Chapter 3 & Web Appendix 3AChapter 3 & Web Appendix 3A

Financial Statements, Cash Flows, and Taxes

Topic Overview

Key Financial Statements (See Best Buy Spreadsheet for Example) Balance sheet Income statements Statement of retained earnings Statement of cash flows

Accounting Income vs. Cash Flow Statement of Cash Flows Individual and Corporate Income Taxes

The annual report

Balance sheet – provides a snapshot of a firm’s financial position at one point in time. (Please review section 3.3)

Income statement – summarizes a firm’s revenues and expenses over a given period of time. (Please review section 3.4)

Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends. (Please review section 3.7)

Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

Homer & Son Balance Sheet: Assets

2006 2005 2006-2005

Assets

Current Assets

900 800 100

Net Fixed Assets

1500 1300 200

Total Assets

2400 2100

Homer & Son Balance Sheet: Liabilities

Liabilities 2006 2005 2006-2005

Acct Pay 450 350 100

Accruals 200 150 50

Notes Payable

150 150

Total CL 800 650

Long-term Debt

600 600

Total Liab 1400 1250

Homer & Son Balance Sheet: Equity and Total Liabilities and Equity

2006 2005

Total Liab 1400 1250

Common Stock

700 700

Retained Earnings

300 150

Total Equity 1000 850

Total Liab & Equity

2400 2100

2006 Homer & Son Income Statement

Sales 3000

Cost of good sold 1800

Gross Profit 1200

SGA Expense 720

Depreciation 100

Operating Inc. 380

Interest Exp 80

EBT 300

Taxes (40%) 120

Net Income 180

Some Balance Sheet Comments

Net Working Capital = Current Assets – Current Liabilities

Assets (particularly Long-term) and Equity on Balance Sheet are Book (or historical-based) Values.

Market Value of Assets and Equity (# of shares x market price/share) can be vastly different for a given firm. For Best Buy: 2/25/2006 Book Value of Equity

= $5.247 billion, 2/25/2006 Market Value= $26.6 billion

Accounting Income vs. Cash Flow

An Income Statement

Sales Cost of Goods Sold Selling & Gen. Adm.

Exp Depreciation Interest Exp Taxable Income Taxes Net Income

Do all items reflect all cash collected and paid?

NO!!! Income statement is on an accrued basis.

What is and who is depreciation?

Net Cash Flow or Simple Income Net Cash Flow or Simple Income Statement Cash FlowStatement Cash Flow

If all other revenues and expenses are in cash or non-cash revenues and expenses net to zero, then

Net Cash Flow(NCF) = Net Income + Depreciation(& Amortization)

2006 Homer & Son, Depreciation = 100; Net Income = 180

NCF = 180 + 100 = 280 Otherwise, Net Cash Flow = Cash

Revenues - Cash Expenses

Statement of Cash Flows

Shows how the firm used and raised cash during the year.

Reconciles the Income Statement by the changes in the Balance Sheet from the beginning of the year to the end of the year

Statement of Cash Flows: General Concepts

Overall: Inflows(or sources) of cash are net

income, depreciation, decreases in assets, and increases in liabilities

Outflows(or uses) of cash are increases in assets, decreases in liabilities, and dividends

Parts of Statement of Cash Flows

Operating Cash Flow = net cash income from income statement: net income, Depreciation,change in A/R, Inv, Other CA, A/P, Accruals (Wages & Taxes), Other CL

Investing Cash Flow = Purchases and Sales of long-term real assets and investments (Marketable Securities)

Financing Cash Flow = issuances and payments of debt and stock: L-T Debt, Common and Preferred Stock, Notes Payable & Dividends Paid

Best Buy Statement of Cash Flow Information (millions$)

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2006 2005 2004

OperatingInvestingFinancingChange in Cash

Using Accounting Data to Measure Other Cash Flows for Investors

Operating Cash Flow = total cash available for new asset investment, and for debt & equity investors.

Free Cash Flow = cash available for debt & equity investors. This measure is often use to value a firm.

Operating Cash Flow (OCF)

OCF = Net Operating Profit After Taxes (NOPAT) + Depreciation & Amortization NOPAT = Earnings Before Interest &

Taxes (EBIT) x (1 – Tax Rate) OCF = EBIT(1 – tax rate) +

Depreciation & Amortization

What is Homer & Son’s 2006 Operating Cash Flow?

Free Cash Flow (FCF)

FCF = Operating Cash Flow (OCF) – Investment in Operating Capital Investment in Operating Capital =

Increase in Gross Fixed Assets (Capital Expenditures) + Increase in Net Operating Working Capital

Increase in Gross Fixed Assets = Increase in Net Fixed Assets + Depreciation

Increase in Net Operating Working Capital = Increase in Current Assets – Increase in non-interest bearing current liabilities

Alternate FCF Definition

This definition is not developed or presented in the chapter itself but is used in some of the problem solutions.

The term Investment in Net Operating Capital is created which is Increase in Net Fixed Assets + Increase in Net Operation Working Capital.

Since depreciation is deducted in the Net Operating Capital term it must be deducted from the OCF term.

FCF = NOPAT – Investment in Net Operating Capital

What is Homer & Son’s 2006 Free Cash Flow?

INCOME TAXES

2006 Single Individual Tax RatesNote: Appendix 3A provides 2004 brackets.

Taxable Income Tax on Base Rate*

0 – 7,550 0 10%7,550 - 30,650 755.00 15%30,650 - 74,200 4,220.00 25%74,200 - 154,800 15,107.50 28%154,800 - 336,550Over 336,550

37,675.5097.653.00

33%35%

*Plus this percentage on the amount over the bracket base.

O

Personal Income Taxes

Marginal tax rate = the tax rate on the next dollar of income.

Wages, tips, and interest income are considered ordinary taxable income.

Deductions: charitable donations, mortgage interest, a portion of student loan interest, personal exemptions, and medical expenses to an extent(> 7.5% of gross income).

Personal Investment Taxes

Interest Income taxed at individual’s marginal tax rate.

Dividend Income tax rate: 15% or less Financial and Real assets held for less than

12 MONTHS and then sold for a gain are considered short-term capital gains and taxed at the taxpayer’s marginal tax rate.

Long-term (held more than 12 months) capital gains are taxed at a max rate of 15%.

Corporate Income Taxes

Corporate deductions from income: operating expenses, depreciation, interest expense.

Dividends paid are NOT deductible. Interest and capital gain income is fully

taxable. 30% (in general) of Dividend income is

taxable. Losses can be carried back 2 years and

carried forward up to 20 years

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.

... ... ...

Assume a corporation has Assume a corporation has $100,000 of taxable income $100,000 of taxable income from operations, $5,000 of from operations, $5,000 of

interest income, and $10,000 of interest income, and $10,000 of dividend income.dividend income.

What’s its tax liability?

State and local government bonds (munis) are generally exempt from federal taxes.

Taxable vs.Taxable vs.Tax Exempt BondsTax Exempt Bonds

After-tax Investment Returns

After-tax Return=Before-tax Return(1-T) After-tax Corporate Dividend Return =

Before-tax Dividend Yield (1 - .3T) Municipal Bond Interest is tax exempt on the

federal level Equivalent pretax return

= Muni Return/(1-T)

Which of the following would you prefer if your marginal tax rate is 28%?

Exxon bonds at 10% or California municipal bonds at 7%.

At what marginal tax rate would you be indifferent be these two bonds?

After-Tax Return Example