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A B C D E F G H

1 1/22/2007
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3 Chapter 3. Tool Kit for Financial Statements, Cash Flows, and Taxes
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5 FINANCIAL STATEMENTS AND REPORTS (Section 3.1)
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7 The annual report contains a verbal section plus four key statements: the balance sheet, income statement, statement of
8 retained earnings, and statement of cash flows. These statements contain a wealth of information that is used by bankers,
9 stock and bond analysts, and managers. Hence, they are quite important. Spreadsheets are used both to create and to
10 analyze these statements, as we demonstrate in this model.
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Regarding statement creation, firms' accounting information is maintained in computer files, which are adjusted as sales
13 occur, materials are purchased, and so forth. The firm's accountants periodically--monthly, quarterly, and annually--
14 extract information from the general files and compile the four statements. These statements-- in both printed and
15 spreadsheet format--are made available to security analysts, and if the firm wants to borrow money, the same information
16 is provided to potential lenders.
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18 The firm's financial staff also uses the data to analyze the firm's condition--its strengths and weaknesses--and this
19 information is used in the quest to improve operations and increase the firm's value.
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21 In this model, we start with the same balance sheet and income statement that was used in the chapter, but in an Excel
22 format, and then we show how Excel (and other spreadsheet packages) can be used to analyze the data.
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In addition, note that in cells which summarize data in other cells, such as sums or differences, the spreadsheet uses
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formulas rather than fixed numbers. For example, the cell for Total assets contains the Sum formula rather than just
33 $2,000. (The cell itself shows $2,000, but if you put the pointer on the cell, then the formula line will show that the cell
34 actually contains a formula.) That way, if the data for any input (cash, for instance) changes, the spreadsheet will
35 automatically recalculate and provide the correct net value for Total assets. As you will see as you go through our models,
36 this automatic recalculation feature is one of the most useful and powerful aspects of Excel and other spreadsheets.
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38 Finally, note that we show just below this introduction, before the financial statements, some information that is used to
39 develop aspects of the financial statements, including the tax rate, number of shares outstanding, and price per share.
40 Generally, in financial models, data that are used to construct statements are shown in an Input Data Section toward the
41 top of the model.
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43 THE BALANCE SHEET (Section 3.2)
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A B C D E F G H
45 INPUT DATA SECTION: Historical Data Used in the Analysis
46 2007 2006
47 Year-end common stock price $23.00 $26.00
48 Year-end shares outstanding (in millions) 50 50
49 Tax rate 40% 40%
50 Weighted average cost of captal (WACC) 11.0% 10.8%
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52 Table 3-1
53 MicroDrive Inc. December 31 Balance Sheets
54 (in millions of dollars)
55 2007 2006
56 Assets
57 Cash and equivalents $10 $15
58 Short-term investments $0 $65
59 Accounts receivable $375 $315
60 Inventories $615 $415
61 Total current assets $1,000 $810
62 Net plant and equipment $1,000 $870
63 Total assets $2,000 $1,680
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65 Liabilities and equity
66 Accounts payable $60 $30
67 Notes payable $110 $60
68 Accruals $140 $130
69 Total current liabilities $310 $220
70 Long-term bonds $754 $580
71 Total debt $1,064 $800
72 Preferred stock (400,000 shares) $40 $40
73 Common stock (50,000,000 shares) $130 $130
74 Retained earnings $766 $710
75 Total common equity $896 $840
76 Total liabilities and equity $2,000 $1,680
77
78 THE INCOME STATEMENT (Section 3.3)
79
80 Table 3-2
81 MicroDrive Income Statements for Years Ending December 31
82 (in millions of dollars)
83 2007 2006
84 INCOME STATEMENT
85 Net sales $3,000.0 $2,850.0
86 Operating costs except depreciation $2,616.2 $2,497.0
87 Earnings before interest, taxes, deprn., and amortization (EBITDA)* $383.8 $353.0
88 Depreciation $100.0 $90.0
89 Amortization $0.0 $0.0
90 Depreciation and amortization $100.0 $90.0
91 Earnings before interest and taxes (EBIT) $283.8 $263.0
92 Less interest $88.0 $60.0
93 Earnings before taxes (EBT) $195.8 $203.0
94 Taxes $78.3 $81.2
95 Net Income before preferred dividends $117.5 $121.8
96 Preferred dividends $4.0 $4.0
97 Net Income available to common stockholders $113.5 $117.8
98
A B C D E F G H
99 Common dividends $57.5 $53.0
100 Addition to retained earnings $56.0 $64.8
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102 *MicroDrive has no amortization charges.
A B C D E F G H
103
104 We can now use the above information to calculate three specific per-share data measures: earnings per share '(EPS),
105 dividends per share (DPS), and book value per share (BVPS). Simply divide the totals by the appropriate number of
106 shares outstanding. Note that BVPS is calculated by dividing total common equity (common stock plus retained earning)
107 by shares outstanding.
108
109 Per-share Data
110 Earnings per share (EPS) $2.27 $2.36
111 Dividends per share (DPS) $1.15 $1.06
112 Book value per share (BVPS) $17.92 $16.80
113 Cash flow per share (CFPS) $4.27 $4.16
114 The per share data gives managers and investors a quick look at some items that affect the price of the stock.
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116 STATEMENT OF RETAINED EARNINGS (Section 3.4)
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118 The statement of retained earnings takes the previous year's balance of retained earnings, adds the current year's net
119 income, and then subtracts dividends paid to common stockholders. The end result is the new balance of retained
120 earnings. MicroDrive's statement is shown below, in millions:
121
122 Table 3-3
123 2007
124 Balance of Retained Earnings, Dec. 31, 2006 $710.0
125 Add: Net Income, 2007 $113.5
126 Less: Dividends to common stockholders -$57.5
127 Balance of Retained Earnings, Dec. 31, 2007 $766.0
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129
130 NET CASH FLOW (Section 3.5)
131 2007 2006
132 Net income $113.5 $117.8
133 Depreciation $100.0 $90.0
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135 Net cash flow $213.5 $207.8
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137 STATEMENT OF CASH FLOWS (Section 3.6)
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139 Information from the balance sheet and income statement can be used to construct the Statement of
140 Cash Flows, which is shown below for MicroDrive, in millions of dollars.
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142 Table 3-4
143 MicroDrive Statement of Cash Flows for Years Ending Dec. 31
144 (in millions of dollars)
145
146 Operating Activities
147 Net Income before preferred dividends $117.5
148 Noncash adjustments
149 Depreciation and amortization $100.0
150 Due to changes in working capital
151 Increase in accounts receivable ($60.0)
152 Increase in inventories ($200.0)
153 Increase in accounts payable $30.0
154 Increase in accruals $10.0
155 Net cash provided by operating activities ($2.5)
156
157 Investing activities
A B C D E F G H
158 Cash used to acquire fixed assets ($230.0)
159 Sale of short-term investments $65.0
160 Net cash provided by investing activities ($165.0)
161
162 Financing Activities
163 Increase in notes payable $50.0
164 Increase in bonds $174.0
165 Payment of common and preferred dividends ($61.5)
166 Net cash provided by financing activities $162.5
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168 Net change in cash and equivilents ($5.0)
169 Cash and securities at beginning of the year $15.0
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171 Cash and securities at end of the year $10.0
172
A B C D E F G H
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175 MODIFYING ACCOUNTING DATA FOR MANAGERIAL DECISIONS (Section 3.7)
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177
178 Now that the statements have been developed, we can use the data contained in them to calculate some items that are of
179 interest to managers, investors, and lenders. All of these items are used more extensively in subsequent chapters, where we
180 look in more depth at how historical financial statements are analyzed and how future financial results are predicted.
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182 Net Operating Working Capital
183 Those current assets used in operations are called operating working capital, and operating working capital less operating
184 current liabilities is called Net Operating Working Capital.
185
Operating
Operating
186 2007 NOWC = - current
current assets
liabilities
187 = $1,000 - $200
188 2007 NOWC = $800
189
Operating
Operating
190 2006 NOWC = - current
current assets
liabilities
191 = $745 - $160
192 2006 NOWC = $585
193
194 Total Net Operating Capital (also just called Operating Capital)
195 The Total Net Operating Capital is Net Operating Working Capital plus any fixed assets.
196
197 2007 TOC = NOWC + Fixed assets
198 = $800 + $1,000
199 2007 TOC = $1,800
200
201 2006 TOC = NOWC + Fixed assets
202 = $585 + $870
203 2006 TOC = $1,455
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205 Net Operating Profit After Taxes
206 NOPAT is the amount of profit MicroDrive would generate if it had no debt and held no financial assets.
208
209 2007 NOPAT = EBIT x (1-T)
210 = $284 x 60%
211 2007 NOPAT = $170.3
212
213 2006 NOPAT = EBIT x (1-T)
214 = $263 x 60%
215 2006 NOPAT = $157.8
216
217 Free Cash Flow
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219 MicroDrive's Free Cash Flow caluclation is the cash flow actually availabe for distribution to investors after the company
220 has made all necessary investments in fixed assets and working capital to sustain ongoing operations.
221
222 2007 FCF = NOPAT + Depr. - Gross investment in operating capital
223 = $270.3 - $445
A B C D E F G H
224 2007 FCF = -$174.7
225 or
226
227 2007 FCF = NOPAT - Net investment in operating capital
228 = $170.3 - $345
229 2007 FCF = -$174.7
230
231 MVA AND EVA (Section 3.8)
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233 Market Value Added is the difference between the market value of MicroDrive's stock and the
234 amount of equity capital supplied by shareholders.
235
236 2007 MVA = Stock price x # of shares - Total common equity
237 = $23.00 x 50 - $896
238 = $1,150 - $896
239 2007 MVA = $254
240
241 2006 MVA = Stock price x # of shares - Total common equity
242 = $26.00 x 50 - $840
243 = $1,300 - $840
244 2006 MVA = $460
245
246 Economic Value Added
247 Economic Value Added represents MicroDrive's residual income that remains after the cost of all
248 capital, including equity capital, has been deducted.
249
250 2007 EVA = NOPAT - Operating Capital x Weighted average cost of capital
251 = $170.3 - $1,800 x 11%
252 = $170.3 - $198.0
253 2007 EVA = -$27.7
254
255 2006 EVA = NOPAT - Operating Capital x Weighted average cost of capital
256 = $157.8 - $1,455 x 11%
257 = $157.8 - $157.1
258 2006 EVA = $0.7
259
260 Return on Invested Capital
261 The Return on Invested Capital tells us the amount of NOPAT per dollar of operating capital.
262
263 2007 ROIC = NOPAT ÷ Operating Capital
264 $170.30 ÷ $1,800
265 2007 ROIC = 9.46%
266
267 2006 ROIC = NOPAT ÷ Operating Capital
268 $157.80 ÷ $1,455
269 2006 ROIC = 10.85%
270
271
272 Table 3-5
273 MVA and EVA for MicroDrive (Millions of Dollars)
274 2007 2006
275 MVA Calculation
276 Price per share $23.0 $26.0
277 Number of shares (millions) 50.0 50.0
Individual Tax Table for the 2006 Tax Year

If an individual's He/she pays this Plus this percentage Average tax


taxable income amount on the on the excess rate at
is between: base of the bracket over the base top of bracket
(1) (2) (3) (4) (5)
$0 $7,550 $0.00 10.0% 10.0%
$7,550 $30,650 $755.00 15.0% 13.8%
$30,650 $74,200 $4,220.00 25.0% 20.4%
$74,200 $154,800 $15,107.50 28.0% 24.3%
$154,800 $336,550 $37,675.50 33.0% 29.0%
$336,550 and up $97,653.00 35.0% 35.0%

Married (Joint Return) Tax Table for the 2006 Tax Year

If a couple's It pays this Plus this percentage Average tax


taxable income amount on the on the excess rate at
is between: base of the bracket over the base top of bracket
(1) (2) (3) (4) (5)
$0 $15,100 $0.00 10.0% 10.0%
$15,100 $61,300 $1,510.00 15.0% 13.8%
$61,300 $123,700 $8,440.00 25.0% 19.4%
$123,700 $188,450 $24,040.00 28.0% 22.4%
$188,450 $336,550 $42,170.00 33.0% 27.1%
$336,550 and up $91,043.00 35.0% 35.0%

Other Tax Data: Exemption phase-out begins for:


Individuals
Exemption per person = $3,300 $150,500
Capital gains rate (most investments) = 20%
Standard deduction (individual) = $5,150 Phase-out begins:
Standard deduction (married filing joint) = $10,300 Phase-out begins:
Base on social security (OASDI)= $87,900
Rate on social security (OASDI, payroll)= 6.2%
Rate on social security (OASDI, self-employed)= 12.4%
Rate on medicare (payroll) = 1.45%
Rate on medicare (self-employed) = 2.90%

Example
Find the tax, the marginal tax rate, and the average tax rate for the following situation.

Taxable Income: $35,000

Base taxable income: $30,650.00


Base tax: $4,220.00
Marginal tax rate: 25.0%

Tax: $5,307.50
Average tax rate: 15.2%

Returns to Investor under Bond and Stock Financing


Use Bonds Use Stock
(1) (2)
Sales $5,000,000 $5,000,000
Average rate at:
$1,000,000
$10,000,000

Average rate at:


$1,000,000
$10,000,000

on phase-out begins for:


Married
$225,750

$150,500
$150,500
SECTION 3.2
SOLUTIONS TO SELF-TEST

3 A firm has $8 million in total assets. It has $3 million in current liabilities, $2 million in long-
term debt, and $1 million in preferred stock. What is the total value of common equity?

Total assets $8,000,000


Current liabilities $3,000,000
Long-term debt $2,000,000
Preferred stock $1,000,000

Common equity $2,000,000


SECTION 3.3
SOLUTIONS TO SELF-TEST

5 A firm has $2,000,000 million in earnings before taxes. The firm has an interest expense of
$300,000 and depreciation of $200,000; it has no amortization. What is its EBITDA?

Earnings before taxes $2,000,000


Interest $300,000
Depreciation $200,000
Amortization $0

EBITDA $2,500,000
SECTION 3.4
SOLUTIONS TO SELF-TEST

4 A firm had a retained earnings balance of $3 million in the previous year. In the current year, its net
income is $2.5 million. If it pays $1 million in common dividends in the current year, what it its resulting
retained earnings balance?

Previous retained earnings balance $3,000,000


Current net income $2,500,000
Common dividends $1,000,000

Current retained earnings balance $4,500,000


SECTION 3.5
SOLUTIONS TO SELF-TEST

3 A firm has net income of $5 million. Assuming that depreciation of $1 million is its only noncash
expense, what is the firm’s net cash flow?

Net income $5,000,000


Depreciation $1,000,000

Net cash flow $6,000,000


SECTION 3.6
SOLUTIONS TO SELF-TEST

3 A firm has inventories of $2 million for the previous year and $1.5 million for the current year. What impact does
this have on net cash provided by operations?

Previous year's inventories $2,000,000


Current year's inventories $1,500,000

Change in net cash provided by operations $500,000


urrent year. What impact does
SECTION 3.7
SOLUTIONS TO SELF-TEST

5 A firm’s total net operating capital for the previous year was $2 million. For the current year, its total net
operating capital is $2.5 million and its NOPAT is $1.2 million. What is its free cash flow for the current year?

Previous year's total net operating capital $2,000,000


Current year's total net operating capital $2,500,000
Current year's NOPAT $1,200,000

Net investment in operating capital $500,000

Free cash flow $700,000


urrent year, its total net
flow for the current year?
SECTION 3.8
SOLUTIONS TO SELF-TEST

3 A firm has $100 million in total net operating capital. Its return on invested capital is 14 percent, and its weighted
average cost of capital is 10 percent. What is its EVA?

Total net operating working capital $10,000,000


ROIC 14%
WACC 10%

Free cash flow $400,000


14 percent, and its weighted
SECTION 3.8
SOLUTIONS TO SELF-TEST

2 If a corporation has $85,000 in taxable income, what is its tax liability?

Taxable income $85,000

Base amount of tax from Table 3-6 $13,750


Base of tax range $75,000
Taxable income above range $10,000
Tax rate in base 34%

Tax liability $17,150