T2.1 Chapter Outline
Chapter 9-10
Financial Statements, Taxes, and Cash Flow
Chapter Organization
 2.1 The Balance Sheet
 2.2 The Income Statement
 2.3 Taxes
 2.4 Cash Flow
 2.5 Summary and Conclusions
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T2.2 The Balance Sheet (Figure 2.1)
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T2.3 GAAP versus Cash Flow Time Line
Revenue
recognized
and
matched
expenses
Sale of goods
on credit
Time
Pay
Payroll
forchecks utilities
raw goods
issued
Pay
accounts
Cash flow
Cash flow
Cash flow
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Collect
receivable
Cash flow
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T2.4 Corporate Tax Rates
Key issues:


What are corporate tax rates?
What is an average rate? A marginal rate?
A. Corporate tax brackets under the 1993 Omnibus Budget Reconciliation Act
Taxable Income
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Marginal Rates
$0 - 50,000
15%
50,001 - 75,000
25%
75,001 - 100,000
34%
100,001 - 335,000
39%
335,001 - 10,000,000
34%
10,000,001 - 15,000,000
35%
15,000,001 - 18,333,333
38%
18,333,334 +
35%
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T2.5 Marginal versus Average Corporate Tax Rates
 What are marginal corporate tax rates?
 What are average corporate tax rates at the top of each bracket?
Marginal and average tax rates under the 1993 Omnibus Budget
Reconciliation Act
Taxable Income
Rates
Marginal Tax
Cumulative Average Tax
Tax Liability
Rates
$0 - 50,000
15%
$7,500
15.00%
50,001 - 75,000
25%
13,750
18.33%
75,001 - 100,000
34%
22,250
22.25%
100,001 - 335,000
39%
113,900
34.00%
335,001 - 10 mil
34%
3.4 mil
34.00%
10 mil - 15 mil
35%
5,150,000
34.33%
15 mil - 18.33 mil
38%
6,416,667
35.00%
18.33 mil +
35%
N/A
35.00%
Notice that, while marginal rates fluctuate and rise as high as 39%, average rates increase
steadily with taxable income, until the 35% level is reached.
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T2.6 Cash Flow Example
Balance Sheet
Beg
End
Beg
End
$100
$150
A/P
$100
$150
A/R
200
250
N/P
200
200
Inv
300
300
C/L
300
350
C/A
$600
$700
LTD
$400
$420
NFA
400
500
C/S
50
60
R/E
250
370
$300
$430
$1000
$1200
Cash
Total
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$1000
$1200
Total
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T2.6 Cash Flow Example (continued)
Income Statement
Sales
$2000
Costs
1400
Depreciation
100
EBIT
500
Interest
100
Taxable Income
400
Taxes
200
Net Income
Dividends
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Addition to R/E
$200
$_____
_____
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T2.6 Cash Flow Example (continued)
Income Statement
Sales
$2000
Costs
1400
Depreciation
100
EBIT
500
Interest
100
Taxable Income
400
Taxes
200
Net Income
Dividends
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Addition to R/E
$200
80
$120
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T2.6 Cash Flow Example (concluded)
A.
Cash flow from assets
1.
Operating cash flow
=
=
=
EBIT + _____________ – Taxes
$500 + 100 – 200
$_____
2.
Change in NWC
=
=
=
___________ – ___________
$350 – $_____
$_____
3.
Net capital spending
=
=
=
$_____ + Dep – _____
$500 + 100 – 400
$_____
4.
Cash flow from assets
=
=
=
OCF – chg. NWC – Cap. sp.
$400 – 50 – 200
$150
B.
Cash flow to creditors and stockholders
1.
Cash flow to creditors
=
=
=
Int. paid – _________________
$100 – 20
$80
2.
Cash flow to stockholders
=
=
=
Div. paid – ________________
$80 – 10
$70
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Check: $___ from assets = $___ to Bondholders + $___ to Stockholders
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T2.6 Cash Flow Example (concluded)
A.
Cash flow from assets
1.
Operating cash flow
=
=
=
EBIT + Depreciation – Taxes
$500 + 100 – 200
$400
2.
Change in NWC
=
=
=
Ending NWC – Beginning NWC
$350 – 300
$50
3.
Net capital spending
=
=
=
Ending NFA + Dep – Beginning NFA
$500 + 100 – 400
$200
4.
Cash flow from assets
= OCF – chg. NWC – Cap. sp.
= $400 – 50 – 200
= $150
B.
Cash flow to creditors and stockholders
1.
Cash flow to creditors
=
=
=
Int. paid – Net new Borrowing
$100 – 20
$80
2.
Cash flow to stockholders
=
=
=
Div. paid – Net new Equity
$80 – 10
$70
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Check: $150 from assets = $80 to bondholders + $70 to stockholders
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T2.7 Cash Flow Summary


I. The cash flow identity
Cash flow from assets
=
Cash flow to creditors (bondholders)
+ Cash flow to stockholders (owners)
II. Cash flow from assets
Cash flow from assets
=
Operating cash flow
– Net capital spending
– Additions to net working capital (NWC)
where
Operating cash flow
=
Net capital spending
=
Change in NWC
=
Earnings before interest and taxes (EBIT)
+ Depreciation – Taxes
Ending net fixed assets – Beginning net fixed assets
+ Depreciation
Ending NWC – Beginning NWC

III. Cash flow to creditors
Cash flow to creditors = Interest paid – Net new borrowing

IV. Cash flow to stockholders
Cash flow to stockholders = Dividends paid – Net new equity raised
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T2.8 Hermetic, Inc. Balance Sheet
as of December 31
($ in thousands)
Assets
1998
1999
Current assets
Cash
45
$
50
Accounts receivable
260
310
Inventory
320
385
Total
$ 625
$ 745
985
1100
$1610
$1845
Fixed assets
Net plant and equipment
Total assets
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$
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T2.8 Hermetic, Inc. Balance Sheet (concluded)
Liabilities and equity
1998
1999
$ 210
110
$ 320
$ 260
175
$ 435
205
225
Stockholders’ equity
Common stock and
paid-in surplus
Retained earnings
Total
290
795
$1085
290
895
$1185
Total liabilities and equity
$1610
$1845
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
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T2.9 Hermetic, Inc. Income Statement
($ in thousands)
Net sales
Cost of goods sold
Depreciation
Earnings before interest
and taxes
Interest
Taxable income
Taxes
Net income
Dividends
Addition to retained earnings
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$710.00
480.00
30.00
$200.00
20.00
180.00
53.45
$126.55
26.55
$100.00
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T2.10 Hermetic, Inc. Cash Flow from Assets
Cash flow from assets:
 Operating cash flow:
EBIT
+ Depreciation
– Taxes


Change in net working capital:
Ending net working capital
– Beginning net working capital
Net capital spending:
Ending net fixed assets
– Beginning net fixed assets
+ Depreciation
Cash flow from assets:
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$
200.00
+ 30.00
– 53.45
$ 176.55
$
310.00
– 305.00
$
5.00
$ 1,100.00
– 985.00
+ 30.00
$ 145.00
$
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T2.10 Hermetic, Inc. Cash Flow from Assets (concluded)
Total cash flow to creditors and stockholders:

Cash flow to creditors:
Interest paid
$
– Net new borrowing

– 20.00
$
0.00
$
26.55
Cash flow to stockholders:
Dividends paid
– Net new equity raised
Cash flow to creditors and stockholders
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2000
20.00
0.00
$
26.55
$
26.55
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T2.11 Chapter 2 Quick Quiz
The taxable income of LaRussa Corp. is $1,000,000. Calculate LaRussa’s (a)
dollar tax liability, (b) average tax rate, and (c) marginal tax rate.
(a) Dollar tax liability =
.15(_______) + .25(_______) + .34(_______)
+ .39(________) + .34(________) = $340,000
(b) Average tax rate = ________/__________ = ___
(c) Marginal tax rate = ___
Why should financial decision-makers be concerned about the firm’s marginal
rate? Its average rate?
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T2.11 Chapter 2 Quick Quiz
The taxable income of LaRussa Corp. is $1,000,000. Calculate LaRussa’s (a) dollar
tax liability, (b) average tax rate, and (c) marginal tax rate.
(a) Dollar tax liability =
.15($50,000) + .25($25,000) + .34($25,000)
+ .39($235,000) + .34($665,000) = $340,000
(b) Average tax rate = $340,000/$1,000,000 = 34%
(c) Marginal tax rate = 34%
Why should financial decision-makers be concerned about the firm’s marginal rate?
Its average rate?
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T2.12 Solution to Problem 2.6
The Hankey Co. had $145,000 in 1999 taxable income. Using the rates
from Table 2.3, calculate the company’s 1999 income taxes.
Taxable Income
Marginal Tax
Rates
$0 - 50,000
15%
50,001 - 75,000
25%
75,001 - 100,000
34%
100,001 - 335,000
39%
335,001 - 10,000,000
34%
10,000,001 - 15,000,000
35%
15,000,001 - 18,333,333
38%
18,333,333 +
35%
Tax = .15(_____) + .25(_____) + .34(_____) + .39(_____)
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T2.12 Solution to Problem 2.6
The Hankey Co. had $145,000 in 1999 taxable income. Using the rates
from Table 2.3, calculate the company’s 1999 income taxes.
Taxable Income
Marginal Tax
Rates
$0 - 50,000
15%
50,001 - 75,000
25%
75,001 - 100,000
34%
100,001 - 335,000
39%
335,001 - 10,000,000
34%
10,000,001 - 15,000,000
35%
15,000,001 - 18,333,333
38%
18,333,333 +
35%
Tax = .15(50,000) + .25(25,000) + .34(25,000) + .39(45,000) = $39,800
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T2.13 Solution to Problem 2.11
 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed
long-term debt of $2 million, and the December 31, 1999 balance
sheet showed long-term debt of $2.9 million. The 1999 income
statement showed interest expense of $700,000. What was cash
flow to creditors during 1999?
Cash flow to creditors = Interest paid – Net new borrowing

Interest paid = $700,000

Net new borrowing
Cash flow to creditors
= $_______ – 2 million = $_______
= $700,000 – (_______)
= _______
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T2.13 Solution to Problem 2.11
 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed
long-term debt of $2 million, and the December 31, 1999 balance
sheet showed long-term debt of $2.9 million. The 1999 income
statement showed interest expense of $700,000. What was cash
flow to creditors during 1999?
Cash flow to creditors = Interest paid – Net new borrowing

Interest paid = $700,000

Net new borrowing
Cash flow to creditors
= $2.9 million – 2 million = $900K
= $700,000 – 900,000
= –$200,000
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T2.14 Solution to Problem 2.12
 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed $500,000 in
the common stock account, and $6.6 million in the additional paid-in surplus
account. The December 31, 1999 balance sheet showed $550,000 and $7.0
million in the same two accounts. If the company paid out $300,000 in cash
dividends during 1999, what was the cash flow to stockholders for the year?
Cash flow to stockholders = Dividends paid – Net new equity
 Dividends paid = ________
 Net new equity = (________+________) – ________ + ________)
Cash flow to stockholders
 = ________– ________
 = ________
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T2.14 Solution to Problem 2.12
 The December 31, 1998 balance sheet Pearl Jelly, Inc. showed $500,000 in
the common stock account, and $6.6 million in the additional paid-in surplus
account. The December 31, 1999 balance sheet showed $550,000 and $7.0
million in the same two accounts. If the company paid out $300,000 in cash
dividends during 1999, what was the cash flow to stockholders for the year?
Cash flow to stockholders = Dividends paid – Net new equity
 Dividends paid = $300,000
 Net new equity = ($550,000 + 7m) – ($500,000 + 6.6m) = $450,000
Cash flow to stockholders
 = $300,000 – 450,000
 = –$150,000
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T2.15 Solution to Problem 2.13
 Given the information for Pearl Jelly, Inc. in problems 11 and 12, suppose you also
know that the firm’s net capital spending during 1999 was $500,000, and that the
firm reduced its net working capital investment by $135,000. What was the firm’s
1999 operating cash flow, or OCF?
Cash flow from assets (CFA) =
Cash flow to creditors + Cash flow to stockholders
Cash flow to creditors = – $200,000
Cash flow to stockholders = –$150,000
So, Cash flow from assets = –$200K + (–)150,000K = –$350K.
And,
CFA = OCF - chg. in NWC – capital spending
Solving for OCF:
 OCF = CFA + chg. in NWC + capital spending
 OCF = _______ + _______+ _______
 OCF = $ _______
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T2.15 Solution to Problem 2.13
 Given the information for Pearl Jelly, Inc. in problems 11 and 12, suppose you also
know that the firm’s net capital spending during 1999 was $500,000, and that the
firm reduced its net working capital investment by $135,000. What was the firm’s
1999 operating cash flow, or OCF?
Cash flow from assets (CFA) =
Cash flow to creditors + Cash flow to stockholders
Cash flow to creditors = – $200,000
Cash flow to stockholders = –$150,000
So, cash flow from assets = –$200K + (–)150,000K = –$350K.
And,
CFA = OCF – Chg. in NWC – Capital spending
Solving for OCF:
 OCF = CFA + Chg. in NWC + Capital spending
 OCF = –$350K + (– 135,000) + 500,000
 OCF = $15,000
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