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
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
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
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
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 $203,768
Add: Net income, 2001 (160,176)
Less: Dividends paid (11,000)
Balance of retained
earnings, 12/31/01 $32,592
2-7
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)
2-8
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
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 Non-interest.

assets 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
= NOWC + Net fixed assets.
capital
Operating = $913,042 + $939,790

capital01
= $1,852,832.
Operating
capital00 = $1,187,200.
2 - 13
What is your initial assessment of the

expansions 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

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.

-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?

2 - 16
Economic Value Added (EVA)
Operating Income After-Tax

EVA = After Tax Capital Costs
Funds Available Cost of

=
to Investors Capital Used
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?
MVA = Market value Equity capital

.
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 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 Intl Group $177,982 million
Wal-Mart Stores $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 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.
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 $45,000
Dividends 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 = $40,050 = 19.48% 19.5%.

2 - 34
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.
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 $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 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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CFF 302

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2-1

Balance Sheet: Assets

Liabilities and Equity

Statement of Retained Earnings (2001)

Statement of Cash Flows (2001)

L-T INVESTING ACTIVITIES

What can you conclude about

Net cash from operations = -$164,176,

Did the expansion create additional

NOPAT = EBIT(1 Tax rate).

NOPAT01 = -$130,948(1 0.4)

What effect did the expansion have on

NOWC = Current Non-interest.

What effect did the expansion have on

Operating = $913,042 + $939,790

What is your initial assessment of the

Copyright 2002 by Harcourt, Inc. All rights reserved.

What effect did the companys

NCF01 = NI + DEP = ($160,176) + $116,960

What was the free cash flow (FCF)

FCF = OCF Gross capital investment.

Is negative free cash flow always a bad sign?

Economic Value Added (EVA)

Operating Income After-Tax

Funds Available Cost of

Copyright 2002 by Harcourt, Inc. All rights reserved.

In order to generate positive EVA, a

Copyright 2002 by Harcourt, Inc. All rights reserved.

What is the companys EVA?

EVA01 = NOPAT (A-T cost of capital)(Capital)

MVA = Market value Equity capital

During the last year stock price has

Leading Creators of Wealth in the U.S.

Does DLeon pay its suppliers on time?

Copyright 2002 by Harcourt, Inc. 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

2. Sales double as a result of the

How did DLeon finance its expansion?

DLeon financed its expansion with

Copyright 2002 by Harcourt, Inc. All rights reserved.

YES, the company would still have

What happens if DLeon depreciates

No effect on physical assets.

DLeon received a tax credit of

This suggests the company paid at least

Copyright 2002 by Harcourt, Inc. All rights reserved.

April 2001 Single Individual Tax Rates

Taxable Income Tax on Base Rate*

Assume your salary is $45,000, and

On the basis of the information

Calculation of Taxable Income

Copyright 2002 by Harcourt, Inc. All rights reserved.

Copyright 2002 by Harcourt, Inc. All rights reserved.

January 2001 Corporate Tax Rates

Taxable Income Tax on Base Rate*

Assume a corporation has

Whats its tax liability?

Copyright 2002 by Harcourt, Inc. All rights reserved.

Operating income $100,000