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Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA

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. Balance Sheet: Assets. 2000. 1999. Cash. 7,282. 57,600. AR. 632,160. 351,200. Inventories.

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Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA

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  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

  2. Balance Sheet: Assets 2000 1999 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

  3. Liabilities and Equity 2000 1999 Accts payable 524,160 145,600 Notes payable 720,000 200,000 Accruals 489,600 136,000 Total CL 481,600 1,733,760 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

  4. Income Statement 2000 1999 Sales 5,834,400 3,432,000 COGS 5,728,000 2,864,000 Other expenses 680,000 340,000 (573,600) 228,000 EBITDA 116,960 18,900 Depr. & Amort. 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

  5. Other Data 2000 1999 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

  6. Statement of Retained Earnings (2000) Balance of retained earnings, 12/31/99 $203,768 Add: Net income, 2000 (519,936) Less: Dividends paid (11,000) Balance of retained earnings, 12/31/00 ($327,168)

  7. Statement of Cash Flows (2000) OPERATING ACTIVITIES Net income (519,936) 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. (523,936)

  8. L-T INVESTING ACTIVITIES Investment in fixed assets (711,950) FINANCING ACTIVITIES Increase in notes payable 520,000 Increase in long-term debt 676,568 Payment of cash dividends (11,000) Net cash from financing 1,185,568 NET CHANGE IN CASH (50,318) Plus: Cash at beginning of year 57,600 Cash at end of year 7,282

  9. What can you conclude about D’Leon’s financial condition from its statement of CFs? • Net cash from operations = -$523,936, mainly because of negative NI. • The firm borrowed $1,185,568 to meet its cash requirements. • Even after borrowing, the cash account fell by $50,318.

  10. Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 – Tax rate) NOPAT00 = -$690,560(1 – 0.4) = -$690,560(0.6) = -$414,336. NOPAT99 = $125,460.

  11. What effect did the expansion have on net operating working capital (NOWC)? Current assets Non-interest bearing CL NOWC = – NOWC00 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042. NOWC99 = $842,400.

  12. What effect did the expansion have on capital used in operations? Operating capital = NOWC + Net fixed assets. = $913,042 + $939,790 = $1,852,832. = $1,187,200. Operating capital00 Operating capital99

  13. What is your initial assessment of the expansion’s effect on operations? 2000 1999 Sales $5,834,400 $3,432,000 NOPAT ($414,336) $125,460 NOWC $913,042 $842,400 Operating capital $1,852,832 $1,187,200 Net Income ($519,936) $87,960

  14. What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF00 = NI + DEP = ($519,936) + $116,960 = ($402,976). NCF99 = $87,960 + $18,900 = $106,860. OCF00 = NOPAT + DEP = ($414,336) + $116,960 = ($297,376). OCF99 = $125,460 + $18,900 = $144,360.

  15. What was the free cash flow (FCF) for 2000? FCF = NOPAT – Net capital investment = -$414,336 – ($1,852,832 – $1,187,200) = -$414,336 – $665,632 = -$1,079,968. Is negative free cash flow always a bad sign?

  16. Economic Value Added (EVA) Operating IncomeAfter Tax After-TaxCapital Costs EVA = – = – = NOPAT – After-Tax Cost of Capital Cost ofCapital Used Funds Availableto Investors

  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.

  18. What is the company’s EVA? Assume the firm’s after-tax cost of capital was 11% in 1999 and 13% in 2000. EVA00 = NOPAT – (A-T cost of capital)(Capital) = -$414,336 – (0.13)($1,852,832) = -$414,336 – $240,868 = -$655,204. EVA99 = $125,460 – (0.11)($1,187,200) = $125,460 – $130,592 = -$5,132.

  19. Would you conclude that the expansion increased or decreased MVA? Market value of equity Equity capital supplied MVA = – During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined.

  20. Leading Creators of Wealth in the U. S. Market Value Added in 1999 Company Market Value Added Microsoft $328,257 million General Electric $285,320 million Intel $166,902 million Wal-Mart Stores $159,444 million Coca-Cola $157,536 million Merck $153,170 million Pfizer $148,245 million Cisco Systems $135,650 million Lucent Technologies $127,265 million Bristol-Myers Squibb $119,350 million

  21. Does D’Leon 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 D’Leon’s trade credit.

  22. 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.

  23. 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

  24. 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.

  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.

  26. Would D’Leon have required external capital if they had broken even in 2000 (Net Income = 0)? • YES, the company would still have to finance its increase in assets.

  27. 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.

  28. Other policies that affect financial statements • Inventory valuation methods. • Capitalization of R&D expenses. • Policies for funding the company’s retirement plan.

  29. 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.

  30. Why did the stock fall after the dividend was cut? • Management was “signaling” that the firm’s operations were in trouble. • The dividend cut lowered expectations for future cash flows, which caused the stock price to decline.

  31. What were some other sources of financing for D’Leon in 2000? • Bank loans: Notes payable increased by $520,000. • Credit from suppliers: A/P increased by $378,560. • Employees: Accruals increased by $353,600.

  32. D’Leon received a tax credit of $346,624 in 2000. • This suggests the company paid at least $346,624 in taxes during the past 2 years. • If D’Leon’s 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.

  33. INCOME TAXES

  34. April 2000 Single Individual Tax Rates Taxable Income Tax on Base Rate* 0 - 25,750 0 15% 25,750 - 62,450 3,862.50 28% 62,450 - 130,250 14,138.50 31% 130,250 - 283,150 35,156.50 36% Over 283,150 90,200.50 39.6% *Plus this percentage on the amount over the bracket base.

  35. Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,750 and your itemized deductions are $4,850. On the basis of the information above and the April 2000 tax rate schedule, what is your tax liability?

  36. Calculation of Taxable Income Salary $45,000 Dividends 3,000 Personal exemptions (2,750) Deductions (4,850) Taxable Income $40,400

  37. 40,400 - 25,750 • Tax Liability: TL = $3,862.50 + 0.28($14,650) = $7,964.50 »$7,965. • Marginal Tax Rate = 28%. • Average Tax Rate: Tax rate = = 19.71% »19.7%. $7,965 $40,400

  38. January 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.

  39. 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?

  40. 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.

  41. Taxable vs. Tax-Exempt Bonds State and local government bonds (munis) are generally exempt from federal taxes.

  42. Exxon bonds at 10% vs. 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.

  43. 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%.

  44. 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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