You are on page 1of 44

Chapter 2

Financial Statements, Cash Flow, and Taxes

1

Topics in Chapter
  


  

Income statement Balance sheet Statement of cash flows Free cash flow MVA and EVA Corporate taxes Personal taxes
2

Determinants of Intrinsic Value: Calculating FCF
Sales revenues − Operating costs and taxes − Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF∞ ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average cost of capital (WACC)

Market interest rates
Market risk aversion

Cost of debt Cost of equity

Firm’s debt/equity mix
Firm’s business risk
3

Income Statement
2009 Sales COGS Other expenses $3,432,000 2,864,000 340,000 2010 $5,834,400 4,980,000 720,000

Deprec.
Tot. op. costs EBIT Int. expense EBT Taxes (40%) Net income $

18,900
3,222,900 209,100 62,500 146,600 58,640 87,960

116,960
5,816,960 17,440 176,000 (158,560) (63,424) ($ 95,136)
4

4 million. However.What happened to sales and net income?     Sales increased by over $2. 5 . Net income was negative. Costs shot up by more than sales. the firm received a tax refund since it paid taxes of more than $63.424 during the past two years.

800 263.360 1.600 351.287.282 20.950 Less: Depr.200 344.200 1.800 $1. AR Inventories Total CA Gross FA $ 9.000 $ 2010 7.Balance Sheet: Assets 2009 Cash S-T invest. Net FA Total assets 146.202.000 632.000 48.000 491.886.160 1.592 6 .160 939.802 1.200 715.124.946.468.790 $2.

7 .Effect of Expansion on Assets    Net fixed assets almost tripled in size. AR and inventory almost doubled. Cash and short-term investments fell.

000 136.600 323.768 663.800 97.Balance Sheet: Liabilities & Equity 2009 Accts.328.768 $1.000 284.000 460. payable Notes payable Accruals Total CL Long-term debt Common stock $ 145.960 1. earnings Total equity Total L&E 203.600 200.468.886.000 720.632 557.000.000 Ret.432 460.000 481.632 $2.000 2010 $ 324.592 8 .960 1.

Long-term debt increased to help finance the expansion. Retained earnings fell. due to the year’s negative net income and dividend payment.What effect did the expansion have on liabilities & equity?     CL increased as creditors and suppliers “financed” part of the expansion. The company didn’t issue any stock. 9 .

936) 10 .136) 116.960 (280.Statement of Cash Flows: 2010 Operating Activities Net Income Adjustments: Depreciation Change in AR Change in inventories Change in AP Change in accruals Net cash provided (used) by ops. ($ 95.160) 178.400 148.960) (572.960 ($503.

600 ($683. act.350) 11 .950) 28. Net cash prov.Investing Activities Cash used to acquire FA Change in S-T invest. (used) by inv. ($711.

568 Payment of cash dividends (11. act.568 12 .000) Net cash provided (used) by fin.185.000 Change in long-term debt 676.Financing Activities Change in notes payable $ 520. $1.

936) (683. Net change in cash Cash at beginning of year Cash at end of year $ ($ 503.568 (1.Summary of Statement of CF Net cash provided (used) by ops.350) 1. Net cash to acquire FA Net cash prov.000 7. act.718) 9.185.282 13 . (used) by fin.

What can you conclude from the statement of cash flows?     Net CF from operations = -$503.718. The firm spent $711. because of negative net income and increases in working capital.936. The firm borrowed heavily and sold some short-term investments to meet its cash requirements. Even after borrowing. 14 .950 on FA. the cash account fell by $1.

15 . A company’s value depends on the amount of FCF it can generate.What is free cash flow (FCF)? Why is it important?   FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

Buy nonoperating assets (e. marketable securities. Pay dividends. investments in other companies. Buy back stock. 3.) 16 . etc.g. Pay interest on debt. 5. 2.What are the five uses of FCF? 1. Pay back principal on debt. 4..

Calculating Free Cash Flow in 5 Easy Steps Step 1 Step 2 Earning before interest and taxes X (1 − Tax rate) Net operating profit after taxes Operating current assets − Operating current liabilities Net operating working capital Step 3 Net operating working capital + Operating long-term assets Total net operating capital Step 5 Step 4 Net operating profit after taxes − Net investment in operating capital Total net operating capital this year − Total net operating capital last year Net investment in operating capital 17 Free cash flow .

NOPAT09 = $125.440(1 .Net Operating Profit after Taxes (NOPAT) NOPAT = EBIT(1 .0.Tax rate) NOPAT10 = $17.4) = $10.460. 18 .464.

receivables. Op CA exclude: short-term investments. 19 . inventory.   Op CA include: cash.What are operating current assets?  Operating current assets are the CA needed to support operations. because these are not a part of operations.

  Op CL include: accounts payable and accruals. not a part of operations. 20 . because this is a source of financing. Op CL exclude: notes payable.What are operating current liabilities?  Operating current liabilities are the CL resulting as a normal part of operations.

282 + $632.000 + $284.Net Operating Working Capital (NOWC) NOWC NOWC10 = Operating CA Operating CL NOWC09 = ($7.317.360) .800.842. 21 .160 + $1.287.($324. = $793.960) = $1.

600.790 = $2.632. Operating Capital 2009 = $1.Total net operating capital (also called operating capital)    Operating Capital= NOWC + Net fixed assets. Operating Capital 2010 = $1.842 + $939.138. 22 .257.317.

632 .($2.257.464 .Free Cash Flow (FCF) for 2010 FCF = NOPAT .464 .568.032 = -$1.108.600) = $10.138.119. How do you suppose investors reacted? 23 .$1.$1.Net investment in operating capital = $10.

600 $11.568 Total uses of FCF = −$1.Uses of FCF After-tax interest payment = Payment of dividends = Repurchase (Issue) stock = Purch.196.600 Reduction (increase) in debt = −$1.568 24 .000 $0 −$28.108. (Sale) of ST investments = $105.

257.5%. ROIC09 = 11.632 = 0.464 / $2.Return on Invested Capital (ROIC) ROIC = NOPAT / operating capital ROIC10 = $10.0%. 25 .

in 2008 Qualcomm had high growth. Investors did not get the return they require.The firm’s cost of capital is 10%. but a high ROIC. For example. negative FCF. The ROIC of 0. but that’s ok if ROIC > WACC.5% is less than the WACC of 10%. Did the growth add value?   No. 26 . Note: High growth usually causes negative FCF (due to investment in capital).

(WACC)(Capital) 27 .Economic Value Added (EVA)  WACC is weighted average cost of capital  EVA = NOPAT.

EVA09 = $125.464 .763 = -$215. 28 .464 .257.632) = $10.10)($1.$113.600) = $125.(0.$225.(WACC)(Capital) = $10.460 .600.138.460 .299.1)($2.Economic Value Added (WACC = 10% for both years) EVA EVA10 = NOPAT.860 = $11.(0.

000 $0.Stock Price and Other Data 2009 Stock price # of shares EPS DPS $8.000 -$0.50 100.95 $0.00 100.11 29 .22 2010 $6.88 $0.

Book Value of the Firm Market Value = (# shares of stock)(price per share) + Value of debt Book Value = Total common equity + Value of debt (More…) 30 .Market Value Added (MVA)    MVA = Market Value of the Firm .

MVA (Continued)  If the market value of debt is close to the book value of debt. then MVA is:  MVA = Market value of equity – book value of equity 31 .

)  Market Value of Equity 2010:  (100.   MVA10 = $600.632 = $42. MVA09 = $850.$663.2010 MVA (Assume market value of debt = book value of debt.000 .232.  Book Value of Equity 2010:  $557.000 .632.000)($6. 32 .00) = $600.000.368.768 = $186.$557.

Key Features of the Tax Code   Corporate Taxes Individual Taxes 33 .

3M 18.250 113.000 100.335.000 .15M 15M .000 Tax on Base 0 7.667 34% 39% 34% 35% 38% 35% 34 .500 Rate on amount above base 15% 25% 75.000 50.416.000 5.2009 Corporate Tax Rates Taxable Income 0 -50.750 22.18.150.3M and up 13.100.000 335.000 .000 6.10M 10M .000 .900 3.75.400.000 .

35 .3 million taxable income.   Below $18.Features of Corporate Taxation  Progressive rate up until $18. the marginal rate and the average rate are 35%. Above $18.3 million.3 million. the marginal rate is not equal to the average rate.

)  A corporation can:    deduct its interest expenses but not its dividend payments. carry forward losses for 20 years.Features of Corporate Taxes (Cont. 36 .* exclude 70% of dividend income if it owns less than 20% of the company’s stock *Losses in 2001 and 2002 can be carried back for five years. carry back losses for two years.

000 of dividend income. What is its tax liability? 37 . $5.000 of interest income.Example   Assume a corporation has $100. and $10.000 of taxable income from operations.

0.7($10.000 5.000 .Exclusion = $10.000* $108. 38 .000.000 3.000) = $3.000 *Dividends .Example (Continued) Operating income Interest income Taxable dividend income Taxable income $100.

39 .250 + 0.39 ($8.000) = $25.000 Tax = $22.000 Tax on base = $22.000 = $8.000 .Example (Continued) Taxable Income = $108.250 Amount over base = $108.$100.370.

e. Dividends are taxed at the same rate as capital gains. The rate on long-term (i.Key Features of Individual Taxation     Individuals face progressive tax rates. more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset.. from 10% to 35%. 40 .. Interest on municipal (i.e. state and local government) bonds is not subject to Federal taxation.

Taxable versus Tax Exempt Bonds  State and local government bonds (municipals. 41 . or “munis”) are generally exempt from federal taxes.

After-tax interest income: ExxonMobil = 0. CAL = 0.10($5.25) ExxonMobil = 0.000)(0.10($5.000) 0.10($5.000)(0.ExxonMobil bonds at 10% versus California muni bonds at 7%      T = Tax rate = 25.0%. 42 .0 = $350.07($5.75) = $375.000) .

00% = 10.0%(1-T) T = 30.0%.Breakeven Tax Rate   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. 43 .

and hence high tax bracket.Implications    If T > 30%. buy tax exempt munis. individuals should buy munis. buy corporate bonds. If T < 30%. 44 . Only high income.