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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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 2-2 Balance Sheet: Assets Cash AR Inventories Total CA Gross FA Less: Deprec. Net FA Total Assets Copyright © 2001 by Harcourt, Inc. 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 All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 2-4 Income Statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest exp. EBT Taxes (40%) Net income Copyright © 2001 by Harcourt, Inc. 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 All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. $203,768 (519,936) (11,000) ($327,168) All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. (519,936) 116,960 378,560 353,600 (280,960) (572,160) (523,936) All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. (50,318) 57,600 7,282 All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 13 What is your initial assessment of the expansion’s effect on operations? Sales NOPAT NOWC Operating capital Net Income Copyright © 2001 by Harcourt, Inc. 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 All rights reserved. 2 - 14 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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? Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 16 Economic Value Added (EVA) Operating Income After-Tax EVA = – After Tax Capital Costs Cost of = Funds Available – Capital Used to Investors = NOPAT Copyright © 2001 by Harcourt, Inc. – After-Tax Cost of Capital All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. 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 All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 28 Other policies that affect financial statements Inventory valuation methods. Capitalization of R&D expenses. Policies for funding the company’s retirement plan. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 33 INCOME TAXES Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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? Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 36 Calculation of Taxable Income Salary Dividends $45,000 3,000 Personal exemptions (2,750) Deductions (4,850) Taxable Income Copyright © 2001 by Harcourt, Inc. $40,400 All rights reserved. 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 Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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? Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 41 Taxable vs. Tax-Exempt Bonds State and local government bonds (munis) are generally exempt from federal taxes. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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. Copyright © 2001 by Harcourt, Inc. All rights reserved. 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%. Copyright © 2001 by Harcourt, Inc. All rights reserved. 2 - 44 Implications If T > 30%, buy tax-exempt munis. If T < 30%, buy corporate bonds. Only high income people should buy munis. Copyright © 2001 by Harcourt, Inc. All rights reserved.