1. Financial Statements, Cash Flow, and Taxes
CHAPTER 2
Financial Statements, Cash Flow, and Taxes
Balance sheet
Income statement
Statement of cash flows
Accounting income vs. cash flow
MVA and EVA
Personal taxes
Corporate taxes

2. Balance Sheet: Assets
2000
1999
Cash
7,282
57,600 AR
632,160
351,200
Inventories
1,287,360
715,200
Total CA
1,926,802
1,124,000
Gross FA
1,202,950
491,000
Less: Deprec.
263,160
146,200
Net FA
939,790
344,800
Total Assets
2,866,592
1,468,800

3. Liabilities and Equity
2000
1999
Accts payable
524,160
145,600
Notes payable
720,000
200,000
Accruals
489,600
136,000
Total CL
1,733,760
481,600
Long-term debt
1,000,000
323,432
Common stock
460,000
460,000
Retained earnings
(327,168)
203,768
Total equity
132,832
663,768
Total L&E
2,866,592
1,468,800

4. Income Statement
2000
1999
Sales
5,834,400
3,432,000
COGS
5,728,000
2,864,000
Other expenses
680,000
340,000
EBITDA
(573,600)
228,000
Depr. & Amort.
116,960
18,900
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

5. Other Data
2000
1999
No. of shares
100,000
100,000
EPS
($5.199)
$0.88
DPS
$0.110
$0.22
Stock price
$2.25
$8.50
Lease pmts
$40,000
$40,000

6. 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)
earnings, 12/31/00 ($327,168)

7. Statement of Cash Flows (2000)
OPERATING ACTIVITIES
Net income
(519,936)
Add (Sources of cash):
Depreciation
116,960
Increase in A/P
378,560
Increase in accruals
353,600
Subtract (Uses of cash):
Increase in A/R
(280,960)
Increase in inventories
(572,160)
Net cash provided by ops.
(523,936)

8. L-T INVESTING ACTIVITIES
Investment in fixed assets
(711,950)
FINANCING ACTIVITIES
Increase in notes payable
520,000
Increase in long-term debt
676,568
Payment of cash dividends
(11,000)
Net cash from financing
1,185,568
NET CHANGE IN CASH
(50,318)
Plus: Cash at beginning of year
57,600
Cash at end of year
7,282

9. What can you conclude about D’Leon’s financial condition from its statement of CFs?
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.

10. Did the expansion create additional net operating profit after taxes (NOPAT)?
NOPAT = EBIT(1 – Tax rate)
NOPAT00 = -$690,560(1 – 0.4)
= -$690,560(0.6)
= -$414,336.
NOPAT99 = $125,460.

11. What effect did the expansion have on
net operating working capital (NOWC)?
Current
assets
Non-interest
bearing CL
NOWC
= –
NOWC00 = ($7,282 + $632,160 + $1,287,360)
– ($524,160 + $489,600)
= $913,042.
NOWC99 = $842,400.

12. 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
capital00
Operating
capital99

13. What is your initial assessment of the expansion’s effect on operations?
Sales $5,834,400 $3,432,000
NOPAT ($414,336) $125,460
NOWC $913, $842,400
Operating capital $1,852, $1,187,200
Net Income ($519,936) $87,960

14. What effect did the company’s expansion have on its net cash flow and operating cash flow?
NCF00 = NI + DEP = ($519,936) + $116,960
= ($402,976).
NCF99 = $87,960 + $18,900 = $106,860.
OCF00 = NOPAT + DEP
= ($414,336) + $116,960
= ($297,376).
OCF99 = $125,460 + $18,900
= $144,360.

15. 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. Economic Value Added (EVA)
Operating Income After Tax
After-Tax Capital Costs
EVA = –
= –
= NOPAT – After-Tax Cost of Capital
Cost of Capital Used
Funds Available to Investors

17. EVA Concepts
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.

18. What is the company’s EVA?
Assume the firm’s after-tax cost of capital was 11% in 1999
and 13% in 2000.
EVA00 = NOPAT – (A-T cost of capital)(Capital)
= -$414,336 – (0.13)($1,852,832)
= -$414,336 – $240,868
= -$655,204.
EVA99 = $125,460 – (0.11)($1,187,200)
= $125,460 – $130,592
= -$5,132.

19. Would you conclude that the expansion increased or
decreased MVA?
Market value
of equity
Equity capital
supplied
MVA = –
During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined.

20. Leading Creators of Wealth in the U. S.
Market Value Added in 1999
Company Market 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

21. Does D’Leon pay its suppliers on time?
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.

22. Does it appear that D’Leon’s sales price exceeds its cost per unit sold?
No, the negative NOPAT and decline in cash position shows that D’Leon is spending more on its operations than it is taking in.

23. What effect would each of these actions have on D’Leon’s cash account?
1. The company offers 60-day credit terms. The improved terms are matched by its competitors, so sales remain constant.
A/R would é
Cash would ê

24. 2. Sales double as a result of the
change in credit terms.
Short run: Inventory and fixed assets é to meet increased sales. A/R é , Cash ê. Company may have to seek additional financing.
Long-run: Collections increase and the company’s cash position would improve.

25. How did D’Leon finance its expansion?
D’Leon financed its expansion with external capital.
D’Leon issued long-term debt which reduced its financial strength and flexibility.

26. 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. What happens if D’Leon depreciates its fixed assets 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.

28. Other policies that affect financial statements
Inventory valuation methods.
Capitalization of R&D expenses.
Policies for funding the company’s retirement plan.

29. Does the company’s positive stock price ($2
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. 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. 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. 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. INCOME TAXES

34. April 2000 Single Individual Tax Rates
Taxable Income
Tax on Base
Rate*
0 - 25,750
15%
25, ,450
3,862.50
28%
62, ,250
14,138.50
31%
130, ,150
35,156.50
36%
Over 283,150
90,200.50
39.6%
*Plus this percentage on the amount over the bracket base.

35. Assume your salary is $45,000, and you received $3,000 in dividends
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. Calculation of Taxable Income
Salary
$45,000
Dividends
3,000
Personal exemptions
(2,750)
Deductions
(4,850)
Taxable Income
$40,400

37. 40, ,750
Tax Liability:
TL = $3, ($14,650)
= $7, » $7,965.
Marginal Tax Rate = 28%.
Average Tax Rate:
Tax rate = = 19.71% » 19.7%.
$7,965
$40,400

38. January 2000 Corporate Tax Rates
Taxable Income
Tax on Base
Rate*
0 - 50,000
15%
50, ,000
7,500
25%
75, ,000
13,750
34%
100, ,000
22,250
39%
Over 18.3M
6.4M
35%
*Plus this percentage on the amount over the bracket base.

39. What’s its tax liability?
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. Operating income
$100,000
Interest income
5,000
Taxable dividend
income
3,000*
Taxable income
$108,000
Tax = $22, ($8,000)
= $25,370.
*Dividends – Exclusion
= $10,000 – 0.7($10,000) = $3,000.

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

42. 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. At what tax rate would you be indifferent to muni vs. corp?
Solve for T in this equation:
Muni yield = Corp Yield(1 – T)
7.00% = 10.0%(1 – T)
T = 30.0%.

44. Implications
If T > 30%, buy tax-exempt munis.
If T < 30%, buy corporate bonds.
Only high income people should buy munis.