2-1

CHAPTER 2
Financial Statements,
Cash Flow, and Taxes
 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income versus cash flow
 MVA and EVA
 Personal taxes
 Corporate taxes
 2-2

Balance Sheets: Assets

2001 2000
Cash 7,282 9,000
Short-term inv. 0 48,600
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: Depr. 263,160 146,200
Net FA 939,790 344,800
Total assets 2,866,592 1,468,800
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Liabilities and Equity

2001 2000
Accts payable 524,160 145,600
Notes payable 720,000 200,000
Accruals 489,600 136,000
Total CL 1,733,760 481,600
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 L&E 2,866,592 1,468,800
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Income Statement

2001 2000
Sales 5,834,400 3,432,000
COGS 5,728,000 2,864,000
Other expenses 680,000 340,000
Deprec. 116,960 18,900
Tot. op. costs 6,524,960 3,222,900
EBIT (690,560) 209,100
Interest exp. 176,000 62,500
EBT (866,560) 146,600
Taxes (40%) (346,624) 58,640
Net income (519,936) 87,960
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Other Data

2001 2000
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
 2-6

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)
 2-7

Statement of Cash Flows: 2001

OPERATING ACTIVITIES
Net Income (519,936)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP378,560
Change in accruals 353,600
Net cash provided by ops.
(523,936)
 2-8
L-T INVESTING ACTIVITIES
Investments in fixed assets (711,950)
FINANCING ACTIVITIES
Change in s-t investments 48,600
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash from financing 1,234,168
Sum: net change in cash (1,718)
Plus: cash at beginning of year 9,000
Cash at end of year 7,282
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What can you conclude about the

company’s financial condition from its
statement of cash flows?
 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.
 2 - 10

What effect did the expansion have on

net operating working capital (NOWC)?

Operating Operating
NOWC = -
CA CL

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

- ($524,160 + $489,600)
= $913,042.

NOWC00 = $793,800.
 2 - 11

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
= $1,138,600.
capital00
 2 - 12

Did the expansion create additional net

operating profit after taxes (NOPAT)?

NOPAT = EBIT(1 - Tax rate)

NOPAT01 = -$690,560(1 - 0.4)

= -$690,560(0.6)
= -$414,336.

NOPAT00 = $125,460.
 2 - 13

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
 2 - 14

What effect did the company’s

expansion have on its net cash flow
and operating cash flow?

NCF01 = NI + DEP = -$519,936 + $116,960

= -$402,976.
NCF00 = $87,960 + $18,900 = $106,860.
OCF01 = NOPAT + DEP
= -$414,336 + $116,960
= -$297,376.
OCF00 = $125,460 + $18,900
= $144,360.
 2 - 15

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?

 2 - 16

What is the company’s EVA?

Assume the firm’s after-tax cost of
capital (COC) was 11% in 2000
and 13% in 2001.

EVA01 = NOPAT- (COC)(Capital)

= -$414,336 - (0.13)($1,852,832)
= -$414,336 - $240,868
= -$655,204.

EVA00 = $125,460 - (0.11)($1,138,600)

= $125,460 - $125,246
= $214.
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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 - 18

Does the company 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 trade credit.
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Does it appear that the sales price

exceeds the cost per unit sold?

 No, the negative NOPAT shows

that the company is spending
more on it’s operations than it is
taking in.
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What effect would each of these

actions have on the 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 
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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.
 2 - 22

How was the expansion financed?

 The expansion was financed

primarily with external capital.
 The company issued long-term debt
which reduced its financial strength
and flexibility.
 2 - 23

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.
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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.
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Other policies that

can affect financial statements

 Inventory valuation methods.

 Capitalization of R&D expenses.
 Policies for funding the company’s
retirement plan.
 2 - 26

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.
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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.
 2 - 28

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.
 2 - 29

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.
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2000 Tax Year Single Individual

Tax Rates
Taxable Income Tax on Base Rate*
0 - 26,250 0 15%
25,620 - 63,550 3,937.50 28%
63,550 - 132,600 14,381.50 31%
132,600 - 288,350 35,787.00 36%
Over 288,350 91,857.00 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 $4,550.

On the basis of the information

above and the 2000 tax year tax rate
schedule, what is your tax liability?
 2 - 32

Calculation of Taxable Income

Salary $45,000
Dividends 3,000
Personal exemptions (2,800)
Deductions (4,550)
Taxable Income $40,650
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$40,650 - $26,250

 Tax Liability:
TL = $3,937.50 + 0.28($14,400)
= $7,969.50.
 Marginal Tax Rate = 28%.
 Average Tax Rate:
$9,969.5
Tax rate = $40,650 = 19.6%.
 2 - 34

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.
 2 - 35

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?

 2 - 36

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.
 2 - 37

Taxable versus Tax Exempt Bonds

State and local government bonds

(municipals, or “munis”) are
generally exempt from federal
taxes.
 2 - 38

 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.
 2 - 39

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%.
 2 - 40

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.