Unit 1 Financial Statements, Cash Flow, and Taxes
Adapted from: Eugene F. Brigham: Fundamentals of Financial Management (Study Guide)
Harcourt College Publishers, 2001.
Overview
Financial management requires the consideration of the types of financial statements firms
must provide to investors. The value of any asset depends on the usable, or after tax, cash
flows the asset is expected to produce. Since the traditional financial statements are designed
more for use by creditors than for corporate managers and stock analysts, the chapter
discusses how to modify accounting data for managerial decisions. In addition, the concepts
of Market Value Added (EVA) and the Economic Value Added (EVA) are defined and
explained. Finally, since it is the after-tax cash flow that is important, the chapter provides an
overview of the federal income tax system.
Outline
Although he economic system has grown enormously since the early days of the barter
system, the original reasons for accounting and financial statements still apply. Investors need
them to make intelligent decisions, managers need them to see how effectively their
enterprises are being run, and taxing authorities need them to assess taxes in a reasonable
manner.
A firm’s annual report to shareholders presents two important types of information. The first
is a verbal statement of the company’s recent operating results and its expectations for the
coming year. The second is a set of quantitative financial statements that report what actually
happened to the firm’s financial position, earnings and dividends over the past few years.
The balance sheet is a statement of the firm’s financial position at a specific point in time. It
shows the firm’s assets and the claims against those assets. Assets, found on the left-hand side
of the balance sheet, are typically shown in the order of their liquidity. Claims, found on the
right-hand side, are generally listed in the order in which they must be paid.
Only cash represents actual money. Non-cash assets should produce cash flows
eventually, but they do not represent cash in hand.
Claims against the assets consist of liabilities and stockholders’ equity:
Assets-Liabilities-Preferred stock=Common stockholders’ equity (Net worth).
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□. Common stockholders’ equity, or the net worth, is capital supplied by common
stock-holders—common stock, paid-in capital, retained earnings, and occasionally, certain
reserves.
□. Preferred stock is a hybrid, or a cross between common stock and debt.
The common equity section of the balance sheet is divided into two accounts: common
stock and retained earnings. The common stock account arises from the issuance of stock to
raise capital. Retained earnings are built up over time as the firm “saves” a part of its earnings
rather than paying all earning out as dividends.
Different methods can be used to determine the value of inventory. These methods, in
turn, affect the reported cost of goods sold, profits, and EPS.
Companies often use the most accelerated method permitted under the law to calculate
depreciation for tax purposes but use straight-line depreciation, which results in a lower
depreciation expenses, for the stockholder reporting.
The balance sheet may be thought of as a snapshot of the firm’s financial position at a
point in time. The balance sheet changes every day as inventory is increased or decreased, as
fixed assets are added or retired, as bank loans are increased or decreased.
The income statement summarizes the firm’s revenues and expenses over a period of time.
Earning per share (EPS) is called “the bottom line,” denoting that of all the items on the
income statement, EPS is the most important.
Depreciation is an annual non-cash charge against income that reflects the estimated
dollar cost of the capital equipment used up in the production process. It applies to tangible
assets, whereas amortization applies to intangible assets. They are often lumped together on
the income statement.
EBITDA represents earning before interest, taxes, depreciation, and amortization.
The statement of retained earnings reports changes in the equity accounts between balance
sheet dates.
The balance sheet account “retained earnings” represents a claim against assets, not
assets per se. Retained earnings as reported on the balance sheet do not represent cash and are
not “available” for the payment of dividends or anything else.
Retained earning represents funds that have already been reinvested in the firm’s
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operating assets.
In finance the emphasis is on the cash flow that the company is expected to generate.
The firm’s net income is important, but cash flows are even more important because
dividends must been paid in cash, and cash is also necessary to purchase the assets required to
continue operations.
A business’s net cash flow generally differs from its accounting profit, because some of
the revenues and expenses listed on the income statement were not paid in cash during the
year.
Net cash flow =Net income - Noncash revenues + Noncash charges.
Typically depreciation and amortization are by far the largest non-cash items, and in
many cases the other non-cash items roughly net out to zero. For this reason, many analysts
assume that
Net cash flow =Net income + Depreciation and amortization.
The statement of cash flows reports the impact of a firm’s operating, investing, and financing
activities on cash flows over an accounting period.
Net cash flow represents the amount of cash a business generates for its shareholders in
a given year. The company’s cash position as reported on the balance sheet is affected by
many factors, including cash flow, changes in working capital, fixed assets, and security
transactions.
The statement separates activities into three categories:
□ Operating activities, which includes net income, depreciation, and changes in current
assets and current liabilities other than cash and short-term debt.
□ Investing activities, which includes investments or sale of fixed assets.
□ Financing activities, which includes cash raised during the year by issuing debt or
stock, and dividends paid or cash buy-backs of outstanding stock or bonds.
Financial managers generally use this statement, along with the cash budget, when
forecasting their companies’ cash position.
The traditional financial statements are designed more for use by creditors and tax collectors
than for managers and equity analysts. Certain modifications are used for corporate decision
making and stock valuation purposes.
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To judge managerial performance one needs to compare managers’ ability to generate
operating income (EBIT) with the operating assets under their control.
□. Operating assets consists of cash, marketable security, accounts receivable,
inventories, and fixed assets necessary to operate the business.
□.
Non-operating assets include cash and marketable securities above the level
required for normal operations, investments in subsidiaries, land held for future use, and the
like.
□. Operating assets can be further divided into working capital and fixed assets such as
plant and equipment.
□. Those current assets used in operations are called operating working capital, and
operating working capital less accounts payable and accruals is called net operating working
capital (NOWC).
● Net operating working capital is the working capital required with investor-supplied
funds.
□. Total operating capital is the sum of net operating working capital and net fixed
assets.
Net income does not always reflect the true performance of a company’s operations or the
effectiveness of its managers and employees.
□. A better measurement for comparing managers’ performance is net operating profit
after taxes (NOPAT), which is the amount of profit a company would generate if it had no
debt and held no non-operating assets.
NOPAT = EBIT (1-Tax rate)
The value of a company’s operations depends on all the future expected free cash flows.
□. Free cash flow is the cash flow actually available for distribution to all investors after
the company has made all the investments in fixed assets, new products, and working capital
necessary to sustain ongoing operations.
● It is defined as after-tax operating profit minus the amount of investment in working
capital and fixed assets necessary to sustain the business.
● Free cash flow is calculated as operating cash less gross investment in operating
capital.
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● It also equals NOPAT less net investment in operating capital.
□. Operating cash flow is NOPAT plus any non-cash adjustments as shown on the
statement of cash flow.
● Operating cash flow = NOPAT + Depreciation.
Negative operating cash flow is not always bad. If free cash flow is negative because NOPAT
is negative, this bad, because the company is probably experiencing operating problems.
□. Exceptions to this might be startup companies; companies that are incurring
significant current expenses to launch a new production line; or high-growth companies,
which will have large investments in capital that cause low free cash flow, but that will
increase future free cash flow.
Since the primary goal of management is to maximize the firm’s stock price, analysts have
come up with adjustments that provide alternative measures of performance. Two of these
measures are Market Value Added (MVA) and Economic Value Added (EVA).
Shareholders’ wealth is maximized by maximizing the difference between the market value of
the firm’s stock and the amount of equity capital that was supplied by shareholders. The
difference is called the Market Value Added (MVA).
MVA = Market value of stock – Equity capital supplied by shareholders
= (Shareholder outstanding)(Stock price) – Total common equity.
Whereas MVA measures the effects of managerial actions since the very inception of a
company, Economic Value Added (EVA) focuses on managerial effectiveness in a given
years.
EVA = NOPAT –After tax dollar cost of capital used to support operations
= EBIT (1 – T) – (Operating capital)(After tax percentage cost of capital).
□. EVA is an estimate of a business’s true economic profit for the year.
□. EVA differs sharply from accounting profit. EVA represents the residual income that
remains after the cost of all capital, including equity capital, has been deducted. Whereas
accounting profit is determined without imposing a charge for equity capital.
□. EVA provides a good measure of the extent to which the firm has added to
shareholder value.
□. EVA can be determined for decisions as well as for the company as a whole, so it
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provides a useful basis for determining managerial compensation at all levels.
When EVA or MVA are used to evaluate managerial performance as part of an incentive
compensation program, EVA is the measure that is typically used.
□. MVA is used primarily to evaluate top corporate officers over periods of five to ten
years, or longer.
Federal income tax is comprised of tax laws that have been charged by Congress, every three
or four years since its inception in 1913. Certain parts of our system are tied to the inflation
rate, which induces change automatically each year. Consequently, current tax rate schedules
and other pertinent data should be reviewed before filing returns. Because of the magnitude
of the tax bite, taxes play a critical role in many financial decisions, and business managers
and investors usually rely on tax specialists.
Individuals pay taxes on wages and salaries, on investment income (dividends, interest, and
profits from the sale of securities), and on the profits of proprietorships and partnerships.
U.S. income taxes are progressive; that is, the higher the income, the larger the
percentage paid in taxes. Marginal tax rates begin at 15 percent and rise to 39.6 percent.
□. The marginal tax rate is the tax applicable to the last unit of income.
□. The average tax rate is calculated as taxes paid divided by taxable income.
□. Taxable income is gross income minus exemptions and allowable deductions as set
forth in the Tax Code.
□. Bracket creep is a situation that occurs when progressive tax rates combine with
inflation to cause a greater portion of each taxpayers real income to be paid as taxes.
Because dividends are paid from corporate income that has already been taxed, there is
double taxation of corporate income.
Interest on most state and local government securities, which are often called municipals,
or “munis,” is not subject to federal income taxes. This creates a strong incentive for
individuals in high tax brackets to purchase such securities.
Gains and losses on the sale of capital assets such as stocks, bonds, and real estate have
historically received special tax treatment.
□. Short-term capital gains, in which the asset is sold within one year of the time it was
purchased, are added to such ordinary income as wages, dividends, and interest and then are
taxed at the same rate as ordinary income.
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□. An asset held for more than a year produces a long-term capital gain, and its rate is
caped at 20 percent.
□. The lower capital gains tax rate stimulates capital formation and investment, hence
economic growth.
Corporations pay taxes on profits.
Corporate tax rates are also progressive up to $18,333,333 of taxable income, but are
constant thereafter. Managerial tax rates range from 15 to 39 percent.
□. If the corporation pays its own after-tax income out to its stockholders as dividends,
the income is ultimately subject to triple taxation, hence the 70 percent exclusion on
inter-corporate dividends.
Interest and dividend income received by corporation are taxed.
□. Interest is taxed as ordinary income at regular corporate tax rates.
□. However, 70 percent of dividends received by one corporation from another is
excluded from taxable income. The remaining 30 percent is taxed at the ordinary rate. Thus
the effective tax rate on dividends received by a 35 percent marginal tax bracket corporation
is 0.30(35%)=10.5%.
The tax system favors debt financing over equity financing.
□. Interest paid is tax-deductible business expenses.
□. Dividends on common and preferred stock are not deductible. Thus, a 40 percent
federal-plus-state tax bracket corporation must earn $1/(1.0-0.40) = $1.67 before taxes to pay
$1 of dividends, but only $1 of pretax income is required to pay $1 of interest.
Before 1987, long-term corporate capital gains were taxed at lower rates than ordinary
income. However, at present, long-term capital gains are taxed as ordinary income.
Ordinary corporate operating losses can be carried back to each of the preceding 2 years
and forward for the next 20 years in the future to offset taxable income in those years. The
purpose of permitting this loss treatment is to avoid penalizing corporations whose incomes
fluctuate substantially from year to year.
The Internal Revenue Code imposes a penalty on corporation that retain earnings if the
purpose of this improper accumulation is to enable stockholders to avoid personal income tax
on dividends.
If a corporation owns 80 percent or more of another corporation’s stock, it can aggregate
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profits and losses and file a consolidated tax return. Thus, losses in one area can offset profits
in another.
Small businesses that meet certain restrictions may be set up as S corporations, which
receive benefits of the corporate form of organization, especially limited liabilities, yet are
taxed as proprietorships or partnerships rather than as corporations. This treatment would be
preferred by owners of small corporations in which all or most of the income earned each
year is distributed as dividends because the income would be taxed only once at the
individual level.
Depreciation plays an important role in income tax calculations. The large it is, the lower
taxable income and tax bill, hence the higher cash flow from operations. Congress specifies
in the Tax Code both the life over which assets can be depreciated for tax purposes and the
methods of depreciation to be used.
Questions (Financial Statements, Cash Flow, and Taxes)
1. The income statement reports the results of operations during the past year, the most
important item is _________ ______ ________ .
2. Typically, assets are listed in order of their ___________, while liabilities are listed in the
order in which they must be paid.
3. The two accounts that normally make up the common equity section of the balance sheet
are ______ ______ and _______ _________.
4. Retained earnings are generally reinvested in ________ _______ and are not held in the
form of cash.
5. the three major categories of the Statement of Cash Flows associated with _________
activities, _________ ________ _________ activities, and ___________ activities.
6. The _________ ____ ________ _______ reports changes in the equity accounts between
balance sheet dates.
7. In finance the emphasis is on the _______ _______ that the company is expected to
generate.
8. _________ _______ consist of cash, marketable securities, account receivable,
inventories, and fixed assets necessary to operate the business.
9. Those current assets used in operations are called ________ ________ _________.
10. ______ ________ _______ is the sum of net operating capital and net fixed assets.
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11. ______ _______ _______ is the cash flow actually available for distribution to all
investors after the company has made all the investments in fixed assets and working
capital necessary to sustain ongoing operation.
12. ________ ________ _______ focuses on managerial effectiveness in a given year and is
an estimate of a business’s true economic profit for the year.
13. A _________ tax system is one which tax rates are at higher at higher levels of income.
14. In order to qualify as longer-term capital gain or loss, an asset must be held for more than
______ ______.
15. interest income received by a corporation is taxed as _________ income. However, only
____ percent of individuals received from another corporation is subject to taxation.
16. The Tax Code permits a corporation to be taxed at the owners’ personal tax rates and
avoid the impact of _________ taxation of dividends. This type of corporation is called a
____ corporation.
17. The fact that 70 percent of inter-corporate dividends received by a corporation is excluded
from taxable income has encouraged debt financing over equity financing.
a. True b. false
18. An individual with substantial personal wealth and income is considering the possibility
of opening a new business. The business will have a relatively high degree of risk, and
losses will be incurred for the first several years. Which legal form of business
organization would probably be best?
a. Proprietorship
b. S corporation
d. Limited partnership
e. Partnership
c. Corporation
19. Which of the following statement is most correct?
a. In order to avoid double taxation and to escape the frequently higher tax rate applied
to capital gains, stockholders generally prefer to have corporation pay dividends
rather than to retain their earnings and reinvest the money in the business.
b. Under the current tax laws, when investors pay taxes on their dividend income, they
are being subject to a form of double taxation.
c. The fact that a percentage of interest received by one corporation, which is paid by
another corporation, is excluded from taxable income has encouraged firms to use
more debt financing relative to equity financing.
d. If the tax law stated that $0.50 out of every $1.00 of interest paid by a corporation
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was allowed as a tax deductible expenses, these would probably encourage
companies to use more debt financing than they presently do, other things held
constant.
e. Statement b and d are correct.
Problems
(The following data apply to the next three problems)
Sons, Inc. has operating income (EBIT) of $2,250,000. the company’s depreciation expense
is $450,000, its interest expense is $120,000, and it faces a 40 percent tax rate.
1. What is the company’s net income
a. $1,008,000
b. $1,278,000
c. $1,475,000
d. $1,728,000
e. $1.800,000
c. $1,475,000
d. $1,728,000
e. $1.800,000
c. $1,475,000
d. $1,728,000
e. $1.800,000
2. What is its net cash flow?
a. $1,008,000
b. $1,278,000
3. What is its operating cash flow?
a. $1,008,000
b. $1,278,000
(The following data apply to the next two problems)
GPD Corporation has operating income (EBIT) of $300,000, total assets of $1,500,000, and
its capital structure consists of 40 percent debt and 60 percent equity. Total assets were equal
to total operating capital. The firm’s after tax cot of capital is 10.5 percent and its tax rate is
40 percent. The firm has 50,000 shares of common stock currently outstanding and the
current price of a share of stock is $27.00.
4. What is the firm’s market Value Added (MVA)?
a. $22,500
b. $87,575
c. $187,740
d. $450,000
e. $575,000
5. What is the firm’s Economic Value Added (EVA)?
a. $22,500
b. $87,575
c. $187,740
d. $450,000
e. $575,000
6. A firm purchases $10 million of corporate bonds that paid a 16 percent interest rate, or
$1.6 million in interest. If the firm’s marginal tax rate is 35 percent, what is the after tax
interest yield?
7. Refer to problem 6. the firm also invests in the common stock of another company having
a 16 percent before-tax dividend yield. What is the after-tax dividend yield?
8. The Carter Company’s taxable income and income tax payments are shown below for
1997 through 2000:
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Assume that Carter’s tax rate for all 4
Year
Taxable income Tax payment
1997
$10,000
$1,500
years was a flat 15 percent. In 2001, Carter
1998
5,000
750
incurred a loss of $17,000. Using corporate
1999
12,000
1,800
loss carrying back (2 years), what is
2000
8,000
1,200
Carter’s adjusted tax payment for 2000?
a. $850
b. $750
c. $610
d. $550
e. $450.
9. A firm can undertake a new project that will generate a before-tax return of 20 percent or
it can invest the same funds in the preferred stock of another company that yields 13
percent before taxes. If the only consideration is which alternative provides the highest
relevant (after-tax) return and the applicable tax rate is 35 percent, should the firm invest
in the preferred stock?
a. Preferred stock; its relevant return is 12 percent.
b. Project; its relative return is 1.36 percentage points higher.
c. Preferred stock; its relevant return is 0.22 percentage points higher.
d. Project; its after-tax return is 20 percent.
e. Either alternative can be chosen; they have the same relevant return.
10. Cooley Corporation has $20,000 that it plans to invest in marketable securities. It is
choosing between MCI bonds that yield 10 percent, state of Colorado municipal bonds
that yield 7 percent, and MCI preferred stock with a dividend yield of 8 percent. Cooley
corporate tax rate is 25 percent, and 70 percent of its dividends received are tax exempt.
What is the after-tax rate of return on the highest yielding security?
a. 7.4%
b.7.0%
c. 7.5%
d. 6.5%
e. 6.0%
Answers for questions(Financing Statement, Cash Flow, and Taxes )
1. earnings per share
2. liquidity 3. common stock; retained earning. 4. operating asset
5. operating; long-term investing; financing 6. Statement of Retained Earning. 7. cash
flow 8. operating assets 9. operating working capital
free cash flow
10. total operating capital
11.
12. Economic Value Added (EVA) 13. progressive 14. one year
15.
ordinary 30 16. double S
17. b. Debt financing is encouraged by the fact that interest payments are tax deductible while
dividends are not.
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18. d. The S corporation limits the liability of the individual, but permits losses to be
deducted against personal income.
19. Statement a is incorrect. To avoid double taxation, stockholders would preferred that
corporations retain more of its earnings because longer-term capital gains are taxed at 20
percent. Statement c is incorrect. Debt financing has been encouraged by the fact that interest
on debt is tax deductible. Statement d is incorrect. Currently, interest on debt is fully tax
deductible; allowing 50 percent of interest to be tax deductible would discourage debt
financing.
Answers for Problems (Financing Statement, Cash Flow, and Taxes )
1. b. EBIT
$2,250,000
Interest
___120,000
EBT
$2,130,000
Taxes(40%)
___852,000
Net Income
$1,278,000
2. Net cash flow = net income + Depreciation = $1,278,000 +$450,000
3. Operating cash flow =EBIT(1-T) + Depreciation=$2,250,000(0.6)+$450,000= $1,800,000
4. Market Value Added = (Share outstanding)(P0) – Total common equity
= 50,000($27.00) – (0.6)($1,500,000)
= $450,000
5. a. Economic Value Added = EBIT(1-T)-(Operating Capital)(After tax percentage cost)
= $300,000(0.6)-($1,500,000)(0.105)
= $22,500
6. c. AT = 16%(1-0.35) =10.40%.
7. e. AT = BT (1- Effective T) =16%[1-0.35(0.30)] = 14.32%.
8. e.
Year
Taxable income Tax payment
The carrying-back can only go back 2
1997
$10,000
$1,500
years. Thus, there were no adjustments
1998
5,000
750
made in 1997 and 1998. after a $12,000
1999
0
0
adjustment in 1999, there was still a
2000
3,000
450
$5,000 loss remaining to apply to 2000.
the 2000 adjusted tax payment is
$3,000(0.15)=$450. Thus, Carter received a total of $2,550 in tax refunds after the
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adjustment.
9. b. The project is fully taxable; thus its after-tax return is as follows:
ATproj.= 20%(1-0.35) = 13%.
For the preferred stock
ATpref. = 13%[1-0.35(0.30)] = 11.64%.
Therefore, the new project should be chosen since its after-tax return is 1.36 percentage
points higher.
10. c. ATColorado= 7%.
ATMCI bond = 10% -10%(0.25) = 7.5%.
ATMCI pref. = 8% -0.3(8%)(0.25) = 7.4%.
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