T2.1 Chapter Outline
Chapter 2
Financial Statements, Taxes, and Cash Flow
Chapter Organization
 2.1 The Balance Sheet
 2.2 The Income Statement
 2.3 Cash Flow
 2.4 Taxes
 2.5 Capital Cost Allowance
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T2.2 The Balance Sheet (Figure 2.1)
T2.2 The Balance Sheet
 Components



Assets
Current: Will convert to cash within
12 month
Long-Term: Capital assets (tangible:
machinery, Intangible: patent)
Liabilities:
Current: Life less than a year
Long-Term: Bonds
Owners’ Equity: Residual value of the
firm
T2.2 The Balance Sheet
 Key concepts of a balance sheet


Liquidity: Ease with which an asset can
be converted to cash. Most
liquid assets are listed first
Net Working Capital (NWC)
• Current Assets minus Current
Liabilities.
NWC>0: Cash that will be
received in the next 12 month
is greater than what has to be
paid during that period. Sign of
a healthy firm.
 Debt vs Equity
= Assets – Liabilities
 Financial Leverage: debt act as a lever, it
magnifies both losses and gains.
 Equity
 Market vs Book Value
 Assets
entered at historical costs
 Inventory, fixed assets, equity
T2.6 Cash Flow Summary (cont’d)

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 = Earnings before interest and taxes (EBIT)
+ Depreciation – Taxes
Net capital spending
= Ending net fixed assets –
Beginning net fixed assets
+ Depreciation
Change in NWC
= 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
T2.7 Taxes
Key issues:
 What is an average tax rate?
 What is a marginal tax rate?
 Why do we pay attention to marginal tax
rates?
 What are corporate tax rates?
 What are individual tax rates?
 How does the difference between
corporate and individual tax rates affect
corporate finance?
Ideal Tax system
An ideal tax system has three features:
The tax burden is equitably distributed
among tax payers
Distortions are minimal
Easy to administer
Q: What is a distortion?
T2.7 Federal Individual Tax Rates (2001)
Taxable Income
$
1
Tax
0
+ .16×Income
30,754
4,921 + .22×(Income – 30,754)
61,509
11,687 + .26×(Income – 61,509)
100,000
21,687 + .29×(Income – 61,509)
T2.7 Ontario Tax Rates (2002)
Taxable Income
$0 – 31,892
31,892 – 63,786
>63,786
Tax Rate
.0605×Income
1,930 + .0915 ×(Income – 31,892)
4,848 + .1116 ×(Income – 63,786)
Average vs Marginal Tax Rate
 Consider and individual with an income of
$70,000.
 Marginal tax rate is the tax paid on the next
dollar earned, i.e. 0.26 + 0.1116 = 37.16%
(Ontario taxes, excluding surtaxes)
 Average tax rate is
total taxes paid ÷ income
 Average tax rate < marginal tax rate
T2.7 Tax Rates (2002)
Tax rates for top bracket incomes (>$100,000), including
surtaxes
Ordinary income (wages, salary, unincorporated income,
interest income): 46.41%
Capital gains: 50% of income tax  23.20%
Canadian dividends: 31.34%
1.25 × (fed tax rate - .1333) + (prov tax rate) + surtaxes
T2.8 Example
Marginal Tax Rate
Dividends
Gross up at 25%
Grossed up dividends
Federal Tax on dividends
16%
22%
26%
$1,000
$1,000
$1,000
250
250
250
1250
1250
1250
200
275
325
Less Dividend Tax Credit
(13.333% x $1,250)
(166.67)
(166.67) (166.67)
Federal Tax Payable
33.33
108.33
158.33
Provincial Tax: applied on $1,000
60.50
91.50
111.60
Total Tax
93.83
199.83
269.93
Effective Combined Tax Rates
9.4%
20%
27%
T2.9 Corporate Tax Rates (2002)
FEDERAL
ONTARIO
COMBINED
Basic Corporations
25%
12.5%
38.62%
Manufacturing and
21
11.0
33.12
12
6.0
19.12
Processing
All Small Corporations
(Taxable Income below
$200 thousand)
Capital Gains, Carry-Forward and Carry-Back
 Asset sold at a price higher (lower) than
purchase price
= capital gain (loss) for the firm
 Capital gains taxed at 50% of marginal tax
rate
 Capital losses can be carried
back over the three preceding years;
forward for up to seven years
 Carry-back and carry forward features
reduces previous and future taxable capital
gains
 Capital Cost Allowance (CCA)
Depreciation for tax purposes in Canada
 CCA may not be the same as depreciation
under GAAP
 Income actually taxed may be lower than
taxable income under GAAP if CCA rate is
higher than depreciation rate for GAAP
reporting
Class Rate
Assets
1
4%
Buildings acquired after 1987
8
20%
Furniture, photocopiers
10
30%
Vans, trucks, tractors
and computer equipment
13 Straight-line Leasehold improvements
16
40%
Taxicabs and rental cars
22
50%
Pollution control equipment
43
30%
Manufacturing equipment
 Incentive behind CCA: lower taxes increase
cash flow
 Half-year rule: Only half of the asset value
can be used for CCA purposes in the first
year.
 Measure to discourage business owners to
purchase significant capital assets on the
last day of the taxation year.
T2.11
CCA Example
Depreciation on $22,000 Photocopier (CCA Class 8)
Year
UCC t
CCA
UCC t+1
1
11,000
2,200
$19,800
2
19,800
3,960
15,840
3
15,840
3,168
12,672
4
12,672
2,534
10,138
5
10,138
2,028
8,110
6
8,110
1,622
6,488
 UCC: undepreciated capital cost
Asset Purchases and Sales
 When an asset is sold, UCC in its class is reduced
by the sales proceeds or original cost, whichever
is less
 adjusted cost of disposal
 Example: photocopier sold for $12,000 at the end
of the fourth year: UCC = $10,138
 asset pool is reduced by $12,000
 If photocopier is sold for $9,000 at the end of the
fourth year
 asset pool is reduced by $9,000 and $1,138
depreciates forever
 When a pool is terminated, the sale of asset
creates a terminal loss or terminal gain
 Terminal gain: proceeds from sale greater
than UCC, the difference is added to income
and taxed; CCA is recaptured
 Terminal loss: proceeds from sale smaller
than UCC, the difference is deducted from
income; tax savings
Example of a terminal loss
 An import-export business decided to sell
its warehouse, because it is better to lease
instead. The business received $30,000 for
the warehouse. The business had then no
more assets this class.
UCC = $35,000
Warehouse sold for $30,000
Terminal loss = $5,000, which can be
deducted from the business income
Example of a Terminal Gain
 A clothing company bought a sewing
machine in 1999 for $10,000. The company
has decided to concentrate solely on
retailing. The sewing machine was sold in
2001 for $12,000.
UCC = $9,500
Capital gain = $2,000, taxed at 50% of
marginal tax rate
$10,000 - $9,500 = $500 is the terminal
gain, which will be added to income
and taxed as income
 A pool need not be terminated to have a recapture
CCA.
 There is a recapture of CCA whenever
Net sales of assets in a pool outweighs
the UCC of the pool
 Ex: UCC of pool of assets of class 10 (cars, etc) is
$10,000 total.
A luxury car, with original cost $50,000, is sold
for $70,000.
Capital gain: $20,000
Adjusted cost of disposal, $50,000, is greater
than $10,000
Recaptured CCA = $50,000 - $10,000 = $40,000
 A terminal gain is not a capital gain
 There need not be a capital gain to have a
terminal gain