CFF 302

2-1
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
Copyright 2002 by Harcourt, Inc.
All rights reserved.
2-2
Balance Sheet: Assets
Cash
AR
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
2001
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2000
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
2-3
Liabilities and Equity
2001
2000
Accts payable
524,160
145,600
Notes payable
636,808
200,000
Accruals
489,600
136,000
Total CL
1,650,568
481,600
Long-term debt
723,432
323,432
Common stock
460,000
460,000
Retained earnings
32,592
203,768
Total equity
492,592
663,768
Total L&E
2,866,592 1,468,800
2-4
Income Statement
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest exp.
EBT
Taxes (40%)
Net income
2001
2000
6,034,000 3,432,000
5,528,000 2,864,000
519,988
358,672
(13,988)
209,328
116,960
18,900
(130,948)
190,428
136,012
43,828
(266,960)
146,600
(106,784)
58,640
(160,176)
87,960
2-5
Other Data
2001
2000
No. of shares
100,000
100,000
EPS
($1.602)
$0.88
DPS
$0.110
$0.22
Stock price
$2.25
$8.50
Lease pmts
$40,000
$40,000
2-6
Statement of Retained Earnings (2001)
Balance of retained
earnings, 12/31/00
Add: Net income, 2001
Less: Dividends paid
Balance of retained
earnings, 12/31/01
$203,768
(160,176)
(11,000)
$32,592
2-7
Statement of Cash Flows (2001)

OPERATING ACTIVITIES
Net income
Add (Sources of cash):
Depreciation
Increase in A/P
Increase in accruals
Subtract (Uses of cash):
Increase in A/R
Increase in inventories
Net cash provided by ops.
(160,176)
116,960
378,560
353,600
(280,960)
(572,160)
(164,176)
2-8
L-T INVESTING ACTIVITIES

Investment in fixed assets
(711,950)
FINANCING ACTIVITIES
Increase in notes payable
Increase in long-term debt
Payment of cash dividends
Net cash from financing
436,808
400,000
(11,000)
825,808
NET CHANGE IN CASH
(50,318)
Plus: Cash at beginning of year

Cash at end of year
57,600
7,282
2-9
What can you conclude about

DLeons financial condition from its
statement of CFs?
Net cash from operations = -$164,176,
mainly because of negative NI.
The firm borrowed $825,808 to meet its
cash requirements.
Even after borrowing, the cash account

fell by $50,318.
2 - 10
Did the expansion create additional

net operating profit after taxes
(NOPAT)?
NOPAT = EBIT(1 Tax rate).
NOPAT01 = -$130,948(1 0.4)

= -$130,948(0.6)
= -$78,569.
NOPAT00 = $114,257.
2 - 11
What effect did the expansion have on

net operating working capital
(NOWC)?
NOWC =
Current
assets
Non-interest.
bearing CL
NOWC01 = ($7,282 + $632,160 + $1,287,360)

($524,160 + $489,600)
= $913,042.
NOWC00 = $842,400.
2 - 12
What effect did the expansion have on

capital used in operations?
Operating
capital = NOWC + Net fixed assets.
Operating
= $913,042 + $939,790
capital01
= $1,852,832.
Operating
= $1,187,200.
capital00
2 - 13
What is your initial assessment of the

expansions effect on operations?
Sales
NOPAT
NOWC
Operating capital
Net Income
2001
2000
$6,034,000
($78,569)
$913,042
$1,852,832
($160,176)
$3,432,000
$114,257
$842,400
$1,187,200
$87,960
2 - 14
What effect did the companys

expansion have on its net cash flow
and operating cash flow?
NCF01 = NI + DEP = ($160,176) + $116,960
= ($43,216).
NCF00 = $87,960 + $18,900 = $106,860.
OCF01 = NOPAT + DEP
= ($78,569) + $116,960
= $38,391.
OCF00 = $114,257 + $18,900
= $133,157.
2 - 15
What was the free cash flow (FCF)

for 2001?
FCF = OCF Gross capital investment.
-ORFCF = NOPAT Net capital investment
= -$78,569 ($1,852,832 $1,187,200)
= -$78,569 $665,632
= -$744,201.
Is negative free cash flow always a bad sign?
2 - 16
Economic Value Added (EVA)

Operating Income
After-Tax
EVA =
After Tax
Capital Costs
Cost of
= Funds Available
Capital Used
to Investors
After-Tax
=
NOPAT
.
Cost of Capital
2 - 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.
2 - 18
What is the companys EVA?

Assume the firms after-tax
percentage cost of capital was
10% in 2000 and 13% in 2001.
EVA01 = NOPAT (A-T cost of capital)(Capital)
= -$78,569 (0.13)($1,852,832)
= -$78,569 $240,868
= -$319,437.
EVA00 = $114,257 (0.10)($1,187,200)

= $114,257 $118,720
= -$4,463.
2 - 19
Would you conclude that

the expansion increased or
decreased MVA?
Market value Equity capital
MVA = of equity
supplied .
During the last year stock price has
decreased 73%, so market value of
equity has declined. Consequently,
MVA has declined.
2 - 20
Leading Creators of Wealth in the U.S.

Market Value Added in 2000
Company
General Electric
Microsoft
Cisco Systems
Intel
Pfizer
Merck
EMC
Oracle
American Intl Group
Wal-Mart Stores
Market Value Added

$502,307 million
$388,922 million
$377,883 million
$281,832 million
$260,984 million
$193,348 million
$191,904 million
$180,885 million
$177,982 million
$177,450 million
2 - 21
Does DLeon pay its suppliers on time?
Probably not.
A/P increased 260% over the past
year, while sales increased by only
76%.
If this continues, suppliers may cut
off DLeons trade credit.
2 - 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.
2 - 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
Cash would
2 - 24
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 companys cash
position would improve.
2 - 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.
2 - 26
Would DLeon have required external

capital if they had broken even in
2001 (Net Income = 0)?
YES, the company would still have
to finance its increase in assets.
Looking to the Statement of Cash
Flows, we see that the firm made an
investment of $711,950 in net fixed
assets. Therefore, they would have
needed to raise additional funds.
2 - 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.
2 - 28
DLeon received a tax credit of

$106,784 in 2001.
This suggests the company paid at least
$106,784 in taxes during the past 2 years.
If DLeons payments over the past 2 years
were less than $106,784 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.
2 - 29
INCOME TAXES
2 - 30
April 2001 Single Individual Tax Rates

Taxable Income
0 - 26,250
26,250 - 63,550
63,550 - 132,600
132,600 - 288,350
Over 288,350
Tax on Base
Rate*
0
3,937.50
14,381.50
35,787.00
91,857.00
15%
28%
31%
36%
39.6%
*Plus this percentage on the amount over the

bracket base.
2 - 31
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 $5,150.
On the basis of the information

above and the April 2001 tax rate
schedule, what is your tax liability?
2 - 32
Calculation of Taxable Income
Salary
Dividends
$45,000
3,000
Personal exemptions
(2,800)
Deductions
(5,150)
Taxable Income
$40,050
2 - 33
40,050 - 26,250
Tax Liability:
TL = $3,937.50 + 0.28($13,800)
= $7,801.50 $7,802.
Marginal Tax Rate = 28%.
Average Tax Rate:
$7,802
Tax rate =
= 19.48% 19.5%.
$40,050
2 - 34
January 2001 Corporate Tax Rates

Taxable Income
0 - 50,000
50,000 - 75,000
75,000 - 100,000
100,000 - 335,000
...
Over 18.3M
Tax on Base
0
7,500
13,750
22,250
...
6.4M
Rate*
15%
25%
34%
39%
...
35%
*Plus this percentage on the amount over the

bracket base.
2 - 35
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?
2 - 36
Operating income
Interest income
Taxable dividend
income
Taxable income
$100,000
5,000
3,000*
$108,000
Tax = $22,250 + 0.39 ($8,000)

= $25,370.
*Dividends Exclusion
= $10,000 0.7($10,000) = $3,000.
2 - 37
Taxable vs. Tax-Exempt Bonds
State and local government bonds

(munis) are generally exempt from
federal taxes.
2 - 38
Exxon Mobil bonds at 10% vs. California

muni bonds at 7%.
T = Tax rate = 28%.
After-tax interest income:
Exxon Mobil = 0.10($5,000)
0.10($5,000)(0.28)
= 0.10($5,000)(0.72) = $360.
CAL = 0.07($5,000) 0 = $350.
2 - 39
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%.
2 - 40
Implications
If T > 30%, buy tax-exempt munis.

If T < 30%, buy corporate bonds.
Only high income people should
buy munis.

CFF 302

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2-1

All rights reserved.

Balance Sheet: Assets

Liabilities and Equity

All rights reserved.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Statement of Retained Earnings (2001)

Statement of Cash Flows (2001)

L-T INVESTING ACTIVITIES

NET CHANGE IN CASH

Plus: Cash at beginning of year

What can you conclude about

Even after borrowing, the cash account

All rights reserved.

Did the expansion create additional

NOPAT01 = -$130,948(1 0.4)

All rights reserved.

What effect did the expansion have on

NOWC01 = ($7,282 + $632,160 + $1,287,360)

All rights reserved.

What effect did the expansion have on

All rights reserved.

What is your initial assessment of the

Copyright 2002 by Harcourt, Inc.

All rights reserved.

What effect did the companys

All rights reserved.

What was the free cash flow (FCF)

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Economic Value Added (EVA)

Copyright 2002 by Harcourt, Inc.

All rights reserved.

In order to generate positive EVA, a

All rights reserved.

What is the companys EVA?

EVA00 = $114,257 (0.10)($1,187,200)

All rights reserved.

Would you conclude that

All rights reserved.

Leading Creators of Wealth in the U.S.

Market Value Added

Does DLeon pay its suppliers on time?

All rights reserved.

Does it appear that DLeons sales

No, the negative NOPAT and

Copyright 2002 by Harcourt, Inc.

All rights reserved.

What effect would each of these

1. The company offers 60-day credit

All rights reserved.

2. Sales double as a result of the

All rights reserved.

How did DLeon finance its expansion?

DLeon financed its expansion with

All rights reserved.

Would DLeon have required external

All rights reserved.

What happens if DLeon depreciates its

All rights reserved.

DLeon received a tax credit of

All rights reserved.

Copyright 2002 by Harcourt, Inc.