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Balance sheet Income statementStatement of cash flowsAccounting income versus cash flowMVA and EVAPersonal taxesCorporate taxes

CHAPTER 2Financial Statements,Cash Flow, and Taxes

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Balance Sheets: Assets

2001 2000Cash 7,282 9,000Short-term inv. 0 48,600AR 632,160 351,200Inventories 1,287,360 715,200

Total CA 1,926,802 1,124,000

Gross FA 1,202,950 491,000Less: Depr. 263,160 146,200

Net FA 939,790 344,800Total assets 2,866,592 1,468,800

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1,733,760

Liabilities and Equity

2001 2000Accts payable 524,160 145,600Notes payable 720,000 200,000Accruals 489,600 136,000

Total CL 481,600Long-term debt 1,000,000 323,432

Common stock 460,000 460,000Retained earnings (327,168) 203,768

Total equity 132,832 663,768Total L&E 2,866,592 1,468,800

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(519,936)

Income Statement

Sales 5,834,400 3,432,000COGS 5,728,000 2,864,000Other expenses 680,000 340,000Deprec. 116,960 18,900

Tot. op. costs 6,524,960 3,222,900EBIT (690,560) 209,100

Interest exp. 176,000 62,500EBT (866,560) 146,600

Taxes (40%) (346,624) 58,640Net income 87,960

2001 2000

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Other Data

No. of shares 100,000 100,000

EPS ($5.199) $0.88

DPS $0.110 $0.22Stock price $2.25 $8.50

Lease pmts $40,000 $40,000

2001 2000

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Statement of Retained Earnings (2001)

Balance of retained

earnings, 12/31/00 $203,768

Add: Net income, 2001 (519,936)

Less: Dividends paid (11,000)

Balance of retained

earnings, 12/31/01 ($327,168)

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Statement of Cash Flows: 2001

OPERATING ACTIVITIESNet Income (519,936)Adjustments:

Depreciation 116,960Change in AR (280,960)Change in inventories (572,160)Change in AP378,560Change in accruals 353,600

Net cash provided by ops.

(523,936)

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L-T INVESTING ACTIVITIES

Investments in fixed assets (711,950)FINANCING ACTIVITIES

Change in s-t investments 48,600Change in notes payable 520,000

Change in long-term debt 676,568Payment of cash dividends (11,000)

Net cash from financing 1,234,168Sum: net change in cash (1,718)

Plus: cash at beginning of year 9,000Cash at end of year 7,282

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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 accountfell by $1,718.

What can you conclude about the

companys financial condition from itsstatement of cash flows?

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What effect did the expansion have on

net operating working capital (NOWC)?

NOWC01 = ($7,282 + $632,160 + $1,287,360)

- ($524,160 + $489,600)

= $913,042.

NOWC00 = $793,800.

= -Operating

CA

Operating

CLNOWC

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What effect did the expansion have on

capital used in operations?

= NOWC + Net fixed assets.

= $913,042 + $939,790

= $1,852,832.

= $1,138,600.

Operatingcapital01

Operatingcapital00

Operatingcapital

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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.

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What is your initial assessment of the

expansions effect on operations?

2001 2000

Sales $5,834,400 $3,432,000NOPAT ($414,336) $125,460

NOWC $913,042 $793,800

Operating capital $1,852,832 $1,138,600

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What effect did the companys

expansion have on its net cash flowand 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.

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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?

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What is the companys EVA?

Assume the firms after-tax cost ofcapital (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.

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Would you conclude

that the expansion increased ordecreased MVA?

MVA = - .

During the last year stock price hasdecreased 73%, so market value ofequity has declined. Consequently,MVA has declined.

Equity capitalsuppliedMarket valueof equity

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Probably not.

A/P increased 260% over the pastyear, while sales increased by only70%.

If this continues, suppliers may cutoff trade credit.

Does the company pay its suppliers

on time?

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No, the negative NOPAT showsthat the company is spendingmore on its operations than it is

taking in.

Does it appear that the sales price

exceeds the cost per unit sold?

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1. The company offers 60-day creditterms. The improved terms arematched by its competitors, so salesremain constant.

What effect would each of these

actions have on the cash account?

A/R would

Cash would

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2. Sales double as a result of thechange in credit terms.

Short-run: Inventory and fixed

assets to meet increasedsales. A/R , Cash . Companymay have to seek additionalfinancing.

Long-run: Collections increaseand the companys cashposition would improve.

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The expansion was financedprimarily with external capital.

The company issued long-term debtwhich reduced its financial strength

and flexibility.

How was the expansion financed?

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Would external capital have been

required if they had broken even in2001 (Net income = 0)?

Yes, the company would still haveto finance its increase in assets.

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What happens if fixed assets are

depreciated over 7 years (as opposedto 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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Other policies that

can affect financial statements

Inventory valuation methods.

Capitalization of R&D expenses.

Policies for funding the companysretirement plan.

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Does the companys positive stock

price ($2.25), in the face of large losses,suggest that investors are irrational?

No, it means that investorsexpect things to get better in

the future.

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Why did the stock price fall

after the dividend was cut?

Management was signaling thatthe firms operations were in trouble.

The dividend cut lowered investors

expectations for future cash flows,which caused the stock price todecline.

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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 increasedby $378,560.

Employees: Accruals increased by$353,600.

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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 havehad to carry forward the amount of its lossthat was not carried back.

If the firm did not receive a full refund itscash position would be even worse.

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2000 Tax Year Single Individual

Tax Rates

Taxable Income Tax on Base Rate*

0 - 26,250 0 15%25,620 - 63,550 3,937.50 28%63,550 - 132,600 14,381.50 31%132,600 - 288,350 35,787.00 36%

Over 288,350 91,857.00 39.6%

*Plus this percentage on the amount over thebracket base.

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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 rateschedule, what is your tax liability?

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Calculation of Taxable Income

Salary $45,000

Dividends 3,000

Personal exemptions (2,800)

Deductions (4,550)

Taxable Income $40,650

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Tax Liability:

TL = $3,937.50 + 0.28($14,400)

= $7,969.50.

Marginal Tax Rate = 28%.

Average Tax Rate:

Tax rate = = 19.6%.

$40,650 - $26,250

$9,969.5$40,650

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2000 Corporate Tax Rates

Taxable Income Tax on Base Rate*

0 - 50,000 0 15%

50,000 - 75,000 7,500 25%75,000 - 100,000 13,750 34%100,000 - 335,000 22,250 39%

Over 18.3M 6.4M 35%

*Plus this percentage on the amount over thebracket base.

... ... ...

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Assume a corporation has $100,000 of

taxable income from operations, $5,000of interest income, and $10,000 of

dividend income.

What is its tax liability?

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Operating income $100,000

Interest income 5,000

Taxable dividendincome 3,000*

Taxable income $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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State and local government bonds(municipals, ormunis) aregenerally exempt from federaltaxes.

Taxable versus Tax Exempt Bonds

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Exxon bonds at 10% versus Californiamuni 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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Solve for T in this equation:

Muni yield = Corp Yield(1-T)

7.00% = 10.0%(1-T)

T = 30.0%.

At what tax rate would you be

indifferent between the muni and thecorporate bonds?

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If T > 30%, buy tax exempt munis.

If T < 30%, buy corporate bonds.

Only high income, and hence hightax bracket, individuals should buymunis.

Implications