1. T2.1 Chapter Outline Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Organization 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow 2.4Taxes 2.5Capital Cost Allowance 2.6Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson,Ltd.

2. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 2 T2.2 The Balance Sheet (Figure 2.1)

3. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 3 T2.2 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

4. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 4 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

5. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 5 Market Value vs Book Notes 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 recent writedowns of assets by the likes of Nortel Cisco and many other high tech. firms

6. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 6 T2.3 Income Statement Components  Revenues  Expenses Cash and non-cash Operating and non-operating  Net Income  Earnings per share  Dividends 3 important concepts for Finance  GAAP & Accrual Accounting & Matching  Non-cash items  Time and Costs

7. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 7 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

8. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 8 T2.4 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.

9. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 9 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

10. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 10 T2.4 GAAP versus Cash Flow Time Line Revenue recognized and matched expenses Sale of goods on credit Time PayPayrollPay Collect for checksutilitiesaccounts raw goodsissuedreceivable Cash flowCash flowCash flowCash flow

11. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 11 T2.5 Cash Flow Example Balance Sheet BegEndBegEnd Cash$100$150A/P$100$150 A/R200250N/P200200 Inv300300C/L300350 C/A$600$700LTD$400$420 NFA400500C/S5060 R/E250370 $300$430 Total$1000$1200Total$1000$1200

12. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 12 T2.5 Cash Flow Example (continued) Income Statement Sales$2000 Costs1400 Depreciation100 EBIT500 Interest100 Taxable Income 400 Taxes200 Net Income$200 Dividends$_____ Addition to R/E _____

13. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 13 T2.5 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

14. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 14 T2.5 Cash Flow Example (concluded) A.Cash flow from assets 1.Operating cash flow= EBIT + _____________ – Taxes = $500 + 100 – 200 = $_____ 2.Change in NWC= ___________ – ___________ = $350 – $_____ = $_____ 3.Net capital spending= $_____ + Dep – _____ = $500 + 100 – 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

15. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 15 T2.5 Cash Flow Example (concluded) A.Cash flow from assets 1.Operating cash flow= EBIT + Depreciation – Taxes = $500 + 100 – 200 = $400 2.Change in NWC= Ending NWC – Beginning NWC = $350 – 300 = $50 3.Net capital spending= Ending NFA + Dep – Beginning NFA = $500 + 100 – 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

16. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 16 T2.6 Cash Flow Summary  I.The cash flow identity Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners) This is based upon the balance sheet identity: Assets = Liabilities + Equity The equivalent cash flow statement is: cash flow to creditors Cash flow from assets = + cash flow to stockholders

17. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 17 T2.6 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

18. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 18 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.

19. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 19 T2.7 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?

20. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 20 T2.7 Individual Tax Rates FEDERAL Taxable Income Tax Rate on Excess $ 1$ --17% 32,000 5,44024 64,00013,12029 Provincial generally applied as a % of the Basic Federal Tax Alberta - 44%

21. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 21 T2.7 Marginal versus Average Tax Rates

22. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 22 T2.7 Individual Tax Rates SELECTED PROVINCIAL (Table 2.5) Resident of Percentage of Basic Federal Tax Alberta44% Newfoundland62 Prince Edward Island57.5 Saskatchewan48 Northwest Territories45 Yukon Territory50

23. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 23 Taxes on Investment Income taxes on dividends and capital gains dividends  two clear goals - avoidance 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 coming down with 50% of the gain now being taxed - down from 75%  tax deferral from only realized gains being taxed results in lower ‘effective tax’

24. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 24 T2.8 ILLUSTRATION OF DIVIDEND TAX CREDIT FOR ALBERTA RESIDENTS Marginal Tax Rate17%24%29% Dividends$1,000$1,000$1,000 Gross up at 25% 250250250 Grossed up dividends 1250 1250 1250 Federal Tax on dividends212.50 300.00 362.50 Less Dividend Tax Credit (13.333% x $1,250)(166.67) (166.67)(166.67) Federal Tax Payable 45.83133.33195.83 Provincial Tax at 44% of Federal Tax 20.1758.6786.17 Total Tax 66.00192.00282.00 Effective Combined Tax Rates 6.6%19.2%28.2% NOTE: Marginal tax rates apply to incomes of less than 32,000 (17%), more than 32,000 but less than 64000 (25%), and more than 64,000 (29%)

25. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 25 T2.9 Corporate Tax Rates FEDERALONTARIOCOMBINED Basic Corporations 27% 14.82% 42.12% Manufacturing and Processing 21 12.82 34.12 All Small Corporations 12 7.32 19.72 (Taxable Income below $200 thousand)

26. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 26 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

27. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 27 Capital Cost Allowance Key concepts and terms:  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

28. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 28 T 2.10 Capital Cost Allowance - Depreciation for tax purposes ClassRateAssets 14%Buildings acquired after 1987 820%Furniture, photocopiers 1030%Vans, trucks, tractors and computer equipment 13 Straight-lineLeasehold improvements 1640%Taxicabs and rental cars 2250%Pollution control equipment 4330%Manufacturing equipment

29. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 29 T2.11CCA Example Depreciation on $22,000 Photocopier (CCA Class 8) Year UCC t CCA UCC t+1 111,0002,200$8,800 219,8003,960 15,840 315,8403,168 12,672 412,6722,534 10,138 510,1382,028 8,110 68,1101,622 6,488

30. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 30 T2.12 Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets19981999 Current assets Cash$ 45$ 50 Accounts receivable260310 Inventory320385 Total$ 625$ 745 Fixed assets Net plant and equipment9851100 Total assets$1610$1845

31. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 31 T2.12 Hermetic, Inc. Balance Sheet (concluded) Liabilities and equity19981999 Current liabilities Accounts payable$ 210$ 260 Notes payable110175 Total$ 320$ 435 Long-term debt205225 Stockholders’ equity Common stock and paid-in surplus290290 Retained earnings795895 Total$1085$1185 Total liabilities and equity$1610$1845

32. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 32 T2.13 Hermetic, Inc. Income Statement ($ in thousands) Net sales$710.00 Cost of goods sold480.00 Depreciation30.00 Earnings before interest and taxes$200.00 Interest20.00 Taxable income180.00 Taxes53.45 Net income$126.55 Dividends 26.55 Addition to retained earnings $100.00

33. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 33 T2.14 Hermetic, Inc. Cash Flow from Assets Cash flow from assets: Operating cash flow: EBIT$ 200.00 + Depreciation+ 30.00 – Taxes– 53.45 $ 176.55 Change in net working capital: Ending net working capital$ 310.00 – Beginning net working capital– 305.00 $ 5.00 Net capital spending: Ending net fixed assets$ 1,100.00 – Beginning net fixed assets– 985.00 + Depreciation+ 30.00 $ 145.00 Cash flow from assets: $ 26.55

34. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 34 T2.14 Hermetic, Inc. Cash Flow from Assets (concluded) Total cash flow to creditors and stockholders: Cash flow to creditors: Interest paid$ 20.00 – Net new borrowing– 20.00 $ 0.00 Cash flow to stockholders: Dividends paid$ 26.55 – Net new equity raised0.00 $ 26.55 Cash flow to creditors and stockholders$ 26.55

35. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 35 T2.15 Chapter 2 Quick Quiz The taxable income of Harrold Schwarz, an Ontario resident, is $63,000. Calculate Schwarz’s (a) dollar tax liability, (b) average tax rate, and (c) marginal tax rate. (a) Dollar tax liability = [Federal].17(_______) +.24(_______) +.29(_______) [Ontario]+.0637(________) +.0962(________) +.1116(________) (b) Average tax rate = ________/__________ = ___ (c) Marginal tax rate = ___ Why should financial decision-makers be concerned about the firm’s marginal rate? Its average rate?

36. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 36 T2.15 Chapter 2 Quick Quiz The taxable income of Harrold Schwarz, an Ontario resident, is $63,000. Calculate Schwarz’s (a) dollar tax liability, (b) average tax rate, and (c) marginal tax rate. (a) Dollar tax liability = [Federal].17(32,000) +.24(31,000) +.29(0) [Ontario]+.0637(30,004) +.0962(29,996) +.1116(3,000)=18,012 (b) Average tax rate = 18,012/63,000 = 28.6% (c) Marginal tax rate = 35.16% Why should financial decision-makers be concerned about the firm’s marginal rate? Its average rate?

37. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 37 T2.16 Solution to Problem 2.12 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 2000 balance sheet showed long-term debt of $2.9 million. The 2000 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 – (_______) =_______

38. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 38 T2.16 Solution to Problem 2.12 The December 31, 1999 balance sheet Pearl Jelly, Inc. showed long-term debt of $2 million, and the December 31, 2000 balance sheet showed long-term debt of $2.9 million. The 2000 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

39. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 39 T2.17 Solution to Problem 2.13 The December 31, 1999 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 2000, 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  = ________– ________  = ________

40. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 40 T2.17 Solution to Problem 2.13 The December 31, 1999 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 2000, 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 = ($550,000 + 7m) – ($500,000 + 6.6m) = $450,000 Cash flow to stockholders  = $300,000 – 450,000  = –$150,000

41. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 41 T2.18 Solution to Problem 2.14 Given the information for Pearl Jelly, Inc. in problems 12 and 13, suppose you also know that the firm’s net capital spending during 2000 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 2000 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 = $ _______

42. copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 42 T2.18 Solution to Problem 2.14 Given the information for Pearl Jelly, Inc. in problems 12 and 13, suppose you also know that the firm’s net capital spending during 2000 was $500,000, and that the firm reduced its net working capital investment by $135,000. What was the firm’s 2000 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