Financial Statements, Cash Flow, and Taxes

Chapter 2
Financial Statements, Cash

Flow, and Taxes
Topics in Chapter
Income statement
Balance sheet
Statement of cash flows
Free cash flow
MVA and EVA
Corporate taxes
Personal taxes
2
Determinants of Intrinsic Value:

FCF
SalesCalculating
revenues
Operating costs and taxes
Required investments in operating capital
Free cash flow
=
(FCF)
Value =
FCF1
FCF2
+
(1 + WACC)1 (1 + WACC)2
...
+
FCF
+
(1 +
WACC)
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Firms debt/equity mix
Cost of equity
Firms business risk

3
Income Statement
2009
$3,432,000
2,864,000
Sales
COGS
Other
expenses
340,000
Deprec.
18,900
Tot. op. costs 3,222,900
EBIT
209,100
Int. expense
62,500
EBT
146,600
Taxes (40%)
58,640
Net income
$ 87,960
2010
$5,834,400
4,980,000
720,000
116,960
5,816,960
17,440
176,000
(158,560)
(63,424)
4
($ 95,136)
What happened to sales

and net income?
Sales increased by over $2.4

million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax
refund since it paid taxes of more
than $63,424 during the past two
years.
5
Balance Sheet: Assets

Cash
S-T invest.
AR
Inventories
Total CA
Gross FA
Less: Depr.
Net FA
Total assets
2009
$
9,000
48,600
351,200
715,200
1,124,000
491,000
146,200
344,800
$1,468,800
2010
$
7,282
20,000
632,160
1,287,360
1,946,802
1,202,950
263,160
939,790
$2,886,592
6
Effect of Expansion on
Assets
Net fixed assets almost tripled in

size.
AR and inventory almost doubled.
Cash and short-term investments
fell.
Balance Sheet: Liabilities

& Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
2009
$ 145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
$1,468,800
2010
$ 324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592
8
What effect did the

expansion have on
liabilities & equity?
CL increased as creditors and

suppliers financed part of the
expansion.
Long-term debt increased to help
finance the expansion.
The company didnt issue any
stock.
Retained earnings fell, due to the
years negative net income and
9
dividend payment.
Statement of Cash Flows:

2010
Operating Activities
Net Income
Adjustments:
Depreciation
Change in AR
Change in inventories
Change in AP
Change in accruals
($
95,136)
116,960
(280,960)
(572,160)
178,400
148,960
10
Investing Activities
Cash used to acquire FA
Change in S-T invest.
Net cash prov. (used) by inv.
act.
($711,950
)
28,600
($683,350
)
11
Financing Activities
Change in notes payable
Change in long-term debt
Payment of cash dividends
Net cash provided (used) by fin.
act.
$
520,000
676,568
(11,000)
$1,185,56
8
12
Summary of Statement of
CF
Net cash provided (used) by
ops.
Net cash to acquire FA
($
503,936)
(683,350)
Net cash prov. (used) by fin.

act.
Net change in cash
1,185,568
(1,718)
Cash at beginning of year

Cash at end of year
9,000
$
13
7,282
What can you conclude

from the statement of
cash flows?
Net CF from operations = -$503,936,

because of negative net income and
increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold
some short-term investments to meet
its cash requirements.
Even after borrowing, the cash account
fell by $1,718.
14
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.
A companys value depends on the
amount of FCF it can generate.
15
What are the five uses of

FCF?
1.
2.
3.
4.
5.
Pay interest on debt.

Pay back principal on debt.
Pay dividends.
Buy back stock.
Buy nonoperating assets (e.g.,
marketable securities,
investments in other companies,
etc.)
16
Calculating Free Cash Flow in 5 Easy Steps

Step 1
Step 2
Earning before interest and taxes

X (1 Tax rate)
Net operating profit after taxes
Operating current assets

Operating current liabilities
Net operating working capital
Step 3
Net operating working capital

+ Operating long-term assets
Total net operating capital
Step 5
Step 4
Net operating profit after taxes

Net investment in operating capital
Free cash flow
Total net operating capital this year

Total net operating capital last year
Net investment in operating capital
17
Net Operating Profit after

Taxes (NOPAT)
NOPAT = EBIT(1 - Tax rate)
NOPAT10 = $17,440(1 - 0.4)
= $10,464.
NOPAT09 = $125,460.
18
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.
19
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.
20
Net Operating Working

Capital (NOWC)
NOWC = Operating
CA
Operating
CL
NOWC10 = ($7,282 + $632,160 + $1,287,360)

- ($324,000 + $284,960)
= $1,317,842.
NOWC09 = $793,800.
21
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.
22
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?
23
Uses of FCF
After-tax interest payment =
Reduction (increase) in debt =
Payment of dividends =
Repurchase (Issue) stock =
Purch. (Sale) of ST
investments =
Total uses of FCF =
$105,600
$1,196,568
$11,000
$0
$28,600
$1,108,568
24
Return on Invested Capital

(ROIC)
ROIC = NOPAT / operating capital
ROIC10 = $10,464 / $2,257,632 =
0.5%.
ROIC09 = 11.0%.
25
The firms 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 thats ok if ROIC > WACC.
For example, in 2008 Qualcomm had
high growth, negative FCF, but a high
ROIC.
26
Economic Value Added

(EVA)
WACC is weighted average cost of

capital
EVA = NOPAT- (WACC)(Capital)
27
Economic Value Added

(WACC = 10% for both
years)
EVA = NOPAT- (WACC)(Capital)
EVA10
= $10,464 - (0.1)($2,257,632)
= $10,464 - $225,763
= -$215,299.
EVA09 = $125,460 - (0.10)
($1,138,600)
= $125,460 - $113,860
= $11,600.
28
Stock Price and Other Data

Stock price
# of shares
2009
2010
$8.50
$6.00
100,000
100,000
EPS
$0.88
-$0.95
DPS
$0.22
$0.11
29
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)
30
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
31
2010 MVA (Assume market

value of debt = book value of
debt.)
Market Value of Equity 2010:
Book Value of Equity 2010:
(100,000)($6.00) = $600,000.
$557,632.
MVA10 = $600,000 - $557,632 =

$42,368.
MVA09 = $850,000 - $663,768 =
$186,232.
32
Key Features of the Tax

Code
Corporate Taxes
Individual Taxes
33
2009 Corporate Tax Rates

Taxable Income
0 -50,000
50,000 - 75,000
75,000 - 100,000
100,000 - 335,000
335,000 - 10M
10M - 15M
15M - 18.3M
18.3M and up
Tax on Rate on amount

Base
above base
0
7,500
13,750
22,250
113,900
3,400,000
5,150,000
6,416,667
15%
25%
34%
39%
34%
35%
38%
35%
34
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%.
35
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 companys stock
*Losses in 2001 and 2002 can be carried back for five

years.
36
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?
37
Example (Continued)
$100,000
Operating income
5,000
Interest income
Taxable dividend
3,000*
incom
$108,000
Taxable
income
e
*Dividends - Exclusion
= $10,000 - 0.7($10,000) =38 $3,000.
Example (Continued)
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.
39
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.
40
Taxable versus Tax Exempt

Bonds
State and local government bonds

(municipals, or munis) are
generally exempt from federal
taxes.
41
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.
42
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%.
43
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.
44

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Chapter 2

Financial Statements, Cash

Determinants of Intrinsic Value:

Firms debt/equity mix

Firms business risk

What happened to sales

Sales increased by over $2.4

Balance Sheet: Assets

Net fixed assets almost tripled in

Balance Sheet: Liabilities

What effect did the

CL increased as creditors and

Statement of Cash Flows:

Net cash prov. (used) by fin.

Cash at beginning of year

What can you conclude

Net CF from operations = -$503,936,

What is free cash flow

FCF is the amount of cash

What are the five uses of

Pay interest on debt.

Calculating Free Cash Flow in 5 Easy Steps

Earning before interest and taxes

Operating current assets

Net operating working capital

Net operating profit after taxes

Free cash flow

Total net operating capital this year

Net Operating Profit after

What are operating

Operating current assets are the

Op CA include: cash, inventory,

What are operating

Operating current liabilities are the

Op CL include: accounts payable and

Net Operating Working

NOWC10 = ($7,282 + $632,160 + $1,287,360)

Total net operating capital

Operating Capital= NOWC + Net

Free Cash Flow (FCF) for

Return on Invested Capital

The firms cost of capital is

No. The ROIC of 0.5% is less than the

Economic Value Added

WACC is weighted average cost of

EVA = NOPAT- (WACC)(Capital)

Economic Value Added

Stock Price and Other Data

Market Value Added (MVA)

MVA = Market Value of the Firm Book Value of the Firm

If the market value of debt is close

MVA = Market value of equity

2010 MVA (Assume market

Market Value of Equity 2010:

Book Value of Equity 2010:

MVA10 = $600,000 - $557,632 =

Key Features of the Tax

2009 Corporate Tax Rates

Tax on Rate on amount