1. 6 - 1 Copyright © 2002 South-Western Balance sheet Income statement Statement of cash flows Accounting income versus cash flow MVA and EVA Personal taxes Corporate taxes CHAPTER 6 Accounting for Financial Management

2. 6 - 2 Copyright © 2002 South-Western 2001 2000 Cash7,2829,000 Short-term inv.048,600 AR632,160351,200 Inventories1,287,360715,200 Total CA1,926,8021,124,000 Gross FA1,202,950491,000 Less: Depr. 263,160146,200 Net FA939,790344,800 Total assets2,866,5921,468,800 Balance Sheets: Assets

3. 6 - 3 Copyright © 2002 South-Western 1,733,760 Liabilities and Equity 20012000 Accts payable524,160145,600 Notes payable720,000200,000 Accruals 489,600 136,000 Total CL481,600 Long-term debt1,000,000323,432 Common stock460,000 Retained earnings (327,168) 203,768 Total equity 132,832 663,768 Total L&E2,866,5921,468,800

4. 6 - 4 Copyright © 2002 South-Western (519,936) Income Statement Sales5,834,4003,432,000 COGS5,728,0002,864,000 Other expenses680,000340,000 Deprec. 116,960 18,900 Tot. op. costs6,524,9603,222,900 EBIT(690,560)209,100 Interest exp. 176,000 62,500 EBT (866,560) 146,600 Taxes (40%) (346,624) 58,640 Net income 87,960 20012000

5. 6 - 5 Copyright © 2002 South-Western Other Data No. of shares100,000 EPS($5.199)$0.88 DPS$0.110$0.22 Stock price$2.25$8.50 Lease pmts$40,000 20012000

6. 6 - 6 Copyright © 2002 South-Western Statement of Retained Earnings (2001) Balance of retained earnings, 12/31/00$203,768 Add: Net income, 2001(519,936) Less: Dividends paid(11,000) Balance of retained earnings, 12/31/01($327,168)

7. 6 - 7 Copyright © 2002 South-Western Statement of Cash Flows: 2001 OPERATING ACTIVITIES Net Income(519,936) Adjustments: Depreciation116,960 Change in AR(280,960) Change in inventories(572,160) Change in AP378,560 Change in accruals353,600 Net cash provided by ops. (523,936)

8. 6 - 8 Copyright © 2002 South-Western L-T INVESTING ACTIVITIES Investments in fixed assets(711,950) FINANCING ACTIVITIES Change in s-t investments48,600 Change in notes payable520,000 Change in long-term debt676,568 Payment of cash dividends(11,000) Net cash from financing1,234,168 Sum: net change in cash(1,718) Plus: cash at beginning of year9,000 Cash at end of year7,282

9. 6 - 9 Copyright © 2002 South-Western Net cash from operations = -$523,936, mainly because of negative net income. The firm borrowed $1,185,568 and sold $48,600 in short-term investments to meet its cash requirements. Even after borrowing, the cash account fell by $1,718. What can you conclude about the company’s financial condition from its statement of cash flows?

10. 6 - 10 Copyright © 2002 South-Western What effect did the expansion have on net operating working capital (NOWC)? NOWC 01 = ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600) = $913,042. NOWC 00 = $793,800. = - Operating CA Operating CL NOWC

11. 6 - 11 Copyright © 2002 South-Western What effect did the expansion have on capital used in operations? = NOWC + Net fixed assets. = $913,042 + $939,790 = $1,852,832. = $1,138,600. Operating capital 01 Operating capital 00 Operating capital

12. 6 - 12 Copyright © 2002 South-Western Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 - Tax rate) NOPAT 01 = -$690,560(1 - 0.4) = -$690,560(0.6) = -$414,336. NOPAT 00 = $125,460.

13. 6 - 13 Copyright © 2002 South-Western What is your initial assessment of the expansion’s effect on operations? 2001 2000 Sales$5,834,400 $3,432,000 NOPAT($414,336)$125,460 NOWC$913,042 $793,800 Operating capital$1,852,832 $1,138,600

14. 6 - 14 Copyright © 2002 South-Western What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF 01 = NI + DEP= -$519,936 + $116,960 = -$402,976. NCF 00 = $87,960 + $18,900 = $106,860. OCF 01 = NOPAT + DEP = -$414,336 + $116,960 = -$297,376. OCF 00 = $125,460 + $18,900 = $144,360.

15. 6 - 15 Copyright © 2002 South-Western What was the free cash flow (FCF) for 2001? FCF = NOPAT - Net capital investment = -$414,336 - ($1,852,832 - $1,138,600) = -$414,336 - $714,232 = -$1,128,568. How do you suppose investors reacted?

16. 6 - 16 Copyright © 2002 South-Western What is the company’s EVA? Assume the firm’s after-tax cost of capital (COC) was 11% in 2000 and 13% in 2001. EVA 01 = NOPAT- (COC)(Capital) = -$414,336 - (0.13)($1,852,832) = -$414,336 - $240,868 = -$655,204. EVA 00 = $125,460 - (0.11)($1,138,600) = $125,460 - $125,246 = $214.

17. 6 - 17 Copyright © 2002 South-Western Would you conclude that the expansion increased or decreased MVA? MVA = -. During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined. Equity capital supplied Market value of equity

18. 6 - 18 Copyright © 2002 South-Western Probably not. A/P increased 260% over the past year, while sales increased by only 70%. If this continues, suppliers may cut off trade credit. Does the company pay its suppliers on time?

19. 6 - 19 Copyright © 2002 South-Western No, the negative NOPAT shows that the company is spending more on it’s operations than it is taking in. Does it appear that the sales price exceeds the cost per unit sold?

20. 6 - 20 Copyright © 2002 South-Western 1.The company offers 60-day credit terms. The improved terms are matched by its competitors, so sales remain constant. What effect would each of these actions have on the cash account? A/R would  Cash would 

21. 6 - 21 Copyright © 2002 South-Western 2.Sales double as a result of the change in credit terms. Short-run: Inventory and fixed assets  to meet increased sales. A/R , Cash . Company may have to seek additional financing. Long-run: Collections increase and the company’s cash position would improve.

22. 6 - 22 Copyright © 2002 South-Western The expansion was financed primarily with external capital. The company issued long-term debt which reduced its financial strength and flexibility. How was the expansion financed?

23. 6 - 23 Copyright © 2002 South-Western Would external capital have been required if they had broken even in 2001 (Net income = 0)? Yes, the company would still have to finance its increase in assets.

24. 6 - 24 Copyright © 2002 South-Western What happens if fixed assets are depreciated 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.

25. 6 - 25 Copyright © 2002 South-Western Other policies that can affect financial statements Inventory valuation methods. Capitalization of R&D expenses. Policies for funding the company’s retirement plan.

26. 6 - 26 Copyright © 2002 South-Western 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.

27. 6 - 27 Copyright © 2002 South-Western Why did the stock price fall after the dividend was cut? Management was “signaling” that the firm’s operations were in trouble. The dividend cut lowered investors’ expectations for future cash flows, which caused the stock price to decline.

28. 6 - 28 Copyright © 2002 South-Western What were some other sources of financing used in 2001? Selling financial assets: Short term investments decreased by $48,600. Bank loans: Notes payable increased by $520,000. Credit from suppliers: A/P increased by $378,560. Employees: Accruals increased by $353,600.

29. 6 - 29 Copyright © 2002 South-Western What is the effect of the $346,624 tax credit received in 2001. This suggests the company paid at least $346,624 in taxes during the past 2 years. If the 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.

30. 6 - 30 Copyright © 2002 South-Western 2000 Tax Year Single Individual Tax Rates Taxable IncomeTax on BaseRate* 0 - 26,250015% 25,620 - 63,550 3,937.50 28% 63,550 - 132,60014,381.5031% 132,600 - 288,35035,787.0036% Over 288,350 91,857.00 39.6% *Plus this percentage on the amount over the bracket base.

31. 6 - 31 Copyright © 2002 South-Western Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,800 and your itemized deductions are $4,550. On the basis of the information above and the 2000 tax year tax rate schedule, what is your tax liability?

32. 6 - 32 Copyright © 2002 South-Western Calculation of Taxable Income Salary$45,000 Dividends3,000 Personal exemptions(2,800) Deductions(4,550) Taxable Income$40,650

33. 6 - 33 Copyright © 2002 South-Western Tax Liability: TL= $3,937.50 + 0.28($14,400) = $7,969.50. Marginal Tax Rate = 28%. Average Tax Rate: Tax rate = = 19.6%. $40,650 - $26,250 $9,969.5 $40,650

34. 6 - 34 Copyright © 2002 South-Western 2000 Corporate Tax Rates Taxable IncomeTax on BaseRate* 0 - 50,000015% 50,000 - 75,0007,50025% 75,000 - 100,00013,75034% 100,000 - 335,00022,25039% Over 18.3M6.4M35% *Plus this percentage on the amount over the bracket base..........

35. 6 - 35 Copyright © 2002 South-Western 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?

36. 6 - 36 Copyright © 2002 South-Western Operating income$100,000 Interest income5,000 Taxable dividend income3,000* Taxable income$108,000 Tax= $22,250 + 0.39 ($8,000) = $25,370. *Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000.

37. 6 - 37 Copyright © 2002 South-Western State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes. Taxable versus Tax Exempt Bonds

38. 6 - 38 Copyright © 2002 South-Western Exxon bonds at 10% versus 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.

39. 6 - 39 Copyright © 2002 South-Western Solve for T in this equation: Muni yield= Corp Yield(1-T) 7.00%= 10.0%(1-T) T= 30.0%. At what tax rate would you be indifferent between the muni and the corporate bonds?

40. 6 - 40 Copyright © 2002 South-Western 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. Implications