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CHAPTER 3
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
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Balance Sheet: Assets

2001 2000
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
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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
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Income Statement
2001 2000
Sales 6,034,000 3,432,000
COGS 5,528,000 2,864,000
Other expenses 519,988 358,672
EBITDA (13,988) 209,328
Depr. & Amort. 116,960 18,900
EBIT (130,948) 190,428
Interest exp. 136,012 43,828
EBT (266,960) 146,600
Taxes (40%) (106,784) 58,640
Net income (160,176) 87,960
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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
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Statement of Retained Earnings (2001)

Balance of retained
earnings, 12/31/00 $203,768
Add: Net income, 2001 (160,176)
Less: Dividends paid (11,000)
Balance of retained
earnings, 12/31/01 $32,592

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Statement of Cash Flows (2001)

OPERATING ACTIVITIES
Net income (160,176)
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)
Net cash provided by ops. (164,176)
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L-T INVESTING ACTIVITIES

Investment in fixed assets (711,950)
FINANCING ACTIVITIES
Increase in notes payable 436,808
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash from financing 825,808
NET CHANGE IN CASH (50,318)
Plus: Cash at beginning of year 57,600
Cash at end of year 7,282
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What can you conclude about
D’Leon’s 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.
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 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.
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What effect did the expansion have on

net operating working capital
(NOWC)?

Current Non-interest
NOWC = – .
assets bearing CL
NOWC01 = ($7,282 + $632,160 + $1,287,360)
– ($524,160 + $489,600)
= $913,042.

NOWC00 = $842,400.
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What effect did the expansion have on

capital used in operations?

Operating
= NOWC + Net fixed assets.
capital

Operating
= $913,042 + $939,790
capital01
= $1,852,832.

Operating
= $1,187,200.
capital00
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What is your initial assessment of the

expansion’s effect on operations?

2001 2000
Sales $6,034,000 $3,432,000
NOPAT ($78,569) $114,257
NOWC $913,042 $842,400
Operating capital $1,852,832 $1,187,200
Net Income ($160,176) $87,960

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What effect did the company’s
expansion have on its net cash flow
and operating cash flow?

NCF01 = NI + DEP = ($160,176) +

$116,960
= ($43,216).
NCF 00 = $87,960 + $18,900 = $106,860.
OCF01 = NOPAT + DEP
= ($78,569) + $116,960
= $38,391.
OCF00 = $114,257 + $18,900
= $133,157.
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What was the free cash flow (FCF)

for 2001?

FCF = OCF – Gross capital investment.

-OR-
FCF = 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?

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Economic Value Added (EVA)

Operating Income After-Tax

EVA = –After Tax Capital Costs

= Funds
– Available Cost of
to Investors Capital Used
= NOPAT – After-Tax
.
Cost of Capital

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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.

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What is the company’s EVA?

Assume the firm’s 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.
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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.
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Leading Creators of Wealth in the U.S.

Market Value Added in 2000
Company Market Value Added
General Electric $502,307 million
Microsoft $388,922 million
Cisco Systems $377,883 million
Intel $281,832 million
Pfizer $260,984 million
Merck $193,348 million
EMC $191,904 million
Oracle $180,885 million
American Int’l Group $177,982 million
Wal-Mart Stores $177,450 million
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 2 - 21

Does D’Leon 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 D’Leon’s trade credit.

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Does it appear that D’Leon’s sales

price exceeds its cost per unit sold?

 No, the negative NOPAT and

decline in cash position shows
that D’Leon is spending more on
its operations than it is taking in.

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What effect would each of these
actions have on D’Leon’s 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 company’s cash
position would improve.
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 2 - 25

How did D’Leon finance its expansion?

 D’Leon financed its expansion with

external capital.
 D’Leon issued long-term debt
which reduced its financial strength
and flexibility.

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 2 - 26
Would D’Leon 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.
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What happens if D’Leon 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.
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D’Leon 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 D’Leon’s 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.
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INCOME TAXES

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April 2001 Single Individual Tax Rates

Taxable Income Tax on Base Rate*

0 - 26,250 0 15%
26,250 - 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.

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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?
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Calculation of Taxable Income

Salary $45,000
Dividends 3,000
Personal exemptions (2,800)
Deductions (5,150)
Taxable Income $40,050

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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

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January 2001 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.
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Assume a corporation has $100,000

of taxable income from operations,
$5,000 of interest income, and
$10,000 of dividend income.

What’s its tax liability?

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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.
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Taxable vs. Tax-Exempt Bonds

State and local government bonds

(munis) are generally exempt from
federal taxes.

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 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.
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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%.

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Implications

 If T > 30%, buy tax-exempt munis.

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

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