1. 2 - 1 Copyright © 1999 by The Dryden PressAll rights reserved. Balance sheet Income statement Statement of cash flows Accounting income versus cash flow MVA and EVA Corporate tax CHAPTER 2 Financial Statements, Cash Flow, and Taxes

2. 2 - 2 Copyright © 1999 by The Dryden PressAll rights reserved. 1998 1997 Cash7,2829,000 Short-term inv.048,600 AR632,160351,200 Inventories1,287,360715,200 Total CA1,926,8021,124,000 Gross FA1,202,950491,000 Less: Depr. 263,160146,200 Net FA939,790344,800 Total assets2,866,5921,468,800 Balance Sheets: Assets

3. 2 - 3 Copyright © 1999 by The Dryden PressAll rights reserved. 1,733,760 Liabilities and Equity 19981997 Accts payable524,160145,600 Notes payable720,000200,000 Accruals 489,600 136,000 Total CL481,600 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 © 1999 by The Dryden PressAll rights reserved. (519,936) Income Statement Sales5,834,4003,432,000 COGS5,728,0002,864,000 Other expenses680,000340,000 Deprec. 116,960 18,900 Tot. op. costs6,524,9603,222,900 EBIT(690,560)209,100 Interest exp. 176,000 62,500 EBT (866,560) 146,600 Taxes (40%) (346,624) 58,640 Net income 87,960 19981997

5. 2 - 5 Copyright © 1999 by The Dryden PressAll 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 19981997

6. 2 - 6 Copyright © 1999 by The Dryden PressAll rights reserved. Statement of Retained Earnings (1998) Balance of retained earnings, 12/31/97$203,768 Add: Net income, 1998(519,936) Less: Dividends paid(11,000) Balance of retained earnings, 12/31/98($327,168)

7. 2 - 7 Copyright © 1999 by The Dryden PressAll rights reserved. Statement of Cash Flows: 1998 OPERATING ACTIVITIES Net Income(519,936) Adjustments: Depreciation116,960 Change in AR(280,960) Change in inventories(572,160) Change in AP378,560 Change in accruals353,600 Net cash provided by ops. (523,936)

8. 2 - 8 Copyright © 1999 by The Dryden PressAll rights reserved. L-T INVESTING ACTIVITIES Investments in fixed assets (711,950) FINANCING ACTIVITIES Change in s-t investments48,600 Change in notes payable520,000 Change in long-term debt676,568 Payment of cash dividends(11,000) Net cash from financing1,234,168 Sum: net change in cash(1,718) Plus: cash at beginning of year9,000 Cash at end of year7,282

9. 2 - 9 Copyright © 1999 by The Dryden PressAll rights reserved. Net cash from operations = -$523,936, mainly because of negative net income. The firm borrowed $1,185,568 and sold $48,600 in short-term investments to meet its cash requirements. Even after borrowing, the cash account fell by $1,718. What can you conclude about the company’s financial condition from its statement of cash flows?

10. 2 - 10 Copyright © 1999 by The Dryden PressAll rights reserved. What effect did the expansion have on net operating working capital (NOWC)? NOWC 98 = ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600) = $913,042. NOWC 97 = $793,800. = - Non-interest bearing CA Non-interest bearing CL NOWC

11. 2 - 11 Copyright © 1999 by The Dryden PressAll rights reserved. What effect did the expansion have on capital used in operations? = NOWC + Net fixed assets. = $913,042 + $939,790 = $1,852,832. = $1,138,600. Operating capital 98 Operating capital 97 Operating capital

12. 2 - 12 Copyright © 1999 by The Dryden PressAll rights reserved. Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 - Tax rate) NOPAT 98 = -$690,560(1 - 0.4) = -$690,560(0.6) = -$414,336. NOPAT 97 = $125,460.

13. 2 - 13 Copyright © 1999 by The Dryden PressAll rights reserved. What is your initial assessment of the expansion’s effect on operations? 1998 1997 Sales$5,834,400 $3,432,000 NOPAT($414,336)$125,460 NOWC$913,042 $793,800 Operating capital$1,852,832 $1,138,600

14. 2 - 14 Copyright © 1999 by The Dryden PressAll rights reserved. What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF 98 = NI + DEP= -$519,936 + $116,960 = -$402,976. NCF 97 = $87,960 + $18,900 = $106,860. OCF 98 = NOPAT + DEP = -$414,336 + $116,960 = -$297,376. OCF 97 = $125,460 + $18,900 = $144,360.

15. 2 - 15 Copyright © 1999 by The Dryden PressAll rights reserved. What was the free cash flow (FCF) for 1998? FCF = NOPAT - Net capital investment = NOPAT - (OC 98 - OC 97 ) = -$414,336 - ($1,852,832 - $1,138,600) = -$414,336 - $714,232 = -$1,128,568. How do you suppose investors reacted?

16. 2 - 16 Copyright © 1999 by The Dryden PressAll rights reserved. What is the company’s EVA? Assume the firm’s after-tax cost of capital (COC) was 11% in 1997 and 13% in 1998. EVA 98 = NOPAT- (COC)(Capital) = -$414,336 - (0.13)($1,852,832) = -$414,336 - $240,868 = -$655,204. EVA 97 = $125,460 - (0.11)($1,138,600) = $125,460 - $125,246 = $214.

17. 2 - 17 Copyright © 1999 by The Dryden PressAll rights reserved. Would you conclude that the expansion increased or decreased MVA? MVA = -. During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined. Equity capital supplied Market value of equity

18. 2 - 18 Copyright © 1999 by The Dryden PressAll 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 trade credit. Does the company pay its suppliers on time?

19. 2 - 19 Copyright © 1999 by The Dryden PressAll rights reserved. No, the negative NOPAT shows that the company is spending more on it’s operations than it is taking in. Does it appear that the sales price exceeds the cost per unit sold?

20. 2 - 20 Copyright © 1999 by The Dryden PressAll 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 the cash account? A/R would  Cash would 

21. 2 - 21 Copyright © 1999 by The Dryden PressAll 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.

22. 2 - 22 Copyright © 1999 by The Dryden PressAll rights reserved. The expansion was financed primarily with external capital. The company issued long-term debt which reduced its financial strength and flexibility. How was the expansion financed?

23. 2 - 23 Copyright © 1999 by The Dryden PressAll rights reserved. Would external capital have been required if they had broken even in 1998 (Net income = 0)? Yes, the company would still have to finance its increase in assets.

24. 2 - 24 Copyright © 1999 by The Dryden PressAll rights reserved. What happens if fixed assets are depreciated over 7 years (as opposed to the current 10 years)? No effect on physical assets. Fixed assets on balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve.

25. 2 - 25 Copyright © 1999 by The Dryden PressAll rights reserved. Other policies that can affect financial statements Inventory valuation methods. Capitalization of R&D expenses. Policies for funding the company’s retirement plan.

26. 2 - 26 Copyright © 1999 by The Dryden PressAll 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.

27. 2 - 27 Copyright © 1999 by The Dryden PressAll rights reserved. Why did the stock price fall after the dividend was cut? Management was “signaling” that the firm’s operations were in trouble. The dividend cut lowered investors’ expectations for future cash flows, which caused the stock price to decline.

28. 2 - 28 Copyright © 1999 by The Dryden PressAll rights reserved. What were some other sources of financing used in 1998? Selling financial assets: Short term investments decreased by $48,600. Bank loans: Notes payable increased by $520,000. Credit from suppliers: A/P increased by $378,560. Employees: Accruals increased by $353,600.

29. 2 - 29 Copyright © 1999 by The Dryden PressAll rights reserved. What is the effect of the $346,624 tax credit received in 1998. This suggests the company paid at least $346,624 in taxes during the past 2 years. If the 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.

30. 2 - 30 Copyright © 1999 by The Dryden PressAll rights reserved. INCOME TAXES

31. 2 - 31 Copyright © 1999 by The Dryden PressAll rights reserved. 1997 Tax Year Single Individual Tax Rates Taxable IncomeTax on BaseRate* 0 - 24,650015% 24,650 - 59,750 3,697.50 28% 59,750 - 124,65013,525.5031% 124,650 - 271,05033,644.5036% Over 271,05086,3480.5039.6% *Plus this percentage on the amount over the bracket base.

32. 2 - 32 Copyright © 1999 by The Dryden PressAll rights reserved. Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,650 and your itemized deductions are $4,550. On the basis of the information above and the 1997 tax year tax rate schedule, what is your tax liability?

33. 2 - 33 Copyright © 1999 by The Dryden PressAll rights reserved. Calculation of Taxable Income Salary$45,000 Dividends3,000 Personal exemptions(2,650) Deductions(4,550) Taxable Income$40,800

34. 2 - 34 Copyright © 1999 by The Dryden PressAll rights reserved. Tax Liability: TL= $3,697.50 + 0.28($16,150) = $8,219.50. Marginal Tax Rate = 28%. Average Tax Rate: Tax rate = = 20.15%. $40,800 - $24,650 $8,219.5 $40,800

35. 2 - 35 Copyright © 1999 by The Dryden PressAll rights reserved. 1997 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..........

36. 2 - 36 Copyright © 1999 by The Dryden PressAll 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 is its tax liability?

37. 2 - 37 Copyright © 1999 by The Dryden PressAll 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.

38. 2 - 38 Copyright © 1999 by The Dryden PressAll rights reserved. State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes. Taxable versus Tax Exempt Bonds

39. 2 - 39 Copyright © 1999 by The Dryden PressAll rights reserved. Exxon bonds at 10% versus 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.

40. 2 - 40 Copyright © 1999 by The Dryden PressAll 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 between the muni and the corporate bonds?

41. 2 - 41 Copyright © 1999 by The Dryden PressAll rights reserved. If T > 30%, buy tax exempt munis. If T < 30%, buy corporate bonds. Only high income, and hence high tax bracket, individuals should buy munis. Implications