1. 1 Chapter 2 Financial Statements, Cash Flow, and Taxes

2. 2 Outline Financial Statements and Reports - Jim Using Accounting Data for Managerial Decisions - Alex The Federal Income Tax System - Krissy

3. 3 Part 1 - Financial Statements and Reports Overview Balance Sheet Income Statement Statement of Stockholder’s Equity (Statement of Retained Earnings) Statement of Cash Flows

4. 4 Overview Financial statements are used for many purposes Managers Investors (i.e. annual report to shareholders) Taxing Authorities Format and style of statements vary by industry Publically traded companies must provide Written reports attempt to explain results on financial statements

5. 5 Balance Sheet Depicts financial condition of the company Shows firm’s assets and claims against the assets Snapshot at a point in time (i.e. end of year) Assets = Liabilities + Stockholder Equity Tax purposes vs. stockholder reporting Depreciation method (accelerated/straight line) Inventory values (FIFO/LIFO) Book values reported, not market values

6. 6 Balance Sheet cont… Assets listed in order of liquidity (cash is first) Liabilities lists claims against assets, in order that they must be paid Common Stock last, since this never has to be “paid off” Common Equity = Equity = Net Worth  assets net of the liabilities Structured Investment Vehicles (SIV’s) – regulatory loophole allowed companies to “hide” assets, using these to borrow from the short-term market and invest in the long-term market

7. 7 Balance Sheet: Assets 20092010 Cash$ 9,000$ 7,282 S-T invest.48,60020,000 AR351,200632,160 Inventories715,2001,287,360 Total CA1,124,0001,946,802 Gross FA491,0001,202,950 Less: Depr.146,200263,160 Net FA344,800939,790 Total assets$1,468,800$2,886,592

8. 8 Balance Sheet: Liabilities & Equity 20092010 Accts. payable$ 145,600$ 324,000 Notes payable200,000720,000 Accruals136,000284,960 Total CL481,6001,328,960 Long-term debt323,4321,000,000 Common stock460,000 Ret. earnings203,76897,632 Total equity663,768557,632 Total L&E$1,468,800$2,886,592

9. 9 Income Statement Summarizes firm’s revenues and expenses over time (i.e. monthly, quarterly, annually) Revenue – Expenses (before common dividends) = Net Income (Profit or Earnings) or Loss 2 Formats  Single or Multiple Step Earnings per share (EPS) is the “bottom line” Net income / # outstanding shares = Earnings per Share EBITDA  Earnings before interest, tax, depreciation, and amortization Better measure of financial strength than net income Depreciation and amortization are noncash expenses

10. 10 Income Statement 20092010 Sales$3,432,000$5,834,400 COGS2,864,0004,980,000 Other expenses340,000720,000 Deprec.18,900116,960 Tot. op. costs3,222,9005,816,960 EBIT209,10017,440 Int. expense62,500176,000 EBT146,600(158,560) Taxes (40%)58,640(63,424) Net income$ 87,960($ 95,136)

11. 11 Statement of Stockholder’s Equity Also referred to as Statement of Retained Earnings Links Income Statement and Balance Sheet Reports changes in equity accounts between balance sheet dates Begin RE (prior year balance sheet) + NI (income statement) - Dividends = End RE Retained Earnings vs. Dividends Growing company may choose to allocate less to dividends, while stable company may not Retained earnings do not represent cash, funds have already been reinvested in the company – cash is not “available”

12. 12 Net Cash Flow Differs from accounting profit Some receivables and expenses not received or paid in cash during the year Depreciation is noncash charge, so must be added back in for cash flow Net cash flow = Net Income – Noncash revenues + Noncash charges Simpler since noncash charges are generally 0  Net cash flow = Net Income + Depreciation and Amortization Even simpler  Net cash flow = Net Income + Depreciation

13. 13 Statement of Cash Flows Statement of Cash Flows summarizes changes in a company’s cash position Create from analysis of General Ledger accounts Financial managers use this, along with cash budget, when forecasting cash positions Since year-end balance sheets are “snapshots” may be almost the same from year to year, this shows how the Net Income was used 3 Sections Operating Activities – NI, depreciation, inventories, etc. Investing Activities – sale/purchase of fixed assets, investing Financing Activities – issuing debt or stocks, dividends

14. 14 Statement of Cash Flows cont… Can help answer questions Is firm generating enough cash to purchase additional assets required for growth? Is firm generating extra cash to repay debt or invest in new products? Firm can “doctor” profits (i.e. depreciate too slowly) Can report positive NI up to the day of bankruptcy Can detect this by looking at net cash flow from operations, which will deteriorate prior to this Many financial analysis information can be found online http://www.sec.gov Other sources on page 56 of textbook

15. 15 Statement of Cash Flows Operating Activities Net Income($ 95,136) Adjustments: Depreciation116,960 Change in AR(280,960) Change in inventories(572,160) Change in AP178,400 Change in accruals148,960 Net cash provided (used) by ops.($503,936)

16. 16 Investing Activities Cash used to acquire FA($711,950) Change in S-T invest.28,600 Net cash prov. (used) by inv. act.($683,350) Statement of Cash Flows

17. 17 Financing Activities Change in notes payable$ 520,000 Change in long-term debt676,568 Payment of cash dividends(11,000) Net cash provided (used) by fin. act.$1,185,568 Statement of Cash Flows

18. 18 Summary of Statement of CF Net cash provided (used) by ops.($ 503,936) Net cash to acquire FA(683,350) Net cash prov. (used) by fin. act.1,185,568 Net change in cash(1,718) Cash at beginning of year9,000 Cash at end of year$ 7,282

19. 19 What is free cash flow (FCF)? Why is it important? FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. CASH IS KING! A company’s value depends on the amount of FCF it can generate. http://www.investopedia.com/video/play/und erstanding-free-cash-flow/#axzz2IYmXvc9b http://www.investopedia.com/video/play/und erstanding-free-cash-flow/#axzz2IYmXvc9b

20. 20 What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

21. 21 Earning before interest and taxes (1 − Tax rate) Net operating profit after taxes X Operating current assets Operating current liabilities Net operating working capital − Total net operating capital Operating long-term assets + Net operating working capital Free cash flow − Net investment in operating capital Net operating profit after taxes − Total net operating capital this year Total net operating capital last year Net investment in operating capital Calculating Free Cash Flow in 5 Easy Steps Step 1Step 2 Step 3 Step 4 Step 5

22. 22 Net Operating Profit after Taxes (NOPAT) NOPAT = EBIT(1 - Tax rate) NOPAT 10 = $17,440(1 - 0.4) = $10,464. NOPAT 09 = $125,460.

23. 23 What are operating current assets? Operating current assets are the CA needed to support operations. Op CA include: cash, inventory, receivables. Op CA exclude: short-term investments, because these are not a part of operations.

24. 24 What are operating current liabilities? Operating current liabilities are the CL resulting as a normal part of operations. Op CL include: accounts payable and accruals. Op CL exclude: notes payable, because this is a source of financing, not a part of operations.

25. 25 Net Operating Working Capital (NOWC) NOWC 10 = ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960) = $1,317,842. NOWC 09 = $793,800. = - Operating CA Operating CL NOWC

26. 26 Total net operating capital (also called operating capital) Operating Capital= NOWC + Net fixed assets. Operating Capital 2010 = $1,317,842 + $939,790 = $2,257,632. Operating Capital 2009 = $1,138,600.

27. 27 Free Cash Flow (FCF) for 2010 FCF = NOPAT - Net investment in operating capital = $10,464 - ($2,257,632 - $1,138,600) = $10,464 - $1,119,032 = -$1,108,568. How do you suppose investors reacted? IT DEPENDS…

28. 28 Uses of FCF After-tax interest payment =$105,600 Reduction (increase) in debt =−$1,196,568 Payment of dividends =$11,000 Repurchase (Issue) stock =$0 Purch. (Sale) of ST investments = −$28,600 Total uses of FCF =−$1,108,568

29. 29 Return on Invested Capital (ROIC) ROIC = NOPAT / operating capital ROIC 10 = $10,464 / $2,257,632 = 0.5%. ROIC 09 = 11.0%. Ex/ An ROIC of 11% means that for every $1 of capital invested in a business, 11 cents of after-tax income was created during that period.

30. 30 The firm’s cost of capital is 10%. Did the growth add value? No. The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require. Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, in 2008 Qualcomm had high growth, negative FCF, but a high ROIC.

31. 31 Economic Value Added (EVA) WACC is weighted average cost of capital EVA = NOPAT- (WACC)(Capital) Economic Value Added - EVA - Video | Investopedia Economic Value Added - EVA - Video | Investopedia

32. 32 Economic Value Added (WACC = 10% for both years) EVA = NOPAT- (WACC)(Capital) EVA 10 = $10,464 - (0.1)($2,257,632) = $10,464 - $225,763 = -$215,299. EVA 09 = $125,460 - (0.10)($1,138,600) = $125,460 - $113,860 = $11,600.

33. 33 Stock Price and Other Data 20092010 Stock price$8.50$6.00 # of shares100,000 EPS$0.88-$0.95 DPS$0.22$0.11

34. 34 Market Value Added (MVA) MVA = Market Value of the Firm - Book Value of the Firm Market Value = (# shares of stock)(price per share) + Value of debt Book Value = Total common equity + Value of debt (More…)

35. 35 MVA (Continued) If the market value of debt is close to the book value of debt, then MVA is: MVA = Market value of equity – book value of equity

36. 36 2010 MVA (Assume market value of debt = book value of debt.) Market Value of Equity 2010: (100,000)($6.00) = $600,000. Book Value of Equity 2010: $557,632. MVA 10 = $600,000 - $557,632 = $42,368. MVA 09 = $850,000 - $663,768 = $186,232.

37. 37 Key Features of the Tax Code Corporate Taxes Individual Taxes

38. 38 2009 Corporate Tax Rates Taxable IncomeTax on BaseRate on amount above base 0 -50,000015% 50,000 - 75,0007,50025% 75,000 - 100,00013,75034% 100,000 - 335,00022,25039% 335,000 - 10M113,90034% 10M - 15M3,400,00035% 15M - 18.3M5,150,00038% 18.3M and up6,416,66735%

39. 39 Features of Corporate Taxation Progressive rate up until $18.3 million taxable income. Below $18.3 million, the marginal rate is not equal to the average rate. Above $18.3 million, the marginal rate and the average rate are 35%.

40. 40 Features of Corporate Taxes (Cont.) A corporation can: deduct its interest expenses but not its dividend payments; carry back losses for two years, carry forward losses for 20 years.* exclude 70% of dividend income if it owns less than 20% of the company’s stock *Losses in 2001 and 2002 can be carried back for five years.

41. 41 Example Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income. What is its tax liability?

42. 42 Operating income $100,000 Interest income 5,000 Taxable dividend income 3,000* Taxable income $108,000 *Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000. Example (Continued)

43. 43 Taxable Income = $108,000 Tax on base = $22,250 Amount over base = $108,000 - $100,000 = $8,000 Tax= $22,250 + 0.39 ($8,000) = $25,370. Example (Continued)

44. 44 Key Features of Individual Taxation Individuals face progressive tax rates, from 10% to 35%. The rate on long-term (i.e., more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset. Dividends are taxed at the same rate as capital gains. Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.

45. 45 Taxable versus Tax Exempt Bonds State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.

46. 46 ExxonMobil bonds at 10% versus California muni bonds at 7% T = Tax rate = 25.0%. After-tax interest income: ExxonMobil = 0.10($5,000) - 0.10($5,000)(0.25) ExxonMobil = 0.10($5,000)(0.75) = $375. CAL = 0.07($5,000) - 0 = $350.

47. 47 Breakeven Tax Rate At what tax rate would you be indifferent between the muni and the corporate bonds? Solve for T in this equation: Muni yield = Corp Yield(1-T) 7.00% = 10.0%(1-T) T = 30.0%.

48. 48 Implications If T > 30%, buy tax exempt munis. If T < 30%, buy corporate bonds. Only high income, and hence high tax bracket, individuals should buy munis.