1. Chapter 3 & Web Appendix 3A
Financial Statements, Cash Flows, and Taxes

2. Topic Overview
Key Financial Statements (See Best Buy Spreadsheet for Example)
Balance sheet
Income statements
Statement of retained earnings
Statement of cash flows
Accounting Income vs. Cash Flow
Statement of Cash Flows
Individual and Corporate Income Taxes

3. The annual report
Balance sheet – provides a snapshot of a firm’s financial position at one point in time. (Please review section 3.3)
Income statement – summarizes a firm’s revenues and expenses over a given period of time. (Please review section 3.4)
Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends. (Please review section 3.7)
Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

4. Homer & Son Balance Sheet: Assets
2006
2005
Assets
Current Assets
900
800
100
Net Fixed Assets
1500
1300
200
Total Assets
2400
2100

5. Homer & Son Balance Sheet: Liabilities
2006
2005
Acct Pay
450
350
100
Accruals
200
150 50
Notes Payable
Total CL
800
650
Long-term Debt
600
Total Liab
1400
1250

6. Homer & Son Balance Sheet: Equity and Total Liabilities and Equity
2006
2005
Total Liab
1400
1250
Common Stock
700
Retained Earnings
300
150
Total Equity
1000
850
Total Liab & Equity
2400
2100

7. 2006 Homer & Son Income Statement
Sales
3000
Cost of good sold
1800
Gross Profit
1200
SGA Expense
720
Depreciation
100
Operating Inc.
380
Interest Exp 80
EBT
300
Taxes (40%)
120
Net Income
180

8. Some Balance Sheet Comments
Net Working Capital = Current Assets – Current Liabilities
Assets (particularly Long-term) and Equity on Balance Sheet are Book (or historical-based) Values.
Market Value of Assets and Equity (# of shares x market price/share) can be vastly different for a given firm.
For Best Buy: 2/25/2006 Book Value of Equity = $5.247 billion, 2/25/2006 Market Value= $26.6 billion

9. Accounting Income vs. Cash Flow
An Income Statement
Sales
Cost of Goods Sold
Selling & Gen. Adm. Exp
Depreciation
Interest Exp
Taxable Income
Taxes
Net Income
Do all items reflect all cash collected and paid?
NO!!! Income statement is on an accrued basis.
What is and who is depreciation?

10. Net Cash Flow or Simple Income Statement Cash Flow
If all other revenues and expenses are in cash or non-cash revenues and expenses net to zero, then
Net Cash Flow(NCF) = Net Income + Depreciation(& Amortization)
2006 Homer & Son, Depreciation = 100; Net Income = 180
NCF = = 280
Otherwise, Net Cash Flow = Cash Revenues - Cash Expenses

11. Statement of Cash Flows
Shows how the firm used and raised cash during the year.
Reconciles the Income Statement by the changes in the Balance Sheet from the beginning of the year to the end of the year

12. Statement of Cash Flows: General Concepts
Overall:
Inflows(or sources) of cash are net income, depreciation, decreases in assets, and increases in liabilities
Outflows(or uses) of cash are increases in assets, decreases in liabilities, and dividends

13. Parts of Statement of Cash Flows
Operating Cash Flow = net cash income from income statement: net income, Depreciation,change in A/R, Inv, Other CA, A/P, Accruals (Wages & Taxes), Other CL
Investing Cash Flow = Purchases and Sales of long-term real assets and investments (Marketable Securities)
Financing Cash Flow = issuances and payments of debt and stock: L-T Debt, Common and Preferred Stock, Notes Payable & Dividends Paid 9

14. Best Buy Statement of Cash Flow Information (millions$)

15. Using Accounting Data to Measure Other Cash Flows for Investors
Operating Cash Flow = total cash available for new asset investment, and for debt & equity investors.
Free Cash Flow = cash available for debt & equity investors. This measure is often use to value a firm.

16. Operating Cash Flow (OCF)
OCF = Net Operating Profit After Taxes (NOPAT) + Depreciation & Amortization
NOPAT = Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
OCF = EBIT(1 – tax rate) + Depreciation & Amortization

17. What is Homer & Son’s 2006 Operating Cash Flow?

18. Free Cash Flow (FCF)
FCF = Operating Cash Flow (OCF) – Investment in Operating Capital
Investment in Operating Capital = Increase in Gross Fixed Assets (Capital Expenditures) + Increase in Net Operating Working Capital
Increase in Gross Fixed Assets = Increase in Net Fixed Assets + Depreciation
Increase in Net Operating Working Capital = Increase in Current Assets – Increase in non-interest bearing current liabilities

19. Alternate FCF Definition
This definition is not developed or presented in the chapter itself but is used in some of the problem solutions.
The term Investment in Net Operating Capital is created which is Increase in Net Fixed Assets + Increase in Net Operation Working Capital.
Since depreciation is deducted in the Net Operating Capital term it must be deducted from the OCF term.
FCF = NOPAT – Investment in Net Operating Capital

20. What is Homer & Son’s 2006 Free Cash Flow?

21. INCOME TAXES

22. 2006 Single Individual Tax Rates Note: Appendix 3A provides 2004 brackets.
Taxable Income
Tax on Base
Rate*
0 – 7,550
10%
7, ,650
755.00
15%
30, ,200
4,220.00
25%
74, ,800
15,107.50
28%
154, ,550
Over 336,550
37,675.50
33%
35% O
*Plus this percentage on the amount over the bracket base.

23. 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).

24. 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%.

25. Corporate Income Taxes
Corporate deductions from income: operating expenses, depreciation, interest expense.
Dividends paid are NOT deductible.
Interest and capital gain income is fully taxable.
30% (in general) of Dividend income is taxable.
Losses can be carried back 2 years and carried forward up to 20 years

26. Taxable Income Tax on Base Rate* 0 - 50,000 15% 50,000 - 75,000 7,500
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.

27. 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?

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

29. 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)

30. 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?