Financial Statements, Cash Flow, And Taxes

2-1

CHAPTER 2 Financial Statements, Cash Flow, and Taxes  Balance sheet  Income statement  Statement of cash flows  Accounting income versus cash flow  MVA and EVA  Personal taxes  Corporate taxes Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2-2

Balance Sheets: Assets Cash Short-term inv. AR Inventories Total CA Gross FA Less: Depr. Net FA Total assets Copyright © 2002 by Harcourt, Inc.

2001 7,282 0 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592

2000 9,000 48,600 351,200 715,200 1,124,000 491,000 146,200 344,800 1,468,800 All rights reserved.

2-3

Liabilities and Equity 2001 2000 Accts payable 524,160 145,600 Notes payable 720,000 200,000 Accruals 489,600 136,000 Total CL 1,733,760 481,600 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 © 2002 by Harcourt, Inc.

All rights reserved.

2-4

Income Statement Sales COGS Other expenses Deprec. Tot. op. costs EBIT Interest exp. EBT Taxes (40%) Net income Copyright © 2002 by Harcourt, Inc.

2001 2000 5,834,400 3,432,000 5,728,000 2,864,000 680,000 340,000 116,960 18,900 6,524,960 3,222,900 (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

2001

2000

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 © 2002 by Harcourt, Inc.

All rights reserved.

2-6

Statement of Retained Earnings (2001)

Balance of retained earnings, 12/31/00 Add: Net income, 2001 Less: Dividends paid Balance of retained earnings, 12/31/01 Copyright © 2002 by Harcourt, Inc.

$203,768 (519,936) (11,000) ($327,168) All rights reserved.

2-7

Statement of Cash Flows: 2001 OPERATING ACTIVITIES Net Income Adjustments: Depreciation Change in AR Change in inventories Change in AP378,560 Change in accruals Net cash provided by ops.

(519,936) 116,960 (280,960) (572,160) 353,600 (523,936)

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2-8

L-T INVESTING ACTIVITIES Investments in fixed assets (711,950) FINANCING ACTIVITIES Change in s-t investments 48,600 Change in notes payable 520,000 Change in long-term debt 676,568 Payment of cash dividends (11,000) Net cash from financing 1,234,168 Sum: net change in cash (1,718) Plus: cash at beginning of year 9,000 Cash at end of year 7,282 Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2-9

What can you conclude about the company’s financial condition from its statement of cash flows?  Net cash from operations = -$523,936, mainly because of negative net income.  The firm borrowed $1,185,568 and sold $48,600 in short-term investments to meet its cash requirements.  Even after borrowing, the cash account fell by $1,718. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 10

What effect did the expansion have on net operating working capital (NOWC)? Operating Operating NOWC = CA CL NOWC01 = ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600) = $913,042. NOWC00 = $793,800. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 11

What effect did the expansion have on capital used in operations? Operating = NOWC + Net fixed assets. capital Operating = $913,042 + $939,790 capital01 = $1,852,832. Operating capital00 = $1,138,600. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 12

Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 - Tax rate) NOPAT01 = -$690,560(1 - 0.4) = -$690,560(0.6) = -$414,336. NOPAT00 = $125,460. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 13

What is your initial assessment of the expansion’s effect on operations?

Sales NOPAT NOWC

2001 $5,834,400 ($414,336) $913,042

2000 $3,432,000 $125,460 $793,800

Operating capital

$1,852,832

$1,138,600

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 14

What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF01 = NI + DEP = -$519,936 + $116,960 = -$402,976. NCF00 = $87,960 + $18,900 = $106,860. OCF01 = NOPAT + DEP = -$414,336 + $116,960 = -$297,376. OCF00 = $125,460 + $18,900 = $144,360. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 15

What was the free cash flow (FCF) for 2001? FCF = NOPAT - Net capital investment = -$414,336 - ($1,852,832 - $1,138,600) = -$414,336 - $714,232 = -$1,128,568. How do you suppose investors reacted? Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 16

What is the company’s EVA? Assume the firm’s after-tax cost of capital (COC) was 11% in 2000 and 13% in 2001. EVA01 = NOPAT- (COC)(Capital) = -$414,336 - (0.13)($1,852,832) = -$414,336 - $240,868 = -$655,204. EVA00 = $125,460 - (0.11)($1,138,600) = $125,460 - $125,246 = $214. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 17

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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 18

Does the company 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 trade credit. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 19

Does it appear that the sales price exceeds the cost per unit sold?

 No, the negative NOPAT shows that the company is spending more on it’s operations than it is taking in.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 20

What effect would each of these actions have on the 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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 21

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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 22

How was the expansion financed?

 The expansion was financed primarily with external capital.  The company issued long-term debt which reduced its financial strength and flexibility.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 23

Would external capital have been required if they had broken even in 2001 (Net income = 0)?

 Yes, the company would still have to finance its increase in assets.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 24

What happens if fixed assets are depreciated 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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 25

Other policies that can affect financial statements

 Inventory valuation methods.  Capitalization of R&D expenses.  Policies for funding the company’s retirement plan.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 26

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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 27

Why did the stock price fall after the dividend was cut?

 Management was “signaling” that the firm’s operations were in trouble.  The dividend cut lowered investors’ expectations for future cash flows, which caused the stock price to decline. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 28

What were some other sources of financing used in 2001?  Selling financial assets: Short term investments decreased by $48,600.  Bank loans: Notes payable increased by $520,000.  Credit from suppliers: A/P increased by $378,560.  Employees: Accruals increased by $353,600. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 29

What is the effect of the $346,624 tax credit received in 2001.  This suggests the company paid at least $346,624 in taxes during the past 2 years.  If the 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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 30

2000 Tax Year Single Individual Tax Rates Taxable Income

Tax on Base

Rate*

0 - 26,250 25,620 - 63,550 63,550 - 132,600 132,600 - 288,350 Over 288,350

0 3,937.50 14,381.50 35,787.00 91,857.00

15% 28% 31% 36% 39.6%

*Plus this percentage on the amount over the bracket base. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 31

Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,800 and your itemized deductions are $4,550. On the basis of the information above and the 2000 tax year tax rate schedule, what is your tax liability?

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 32

Calculation of Taxable Income

Salary Dividends

$45,000 3,000

Personal exemptions

(2,800)

Deductions

(4,550)

Taxable Income

Copyright © 2002 by Harcourt, Inc.

$40,650

All rights reserved.

2 - 33

$40,650 - $26,250  Tax Liability: TL = $3,937.50 + 0.28($14,400) = $7,969.50.  Marginal Tax Rate = 28%.  Average Tax Rate: $9,969.5 Tax rate = $40,650 = 19.6%. Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 34

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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 35

Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income.

What is its tax liability?

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 36

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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 37

Taxable versus Tax Exempt Bonds

State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 38

 Exxon bonds at 10% versus 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 © 2002 by Harcourt, Inc.

All rights reserved.

2 - 39

At what tax rate would you be indifferent between the muni and the corporate bonds? Solve for T in this equation: Muni yield = Corp Yield(1-T) 7.00% = 10.0%(1-T) T = 30.0%.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.

2 - 40

Implications

 If T > 30%, buy tax exempt munis.  If T < 30%, buy corporate bonds.  Only high income, and hence high tax bracket, individuals should buy munis.

Copyright © 2002 by Harcourt, Inc.

All rights reserved.