Chapter 2 - Understanding Financial Statements, Taxes, and Cash Flows 09/02/08

Income Statement SALES SALES - EXPENSES - EXPENSES = PROFIT = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs Taxes

SALES SALES - Cost of Goods Sold GROSS PROFIT GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS TO COMMON STOCKHOLDERS Income Statement

Three Important Issues  Operating income is not affected by how the firm is financed  Interest is tax deductible  Positive net income does not necessarily mean it has any cash

Balance Sheet Total Assets = Total Assets = Outstanding Debt + Shareholders’ Equity

Balance Sheet Assets Liabilities (Debt) & Equity Current Assets Current Assets Cash Cash Marketable Securities Marketable Securities Accounts Receivable Accounts Receivable Inventories Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Machinery & Equipment Buildings and Land Buildings and Land Other Assets Investments & patents Current Liabilities Accounts Payable Accounts Payable Accrued Expenses Accrued Expenses Short-term notes Short-term notes Long-Term Liabilities Long-term notes Long-term notes Mortgages MortgagesEquity Preferred Stock Preferred Stock Common Stock (Par value) Common Stock (Par value) Paid in Capital Paid in Capital Retained Earnings Retained Earnings

Assets  Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.  Cash, marketable securities, accounts receivable, inventories, prepaid expenses.  Fixed Assets: machinery and equipment, buildings, and land.  Other Assets: any asset that is not a current asset or fixed asset.  Intangible assets, such as patents and copyrights.

Financing  Debt Capital: financing provided by a creditor.  Short-term debt: borrowed money that must be repaid within the next 12 months.  Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.  Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

Financing  Equity Capital: shareholders’ investment in the firm.  Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.  Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Common Equity  In balance sheet common equity = common stock (par value + paid-in capital – treasury stock) + retained earnings common equity = common stock (par value + paid-in capital – treasury stock) + retained earnings

Common Equity  Example 12/31/01 12/31/02 12/31/01 12/31/02 Common (par value) 3,000 3,200 Paid in capital 350, ,000 Retained earnings 1,800,000 ? Treasury stock 420, ,000 Total common equity 1,733,000 ? Dividend Paid 2002: 70, net income: 570,000

Free Cash Flows Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors).

Free Cash Flows Cash Flows from Assets = Cash Flows from Financing Cash flows generated through the firm’s assets = Cash flows paid to - or received from - the firm’s investors (creditors & stockholders)

Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Operating income + depreciation - cash tax payments

Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets [Change in current assets] - [change in non-interest bearing current liabilities]

Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet.

Calculating Free Cash Flows: A Financing Perspective Interest payments to creditors - change in debt principal - change in debt principal - dividends paid to stockholders - dividends paid to stockholders - change in stock - change in stock = Financing Free Cash Flows

Taxes  Marginal tax rate: the tax rate that would be applied to the next dollar of taxable income  Average tax rate: taxes owned by a firm divided by the firm’s taxable income  Always marginal

Corporate Income Tax Rates Since 1993 Taxable Income Corporate Tax Rate $1 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001 - $335,000 39% $335,001 - $10,000,000 34% $10,000,001 - $15,000,000 35% $15,000,001 - $18,333,333 38% over $18,333,333 35%

Corporate Income Tax Rates  Example (1) find the taxable income (2) Suppose we have a taxable income of 90,000 50,000 * 15% = 7,500 50,000 * 15% = 7,500 (75,000 – 50,000) * 25% = 6,250 (75,000 – 50,000) * 25% = 6,250 (90,000 – 75,000) * 34% = 5,100 (90,000 – 75,000) * 34% = 5,100 tax : 7, , ,100 = 18,850 tax : 7, , ,100 = 18,850

 Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders.  Calculate the firm’s tax liability.