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1 Chapter 2 Financial Statements, Cash Flow, and Taxes.

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Presentation on theme: "1 Chapter 2 Financial Statements, Cash Flow, and Taxes."— Presentation transcript:

1 1 Chapter 2 Financial Statements, Cash Flow, and Taxes

2 2 Topics in Chapter Balance sheet Income statement Statement of cash flows Free cash flow MVA and EVA Corporate taxes

3 Importance of Financial Statements Form the basis for understanding the financial position of a business Provide information regarding the financial policies and strategies and insight into future performance 10-K and 10-Q 3

4 Balance Sheet 4

5 5 Balance Sheet: Assets Cash$ 9,000$ 7,282 S-T invest.48,60020,000 AR351,200632,160 Inventories715,2001,287,360 Total CA1,124,0001,946,802 Gross FA491,0001,202,950 Less: Depr.146,200263,160 Net FA344,800939,790 Total assets$1,468,800$2,886,592

6 6 Balance Sheet: Liabilities & Equity Accts. payable$ 145,600$ 324,000 Notes payable200,000720,000 Accruals136,000284,960 Total CL481,6001,328,960 Long-term debt323,4321,000,000 Common stock460,000 Ret. earnings203,76897,632 Total equity663,768557,632 Total L&E$1,468,800$2,886,592

7 7 Changes on liabilities & equity CL increased as creditors and suppliers “financed” part of the expansion. Long-term debt increased to help finance the expansion. The company didn’t issue any stock. Retained earnings fell, due to the year’s negative net income and dividend payment.

8 Dell’s Balance Sheet +Balance+Sheet&ann +Balance+Sheet&ann 8

9 Balance Sheet highlights Net plant and equipment= gross plant and equipment– accumulated depreciation Common stock at par and additional paid-in (capital surplus) Retained earnings Annual addition to retained earnings = net income – dividends paid Net worth – common equity 9

10 Income Statement 10 Net Sales Less Cost of Goods Sold (COGS) Less Operating expenses EBITDA Less Depreciation Less Amortizations EBIT Less Interest EBT Less Taxes Net income

11 11 Income Statement Example Sales$3,432,000$5,834,400 COGS2,864,0004,980,000 Other expenses340,000720,000 Deprec.18,900116,960 Tot. op. costs3,222,9005,816,960 EBIT209,10017,440 Int. expense62,500176,000 EBT146,600(158,560) Taxes (40%)58,640(63,424) Net income$ 87,960($ 95,136)

12 Dell’s Income Statement Income+Statement&annual Income+Statement&annual 12

13 MicroDrive Income Statement Table 2-2 MicroDrive Income Statements for Years Ending December 31 (in millions of dollars) INCOME STATEMENT Net sales $3,000.0$2,850.0 Operating costs except depreciation $2,616.2$2,497.0 Earnings before interest, taxes, deprn., and amortization (EBITDA)*$383.8$353.0 Depreciation $100.0$90.0 Amortization $0.0 Depreciation and amortization $100.0$90.0 Earnings before interest and taxes (EBIT) $283.8$263.0 Less interest $88.0$60.0 Earnings before taxes (EBT) $195.8$203.0 Taxes $78.3$81.2 Net Income before preferred dividends $117.5$121.8 Preferred dividends $4.0 Net Income available to common stockholders $113.5$117.8 Common dividends $57.5$53.0 Addition to retained earnings $56.0$64.8 *MicroDrive has no amortization charges. 13

14 Income Statement Highlight Operating expenses Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments, etc. Earnings per common share (EPS) Companies that issued convertible securities (such as bonds convertible into common stock) and stock options, must calculate two types of earnings per share: basic and diluted. 14

15 15 Statement of Cash Flows Provides information about cash inflows and outflows during an accounting period Focuses on CASH. Has THREE sections: Cash flow from Operating Activities (OCF) Cash flow from Investing Activities (ICF) Cash flow from Financing Activities (FCF )

16 16 Compute the changes in some accounts over two periods Which account item goes to Which section ? Accounts receivables Notes payable Depreciation Fixed assets Accruals etc … Operating Investing Financing

17 17 Useful Tip 1 No matter which section you are doing (operating, investing or financing),  IF the change of an account leads to a cash INFLOW, you add that change (+); IF the change leads to a cash OUTFLOW, you subtract that change (-)  inflow: decreases in assets or increases in liabilities or equity. outflow: increases in assets or decreases in liabilities or equity.

18 18 Useful Tip 2 Cash flow from Operating Activities + Cash flow from Investing Activities + Cash flow from Financing Activities = CHANGE in cash account

19 Cash flows from operating activities 1 Net income + depreciation +/- change in A/R +/- change in Inv. +/- change in A/P +/- change in Accruals 19

20 20 Cash flows from operating activities 2 AssetLiability DecreasesAdd + (cash inflow) Subtract - (cash outflow) IncreasesSubtract - (cash outflow) Add + (cash inflow)

21 21 Cash flows from investing activities 1 Investing activities: Buying or selling productive assets (plant & equipment) Buying or selling financial securities (e.g., stocks and bonds of other companies,)

22 22 Cash flows from investing activities 2 Inflows:Means: Decrease in gross fixed assetsFirm sells long-lived assets such as gross property, plant and equipment Decrease in long-term investments Firm sells debt or equity securities of other firms Outflows: Increase in gross fixed assetsFirm buys long-lived assets such as gross property, plant and equipment Increase in long-term investments Firm buys debt or equity securities of other firms

23 23 Cash flows from investing activities 3 Warning: we want changes in GROSS fixed assets. We don’t want the changes in net fixed assets! BUT, if gross fixed assets are not reported in balance sheet …

24 24 Cash flows from investing activities 4 change in gross fixed assets = change in net fixed assets + depreciation

25 25 Cash flows from financing activities 1 +/- changes in N/P +/- changes in current long-term debt +/- changes in long-term debt +/- changes in common and preferred stock +/- changes in capital surplus - Payment of dividends

26 26 Cash flows from financing activities 2 Inflows:Means: increase in notes payable increase in long-term debt Firm borrows money increase in common stockFirm sells equity securities Outflows: decrease in notes payable decrease in long-term debt Firm repays debt decrease in common stockFirm buys back shares Payment of dividendsFirm pays cash to shareholders

27 27 Cash Flows Workshop Solve Assignment 3.1

28 Dell’s Statement of Cash Flow +Cash+Flow&annual +Cash+Flow&annual 28

29 29 Analyzing Statement of Cash Flows 1 Statement of CF can help you analyze a company: 1) Relationship between net income and net cash flow from operations (OCF)  If net income positive, but OCF is negative, could mean:  Company is growing rapidly  Financial mis-management

30 30 Analyzing Statement of Cash Flows 2 2) Net cash flow from investing activities (ICF) If negative, company is making investments  Buying plant & equipment (improve efficiencies)  Buying another company’s stock (strategic reasons, e.g., joint venture) If positive, company is liquidating assets. Why? Financial distress?

31 31 Analyzing Statement of Cash Flows 3 3) Does company have sufficient cash to pay dividends? OCF should exceed dividends. If dividends exceed OCF, why? Company liquidated assets to pay dividends? Company issued equity or borrow to pay dividends? Neither situation is good.

32 32 Analyzing Statement of Cash Flows 4 4) Changes in debt Look at cash flow from financing activities substantial increases in debt (either short-term or long-term) Substituting short-term debt for long- term debt may indicate worsening financial health.

33 33 What is free cash flow (FCF)? Why is it important? FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A company’s value depends on the future FCF it can generate.

34 34 What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock (repurchase). 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

35 35 Earning before interest and taxes (1 − Tax rate) Net operating profit after taxes X Operating current assets Operating current liabilities Net operating working capital − Total net operating capital Operating long-term assets + Net operating working capital Free cash flow − Net investment in operating capital Net operating profit after taxes − Total net operating capital this year Total net operating capital last year Net investment in operating capital Calculating Free Cash Flow in 5 Easy Steps Step 1Step 2 Step 3 Step 4 Step 5

36 36 Step1: Net Operating Profit after Taxes (NOPAT) NOPAT = EBIT(1 - Tax rate) =EBIT - Tax

37 37 Step2: Net Operating Working Capital (NOWC) Operating CA = cash and equivalent + inventory + accounts receivables. Operating CL = accounts payable + accruals = - Operating CA Operating CL NOWC

38 38 Step 3: Total net operating capital (or operating capital) Operating Capital = NOWC + Net fixed assets.

39 Step 4: net investment in operating capital Net investment in operating capital = operating capital this year - operating capital last year 39

40 40 Step 5: Free Cash Flow (FCF) FCF = NOPAT - Net investment in operating capital Equation (2-6)

41 Alternative FCF equation (2-9) 41 FCF = operating cash flow - gross investment in long-term operating asset - investment in NOWC Equation (2-9)

42 Is a negative FCF bad? If –NOPAT leads to a –FCF, then bad. High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. ROIC: return on invested capital ROIC = NOPAT / operating capital 42

43 43 Market Value Added (MVA) MVA = Market Value of the Firm - Book Value of the Firm Market Value = (# shares of stock)(price per share) + Value of debt Book Value = Total common equity + Value of debt

44 44 MVA (Continued) If the market value of debt is close to the book value of debt, then MVA = Market value of equity – book value of equity This applies when it is hard to find the market value of debt.

45 45 MVA (Assume market value of debt = book value of debt.) Market Value of Equity 2010: (100,000)($6.00) = $600,000. Book Value of Equity 2010: $557,632. MVA = $600,000 - $557,632 = $42,368.

46 46 Economic Value Added (EVA) EVA = NOPAT – Operating capital x WACC = Operating capital x ROIC – Operating capital x WACC = Operating capital (ROIC-WACC)

47 MVA and EVA (Table 2-5) 47 Table 2-5 MVA and EVA for MicroDrive (Millions of Dollars) MVA Calculation Price per share $23.0$26.0 Number of shares (millions) 50.0 Market value of equity = Share price (number of shares)$1,150.0$1,300.0 Book value of equity $896.0$840.0 MVA = Market value - Book value $254.0$460.0 EVA Calculation EBIT $283.8$263.0 Tax rate 40% NOPAT = EBIT (1-T) $170.3$157.8 Total investor-supplied operating capital a $1,800.0$1,455.0 Weighted average cost of capital, WACC (%) 11.0%10.8% Dollar cost of capital = Operating capital (WACC) $198.0$157.1 EVA = NOPAT – Capital cost -$27.7$0.7 ROIC = NOPAT/Operating capital 9.46%10.85% ROIC – Cost of capital = ROIC – WACC -1.54%0.05% EVA = (Operating capital)(ROIC – WACC) -$27.7$0.7

48 Corporate Tax Rates Taxable IncomeTax on BaseRate on amount above base 0 -50,000015% 50, ,0007,50025% 75, ,00013,75034% 100, ,00022,25039% 335, M113,90034% 10M - 15M3,400,00035% 15M M5,150,00038% 18.3M and up6,416,66735%

49 49 Features of Corporate Taxation Progressive rate up until $18.3 million taxable income. Below $18.3 million, the marginal rate is not equal to the average rate. Above $18.3 million, the marginal rate and the average rate are 35%.

50 After Chapter Homework Problems: (2-3), (2-4), (2-5), (2-10), (2-12 abcde), mini case d,e,f,g,h. Course website: Statement of Cash Flow assignment 3.2,

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