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T2.1 Chapter Outline Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow.

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Presentation on theme: "T2.1 Chapter Outline Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow."— Presentation transcript:

1 T2.1 Chapter Outline Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow 2.4Taxes 2.5Capital Cost Allowance 2.6Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson,Ltd.

2 T2.1 Chapter Outline Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow 2.4Taxes 2.5Capital Cost Allowance 2.6Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson,Ltd.

3 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 3 T2.2 The Balance Sheet (Figure 2.1)

4 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 4 T2.2 The Balance Sheet Components  Assets (Current & Long-Term)  Liabilities (Current & Long-Term)  Owners Equity Key concepts  Liquidity  Net Working Capital Current Assets minus Current Liabilities  Debt vs. Equity  Market vs. Book Value

5 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 5 Liquidity refers to the speed and ease which an asset can be turned into cash  a highly liquid asset then is one which can be quickly sold and turned into cash - without a significant loss in value. Assets are listed on the balance sheet in order of decrreasng liquidity liquidity is important - running the day to day business and being in position to pay interest charges, retire loans, pay dividends, etc.  Trade-off - the more liquid an asset is the lower the return to that asset e.g. Cash balances vs inventory vs fixed assets

6 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 6 Debt v.s. Equity Generally, when a firm borrows it gives the bondholder first claim on the firm’s cash flow and assets....equity holders receive the residual value or whatever is left after the creditors are paid. Thus, shareholders equity is the residual difference between assets and liabilities. The use of debt financing is called financial leverage - debt financing can magnify returns (gains and losses) to shareholders or equity holders  increases the potential return  also increases the risk factor

7 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 7 Market Value vs Book Notes Balance sheet values are book values  GAAP requires assets to be shown at historical cost  current asset book values can be very close to market value  fixed assets can and often have major differences between historical cost and market value  GAAP Accounting principles of objectivity and conservatism are the drivers behind historical cost. No argument about historical cost and because book is usually less than mkt. - they are also conservative( if mkt values fall along way below book - assets will be written down - good examples of this are the recent writedowns of assets by the likes of Nortel Cisco and many other high tech. firms

8 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 8 T2.3 Income Statement Components  Revenues  Expenses Cash and non-cash Operating and non-operating  Net Income  Earnings per share  Dividends 3 important concepts for Finance  GAAP & Accrual Accounting & Matching  Non-cash items  Time and Costs

9 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 9 Cash Flow Key concept in the study of Corporate Finance  liquidity is about turning assets into cash  investment analysis and capital budgeting is about discounted cash flows  valuation of securities is about future discounted cash flow at some rate of discount e.g bonds - future interest payments and principle repayments discounted back at a certain rate

10 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 10 T2.4 Cash Flow Cash flows are essential to valuation  In Finance, one of the main concern is the timing of cash flows. (another being the discount rate)  Since the income statement includes non-cash items, we will have to adjust it to get information on cash flows  Balance sheet activity plays an important role in the determination of the cash balance (e.g.) Collections on accounts receivable Borrowing on accounts payable Work with reported financial statements to determine historical cash flow.

11 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 11 Cash Flow Cash flow from an historical perspective - calculated from financial statements - our focus in this chapter  how to calculate projected cash flow - look at in later chapters as we move into the question of valuation of investments and securities

12 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 12 T2.4 GAAP versus Cash Flow Time Line Revenue recognized and matched expenses Sale of goods on credit Time PayPayrollPay Collect for checksutilitiesaccounts raw goodsissuedreceivable Cash flowCash flowCash flowCash flow

13 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 13 T2.6 Cash Flow Summary  I.The cash flow identity Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners) This is based upon the balance sheet identity: Assets = Liabilities + Equity The equivalent cash flow statement is: cash flow to creditors Cash flow from assets = + cash flow to stockholders

14 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 14 T2.6 Cash Flow Summary (cont’d)  II.Cash flow from assets Cash flow from assets = Operating cash flow – Net capital spending – Additions to net working capital (NWC) where Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC  III.Cash flow to creditors Cash flow to creditors = Interest paid – Net new borrowing  IV. Cash flow to stockholders Cash flow to stockholders = Dividends paid – Net new equity raised

15 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 15 T2.5 Cash Flow Example Balance Sheet BegEndBegEnd Cash$100$150A/P$100$150 A/R200250N/P Inv300300C/L C/A$600$700LTD$400$420 NFA400500C/S5060 R/E $300$430 Total$1000$1200Total$1000$1200

16 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 16 T2.5 Cash Flow Example (continued) Income Statement Sales$2000 Costs1400 Depreciation100 EBIT500 Interest100 Taxable Income400 Taxes200 Net Income$200 Dividends 80 Addition to R/E$120

17 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 17 T2.5 Cash Flow Example (concluded) A.Cash flow from assets 1.Operating cash flow= EBIT + _____________ – Taxes = $ – 200 = $_____ 2.Change in NWC= ___________ – ___________ = $350 – $_____ = $_____ 3.Net capital spending= $_____ + Dep – _____ = $ – 400 = $_____ 4.Cash flow from assets=OCF – chg. NWC – Cap. sp. = $400 – 50 – 200 = $150 B.Cash flow to creditors and stockholders 1.Cash flow to creditors= Int. paid – _________________ = $100 – 20 = $80 2.Cash flow to stockholders=Div. paid – ________________ = $80 – 10 = $70 Check: $___ from assets = $___ to Bondholders + $___ to Stockholders

18 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 18 T2.5 Cash Flow Example (concluded) A.Cash flow from assets 1.Operating cash flow= EBIT + Depreciation – Taxes = $ – 200 = $400 2.Change in NWC= Ending NWC – Beginning NWC = $350 – 300 = $50 3.Net capital spending= Ending NFA + Dep – Beginning NFA = $ – 400 = $200 4.Cash flow from assets=OCF – chg. NWC – Cap. sp. = $400 – 50 – 200 = $150 B.Cash flow to creditors and stockholders 1.Cash flow to creditors= Int. paid – Net new Borrowing = $100 – 20 = $80 2.Cash flow to stockholders=Div. paid – Net new Equity = $80 – 10 = $70 Check: $150 from assets = $80 to bondholders + $70 to stockholders

19 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 19 Taxes - key concepts Earnings and cash flow are on an after tax basis - taxes represent real costs and cash requirements for firms Taxes can be a major factor in investment decisions including mergers and acquisitions.  Tax ‘pools’ of the acquired company can be used in the new entity to shelter income - the value of these pools to the acquiring company needs to be established Financial management considerations - corporate taxation is a complex and specialized field.....good communication between tax experts and other financial staff is important as the after tax impact of business decisions needs to be established.

20 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 20 T2.7 Taxes Key issues:  What is an average tax rate?  What is a marginal tax rate?  Why do we pay attention to marginal tax rates?  What are corporate tax rates?  What are individual tax rates?  How does the difference between corporate and individual tax rates affect corporate finance? How do tax rates relate to the goal of corporate finance?

21 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 21 T2.7 Individual Tax Rates FEDERAL Taxable Income $ Tax Rate % % % UP 29% Provincial generally applied as a % of the Basic Federal Tax - exception Alberta Alberta - 10%

22 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 22 T2.7 Marginal versus Average Tax Rates

23 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 23 T2.7 Individual Tax Rates SELECTED PROVINCIAL (Table 2.5) Resident of Percentage of Basic Federal Tax Alberta44% Newfoundland62 Prince Edward Island57.5 Saskatchewan48 Northwest Territories45 Yukon Territory50

24 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 24 Taxes on Investment Income taxes on dividends and capital gains dividends  two clear goals - avoidance of double taxation with corporations paying dividends from after tax income and full taxation in the hands of shareholders -> dividend tax credit this tax shelter applies to dividends paid by Canadian Corporations thus encouraging Canadian investors to invest in Canadian firms Capital Gains  rates are coming down with 50% of the gain now being taxed - down from 75%  tax deferral from only realized gains being taxed results in lower ‘effective tax’

25 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 25 T2.8 ILLUSTRATION OF DIVIDEND TAX CREDIT FOR ALBERTA RESIDENTS Marginal Tax Rate17%24%29% Dividends$1,000$1,000$1,000 Gross up at 25% Grossed up dividends Federal Tax on dividends Less Dividend Tax Credit (13.333% x $1,250)(166.67) (166.67)(166.67) Federal Tax Payable Provincial Tax at 44% of Federal Tax Total Tax Effective Combined Tax Rates 6.6%19.2%28.2% NOTE: Marginal tax rates apply to incomes of less than 32,000 (17%), more than 32,000 but less than (25%), and more than 64,000 (29%)

26 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 26 T2.9 Corporate Tax Rates FEDERAL ALBERTA COMBINED Basic Corporations % 39.1% Manufacturing and Processing All Small Corporations (Taxable Income below $200 thousand)

27 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 27 Taxable Income taxable income is different from net income  net income needs to conform to GAAP  taxable income is calculated according to tax rules established by the various taxing authorities  e.g. book depreciation vs capital cost allowance book depreciation attempting to match revenues earned from the use of a tangible depreciable asset with the costs associated with the asset capital cost allowance - allowable deductions associated with various types of assets - patchwork of tax rules that often have stemmed from government budget and economic development objectives.  Income is taxed differently across various industries with the ‘rules’ continually changing

28 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 28 Capital Cost Allowance Key concepts and terms:  Classes of assets  Asset purchases and sales net acquisitions are used if multiple purchases one half year rule applies to net acquisitions sale - the balance in the pool is reduced by the lesser of sale price or original cost  Termination of asset pool terminal loss occurs when there is remaining UCC after the last asset disposal - this amount is fully tax deductible recaptured CCA occurs with a negative UCC after the last asset disposal - this amount is fully taxable

29 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 29 T 2.10 Capital Cost Allowance - Depreciation for tax purposes ClassRateAssets 14%Buildings acquired after %Furniture, photocopiers 1030%Vans, trucks, tractors and computer equipment 13 Straight-lineLeasehold improvements 1640%Taxicabs and rental cars 2250%Pollution control equipment 4330%Manufacturing equipment

30 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 30 T2.11CCA Example Depreciation on $22,000 Photocopier (CCA Class 8) Year UCC t CCA UCC t+1 111,0002,200$8, ,8003,960 15, ,8403,168 12, ,6722,534 10, ,1382,028 8,110 68,1101,622 6,488

31 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 31 T2.12 Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets Current assets Cash$ 45$ 50 Accounts receivable Inventory Total$ 625$ 745 Fixed assets Net plant and equipment Total assets$1610$1845

32 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 32 T2.12 Hermetic, Inc. Balance Sheet (concluded) Liabilities and equity Current liabilities Accounts payable$ 210$ 260 Notes payable Total$ 320$ 435 Long-term debt Stockholders’ equity Common stock and paid-in surplus Retained earnings Total$1085$1185 Total liabilities and equity$1610$1845

33 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 33 T2.13 Hermetic, Inc. Income Statement ($ in thousands) Net sales$ Cost of goods sold Depreciation30.00 Earnings before interest and taxes$ Interest20.00 Taxable income Taxes53.45 Net income$ Dividends Addition to retained earnings $100.00

34 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 34 T2.14 Hermetic, Inc. Cash Flow from Assets Cash flow from assets: Operating cash flow: EBIT$ Depreciation – Taxes– $ Change in net working capital: Ending net working capital$ – Beginning net working capital– $ 5.00 Net capital spending: Ending net fixed assets$ 1, – Beginning net fixed assets– Depreciation $ Cash flow from assets: $ 26.55

35 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 35 T2.14 Hermetic, Inc. Cash Flow from Assets (concluded) Total cash flow to creditors and stockholders: Cash flow to creditors: Interest paid$ – Net new borrowing– $ 0.00 Cash flow to stockholders: Dividends paid$ – Net new equity raised0.00 $ Cash flow to creditors and stockholders$ 26.55

36 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 36 T2.16 Solution to Problem 2.12 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 2000 balance sheet showed long-term debt of $2.9 million. The 2000 income statement showed interest expense of $700,000. What was cash flow to creditors during 1999? Cash flow to creditors = Interest paid – Net new borrowing  Interest paid = $700,000  Net new borrowing = $ _______ – 2 million = $ _______ Cash flow to creditors = $700,000 – (_______) =_______

37 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 37 T2.16 Solution to Problem 2.12 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 2000 balance sheet showed long-term debt of $2.9 million. The 2000 income statement showed interest expense of $700,000. What was cash flow to creditors during 1999? Cash flow to creditors = Interest paid – Net new borrowing  Interest paid = $700,000  Net new borrowing = $2.9 million – 2 million = $900K Cash flow to creditors = $700,000 – 900,000 =–$200,000

38 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 38 T2.17 Solution to Problem 2.13 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed $500,000 in the common stock account, and $6.6 million in the additional paid-in surplus account. The December 31, 1999 balance sheet showed $550,000 and $7.0 million in the same two accounts. If the company paid out $300,000 in cash dividends during 2000, what was the cash flow to stockholders for the year? Cash flow to stockholders = Dividends paid – Net new equity  Dividends paid = ________  Net new equity = (________+________) – ________ + ________) Cash flow to stockholders  = ________– ________  = ________

39 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 39 T2.17 Solution to Problem 2.13 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed $500,000 in the common stock account, and $6.6 million in the additional paid-in surplus account. The December 31, 1999 balance sheet showed $550,000 and $7.0 million in the same two accounts. If the company paid out $300,000 in cash dividends during 2000, what was the cash flow to stockholders for the year? Cash flow to stockholders = Dividends paid – Net new equity  Dividends paid = $300,000  Net new equity = ($550, m) – ($500, m) = $450,000 Cash flow to stockholders  = $300,000 – 450,000  = –$150,000

40 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 40 T2.18 Solution to Problem 2.14 Given the information for Pearl Jelly, Inc. in problems 12 and 13, suppose you also know that the firm’s net capital spending during 2000 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 2000 operating cash flow, or OCF? Cash flow from assets (CFA) = Cash flow to creditors + Cash flow to stockholders Cash flow to creditors = – $200,000 Cash flow to stockholders = – $150,000 So, Cash flow from assets = –$200K + ( –) 150,000K = –$350K. And, CFA = OCF - chg. in NWC – capital spending Solving for OCF:  OCF = CFA + chg. in NWC + capital spending  OCF = _______ + _______+ _______  OCF = $ _______

41 copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 41 T2.18 Solution to Problem 2.14 Given the information for Pearl Jelly, Inc. in problems 12 and 13, suppose you also know that the firm’s net capital spending during 2000 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 2000 operating cash flow, or OCF? Cash flow from assets (CFA) = Cash flow to creditors + Cash flow to stockholders Cash flow to creditors = – $200,000 Cash flow to stockholders = – $150,000 So, cash flow from assets = –$200K + ( –) 150,000K = –$350K. And, CFA = OCF – Chg. in NWC – Capital spending Solving for OCF:  OCF = CFA + Chg. in NWC + Capital spending  OCF = –$350K + ( – 135,000) + 500,000  OCF = $15,000


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