Chapter 2 Understanding Financial Statements, Taxes, and Cash Flows 09/02/08 Income Statement SALES - EXPENSES = PROFIT •Cost of Goods Sold •Operating Expenses (marketing, administrative) •Financing Costs •Taxes SALES Income Statement - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS Three Important Issues Operating income is not affected by how the firm is financed Interest is tax deductible Positive net income does not necessarily mean it has any cash Balance Sheet Total Assets = Outstanding Debt + Shareholders’ Equity Balance Sheet Assets Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Investments & patents Liabilities (Debt) & Equity Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset. Intangible assets, such as patents and copyrights. Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt: loans from banks or other sources that lend money for longer than 12 months. Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid. Common Equity In balance sheet common equity = common stock (par value + paid-in capital – treasury stock) + retained earnings Common Equity Example 12/31/01 12/31/02 Common (par value) 3,000 3,200 Paid in capital 350,000 380,000 Retained earnings 1,800,000 ? Treasury stock 420,000 480,000 Total common equity 1,733,000 ? Dividend Paid 2002: 70,000 2002 net income: 570,000 Free Cash Flows Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors). Free Cash Flows Cash Flows from Assets Cash flows generated through the firm’s assets = = Cash Flows from Financing Cash flows paid to - or received from - the firm’s investors (creditors & stockholders) Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Operating income + depreciation - cash tax payments Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets [Change in current assets] - [change in non-interest bearing current liabilities] Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet. Calculating Free Cash Flows: A Financing Perspective Interest payments to creditors = - change in debt principal - dividends paid to stockholders - change in stock Financing Free Cash Flows Taxes Marginal tax rate: the tax rate that would be applied to the next dollar of taxable income Average tax rate: taxes owned by a firm divided by the firm’s taxable income Always marginal Corporate Income Tax Rates Since 1993 Taxable Income $1 - $50,000 $50,001 - $75,000 $75,001 - $100,000 $100,001 - $335,000 $335,001 - $10,000,000 $10,000,001 - $15,000,000 $15,000,001 - $18,333,333 over $18,333,333 Corporate Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% Corporate Income Tax Rates Example (1) find the taxable income (2) Suppose we have a taxable income of 90,000 50,000 * 15% = 7,500 (75,000 – 50,000) * 25% = 6,250 (90,000 – 75,000) * 34% = 5,100 tax : 7,500 + 6,250 + 5,100 = 18,850 Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders. Calculate the firm’s tax liability.