Balance sheet

1
CHAPTER 2 Financial Statements, Cash Flow,and
Taxes

• Balance sheet
• Income statement
• Statement of cash flows
• Accounting income vs. cash flow
• MVA and EVA
• Personal taxes
• Corporate taxes

2
Balance Sheet Assets
2000
1999
Cash
7,282
57,600
AR
632,160
351,200
Inventories
1,287,360
715,200
Total CA
1,926,802
1,124,000
Gross FA
1,202,950
491,000
Less Deprec.
263,160
146,200
Net FA
939,790
344,800
Total Assets
2,866,592
1,468,800
3
Liabilities and Equity
2000
1999
Accts payable
524,160
145,600
Notes payable
720,000
200,000
Accruals
489,600
136,000
Total CL
481,600
1,733,760
Long-term debt
1,000,000
323,432
Common stock
460,000
460,000
Retained earnings
(327,168)
203,768
Total equity
132,832
663,768
Total LE
2,866,592
1,468,800
4
Income Statement
2000
1999
Sales
5,834,400
3,432,000
COGS
5,728,000
2,864,000
Other expenses
680,000
340,000
EBITDA
(573,600)
228,000
116,960
18,900
Depr. Amort.
EBIT
(690,560)
209,100
Interest exp.
176,000
62,500
EBT
(866,560)
146,600
Taxes (40)
(346,624)
58,640
Net income
(519,936)
87,960
5
Other Data
2000
1999
No. of shares
100,000
100,000
EPS
(5.199)
0.88
DPS
0.110
0.22
Stock price
2.25
8.50
Lease pmts
40,000
40,000
6
Statement of Retained Earnings (2000)
Balance of retained earnings, 12/31/99 203,768
Add Net income, 2000 (519,936) Less
Dividends paid (11,000) Balance of retained
earnings, 12/31/00 (327,168)
7
Statement of Cash Flows (2000)
OPERATING ACTIVITIES
Net income
(519,936)
Add (Sources of cash)
Depreciation
116,960
Increase in A/P
378,560
Increase in accruals
353,600
Subtract (Uses of cash)
Increase in A/R
(280,960)
Increase in inventories
(572,160)
(523,936)
Net cash provided by ops.
8
L-T INVESTING ACTIVITIES
Investment in fixed assets
(711,950)
FINANCING ACTIVITIES
Increase in notes payable
520,000
Increase in long-term debt
676,568
Payment of cash dividends
(11,000)
Net cash from financing
1,185,568
NET CHANGE IN CASH
(50,318)
Plus Cash at beginning of year
57,600
Cash at end of year
7,282
9
What can you conclude about DLeons financial
condition from its statement of CFs?

• Net cash from operations -523,936, mainly
  because of negative NI.
• The firm borrowed 1,185,568 to meet its cash
  requirements.
• Even after borrowing, the cash account fell by
  50,318.

10
Did the expansion create additional net operating
profit after taxes (NOPAT)?
NOPAT EBIT(1 Tax rate) NOPAT00
-690,560(1 0.4)
-690,560(0.6) -414,336. NOPAT99 125,460.
11
What effect did the expansion have on net
operating working capital (NOWC)?
Current assets
Non-interest bearing CL
NOWC

NOWC00 (7,282 632,160 1,287,360)
(524,160 489,600)
913,042. NOWC99 842,400.
12
What effect did the expansion have on capital
used in operations?
Operating capital
NOWC Net fixed assets. 913,042
939,790 1,852,832. 1,187,200.
Operating capital00
Operating capital99
13
What is your initial assessment of the
expansions effect on operations?
2000 1999 Sales 5,834,400
3,432,000 NOPAT (414,336) 125,460 NOWC
913,042 842,400 Operating
capital 1,852,832 1,187,200 Net Income
(519,936) 87,960
14
What effect did the companys expansion have on
its net cash flow and operating cash flow?
NCF00 NI DEP (519,936) 116,960
(402,976).
NCF99 87,960 18,900 106,860.
OCF00 NOPAT DEP (414,336) 116,960
(297,376).
OCF99 125,460 18,900 144,360.
15
What was the free cash flow (FCF) for 2000?

• FCF NOPAT Net capital investment
• -414,336 (1,852,832 1,187,200)
• -414,336 665,632
• -1,079,968.
• Is negative free cash flow always a bad
• sign?

16
Economic Value Added (EVA)
Operating IncomeAfter Tax
After-TaxCapital Costs
EVA NOPAT After-Tax
Cost of Capital
Cost ofCapital Used
Funds Availableto Investors
17
EVA Concepts

• In order to generate positive EVA, a firm has to
  more than just cover operating costs. It must
  also provide a return to those who have provided
  the firm with capital.
• EVA takes into account the total cost of
  capital, which includes the cost of equity.

18
What is the companys EVA? Assume the firms
after-tax cost of capital was 11 in 1999 and
13 in 2000.
EVA00 NOPAT (A-T cost of capital)(Capital)
-414,336 (0.13)(1,852,832) -414,336
240,868 -655,204.
EVA99 125,460 (0.11)(1,187,200) 125,460
130,592 -5,132.
19
Would you conclude that the expansion increased
or decreased MVA?
Market value of equity
Equity capital supplied
MVA

During the last year stock price has decreased
73, so market value of equity has declined.
Consequently, MVA has declined.
20
Leading Creators of Wealth in the U. S. Market
Value Added in 1999
Company Market Value Added Microsoft
328,257 million General Electric 285,320
million Intel 166,902 million Wal-Mart
Stores 159,444 million Coca-Cola
157,536 million Merck 153,170
million Pfizer 148,245 million Cisco
Systems 135,650 million Lucent
Technologies 127,265 million Bristol-Myers
Squibb 119,350 million
21
Does DLeon pay its suppliers on time?

• Probably not.
• A/P increased 260 over the past year, while
  sales increased by only 70.
• If this continues, suppliers may cut off DLeons
  trade credit.

22
Does it appear that DLeons sales price exceeds
its cost per unit sold?

• No, the negative NOPAT and decline in cash
  position shows that DLeon is spending more on
  its operations than it is taking in.

23
What effect would each of these actions have on
DLeons cash account?
1. The company offers 60-day credit terms. The
improved terms are matched by its competitors, so
sales remain constant.

• A/R would é
• Cash would ê

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2. Sales double as a result of the change in
credit terms.

• Short run Inventory and fixed assets é to meet
  increased sales. A/R é , Cash ê. Company may
  have to seek additional financing.
• Long-run Collections increase and the companys
  cash position would improve.

25
How did DLeon finance its expansion?

• DLeon financed its expansion with external
  capital.
• DLeon issued long-term debt which reduced its
  financial strength and flexibility.

26
Would DLeon have required external capital if
they had broken even in 2000 (Net Income 0)?

• YES, the company would still have to finance its
  increase in assets.

27
What happens if DLeon depreciates its fixed
assets 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.

28
Other policies that affect financial statements

• Inventory valuation methods.
• Capitalization of RD expenses.
• Policies for funding the companys retirement
  plan.

29
Does the companys 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.

30
Why did the stock fall after the dividend was cut?

• Management was signaling that the firms
  operations were in trouble.
• The dividend cut lowered expectations for future
  cash flows, which caused the stock price to
  decline.

31
What were some other sources of financing for
DLeon in 2000?

• Bank loans Notes payable increased by 520,000.
• Credit from suppliers A/P increased by
  378,560.
• Employees Accruals increased by 353,600.

32
DLeon received a tax credit of 346,624 in 2000.

• This suggests the company paid at least 346,624
  in taxes during the past 2 years.
• If DLeons 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.

33
INCOME TAXES
34
April 2000 Single Individual Tax Rates
Taxable Income
Tax on Base
Rate
0 - 25,750
0
15
25,750 - 62,450
3,862.50
28
62,450 - 130,250
14,138.50
31
130,250 - 283,150
35,156.50
36
Over 283,150
90,200.50
39.6
Plus this percentage on the amount over the
bracket base.
35
Assume your salary is 45,000, and you received
3,000 in dividends. You are single, so your
personal exemption is 2,750 and your itemized
deductions are 4,850.

• On the basis of the information above and the
  April 2000 tax rate schedule, what is your tax
  liability?

36
Calculation of Taxable Income
Salary
45,000
Dividends
3,000
Personal exemptions
(2,750)
Deductions
(4,850)
Taxable Income
40,400
37
40,400 - 25,750

• Tax Liability
• TL 3,862.50 0.28(14,650)
• 7,964.50 7,965.
• Marginal Tax Rate 28.
• Average Tax Rate
• Tax rate 19.71 19.7.

7,965 40,400
38
January 2000 Corporate Tax Rates
Taxable Income
Tax on Base
Rate
0 - 50,000
0
15
50,000 - 75,000
7,500
25
75,000 - 100,000
13,750
34
100,000 - 335,000
22,250
39
... ...
...
Over 18.3M
6.4M
35
Plus this percentage on the amount over the
bracket base.
39
Assume a corporation has 100,000 of taxable
income from operations, 5,000 of interest
income, and 10,000 of dividend income.

• Whats its tax liability?

40
Operating income
100,000
Interest income
5,000
Taxable dividend
income
3,000
Taxable income
108,000
Tax 22,250 0.39 (8,000) 25,370.
Dividends Exclusion 10,000 0.7(10,000)
3,000.
41
Taxable vs. Tax-Exempt Bonds

• State and local government bonds (munis) are
  generally exempt from federal taxes.

42

• Exxon bonds at 10 vs. 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.

43
At what tax rate would you be indifferent to muni
vs. corp?

• Solve for T in this equation
• Muni yield Corp Yield(1 T)
• 7.00 10.0(1 T)
• T 30.0.

44
Implications

• If T 30, buy tax-exempt munis.
• If T
• Only high income people should buy munis.