1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Financial Statements, Taxes and Cash Flow Chapter Two

2. 2.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm’s cash flow from its financial statements

3. 2.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline The Balance Sheet The Income Statement Cash Flow Taxes Capital Cost Allowance Summary and Conclusions

4. 2.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Balance Sheet Components –Assets (Current & Long-Term) –Liabilities (Current & Long-Term) –Owners Equity Key concepts –Liquidity –Net Working Capital Current Assets minus Current Liabilities –Debt vs. Equity –Market vs. Book Value

5. 2.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Balance Sheet - 2.1 The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of liquidity –Ease of conversion to cash –Without significant loss of value Balance Sheet Identity –Assets = Liabilities + Stockholders’ Equity

6. 2.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Balance Sheet - Figure 2.1

7. 2.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Canadian Enterprises Balance Sheet – Table 2.1 See 2.14: Canadian Enterprises Example

8. 2.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Net Working Capital and Liquidity Net Working Capital –Current Assets – Current Liabilities –Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out –Usually positive in a healthy firm Liquidity –Ability to convert to cash quickly without a significant loss in value –Liquid firms are less likely to experience financial distress –However, liquid assets earn a lower return –Tradeoff between liquid and illiquid assets

9. 2.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Debt v.s. Equity Generally, when a firm borrows it gives the bondholder first claim on the firm’s cash flow and assets....equity holders receive the residual value or whatever is left after the creditors are paid. Thus, shareholders equity is the residual difference between assets and liabilities. The use of debt financing is called financial leverage - debt financing can magnify returns (gains and losses) to shareholders or equity holders –increases the potential return –also increases the risk factor

10. 2.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Market Value vs Book Value Balance sheet values are book values –GAAP requires assets to be shown at historical cost –current asset book values can be very close to market value –fixed assets can and often have major differences between historical cost and market value –GAAP Accounting principles of objectivity and conservatism are the drivers behind historical cost. No argument about historical cost and because book is usually less than mkt. - they are also conservative( if mkt values fall along way below book - assets will be written down - good examples of this are the write-downs of assets by the likes of Nortel, Cisco and many other high tech. firms

11. 2.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Market Vs. Book Value The balance sheet provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decision- making process?

12. 2.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2.2 - Quebec Corporation QUEBEC CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000SE6001,100 1,6001,1001,600

13. 2.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Income Statement - 2.2 The income statement is more like a video of the firm’s operations for a specified period of time. You generally report revenues first and then deduct any expenses for the period Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue

14. 2.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Canadian Enterprises Income Statement – Table 2.2 See 2.14: Canadian Enterprises Example

15. 2.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Work the Web Example Publicly traded companies must file regular reports with the Ontario Securities Commission These reports are usually filed electronically and can be searched at the SEDAR site Click on the web surfer, pick a company and see what you can find!

16. 2.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Concept of Cash Flow - 2.3 Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

17. 2.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Key concept in the study of Corporate Finance –liquidity is about turning assets into cash –investment analysis and capital budgeting is about discounted cash flows –valuation of securities is about future discounted cash flow at some rate of discount e.g bonds - future interest payments and principle repayments discounted back at a certain rate

18. 2.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Cash flows are essential to valuation –In Finance, one of the main concern is the timing of cash flows. (another being the discount rate) –Since the income statement includes non-cash items, we will have to adjust it to get information on cash flows –Balance sheet activity plays an important role in the determination of the cash balance (e.g.) Collections on accounts receivable Borrowing on accounts payable –Work with reported financial statements to determine historical cash flow.

19. 2.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Cash flow from an historical perspective - calculated from financial statements - our focus in this chapter –how to calculate Projected cash flow - look at in later chapters as we move into the question of valuation of investments and securities

20. 2.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. GAAP versus Cash Flow Time Line Revenue recognized and matched expenses Sale of goods on credit Time PayPayrollPay Collect for checksutilitiesaccounts raw goodsissuedreceivable Cash flow Cash flowCash flowCash flow

21. 2.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Summary –The cash flow identity Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners) –The balance sheet identity : Assets = Liabilities + Equity

22. 2.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Summary (cont’d) –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

23. 2.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow From Assets Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

24. 2.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Canadian Enterprises OCF (I/S) = EBIT + depreciation – taxes = $509 NCS (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC – beginning NWC = $330 CFFA = 509 – 130 – 330 = $49 CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $25 CFFA = 24 + 25 = $49

25. 2.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Summary Table 2.4

26. 2.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Balance Sheet and Income Statement Information Current Accounts –1998: CA = 1500; CL = 1300 –1999: CA = 2000; CL = 1700 Fixed Assets and Depreciation –1998: NFA = 3000; 1999: NFA = 4000 –Depreciation expense = 300 LT Liabilities and Equity –1998: LTD = 2200; Common Equity = 500; RE = 500 –1999: LTD = 2800; Common Equity = 750; RE = 750 Income Statement Information –EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250

27. 2.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Cash Flows OCF = 2700 + 300 – 1000 = 2000 NCS = 4000 – 3000 + 300 = 1300 Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100 CF From Assets = 2000 – 1300 – 100 = 600 CF to Bondholders = 200 – (2800 – 2200) = -400 CF to Shareholders = 1250 – (750 – 500) = 1000 CF From Assets = -400 + 1000 = 600 The CF identity holds.

28. 2.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Taxes - key concepts Earnings and cash flow are on an after tax basis - taxes represent real costs and cash requirements for firms Taxes can be a major factor in investment decisions including mergers and acquisitions. –Tax ‘pools’ of the acquired company can be used in the new entity to shelter income - the value of these pools to the acquiring company needs to be established Financial management considerations - corporate taxation is a complex and specialized field.....good communication between tax experts and other financial staff is important as the after tax impact of business decisions needs to be established.

29. 2.28 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Taxes - 2.4 The one thing we can rely on with taxes is that they are always changing Marginal vs. average tax rates –Marginal – the percentage paid on the next dollar earned –Average – the tax bill / taxable income Other taxes

30. 2.29 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Taxes Key issues: –What is an average tax rate? –What is a marginal tax rate? –Why do we pay attention to marginal tax rates? –What are corporate tax rates? –What are individual tax rates? –How does the difference between corporate and individual tax rates affect corporate finance? How do tax rates relate to the goal of corporate finance?

31. 2.30 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Individual Tax Rates FEDERAL Taxable Income $ Tax Rate 0- 33218316% 32183-64368 22% 64368-104648 26% 104648- UP 29% Provincial generally applied as a % of the Basic Federal Tax - exception Alberta Alberta - 10%

32. 2.31 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. T2.7 Marginal versus Average Tax Rates

33. 2.32 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Taxes on Investment Income taxes on dividends/interest and capital gains dividends –two clear goals - Partial elimination of double taxation with corporations paying dividends from after tax income and full taxation in the hands of shareholders -> dividend tax credit this tax shelter applies to dividends paid by Canadian Corporations thus encouraging Canadian investors to invest in Canadian firms Capital Gains –rates are at 50% of the gain now being taxed - down from 75% –tax deferral from only realized gains being taxed results in lower ‘effective tax’

34. 2.33 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Taxable Income taxable income is different from net income –net income needs to conform to GAAP –taxable income is calculated according to tax rules established by the various taxing authorities –e.g. book depreciation vs capital cost allowance book depreciation attempting to match revenues earned from the use of a tangible depreciable asset with the costs associated with the asset capital cost allowance - allowable deductions associated with various types of assets - patchwork of tax rules that often have stemmed from government budget and economic development objectives. –Income is taxed differently across various industries with the ‘rules’ continually changing

35. 2.34 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Capital Cost Allowance Key concepts and terms: –Depreciation for tax purposes –Classes of assets –Asset purchases and sales net acquisitions are used if multiple purchases one half year rule applies to net acquisitions sale - the balance in the pool is reduced by the lesser of sale price or original cost –Termination of asset pool terminal loss occurs when there is remaining UCC after the last asset disposal - this amount is fully tax deductible recaptured CCA occurs with a negative UCC after the last asset disposal - this amount is fully taxable

36. 2.35 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Some CCA Classes – Table 2.8

37. 2.36 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: CCA Calculation ABC Corporation purchased $100,000 worth of photocopiers in 2004. Photocopiers fall under asset class 8 with a CCA rate of 20%. How much CCA will be claimed in 2004 and 2005?

38. 2.37 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. CCA Example – Solution Year Beginning Fixed AssetsCCA Ending Fixed Assets 2004 50000 (100,000 x 50%) 10,000 (50,000 x 20%) 40000 (50,000 - 10,000) 2005 90,000 (40,000 + 50,000) 18,000 (90,000 x 20%) 72,000 (90,000 - 18,000)

39. 2.38 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz What is the difference between book value and market value? Which should we use for decision making purposes? What is the difference between accounting income and cash flow? Which do we need to use when making decisions? What is the difference between average and marginal tax rates? Which should we use when making financial decisions? How do we determine a firm’s cash flows? What are the equations and where do we find the information? What is CCA? How is it calculated?

40. 2.39 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 2.6 The balance sheet shows the firm’s accounting value on a particular date. The income statement summarizes a firm’s performance over a period of time. Cash flow is the difference between the dollars coming into the firm and the dollars that go out. Cash flows are measured after-tax. CCA is depreciation for tax purposes in Canada. Remember the half-year rule.