1. 2 - 1 Copyright © 2001 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 Accounting and Finance

2. 2 - 2 Copyright © 2001 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 20001999

3. 2 - 3 Copyright © 2001 by Harcourt, Inc.All rights reserved. Liabilities and Equity 20001999 Accts payable524,160145,600 Notes payable720,000200,000 Accruals 489,600 136,000 Total CL 1,733,760 481,600 Long-term debt1,000,000323,432 Common stock460,000 Retained earnings (327,168) 203,768 Total equity 132,832 663,768 Total L&E2,866,5921,468,800

4. 2 - 4 Copyright © 2001 by Harcourt, Inc.All rights reserved. Income Statement Sales5,834,4003,432,000 COGS5,728,0002,864,000 Other expenses680,000 340,000 EBITDA (573,600) 228,000 Depr. & Amort. 116,96018,900 EBIT(690,560)209,100 Interest exp. 176,000 62,500 EBT (866,560) 146,600 Taxes (40%) (346,624) 58,640 Net income (519,936) 87,960 20001999

5. 2 - 5 Copyright © 2001 by Harcourt, Inc.All rights reserved. Other Data No. of shares100,000 EPS($5.199)$0.88 DPS$0.110$0.22 Stock price$2.25$8.50 Lease pmts$40,000 20001999

6. 2 - 6 Copyright © 2001 by Harcourt, Inc.All rights reserved. Statement of Retained Earnings (2000) Balance of retained earnings, 12/31/99$203,768 Add: Net income, 2000(519,936) Less: Dividends paid(11,000) Balance of retained earnings, 12/31/00($327,168)

7. 2 - 7 Copyright © 2001 by Harcourt, Inc.All rights reserved. (523,936) Statement of Cash Flows (2000) OPERATING ACTIVITIES Net income(519,936) 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.

8. 2 - 8 Copyright © 2001 by Harcourt, Inc.All rights reserved. L-T INVESTING ACTIVITIES Investment in fixed assets(711,950) FINANCING ACTIVITIES Increase in notes payable520,000 Increase in long-term debt676,568 Payment of cash dividends (11,000) Net cash from financing1,185,568 NET CHANGE IN CASH(50,318) Plus: Cash at beginning of year 57,600 Cash at end of year 7,282

9. 2 - 9 Copyright © 2001 by Harcourt, Inc.All rights reserved. Net cash from operations = -$523,936, mainly because of negative NI. The firm borrowed $1,185,568 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?

10. 2 - 10 Copyright © 2001 by Harcourt, Inc.All rights reserved. Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 – Tax rate) NOPAT 00 = -$690,560(1 – 0.4) = -$690,560(0.6) = -$414,336. NOPAT 99 = $125,460.

11. 2 - 11 Copyright © 2001 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 00 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042. NOWC 99 = $842,400.

12. 2 - 12 Copyright © 2001 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 00 Operating capital 99

13. 2 - 13 Copyright © 2001 by Harcourt, Inc.All rights reserved. What is your initial assessment of the expansion’s effect on operations? 2000 1999 Sales$5,834,400 $3,432,000 NOPAT($414,336)$125,460 NOWC $913,042 $842,400 Operating capital $1,852,832 $1,187,200 Net Income ($519,936) $87,960

14. 2 - 14 Copyright © 2001 by Harcourt, Inc.All rights reserved. What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF 00 = NI + DEP= ($519,936) + $116,960 = ($402,976). NCF 99 = $87,960 + $18,900 = $106,860. OCF 00 = NOPAT + DEP = ($414,336) + $116,960 = ($297,376). OCF 99 = $125,460 + $18,900 = $144,360.

15. 2 - 15 Copyright © 2001 by Harcourt, Inc.All rights reserved. What was the free cash flow (FCF) for 2000? FCF = NOPAT – Net capital investment = -$414,336 – ($1,852,832 – $1,187,200) = -$414,336 – $665,632 = -$1,079,968. Is negative free cash flow always a bad sign?

16. 2 - 16 Copyright © 2001 by Harcourt, Inc.All rights reserved. Economic Value Added (EVA) EVA=– =– = NOPAT– After-Tax Cost of Capital Operating Income After Tax After-Tax Capital Costs Funds Available to Investors Cost of Capital Used

17. 2 - 17 Copyright © 2001 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

18. 2 - 18 Copyright © 2001 by Harcourt, Inc.All rights reserved. What is the company’s EVA? Assume the firm’s after-tax cost of capital was 11% in 1999 and 13% in 2000. EVA 00 = NOPAT – (A-T cost of capital)(Capital) = -$414,336 – (0.13)($1,852,832) = -$414,336 – $240,868 = -$655,204. EVA 99 = $125,460 – (0.11)($1,187,200) = $125,460 – $130,592 = -$5,132.

19. 2 - 19 Copyright © 2001 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.

20. 2 - 20 Copyright © 2001 by Harcourt, Inc.All rights reserved. CompanyMarket Value Added Microsoft $328,257 million General Electric $285,320 million Intel $166,902 million Wal-Mart Stores $159,444 million Coca-Cola $157,536 million Merck $153,170 million Pfizer $148,245 million Cisco Systems $135,650 million Lucent Technologies $127,265 million Bristol-Myers Squibb $119,350 million Leading Creators of Wealth in the U. S. Market Value Added in 1999

21. 2 - 21 Copyright © 2001 by Harcourt, Inc.All rights reserved. Probably not. A/P increased 260% over the past year, while sales increased by only 70%. If this continues, suppliers may cut off D’Leon’s trade credit. Does D’Leon pay its suppliers on time?

22. 2 - 22 Copyright © 2001 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?

23. 2 - 23 Copyright © 2001 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 

24. 2 - 24 Copyright © 2001 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.

25. 2 - 25 Copyright © 2001 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?

26. 2 - 26 Copyright © 2001 by Harcourt, Inc.All rights reserved. Would D’Leon have required external capital if they had broken even in 2000 (Net Income = 0)? YES, the company would still have to finance its increase in assets.

27. 2 - 27 Copyright © 2001 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)?

28. 2 - 28 Copyright © 2001 by Harcourt, Inc.All rights reserved. Other policies that affect financial statements Inventory valuation methods. Capitalization of R&D expenses. Policies for funding the company’s retirement plan.

29. 2 - 29 Copyright © 2001 by Harcourt, Inc.All rights reserved. Does the company’s positive stock price ($2.25), in the face of large losses, suggest that investors are irrational? NO, it means that investors expect things to get better in the future.

30. 2 - 30 Copyright © 2001 by Harcourt, Inc.All rights reserved. Why did the stock fall after the dividend was cut? Management was “signaling” that the firm’s operations were in trouble. The dividend cut lowered expectations for future cash flows, which caused the stock price to decline.

31. 2 - 31 Copyright © 2001 by Harcourt, Inc.All rights reserved. What were some other sources of financing for D’Leon in 2000? Bank loans: Notes payable increased by $520,000. Credit from suppliers: A/P increased by $378,560. Employees: Accruals increased by $353,600.

32. 2 - 32 Copyright © 2001 by Harcourt, Inc.All rights reserved. D’Leon received a tax credit of $346,624 in 2000. This suggests the company paid at least $346,624 in taxes during the past 2 years. If D’Leon’s payments over the past 2 years were less than $346,624 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 © 2001 by Harcourt, Inc.All rights reserved. INCOME TAXES

34. 2 - 34 Copyright © 2001 by Harcourt, Inc.All rights reserved. April 2000 Single Individual Tax Rates Taxable IncomeTax on BaseRate* 0 - 25,750015% 25,750 - 62,4503,862.5028% 62,450 - 130,25014,138.5031% 130,250 - 283,15035,156.5036% Over 283,15090,200.5039.6% *Plus this percentage on the amount over the bracket base.

35. 2 - 35 Copyright © 2001 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 $2,750 and your itemized deductions are $4,850. On the basis of the information above and the April 2000 tax rate schedule, what is your tax liability?

36. 2 - 36 Copyright © 2001 by Harcourt, Inc.All rights reserved. Calculation of Taxable Income Salary$45,000 Dividends3,000 Personal exemptions(2,750) Deductions(4,850) Taxable Income$40,400

37. 2 - 37 Copyright © 2001 by Harcourt, Inc.All rights reserved. Tax Liability: TL= $3,862.50 + 0.28($14,650) = $7,964.50  $7,965. Marginal Tax Rate = 28%. Average Tax Rate: Tax rate = = 19.71%  19.7%. 40,400 - 25,750 $7,965 $40,400

38. 2 - 38 Copyright © 2001 by Harcourt, Inc.All rights reserved. January 2000 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 © 2001 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 © 2001 by Harcourt, Inc.All rights reserved. Operating income$100,000 Interest income5,000 Taxable dividend income3,000* 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 © 2001 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 © 2001 by Harcourt, Inc.All rights reserved. Exxon bonds at 10% vs. California muni bonds at 7%. T = Tax rate = 28%. After-tax interest income: Exxon= 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 © 2001 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 © 2001 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