Today’s Agenda Wrap up Chapter 3 and Appendix 3A  Personal Income Taxes  Taxation of Investment Income  MVA and EVA Chapter 4: Ratio Analysis 1

2006 Single Individual Tax Rates Note: Appendix 3A provides 2004 brackets. 2 Taxable IncomeTax on BaseRate* 0 – 7,550010% 7, , % 30, ,2004, % 74, ,80015, % 154, ,550 Over 336,550 37, % 35% *Plus this percentage on the amount over the bracket base. O

Personal Income Taxes Marginal tax rate = the tax rate on the next dollar of income. Wages, tips, and interest income are considered ordinary taxable income. Deductions: charitable donations, mortgage interest, a portion of student loan interest, personal exemptions, and medical expenses to an extent(> 7.5% of gross income). 3

Personal Investment Taxes Interest Income taxed at individual’s marginal tax rate. Dividend Income tax rate: 15% or less Financial and Real assets held for less than 12 MONTHS and then sold for a gain are considered short-term capital gains and taxed at the taxpayer’s marginal tax rate. Long-term (held more than 12 months) capital gains are taxed at a max rate of 15%. 4

State and local government bonds (munis) are generally exempt from federal taxes. Taxable vs. Tax Exempt Bonds 5

After-tax Investment Returns After-tax Return=Before-tax Return(1-T) After-tax Corporate Dividend Return = Before-tax Dividend Yield (1 -.3T) Municipal Bond Interest is tax exempt on the federal level Equivalent pretax return = Muni Return/(1-T) 6

After-Tax Return Example Which of the following would you prefer if your marginal tax rate is 28%?  Exxon bonds at 10% or California municipal bonds at 7%. At what marginal tax rate would you be indifferent be these two bonds? 7

Example Solution 8

9 MVA and EVA Market Value Added (MVA) = Market value of common equity – book value of common equity  Feb 2006 for Best Buy: MV of common equity = $26.60 billion, book value of common equity = $5.25 billion  Feb 2006 Best Buy MVA = $26.6 – $5.25 = $21.35 billion Economic Value Added (EVA) = NOPAT – Annual dollar cost of capital = true economic profit for a given period EVA = EBIT(1-T) – [Total investor supplied operating capital x After-tax percentage cost of capital]

10 Best Buy’s 2006 EVA (millions) Let’s assume Best Buy’s tax rate is 35% and after-tax cost of capital is 17%. EVA = EBIT(1-T) – AT cost of capital x capital Investor supplied capital = current portion of long- term debt + long-term debt + total equity =5853 EBIT = EBT + Interest paid = 1737 EVA = 1737(1-.35) – 0.17(5853) = EVA Break-even cost of capital = 1737(1-.35)/5853 = 19.3%