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

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

4. Balance Sheet

5. Balance Sheet: Assets 2009 2010 Cash $ 9,000 $ 7,282 S-T invest.
$ ,000
$ ,282
S-T invest.
48,600
20,000 AR
351,200
632,160
Inventories
715,200
1,287,360
Total CA
1,124,000
1,946,802
Gross FA
491,000
1,202,950
Less: Depr.
146,200
263,160
Net FA
344,800
939,790
Total assets
$1,468,800
$2,886,592

6. Balance Sheet: Liabilities & Equity
2009
2010
Accts. payable
$ 145,600
$ 324,000
Notes payable
200,000
720,000
Accruals
136,000
284,960
Total CL
481,600
1,328,960
Long-term debt
323,432
1,000,000
Common stock
460,000
Ret. earnings
203,768
97,632
Total equity
663,768
557,632
Total L&E
$1,468,800
$2,886,592

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

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

10. Income Statement 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. Income Statement Example
2009
2010
Sales
$3,432,000
$5,834,400
COGS
2,864,000
4,980,000
Other expenses
340,000
720,000
Deprec.
18,900
116,960
Tot. op. costs
3,222,900
5,816,960
EBIT
209,100
17,440
Int. expense
62,500
176,000
EBT
146,600
(158,560)
Taxes (40%)
58,640
(63,424)
Net income
$ 87,960
($ 95,136)

12. Dell’s Income Statement

13. MicroDrive Income Statement
Table 2-2
MicroDrive Income Statements for Years Ending December 31
(in millions of dollars)
2010
2009
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
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.

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.

15. Statement of Cash Flows
FI Corporate Finance Leng Ling
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. Compute the changes in some accounts over two periods
Accounts receivables
Notes payable
Depreciation
Fixed assets
Accruals etc …
Which account item
goes to
Which section ?
Operating
Investing
Financing

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. FI 3300 - Corporate Finance Leng Ling
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

20. Cash flows from operating activities 2
FI Corporate Finance Leng Ling
Cash flows from operating activities 2
Asset
Liability
Decreases
Add +
(cash inflow)
Subtract -
(cash outflow)
Increases

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

22. Cash flows from investing activities 2
FI Corporate Finance Leng Ling
Cash flows from investing activities 2
Inflows:
Means:
Decrease in gross fixed assets
Firm 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 assets
Firm 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. Cash flows from investing activities 3
FI Corporate Finance Leng Ling
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. Cash flows from investing activities 4
FI Corporate Finance Leng Ling
Cash flows from investing activities 4
change in gross fixed assets
= change in net fixed assets + depreciation

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. Cash flows from financing activities 2
FI Corporate Finance Leng Ling
Cash flows from financing activities 2
Inflows:
Means:
increase in notes payable
increase in long-term debt
Firm borrows money
increase in common stock
Firm sells equity securities
Outflows:
decrease in notes payable
decrease in long-term debt
Firm repays debt
decrease in common stock
Firm buys back shares
Payment of dividends
Firm pays cash to shareholders

27. FI 3300 - Corporate Finance Leng Ling
Cash Flows Workshop
Solve Assignment 3.1

28. Dell’s Statement of Cash Flow

29. Analyzing Statement of Cash Flows 1
FI Corporate Finance Leng Ling
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. 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. 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. Analyzing Statement of Cash Flows 4
FI Corporate Finance Leng Ling
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. 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. 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. Calculating Free Cash Flow in 5 Easy Steps
Earning before interest and taxes
Operating current assets X
(1 − Tax rate) −
Operating current liabilities
Net operating profit after taxes
Net operating working capital
Step 3
Net operating working capital +
Operating long-term assets
Total net operating capital
Step 5
Figure 2-1 in FM13
Step 4
Net operating profit after taxes
Total net operating capital this year −
Net investment in operating capital −
Total net operating capital last year
Net investment in operating capital
Free cash flow

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

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

38. Step 3: Total net operating capital (or 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

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

41. Alternative FCF equation (2-9)
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

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. 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. 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. Economic Value Added (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) Table 2-5
MVA and EVA for MicroDrive (Millions of Dollars)
2010
2009
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 capitala
$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)

48. 2009 Corporate Tax Rates Taxable Income Tax on Base
Rate on amount above base
0 -50,000
15%
50, ,000
7,500
25%
75, ,000
13,750
34%
100, ,000
22,250
39%
335, M
113,900
10M - 15M
3,400,000
35%
15M M
5,150,000
38%
18.3M and up
6,416,667

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, 3.3.