,200.50
15%
28%
31%
36%
39.6%
*Plus this percentage on the amount over the
bracket base.
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2 - 35
Assume your salary is $45,000, and
you received $3,000 in dividends. You
are single, so your personal exemption
is $2,750 and your itemized deductions
are $4,850.
On the basis of the information
above and the April 2000 tax rate
schedule, what is your tax liability?
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2 - 36
Calculation of Taxable Income
Salary
Dividends
$45,000
3,000
Personal exemptions
(2,750)
Deductions
(4,850)
Taxable Income
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$40,400
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2 - 37
40,400 - 25,750
Tax Liability:
TL = $3,862.50 + 0.28($14,650)
= $7,964.50  $7,965.
Marginal Tax Rate = 28%.
Average Tax Rate:
$7,965
Tax rate =
= 19.71%  19.7%.
$40,400
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2 - 38
January 2000 Corporate Tax Rates
Taxable Income
0 - 50,000
50,000 - 75,000
75,000 - 100,000
100,000 - 335,000
...
Over 18.3M
Tax on Base
0
7,500
13,750
22,250
...
6.4M
Rate*
15%
25%
34%
39%
...
35%
*Plus this percentage on the amount over the
bracket base.
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2 - 39
Assume a corporation has
$100,000 of taxable income from
operations, $5,000 of interest
income, and $10,000 of dividend
income.
What’s its tax liability?
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2 - 40
Operating income
Interest income
Taxable dividend
income
Taxable income
$100,000
5,000
3,000*
$108,000
Tax = $22,250 + 0.39 ($8,000)
= $25,370.
*Dividends – Exclusion
= $10,000 – 0.7($10,000) = $3,000.
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2 - 41
Taxable vs. Tax-Exempt Bonds
State and local government bonds
(munis) are generally exempt from
federal taxes.
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2 - 42
 Exxon bonds at 10% vs. California muni
bonds at 7%.
 T = Tax rate = 28%.
 After-tax interest income:
Exxon = 0.10($5,000) – 0.10($5,000)(0.28)
= 0.10($5,000)(0.72) = $360.
CAL = 0.07($5,000) – 0 = $350.
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2 - 43
At what tax rate would you be
indifferent to muni vs. corp?
Solve for T in this equation:
Muni yield = Corp Yield(1 – T)
7.00% = 10.0%(1 – T)
T = 30.0%.
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2 - 44
Implications
If T > 30%, buy tax-exempt munis.
If T < 30%, buy corporate bonds.
Only high income people should
buy munis.
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