1. 2 - 1 Copyright © 2002 by Harcourt, Inc.All rights reserved. Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA Personal taxes Corporate taxes CHAPTER 2 Financial Statements, Cash Flow, and Taxes

2. 2 - 2 Copyright © 2002 by Harcourt, Inc.All rights reserved. Balance Sheet: Assets Cash7,28257,600 AR632,160351,200 Inventories1,287,360 715,200 Total CA1,926,8021,124,000 Gross FA1,202,950491,000 Less: Deprec. 263,160 146,200 Net FA 939,790 344,800 Total Assets2,866,5921,468,800 20012000

3. 2 - 3 Copyright © 2002 by Harcourt, Inc.All rights reserved. Liabilities and Equity 20012000 Accts payable524,160145,600 Notes payable636,808200,000 Accruals 489,600 136,000 Total CL1,650,568481,600 Long-term debt 723,432323,432 Common stock460,000 Retained earnings 32,592 203,768 Total equity 492,592 663,768 Total L&E2,866,5921,468,800

4. 2 - 4 Copyright © 2002 by Harcourt, Inc.All rights reserved. Income Statement Sales6,034,0003,432,000 COGS5,528,0002,864,000 Other expenses519,988 358,672 EBITDA (13,988) 209,328 Depr. & Amort.116,96018,900 EBIT(130,948)190,428 Interest exp. 136,012 43,828 EBT (266,960) 146,600 Taxes (40%) (106,784) 58,640 Net income (160,176) 87,960 20012000

5. 2 - 5 Copyright © 2002 by Harcourt, Inc.All rights reserved. COMMON SIZED FINANCIAL STATEMENTS To common size the Balance Sheet, divide all accounts by the Total Assets. To common size the Income Statement, divide all accounts by Total Sales.

6. 2 - 6 Copyright © 2002 by Harcourt, Inc.All rights reserved. Common Sized Balance Sheet: Assets Cash0.25 3.92 AR 22.05 23.91 Inventories 44.91 48.69 Total CA 67.22 76.53 Gross FA 41.96 33.43 Less: Deprec. 9.18 9.95 Net FA 32.78 23.47 Total Assets 100.00 20012000

7. 2 - 7 Copyright © 2002 by Harcourt, Inc.All rights reserved. Liabilities and Equity 20012000 Accts payable 18.29 9.91 Notes payable 22.21 13.62 Accruals 17.08 9.26 Total CL 57.58 32.79 Long-term debt 25.24 22.02 Common stock 16.05 31.32 Retained earnings 1.14 13.87 Total equity 45.19 Total L&E 100.00 17.18 100.00

8. 2 - 8 Copyright © 2002 by Harcourt, Inc.All rights reserved. Common Sized Income Statement Sales 100.00 COGS 91.61 83.45 Other expenses 8.62 10.45 EBITDA -.23 6.10 Depr. & Amort. 1.94.55 EBIT -2.17 5.55 Interest exp. 2.25 1.28 EBT -4.42 4.27 Taxes (40%) -1.77 1.71 Net income -2.65 2.56 20012000

9. 2 - 9 Copyright © 2002 by Harcourt, Inc.All rights reserved. Other Data No. of shares100,000 EPS($1.602)$0.88 DPS$0.110$0.22 Stock price$2.25$8.50 Lease pmts$40,000 20012000

10. 2 - 10 Copyright © 2002 by Harcourt, Inc.All rights reserved. Statement of Retained Earnings (2001) Balance of retained earnings, 12/31/00$203,768 Add: Net income, 2001(160,176) Less: Dividends paid(11,000) Balance of retained earnings, 12/31/01$32,592

11. 2 - 11 Copyright © 2002 by Harcourt, Inc.All rights reserved. (164,176) Statement of Cash Flows (2001) OPERATING ACTIVITIES Net income(160,176) Add (Sources of cash): Depreciation116,960 Increase in A/P378,560 Increase in accruals353,600 Subtract (Uses of cash): Increase in A/R(280,960) Increase in inventories(572,160) Net cash provided by ops.

12. 2 - 12 Copyright © 2002 by Harcourt, Inc.All rights reserved. L-T INVESTING ACTIVITIES Investment in fixed assets(711,950) FINANCING ACTIVITIES Increase in notes payable436,808 Increase in long-term debt400,000 Payment of cash dividends (11,000) Net cash from financing 825,808 NET CHANGE IN CASH(50,318) Plus: Cash at beginning of year 57,600 Cash at end of year 7,282

13. 2 - 13 Copyright © 2002 by Harcourt, Inc.All rights reserved. Net cash from operations = -$164,176, mainly because of negative NI. The firm borrowed $825,808 to meet its cash requirements. Even after borrowing, the cash account fell by $50,318. What can you conclude about D’Leon’s financial condition from its statement of CFs?

14. 2 - 14 Copyright © 2002 by Harcourt, Inc.All rights reserved. Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 – Tax rate). NOPAT 01 = -$130,948(1 – 0.4) = -$130,948(0.6) = -$78,569. NOPAT 00 = $114,257.

15. 2 - 15 Copyright © 2002 by Harcourt, Inc.All rights reserved. What effect did the expansion have on net operating working capital (NOWC)? NOWC= –. Current assets Non-interest bearing CL NOWC 01 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042. NOWC 00 = $842,400.

16. 2 - 16 Copyright © 2002 by Harcourt, Inc.All rights reserved. What effect did the expansion have on capital used in operations? Operating capital = NOWC + Net fixed assets. = $913,042 + $939,790 = $1,852,832. = $1,187,200. Operating capital 01 Operating capital 00

17. 2 - 17 Copyright © 2002 by Harcourt, Inc.All rights reserved. What is your initial assessment of the expansion’s effect on operations? Sales$6,034,000 $3,432,000 NOPAT ($78,569) $114,257 NOWC $913,042 $842,400 Operating capital $1,852,832 $1,187,200 Net Income ($160,176) $87,960 2000 2001

18. 2 - 18 Copyright © 2002 by Harcourt, Inc.All rights reserved. What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF 01 = NI + DEP= ($160,176) + $116,960 = ($43,216). NCF 00 = $87,960 + $18,900 = $106,860. OCF 01 = NOPAT + DEP = ($78,569) + $116,960 = $38,391. OCF 00 = $114,257 + $18,900 = $133,157.

19. 2 - 19 Copyright © 2002 by Harcourt, Inc.All rights reserved. What was the free cash flow (FCF) for 2001? FCF = OCF – Gross capital investment. -OR- FCF = NOPAT – Net capital investment = -$78,569 – ($1,852,832 – $1,187,200) = -$78,569 – $665,632 = -$744,201. Is negative free cash flow always a bad sign?

20. 2 - 20 Copyright © 2002 by Harcourt, Inc.All rights reserved. Economic Value Added (EVA) EVA=– =– = NOPAT–. Operating Income After Tax After-Tax Capital Costs Funds Available to Investors Cost of Capital Used After-Tax Cost of Capital

21. 2 - 21 Copyright © 2002 by Harcourt, Inc.All rights reserved. In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. EVA takes into account the total cost of capital, which includes the cost of equity. EVA Concepts

22. 2 - 22 Copyright © 2002 by Harcourt, Inc.All rights reserved. What is the company’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2000 and 13% in 2001. EVA 01 = NOPAT – (A-T cost of capital)(Capital) = -$78,569 – (0.13)($1,852,832) = -$78,569 – $240,868 = -$319,437. EVA 00 = $114,257 – (0.10)($1,187,200) = $114,257 – $118,720 = -$4,463.

23. 2 - 23 Copyright © 2002 by Harcourt, Inc.All rights reserved. Would you conclude that the expansion increased or decreased MVA? MVA = –. Market value of equity Equity capital supplied During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined.

24. 2 - 24 Copyright © 2002 by Harcourt, Inc.All rights reserved. CompanyMarket Value Added General Electric $502,307 million Microsoft $388,922 million Cisco Systems $377,883 million Intel $281,832 million Pfizer $260,984 million Merck $193,348 million EMC $191,904 million Oracle $180,885 million American Int’l Group $177,982 million Wal-Mart Stores $177,450 million Leading Creators of Wealth in the U.S. Market Value Added in 2000

25. 2 - 25 Copyright © 2002 by Harcourt, Inc.All rights reserved. Probably not. A/P increased 260% over the past year, while sales increased by only 76%. If this continues, suppliers may cut off D’Leon’s trade credit. Does D’Leon pay its suppliers on time?

26. 2 - 26 Copyright © 2002 by Harcourt, Inc.All rights reserved. No, the negative NOPAT and decline in cash position shows that D’Leon is spending more on its operations than it is taking in. Does it appear that D’Leon’s sales price exceeds its cost per unit sold?

27. 2 - 27 Copyright © 2002 by Harcourt, Inc.All rights reserved. 1.The company offers 60-day credit terms. The improved terms are matched by its competitors, so sales remain constant. What effect would each of these actions have on D’Leon’s cash account? A/R would  Cash would 

28. 2 - 28 Copyright © 2002 by Harcourt, Inc.All rights reserved. 2.Sales double as a result of the change in credit terms. Short run: Inventory and fixed assets  to meet increased sales. A/R , Cash . Company may have to seek additional financing. Long-run: Collections increase and the company’s cash position would improve.

29. 2 - 29 Copyright © 2002 by Harcourt, Inc.All rights reserved. D’Leon financed its expansion with external capital. D’Leon issued long-term debt which reduced its financial strength and flexibility. How did D’Leon finance its expansion?

30. 2 - 30 Copyright © 2002 by Harcourt, Inc.All rights reserved. Would D’Leon have required external capital if they had broken even in 2001 (Net Income = 0)? YES, the company would still have to finance its increase in assets. Looking to the Statement of Cash Flows, we see that the firm made an investment of $711,950 in net fixed assets. Therefore, they would have needed to raise additional funds.

31. 2 - 31 Copyright © 2002 by Harcourt, Inc.All rights reserved. No effect on physical assets. Fixed assets on balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve. What happens if D’Leon depreciates its fixed assets over 7 years (as opposed to the current 10 years)?

32. 2 - 32 Copyright © 2002 by Harcourt, Inc.All rights reserved. D’Leon received a tax credit of $106,784 in 2001. This suggests the company paid at least $106,784 in taxes during the past 2 years. If D’Leon’s payments over the past 2 years were less than $106,784 the firm would have had to carry forward the amount of its loss that was not carried back. If the firm did not receive a full refund its cash position would be even worse.

33. 2 - 33 Copyright © 2002 by Harcourt, Inc.All rights reserved. INCOME TAXES

34. 2 - 34 Copyright © 2002 by Harcourt, Inc.All rights reserved. April 2001 Single Individual Tax Rates Taxable IncomeTax on BaseRate* 0 - 26,250015% 26,250 - 63,5503,937.5028% 63,550 - 132,60014,381.5031% 132,600 - 288,35035,787.0036% Over 288,35091,857.0039.6% *Plus this percentage on the amount over the bracket base.

35. 2 - 35 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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 $5,150. On the basis of the information above and the April 2001 tax rate schedule, what is your tax liability?

36. 2 - 36 Copyright © 2002 by Harcourt, Inc.All rights reserved. Calculation of Taxable Income Salary$45,000 Dividends3,000 Personal exemptions(2,800) Deductions(5,150) Taxable Income$40,050

37. 2 - 37 Copyright © 2002 by Harcourt, Inc.All rights reserved. Tax Liability: TL= $3,937.50 + 0.28($13,800) = $7,801.50  $7,802. Marginal Tax Rate = 28%. Average Tax Rate: Tax rate = = 19.48%  19.5%. 40,050 - 26,250 $7,802 $40,050

38. 2 - 38 Copyright © 2002 by Harcourt, Inc.All rights reserved. January 2001 Corporate Tax Rates Taxable IncomeTax on BaseRate* 0 - 50,000015% 50,000 - 75,0007,50025% 75,000 - 100,00013,75034% 100,000 - 335,00022,25039% Over 18.3M6.4M35% *Plus this percentage on the amount over the bracket base..........

39. 2 - 39 Copyright © 2002 by Harcourt, Inc.All rights reserved. Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income. What’s its tax liability?

40. 2 - 40 Copyright © 2002 by Harcourt, Inc.All rights reserved. Operating income$100,000 Interest income5,000 Taxable dividend income 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.

41. 2 - 41 Copyright © 2002 by Harcourt, Inc.All rights reserved. State and local government bonds (munis) are generally exempt from federal taxes. Taxable vs. Tax-Exempt Bonds

42. 2 - 42 Copyright © 2002 by Harcourt, Inc.All rights reserved. Exxon Mobil bonds at 10% vs. California muni bonds at 7%. T = Tax rate = 28%. After-tax interest income: Exxon Mobil = 0.10($5,000) – 0.10($5,000)(0.28) = 0.10($5,000)(0.72) = $360. CAL= 0.07($5,000) – 0 = $350.

43. 2 - 43 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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 to muni vs. corp?

44. 2 - 44 Copyright © 2002 by Harcourt, Inc.All rights reserved. If T > 30%, buy tax-exempt munis. If T < 30%, buy corporate bonds. Only high income people should buy munis. Implications