T2.1 Chapter Outline Chapter 9-10 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Taxes 2.4Cash Flow 2.5Summary and Conclusions Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.2 The Balance Sheet (Figure 2.1)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.3 GAAP versus Cash Flow Time Line Revenue recognized and matched expenses Sale of goods on credit Time PayPayrollPay Collect forchecksutilitiesaccounts raw goodsissuedreceivable Cash flowCash flowCash flowCash flow

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.4 Corporate Tax Rates Key issues:  What are corporate tax rates?  What is an average rate? A marginal rate? A.Corporate tax brackets under the 1993 Omnibus Budget Reconciliation Act Taxable IncomeMarginal Rates $0 - 50,00015% 50, ,00025% 75, ,00034% 100, ,00039% 335, ,000,00034% 10,000, ,000,00035% 15,000, ,333,33338% 18,333, %

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.5 Marginal versus Average Corporate Tax Rates  What are marginal corporate tax rates?  What are average corporate tax rates at the top of each bracket? Marginal and average tax rates under the 1993 Omnibus Budget Reconciliation Act Taxable IncomeMarginal Tax Cumulative Average Tax RatesTax LiabilityRates $0 - 50,00015%$7, % 50, ,00025%13, % 75, ,000 34%22, % 100, ,00039%113, % 335, mil34%3.4 mil34.00% 10 mil - 15 mil35%5,150, % 15 mil mil38%6,416, % mil +35%N/A35.00% Notice that, while marginal rates fluctuate and rise as high as 39%, average rates increase steadily with taxable income, until the 35% level is reached.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.6 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.6 Cash Flow Example (continued) Income Statement Sales$2000 Costs1400 Depreciation100 EBIT500 Interest100 Taxable Income 400 Taxes200 Net Income$200 Dividends$_____ Addition to R/E _____

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.6 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.6 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.6 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.7 Cash Flow Summary  I.The cash flow identity Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners)  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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.8 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.8 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.9 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.10 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.10 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.11 Chapter 2 Quick Quiz The taxable income of LaRussa Corp. is $1,000,000. Calculate LaRussa’s (a) dollar tax liability, (b) average tax rate, and (c) marginal tax rate. (a) Dollar tax liability =.15(_______) +.25(_______) +.34(_______) +.39(________) +.34(________) = $340,000 (b) Average tax rate = ________/__________ = ___ (c) Marginal tax rate = ___ Why should financial decision-makers be concerned about the firm’s marginal rate? Its average rate?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.11 Chapter 2 Quick Quiz The taxable income of LaRussa Corp. is $1,000,000. Calculate LaRussa’s (a) dollar tax liability, (b) average tax rate, and (c) marginal tax rate. (a) Dollar tax liability =.15($50,000) +.25($25,000) +.34($25,000) +.39($235,000) +.34($665,000) = $340,000 (b) Average tax rate = $340,000/$1,000,000 = 34% (c) Marginal tax rate = 34% Why should financial decision-makers be concerned about the firm’s marginal rate? Its average rate?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.12 Solution to Problem 2.6 The Hankey Co. had $145,000 in 1999 taxable income. Using the rates from Table 2.3, calculate the company’s 1999 income taxes. Taxable IncomeMarginal Tax Rates $0 - 50,00015% 50, ,00025% 75, ,00034% 100, ,00039% 335, ,000,00034% 10,000, ,000,00035% 15,000, ,333,33338% 18,333, % Tax =.15(_____) +.25(_____) +.34(_____) +.39(_____)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.12 Solution to Problem 2.6 The Hankey Co. had $145,000 in 1999 taxable income. Using the rates from Table 2.3, calculate the company’s 1999 income taxes. Taxable IncomeMarginal Tax Rates $0 - 50,00015% 50, ,00025% 75, ,00034% 100, ,00039% 335, ,000,00034% 10,000, ,000,00035% 15,000, ,333,33338% 18,333, % Tax =.15(50,000) +.25(25,000) +.34(25,000) +.39(45,000) = $39,800

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.13 Solution to Problem 2.11 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 1999 balance sheet showed long-term debt of $2.9 million. The 1999 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 – (_______) =_______

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.13 Solution to Problem 2.11 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 1999 balance sheet showed long-term debt of $2.9 million. The 1999 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.14 Solution to Problem 2.12 The December 31, 1998 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 1999, 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  = ________– ________  = ________

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.14 Solution to Problem 2.12 The December 31, 1998 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 1999, 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.15 Solution to Problem 2.13 Given the information for Pearl Jelly, Inc. in problems 11 and 12, suppose you also know that the firm’s net capital spending during 1999 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 1999 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 = $ _______

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T2.15 Solution to Problem 2.13 Given the information for Pearl Jelly, Inc. in problems 11 and 12, suppose you also know that the firm’s net capital spending during 1999 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 1999 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