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Document Type: Book Chapter

Title of Book: Financial Management Theory and Practice (16th Edition)

Author(s) of Book: Eugene F. Brigham, Michael C. Ehrhardt

Chapter Title: Chapter 2 Financial Statements, Cash Flow, and Taxes

Author(s) of Chapter: Eugene F. Brigham, Michael C. Ehrhardt

Year: 2020

Publisher: Cengage Learning

Place of Publishing: the United States of America

The copyright law of the United States (Title 17, United States Code) governs the making of photocopies or other reproductions of copyrighted materials. Under certain conditions specifies in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these conditions is that the photocopy or reproduction is not to be used for any purpose other than private study, scholarship, or research. If a user makes a request for, or later uses, a photocopy or reproduction for purposes in excess of fair use, that user may be liable for copyright infringement.

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Financial Statements, Cash Flow, and Taxes

Apple generated an operating cash flow of almost $64 billion in 2017! The ability to

generate cash flow is the lifeblood of a company and the basis for its fundamental

value. How did Apple use this cash flow? It returned over $46 billion to stockholders by

paying $13 billion in dividends and by repurchasing $33 billion of its own stock.

Many other companies also reported large cash flows, but they used the money

differently. For example, Google generated over $36 billion but returned relatively

little to stockholders, paying no dividends and repurchasing only $4 billion of its

stock. Instead, Google spent $10 billion on capital expenditures (mostly technology

infrastructure). Google also put about $18 billion into short-term investments (such as

Treasury securities), saving for a rainy day.

These well-managed companies used their operating cash flows in different ways,

including capital expenditures, acquisitions, dividend payments, stock repurchases,

and saving for future needs. Which company made the right choices? Only time will tell,

but keep these companies and their different cash flow strategies in mind as you read

this chapter.

56 Part 1 The Company and Its Environment

Intrinsic Value, Free Cash Flow, and Financial Statements

In Chapter 1, we told you that managers should strive to make their weighted average cost of capital (WACC). This chapter focuses on

firms more valuable and that a firm's intrinsic value is determined FCF, including its calculation from financial statements and its in-

by the present value of its free cash flows (FCFs) discounted at the terpretation when evaluating a company and manager.

The textbook's Web site

contains on Excel file that

will guide you through the chapter's calculations.

The file for this chapter is Ch02 Tool Kit.xlsx, and

we encourage you to open

the file and follow along

as you read the chapter.

WWW

See the Securities and

Exchange Commission's

(SEC) Web site for

quarterly reports and

more detailed annual reports that provide

breakdowns for each

major division or

subsidiary. These reports, called 10-Q and 10-K

reports, ore available

on the SEC's Web site at www.sec.gov under the

heading •EDGAR.• Once

there, you con search by

stock ticker symbol.

Sales revenues

- Operating costs and taxes

•

Required investments in operating capital

Free cash flow (FCF)

K� K� K� Value=-----+-----+···+-----

(1 + WACC)1 (1 + WACC)2 (1 + WACC) "'

Market Interest rates

Market risk aversion

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Finn's debt/equity mix

Finn's business risk

The stream of cash flows a firm is expected to generate in the future determines its fun damental value (also called intrinsic value). But how does an investor go about estimating future cash flows, and how does a manager decide which actions are most likely to in crease cash flows? The first step is to understand the financial statements that publicly traded firms must provide to the public. Thus, we begin with a discussion of financial statements, including how to interpret them and how to use them. Value depends on after tax cash flows, so we provide an overview of the federal income tax system and highlight differences between accounting income and cash flow.

2-1 Financial Statements and Reports A company's annual report usually begins with the chairperson's description of the firm's op erating results during the past year and a discussion of new developments that will affect future operations. The annual report also presents four basic financial statements-the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows.

The quantitative and qualitative written materials are equally important. The finan cial statements report what has actually happened to assets, earnings, dividends, and cash flows during the past few years, whereas the written materials attempt to explain why things turned out the way they did.

SELF -TEST

What is the annual report, and what two types of information does it present?

Whot four types of financial statements does the annual report typically include?

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�SPJJrce

See Ch02 Tool Kit.xlsx for

details.

Chapter 2 Financial Statements, Cash Flow, and Taxes

2-2 The Balance Sheet

For illustrative purposes, we use a hypothetical company, MicroDrive, Inc., which pro duces memory components for computers and smartphones. Figure 2-1 shows Micro Drive's most recent balance sheets, which represent "snapshots" of its financial position on the last day of each year. Although most companies report their balance sheets only on the last day of a given period, the "snapshot" actually changes daily as inventories are bought and sold, as fixed assets are added or retired, or as loan balances are increased or paid down. Moreover, a retailer will have larger inventories before Christmas than later in the spring, so balance sheets for the same company can look quite different at different times during the year. The following sections explain the accounts shown in Figure 2-1.

The balance sheet begins with assets, which are the "things" the company owns. Assets are listed in order of liquidity, or length of time it typically takes to convert them to cash at fair market values. The balance sheet also lists the claims that various groups have against the company's value; these are listed in the order in which they must be paid. For example, suppliers may have claims called accounts payable that are due within 30 days, banks may have claims called notes payable that are due within 90 days, and bondholders may have claims that are not due for 20 years or more.

Stockholders' claims represent ownership (or equity) and need never be "paid off." These are residual claims in the sense that stockholders may receive payments only if there is value remaining after other claimants have been paid. The nonstockholder claims are

FIGURE2-1

MicroDrive, Inc.: December 31 Balance Sheets (Millions of Dollars)

A B C D E F G

26 MicroDrive Inc. December 31 Balance Sheets

27 Millions of Dollars

28 Assets 2019 2018

29 Cash and equivalents $100 $102

30 Short-term investments 10 40

31 Accounts receivable 500 384

32 Inventories 1,000 774

33 Total current assets $1,610 $1,300 34 Net property, plant, and equipment (PP&E) 2,000 1,780

35 Total assets $3,610 $3,080

37 Liabilities and Equity

38 Accounts payable $200 $180

39 Notes payable 150 28

40 Accruals 400 370

41 Total current liabilities $750 $578

42 Long-term bonds 520 350

43 Total liabilities $1,270 $928

44 Preferred stock (1,000,000 shares) 100 100

45 Common stock (50,000,000 shares) 500 500

46 Retained earnings 1,740 1,552

47 Total common equity $2,240 $2,052 48 Total liabilities and equity $3,610 $3,080

Source: See the file Ch02 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated

using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values may be inexact.

58 Part 1 The Company and Its Environment

liabilities from the stockholders' perspective. The amounts shown on the balance sheets are called book values because they are based on the amounts recorded by bookkeepers when assets are purchased or liabilities are issued. As you will see throughout this text book, book values may be very different from market values, which are the current values as determined in the marketplace.

The following sections provide more information about specific asset, liability, and equity accounts.

2-2a Assets

Cash, short-term investments, accounts receivable, and inventories are listed as current as sets because MicroDrive is expected to convert them into cash within a year. All assets are stated in dollars, but only cash represents actual money that can be spent. Some marketable securities mature very soon, and these can be converted quickly into cash at prices close to their book values. Such securities are called cash equivalents and are included with cash. Therefore, MicroDrive could write checks for a total of $100 million. Other types of mar ketable securities have a longer time until maturity (but still less than a year). Their market values are less predictable, so they are not included in cash or cash equivalents.

Because it is helpful in financial analysis, MicroDrive's accountants are careful to sep arately identify the cash used in daily operations and the cash that is held for other pur poses. For example, MicroDrive continuously deposits checks from customers and writes checks to suppliers, employees, and so on. Because inflows and outflows do not coincide perfectly, MicroDrive must keep some cash in its bank account. In other words, Micro Drive must have some cash on hand to conduct operations, which is the $100 million in cash reported in Figure 2-1.

MicroDrive reports the total of any other cash, cash equivalents, and marketable securities that are not used to support operation in a separate account called short-term investments. For example, Figure 2-1 shows that MicroDrive has $10 million of short-term investments.

We will always distinguish between the cash that is used to support operations and the cash, cash equivalents, and marketable securities that are held for other purposes. However, be alert when looking at the financial statements from sources outside our book because they don't always separately identify the cash used to support operations.

When MicroDrive sells its products to customers but doesn't demand immediate payment, the customers then have obligations to make the payment, which MicroDrive reports as accounts receivable. The $500 million shown in accounts receivable is the amount of sales for which MicroDrive has not yet been paid.

Figure 2-1 reports inventories of $1,000 million, which is the amount that Micro Drive has tied up in raw materials, work-in-process, and finished goods available for sale. MicroDrive uses the FIFO (first-in, first-out) inventory accounting method to estimate production costs and the value of remaining inventory. The FIFO method assumes, for accounting purposes only, that the first items placed in inventory are the first ones used in production. In contrast, the LIFO (last-in, first-out) method assumes that the items most recently placed in inventory are the first ones used in production. (No matter which method a company chooses for accounting purposes, the company actually can use inven tory in any order it wishes.)

During an inflationary period of rising prices, older purchases of materials have lower costs than newer purchases. This means that FIFO will report lower costs of goods sold on the income statement than LIFO (because FIFO assumes that the older items are used first) but will report higher values for remaining inventory on the balance sheet. Because Micro Drive uses FIFO and because inflation has been occurring: (1) Its balance sheet inventories

(

Chapter 2 Financial Statements, Cash Flow, and Taxes 59

are higher than they would have been had it used LIFO. (2) Its cost of goods sold is lower than it would have been under LIFO. (3) Its reported profits are therefore higher. Thus, the inventory valuation method can have a significant effect on financial statements, which is important to know when comparing companies that use different methods.

Rather than treat the entire purchase price of a long-term asset (such as a factory, plant, or equipment) as an expense in the purchase year, accountants "spread" the purchase cost over the asset's useful life. The amount they charge each year is called the depreciation expense. Some companies report an amount called gross plant and equipment, which is the total cost of the long-term assets they have in place, and another amount called accu mulated depreciation, which is the total amount of depreciation that has been charged on those assets. Some companies, such as MicroDrive, report only net plant and equipment, which is gross plant and equipment less accumulated depreciation. Chapter 11 provides a more detailed explanation of depreciation methods.

2-2b Liabilities and Equity

Accounts payable, notes payable, and accruals are listed as current liabilities because MicroDrive is expected to pay them within a year. When MicroDrive purchases supplies but doesn't immediately pay for them, it takes on obligations called accounts payable. Similarly, when MicroDrive takes out a loan that must be repaid within a year, it signs an IOU called a note payable.

Most companies use the Accrual Accounting Method, which attempts to match rev enues to the periods in which they are earned and expenses to the periods in which the effort to generate income occurred. For example, companies don't pay employees' wages daily, and the amount owed on these items at any point in time usually is reported as a current liability in an account such as "Accrued Wages Payable." Most companies have more than one type of accrued liability, but we combine all such accruals into a sin gle account for MicroDrive to avoid unnecessary complexity. Section 2-5 explains how accruals affect cash flows.

Long-term bonds are also liabilities because they reflect a claim held by someone other than a stockholder. They are not reported as a current liability because the maturity date is more than one year away.

Preferred stock is a hybrid, or a cross between common stock and debt. In the event of bankruptcy, preferred stock ranks below debt but above common stock. Also, the pre ferred dividend is fixed, so preferred stockholders do not benefit if the company's earn ings grow. Most firms do not use much, if any, preferred stock, so "equity" usually means "common equity" unless the words "total" or "preferred" are included.

When a company sells shares of stock, it records the proceeds in the common stock account.1 Retained earnings are the cumulative amount of earnings that have not been paid out as dividends. The sum of common stock and retained earnings is called common equity, or just equity. If a company could actually sell its assets at their book value, and if the liabilities and preferred stock were actually worth their book values, then a company could sell its assets, pay off its liabilities and preferred stock, and the remaining cash would belong to common stockholders. Therefore, common equity is sometimes called the net worth of shareholders-it's the assets minus (or "net of') the liabilities and preferred stock.

1Companies sometimes break the total proceeds into two parts: par value and paid-in capital (or capital surplus). For example, if a company sells shares of stock for $10, it might record $1 of par and $9 of paid-in capital. For most purposes, the distinction between par and paid-in capital is not important, and most compa nies now use no-par stock.

Let's Play Hide-and-Seek!

In a shameful lapse of regulatory accountability, banks and

other financial institutions were allowed to use so-called

structured investment vehicles (SIVs) to hide assets and li

abilities and simply not report them on their balance sheets.

Here's how SIVs worked and why they subsequently failed.

The SIV was set up as a separate legal entity that the bank

owned and managed. The SIV would borrow money in the

short-term market (backed by the credit of the bank) and

then invest in long-term securities. As you might guess, many

SIVs invested in mortgage-backed securities. When the SIV

paid only 3% on its borrowings but earned 10% on its invest

ments, the managing bank was able to report fabulous earn

ings, especially if it also earned fees for creating the mort

gage-backed securities that went into the SIV.

Part 1 The Company and Its Environment

But this game of hide-and-seek didn't have a happy

ending. Mortgage-backed securities began defaulting in

2007 and 2008, causing the SIVs to pass losses through to

the banks. SunTrust, Citigroup, Bank of America, and North

ern Rock are just a few of the many banks that reported

enormous losses in the SIV game. Investors, depositors, and

the government eventually found the hidden assets and

liabilities, but by then the assets were worth a lot less than

the liabilities.

In a case of too little and too late, regulators have closed

many of these loopholes, and it doesn't look like there will be

any more hidden SIVs in the near future. But the damage has

been done, and the entire financial system was put at risk in

large part because of this high-stakes game of hide-and-seek.

SELF-TEST

What is the balance sheet, and what information does it provide?

S,Au.rce

What determines the order of the information shown on the balance sheet?

Why might a company's December 31 balance sheet differ from its June 30 balance sheet?

A firm has $8 million in total assets. It has $3 million in current liabilities, $2 million in long-term debt, and $1 million in preferred stock. What is the reported net worth of shareholders (i.e., the reported common equity)? ($2 million)

2-3 The Income Statement

See Ch02 Tool Kit.xlsx for

details.

Figure 2-2 shows the income statements and selected additional information for Micro Drive. Income statements can cover any period of time, but they are usually prepared monthly, quarterly, and annually. Unlike the balance sheet, which is a snapshot of a firm at a point in time, the income statement reflects performance during the period. The fol lowing sections explain the components of an income statement.

Net sales are the revenues less any discounts or returns. Depreciation and amortiza tion reflect the estimated costs of the assets that wear out in producing goods and services. To illustrate depreciation, suppose that in 2019 MicroDrive purchased a $100,000 machine with a life of 5 years and zero expected salvage value. This $100,000 cost is not expensed in the purchase year but is instead spread out over the machine's 5-year depreciable life.2

In straight-line depreciation, which we explain in Chapter 11, the depreciation charge for a full year would be $100,000/5 = $20,000. The reported depreciation expense on the income statement is the sum of all the assets' annual depreciation charges.

Depreciation applies to tangible assets, such as plant and equipment, whereas an amortization expense applies to intangible assets. For example, if a company acquires another company but pays more than the tangible assets, then the difference is

'Congress occasionally changes the tax laws regarding depreciation and did so again with the 2017 Tax Cut and Jobs Act. We discuss many of the TCJA's features later in this chapter. See Chapter 11 for a more detailed discussion of depreciation for tax purposes.

Chapter 2 Financial Statements, Cash Flow, and Taxes

FIGURE2-2

MicroDrive Income Statements (and Selected Additional Information) for Years Ending December 31

{Millions, Except for Per Share Data)

A B C D E F G 56 2019 2018

57 Net sales $5,000 $4,800 58 Costs of goods sold except depreciation 3,900 3,710

59 Depreciation and amortization• 200 180 60 Other operating expenses 500 470 61 Earnings before interest and taxes (EBIT) $400 $440 62 Less interest 60 40 63 Pre-tax earnings $340 $400 64 Taxes 85 100 65 Net Income before preferred dividends $255 $300 66 Preferred dividends 7 7 67 Net Income available to common stockholders $248 $293

69 Additional Information

70 Common dividends $60.0 $59.4 71 Addition to retained earnings $188.0 $233.6 72 Number of common shares 60 60 73 Stock price per share $31.00 $45.00 74

75 Per Share Data

76 Earnings per share, EPSb $4.13 $4.88

77 Dividends per share, DPS0 $1.00 $0.99

78 Book value er share, BVPSd $37.33 $34.20

Source: See the file Ch02 Tool Klt.x/sx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values may be inexact.

Notes:

'MicroDrivc has no amortization charges.

b EPS =

Net income available to common stockholders

Common shares outstanding

Dividends paid to common stockholders 'DPS=-------------

Common shares outstanding

Total common equity 4BVPS = --------

Common shares outstanding

called goodwill. 3 Other intangible assets include patents, copyrights, trademarks, and similar items. MicroDrive has no amortization charges.

The cost of goods sold (COGS) includes labor, raw materials, and other expenses directly related to the production or purchase of the items or services sold in that period. As reported in most financial statements, the COGS includes depreciation because accounting logic defines depreciation as the cost of assets wearing out by producing goods. In contrast, we report depreciation separately so that analysis later in the chapter will be more transparent.

'The accounting treatment of goodwill resulting from mergers has changed in recent years. Rather than an annual charge, companies are required to periodically evaluate the value of goodwill and reduce net income only if the goodwill's value has decreased materially ("become impaired," in the language of accountants). For example, in 2002 AOL Time Warner wrote off almost $100 billion associated with the AOL merger. It doesn't take too many $100 billion expenses to really hurt net income!

A Matter of Opinion

Investors need to be cautious when they review financial state

ments. Although companies are required to follow generally

accepted accounting principles (GAAP), managers still use a lot

of discretion in deciding how and when to report certain trans

actions. Consequently, two firms in the same operating situ

ation may report financial statements that convey different

impressions about their financial strength. Some variations

Part 1 The Company and Its Environment

may stem from legitimate differences of opinion about the cor

rect way to record transactions. In other cases, managers may

choose to report numbers in a way that helps them present ei

ther higher earnings in the current year or more stable earn

ings over time. As long as they follow GAAP, such actions are

not illegal, but these differences make it harder for investors to

compare companies and gauge their true performances.

Subtracting COGS {including depreciation) and other operating expenses results in earnings before interest and taxes (EBIT). Many analysts add back depreciation to EBIT to calculate EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Because neither depreciation nor amortization is paid in cash, some analysts claim that EBITDA is a better measure of financial strength than is net income. MicroDrive's EBITDA is:

EBITDA = EBIT + Depreciation

= $400 + $200 = $600 million

Alternatively, EBITDA's calculation can begin with sales:

EBITDA = Sales - COGS excluding depreciation - Other expenses

= $5,000 - $3,900 - $500 = $600 million

■

■ However, as we show later in the chapter, EBITDA is not as useful to managers and ana lysts as free cash flow, so we usually focus on free cash flow instead of EBITDA.

Subtracting interest expense from EBIT results in pre-tax income, which is also called earning before tax (EBT), or taxable income. The net income available to common share holders, which equals revenues less expenses, taxes, and preferred dividends (but before paying common dividends), is generally referred to as net income. Net income is also called accounting income, accounting profit, earnings, or profit, particularly in finan cial news reports. Dividing net income by the number of shares outstanding gives earn ings per share (EPS), often called the bottom line. Throughout this book, unless otherwise indicated, net income means net income available to common stockholders.4

'Companies also report "comprehensive income," which is the sum of net income and any "comprehensive" income item, such as the change in market value of a financial asset. For example, a decline in a financial as set's value would be recorded as a loss even though the asset has not been sold. We assume that there are no

comprehensive income items in our examples. Some companies also choose to report "pro forma income." For example, if a company incurs an expense

that it doesn't expect to recur, such as the closing of a plant, it might calculate pro forma income as though it had not incurred the one-time expense. There are no hard-and-fast rules for calculating pro forma income, so many companies find ingenious ways to make pro forma income higher than traditional income. The SEC and the Public Company Accounting Oversight Board (PCAOB) are taking steps to reduce deceptive uses of pro forma reporting.

esource

Chapter 2 Financial Statements, Cash Flow, and Taxes

SELF-TEST

What is an income statement, and what information does it provide?

What is often called the "bottom line"?

What is EB/TOA?

How does the income statement differ from the balance sheet with regard to the time period reported?

A firm has the following information: $2 million in earnings before taxes. The firm has an, interest expense of $300,000 and depreciation af $200,000; it has no amortization. What is its EB/TOA? ($2.5 million)

Now suppose a firm has the following information: $7 million in sales, $4 million of costs of goods sold excluding depreciation and amortization, and $500,000 of other operating expenses. What is its EB/TOA? ($2.5 million)

2-4 Statement of Stockholders' Equity

See Ch02 Tool Klt.xlsx for

details.

Changes in stockholders' equity during the accounting period are reported in the state ment of stockholders' equity. Figure 2-3 shows that MicroDrive earned $248 million dur ing 2019 and paid out $60 million in common dividends . This means that MicroDrive plowed $188 million back into the business: $248 - $60 = $188. Thus, the balance sheet item "Retained earnings" increased from $1,552 million at year-end 2018 to $1740 million at year-end 2019.5 The last column shows the beginning stockholders' equity, any changes, and the end-of-year stockholders' equity.

FIGURE2-3

Note that "Retained earnings" is not a pile of money just waiting to be used; it does not represent assets but is instead a claim against assets. In 2019, MicroDrive's

MicroDrive, Inc.: Statement of Stockholders' Equity for Years Ending December 31 (Millions of Dollars and Millions of Shares)

A I B I C I D I E I F I G I H 99 Preferred Common Common Retained Total - 100 � � ..smcii. Earnin�s Emlin! 101 Balances, Dec. 31, 2018 $100 60 $500 $1,552 $2,152

102 Changes during year: I-- 103 Net income $248 $248 -

104 Cash dividends -

(60) (60)

105 Issuance/repurchase of stock 0 0 0

106 Balances, Dec. 31, 2019 $100 60 $500 $1,740 $2,340

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus,

intermediate calculations using the figure's rounded values may be inexact.

Note: In financial statements, parentheses and red colors denote a negative number.

'A more complicated company might require additional columns and rows to report information regarding new issues of stock, treasury stock acquired or reissued, stock options exercised, and unrealized foreign ex change gains or losses.

Financial Analysis on the Web

A wide range of valuable financial information is available on

the Web. With just a couple of clicks, an investor can easily

find the key financial statements for most publicly traded

companies. Here's a partial (by no means complete) list of

places you can go to get started.

♦ Try Yahoo! Finance's Web site, http://finance.yahoo

.com. Here you will find updated market information

along with links to a variety of interesting research

sites. Enter a stock's ticker symbol, click Search and

Part 1 The Company and Its Environment

select the company, and you will see the stock's cur

rent price along with recent news about the company.

The panel at the top has links to key statistics and to

the company's income statement, balance sheet,

statement of cash flows, and more. The Web site also

has a list of insider transactions, so you can tell if a

company's CEO and other key insiders are buying or

selling their company's stock. In addition, there is a

message board where investors share opinions about

stockholders allowed it to reinvest $188 million ($248 net income - $60 million dividends) instead of distributing the money as dividends-the "retained earnings of $188 million was spent on new assets. Thus, retained earnings, as reported on the bal ance sheet, does not represent cash and is not "available" for the payment of dividends or anything else.6

SELF -TEST

What is the statement of stockholders' equity, and what information does it provide?

Why do changes in retained earnings occur?

Explain why the following statement is true: "The retained earnings account, as reported on the balance sheet, does not represent cash and is not available for the payment of dividends or anything else."

A firm had a retained earnings balance of $3 million in the previous year. In the current year, its net income is $2.5 million. If it pays $1 million in common dividends in the current year, what is its resulting retained earnings balance? ($4.5 million)

2-5 Statement of Cash Flows

Even if a company reports a large net income during a year, the amount of cash reported on its year-end balance sheet may be the same or even lower than its begin ning cash. The reason is that the company can use its net income in a variety of ways, not just keep it as cash in the bank. For example, the firm may use its net income to pay dividends, to increase inventories, to finance accounts receivable, to invest in fixed

6The amount reported in the retained earnings account is not an indication of the amount of cash the firm has. Cash (as of the balance sheet date) is found in the cash account, an asset account. A positive number in the retained earnings account indicates only that the firm earned some income in the past, but its dividends paid were less than its earnings. Even if a company reports record earnings and shows an increase in its retained earnings account, it still may be short of cash.

The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes, and an expensive stereo and hence have a high net worth. But if you have only 23 cents in your pocket plus $5 in your checking account, you will still be short of cash.

Chapter 2 Financial Statements, Cash Flow, and Taxes

the company. To see a complete list of the company's

filings with the SEC, go to www.sec.gov.

♦ Other sources for up-to-date market information are

http://money.cnn.com and www.zacks.com. These

sites also provide financial statements in standard

ized formats.

♦ Both www.bloomberg.com and www.marketwatch

.com have areas where you can obtain stock quotes

along with company financials, links to Wall Street re

search, and links to SEC filings.

♦ If you are looking for charts of key accounting variables

(e.g., sales, inventory, depreciation and amortization,

and reported earnings), as well as financial statements,

take a look at www.smartmoney.com.

♦ Another good place to look is www.reuters.com. Here

you can find links to analysts' research reports, along

with the key financial statements.

In addition to this information, you may be looking for

sites that provide opinions regarding the direction of the

overall market and views regarding individual stocks. Two

popular sites in this category are The Motley Fool's Web site,

www.fool.com, and the Web site for The Street.com, www

.thestreet.com.

assets, to reduce debt, or to buy back common stock. Indeed, many factors affect a company's cash position as reported on its balance sheet. The statement of cash flows separates a company's activities into three categories-operating, investing, and financing-and summarizes the resulting cash balance. Look at Figure 2-4 as you read the following sections.

2-Sa Operating Activities

Net income is not a cash flow! The following sections explain how to determine actual cash flows by adjusting net income and taking into account other short-term operating cash flows.

NONCASH ADJUSTMENTS

Not all revenues and expenses reported on the income statement are received or paid in cash during the year. The most common item is depreciation. As explained in Section 2-2a, depreciation is reported as an expense but is not a cash flow-the cash flow occurred when the asset was purchased, not in the subsequent years.

Other items on the income statement can differ significantly from actual cash flows. For example, companies report one pre-tax income to the public but a different tax able income to the Internal Revenue Service (IRS)! Therefore, a company's reported tax expense can differ significantly from its actual tax payments. For example, Apple's state ment of cash flows shows that it paid almost $6 billion less in taxes than it reported in 2017! Most of Apple's differential between taxes reported and taxes paid was due to its foreign earnings, but there are other reasons this can happen.7 For example, growing companies report lower depreciation expenses to the public than to the IRS. This makes publicly reported taxable income higher than actual taxable income, resulting in higher reported taxes than actual taxes paid.

'Most of Apple's difference in taxes reported and taxes paid was due to provisions in the 2017 tax code that did not tax foreign income until it was repatriated (i.e., returned) to the United States instead of being in vested abroad, even if that investment was simply a foreign bank account. That provision changed for 2018, as we discuss in Section 2-9.

s,Jlurce

See Ch02 Tool Kit.xlsx for details.

FIGUREl-4

Part I The Company and Its Environment

MicroDrive, Inc.: Statement of Cash Flows for Year Ending December 31 {Millions of Dollars)

A B C D

118 Operating Activities

119 Net Income before preferred dividends

120 Noncash atfiustments

121 Depreciation•

122 Working capital atfiustments

123 Increase in accounts recelvable b

124 Increase in inventories

125 Increase in accounts payable

126 Increase in accruals

127 Net cash provided (used) by operating activities

128

129 Investing Activities

130 Cash used to acquire fixed assets c

131 Sale of short-term investments

132 Net cash provided (used) by investing activities

133 134 Financing Activities

135 Increase in notes payable

136 Increase in bonds

137 Payment of common and preferred dividends

138 Net cash provided (used) by financing activities

139

140 Summary

141 Net change in cash and equivalents

142 Cash and securities at beginning of the year

143 Cash and securities at end of the year

144

E F

2019

$255

200

(116)

(226)

$163

($420)

($390)

$122

170

$225

($2)

102

$100

Source: See the file Ch02 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/'s full precision. Thus, intermediate calculations using the figure's rounded values may be inexact.

Notes:

•Depreciation is a noncash expense that is deducted when calculating net income. It must be added back to show cash flow from operations.

b An increase in a current asset decreases cash. An increase in a current liability increases cash. See the text in this section for examples and explanations.

'The net increase in fixed assets (e.g., net plant and equipment) is $220 million; however, this net amount is after a deduction for the year's depreciation expense. Depreciation expense must be added back to find the increase in gross fixed assets. From the company's income statement, we see that the year's depreciation expense is $200 million; thus, expenditures on fixed assets were actually $420 million.

CHANGES IN WORKING CAPITAL

A firm's investment in current assets-cash, marketable securities, inventory, and accounts receivable-is called working capital. Increases in current assets other than cash (such as inventories and accounts receivable) decrease cash, whereas decreases in these ac counts increase cash. For example, if inventories are to increase, then the firm must use cash to acquire the additional inventory. Conversely, if inventories decrease, this generally means the firm is selling inventories and not replacing all of them, hence generating cash.

Chapter 2 Financial Statements, Cash Flow, and Taxes 67

Here's how we keep track of whether a change in assets increases or decreases cash flow: If the amount we own goes up (like getting a new laptop computer), it means we have spent money, and our cash goes down. On the other hand, if something we own goes down (like selling a car), our cash goes up.

Now consider a current liability, such as accounts payable. If accounts payable increase, then the firm has received additional credit from its suppliers, which saves cash; however, if payables decrease, this means it has used cash to pay off its suppliers. Therefore, increases in current liabilities such as accounts payable increase cash, whereas decreases in current liabilities decrease cash. To keep track of the cash flow's direction, think about the impact of getting a student loan. The amount you owe goes up, and your cash goes up. Now think about paying off the loan: The amount you owe goes down, but so does your cash.

2-Sb Investing Activities

Investing activities include transactions involving fixed assets or short-term financial in vestments. For example, if a company buys new IT infrastructure, its cash goes down at the time of the purchase. On the other hand, if it sells a building or a Treasury bond, its cash goes up.

2-Sc Financing Activities

Financing activities include raising cash by issuing short-term debt, long-term debt, or stock. Because dividend payments, stock repurchases, and principal payments on debt reduce a company's cash, such transactions are included here as negative cash flows.

2-Sd Putting the Pieces Together

The statement of cash flows is used to help answer questions such as these: Is the firm generating enough cash to purchase the additional assets required for growth? Is the firm generating any extra cash it can use to repay debt or to invest in new products? Such in formation is useful both for managers and investors, so the statement of cash flows is an important part of the annual report.

Figure 2-4 shows MicroDrive's statement of cash flows as it would appear in the company's annual report. The top section shows cash generated by and used in oper ations: For MicroDrive, operations provided $163 million. This subtotal is in many respects the most important figure in any of the financial statements. Profits as reported on the income statement can be "doctored" by such tactics as depreciating assets too slowly, not recognizing bad debts promptly, and the like. However, it is far more difficult to simultaneously doctor profits and the working capital accounts. It is not uncommon for a company to report positive net income right up to the day it declares bankruptcy, but the cash provided by operations almost always began to dete riorate much earlier, and analysts who kept an eye on cash flow could have predicted trouble. Therefore, if you are ever analyzing a company and are pressed for time, look first at the trend in cash provided by operating activities because it will tell you more than any other single number.

The second section shows investing activities. MicroDrive purchased fixed assets totaling $420 million (a negative cash flow) and sold short-term investments for $30 mil lion (a positive cash flow). Therefore, investing activities used a total of $390 million, decreasing MicroDrive's cash.

Filling in the GAAP

While U.S. companies adhere to generally accepted account

ing principles (GAAP), when preparing financial statements,

most other developed countries use International Financial

Reporting Standards (IFRS). The U.S. GAAP system is rules

based, with thousands of instructions, or "guidances," for

how individual transactions should be reported in financial

statements. IFRS, on the other hand, is a principles-based

system in which detailed instructions are replaced by overall

guiding principles.

For example, whereas GAAP provides extensive and

detailed rules about when to recognize revenue from any

conceivable activity, IFRS provides just four categories of

revenue and two overall principles for timing recognition.

This means that even the most basic accounting measure,

revenue, is different under the two standards-total rev

enue, or sales, under GAAP won't typically equal total rev

enue under IFRS. Thus, financial statements prepared

under GAAP cannot be compared directly to IFRS financial

Part 1 The Company and Its Environment

statements, making comparative financial analysis of U.S.

and international companies difficult. Perhaps more prob

lematic is that the IFRS principles allow for more company

discretion in recording transactions. This means that two

companies may treat identical transactions differently

when using IFRS, which makes company-to-company com

parisons more difficult.

The U.S. Financial Accounting Standards Board (FASB)

and the International Accounting Standards Board (IASB)

have been working to merge the two sets of standards since

2002. Some of the joint standards are completed, such as the

all-important revenue recognition standard, but many other

standards had not been adopted as of early 2018. In fact, it

seems likely that the adoption of worldwide standards will

not happen in the near future.

To keep abreast of developments in IFRS/GAAP conver

gence, visit the IASB Web site at www.iasb.org and the FASB

Web site at www.fasb.org.

The third section, financing activities, includes borrowing from banks (notes payable), selling new bonds, and paying dividends on common and preferred stock. MicroDrive raised $292 million by taking out short-term loans and issuing new bonds, but it paid $67 million in preferred and common dividends. Therefore, financing activities provided $225 million.

The last section shows the summary. When all of the previous activities are totaled, we see that MicroDrive's cash outflows exceeded its cash inflows by $2 million during 2019; that is, its net change in cash was a negative $2 million.

MicroDrive's statement of cash flows should be worrisome to its managers and to outside analysts. The company had $5 billion in sales but generated only $163 mil lion from operations, not nearly enough to cover the $420 million it spent on fixed assets and the $67 million it paid in dividends. It covered these cash outlays by borrow ing heavily and by liquidating short-term investments. Obviously, this situation can not continue year after year, so MicroDrive managers will have to make changes. We will return to MicroDrive throughout the textbook to see what actions its managers are planning.

SELF-TEST

What types of questions does the statement of cash flows answer?

Identify and briefly explain the three categories of activities in the statement of cash flows.

A firm has inventories of $2 million for the previous year and $1.5 million for the current year. What impact does this have on net cash provided by operations? (Increase of $500,000)

(

Chapter 2 Financial Statements, Cash Flow, and Taxes 69

2-6 Net Cash Flow

Some analysts calculate and use net cash flow, which is defined as:

Net cash flow = Net income - Noncash revenues + Noncash expenses ■ where net income is the net income available for distribution to common shareholders. Depreciation and amortization usually are the largest noncash items, and in many cases the other noncash items roughly net out to zero. For this reason, net cash flow often equals net income plus depreciation and amortization:

Net cash flow = Net income + Depreciation and amortization ■ We can illustrate Equation 2-4 with data for MicroDrive taken from Figure 2-2:

Net cash flow = $248 + $200 = $448 million

The definition used here is easy to calculate by pen and paper, so it was once used as a performance metric measure to evaluate financial statements. However, advances in tech nology and finance have made this measure less useful than the other measures of cash flow that we discuss in the remainder of the book. We describe this measure only so that you will be familiar with it if you see it elsewhere.

SELF-TEST

Differentiate between net cash flow and accounting profit.

A firm has net income of $5 million. Assuming that depreciation of $1 million is its only noncash expense, what is the firm's net cash flow? ($6 million)

2-7 Free Cash Flow: The Cash Flow Available

for Distribution to Investors

So far in the chapter we have focused on financial statements as presented in the annual report. When you studied income statements in accounting, the emphasis was probably on the firm's net income. However, the intrinsic value of a company is determined by the stream of cash flows that investors expect to receive now and in the future. A com pany generates these cash flows through its operating activities. These are called free cash flows (FCFs).

We can calculate FCF in two different ways, by how it is used and by how it is gener ated. In terms of how it is used, FCF is the cash flow available for distribution to all the company's investors after the company has made all investments necessary to sustain ongo ing operations. In terms of how it is generated, FCF is equal to after-tax operating profit minus the amount of new expenditures necessary to sustain the business. Always keep in mind that the way for managers to make their companies more valuable is to increase free cash flow now and in the future.

Figure 2-5 shows the five steps in calculating free cash flow. As we explain each individual step in the following sections, refer back to Figure 2-5 to keep the big picture in mind.

FIGURE2•5

Part 1 The Company and Its Environment

Calculating Free Cash Flow

Step 1 Step2

(Earnings before interest and taxes) ( Operating current assets)

x( (1- Tax rate)) - (operating current liabilities 1

( Net operating profit after taxes) ( Net operating working capital)

Step 3 • ( Net operating working capital)

+ ( Operating long-term assets)

Steps ,Ir ( Total net operating capital)

Step4 • ( Net operatln1 profit after taxes ) ( Total net operating capital this year)

-( Net investment in operating capital ) ... - ( Total net operating capital last year)

( Free cash flow ) ( Net investment in operating capital)

2-7a Net Operating Profit after Taxes (NOPAT)

If two companies have different amounts of debt, thus different amounts of interest charges, they could have identical operating performances but different net incomes: The one with more debt would have a lower net income. Net income is important, but it does not always reflect the true performance of a company's operations or the effectiveness of its managers. A better measure for comparing managers' performance is net operating profit after taxes (NO PAT), which is the amount of profit a company would generate if it had no debt and held no financial assets. NOPAT is defined as follows:8

NOPAT = EBIT(l - Tax rate) ■ Using data from the income statements of Figure 2-2, MicroDrive's 2019 NOPAT is:

NOPAT = $400(1 - 0.25) = $300 million

This means MicroDrive generated an after-tax operating profit of $300 million, less than its previous NOPAT of $440(1 - 0.25) = $330 million.

'For firms with a more complicated tax situation, it is better to define NO PAT as follows: NO PAT = (Net income before preferred dividends) + (Net interest expense){! - Tax rate). Also, if a firm is able to defer paying some taxes, perhaps by the use of accelerated depreciation, then it needs to adjust NO PAT to reflect the taxes it actu ally paid on operating income. See P. Daves, M. Ehrhardt, and R. Shrieves, Corporate Valuation: A Guide for Managers and Investors (Mason, OH: Thomson South-Western, 2004) for a detailed explanation of these and other adjustments.

()

Chapter 2 Financial Statements, Cash Flow, and Taxes

2-7b Net Operating Working Capital

Most companies need some current assets to support their operating activities. For example, all companies must carry some cash to "grease the wheels" of their operations. If it does not hold any cash, a company might have overdrafts because it is impossible to perfectly time the actual cash in bank accounts due to writing and depositing checks. Companies must also have other current assets, such as inventory and accounts receiv able, which are required for normal operations. The short-term assets normally used in a company's operating activities are called operating current assets.

Not all current assets are operating current assets. For example, holdings of short-term marketable securities generally result from investment decisions made by the treasurer and not as a natural consequence of operating activities. Therefore, short-term invest ments are nonoperating assets and normally are excluded when calculating operating current assets. A useful rule of thumb is that if an asset pays interest, it should not be clas sified as an operating asset.

In this textbook, we will always distinguish between the cash needed for operations and the marketable securities held as short-term investments. However, many companies don't make such a clean distinction. For example, Apple reported $22 billion in cash in 2017, in addition to $54 billion in short-term investments. With total assets of $375 bil lion, Apple certainly doesn't need to have 14% ($54/$375 = 0.14) of its assets in cash to run its business operations. Therefore, if we were calculating operating current assets for Apple, we would classify about $7 billion as cash and the remainder as short-term invest ments: $22 - $7 + $54 = $69 billion. The reverse situation is possible, too, where a com pany reports very little cash but many short-term investments. In such a case, we would classify some of the short-term investments as operating cash when calculating operating current assets.

Some current liabilities-especially accounts payable and accruals-arise in the normal course of operations. Such short-term liabilities are called operating current liabilities. Not all current liabilities are operating current liabilities. For example, consider the current liability shown as notes payable to banks. The company could have raised an equivalent amount as long-term debt or could have issued stock, so the choice to borrow from the bank was a financing decision and not a consequence of operations. Again, the rule of thumb is that if a liability charges interest, it is not an operating liability.

If you are ever uncertain about whether an item is an operating asset or operating liability, ask yourself whether the item is a natural consequence of operations or if it is a discretionary choice, such as a particular method of financing or an investment in a particular financial asset. If it is discretionary, then the item is not an operating asset or liability.

Notice that each dollar of operating current liabilities is a dollar that the company does not have to raise from investors in order to conduct its short-term operating activi ties. Therefore, we define net operating working capital (NOWC) as operating current assets minus operating current liabilities. In other words, net operating working capital is the working capital acquired with investor-supplied funds. Here is the definition in equation form:

Net operating Operating current =

working capital assets Operating current

liabilities ■

72 Part 1 The Company and Its Environment

We can apply these definitions to MicroDrive, using the balance sheet data given in Figure 2-1. Here is its net operating working capital at year-end 2019:

NOWC == Operating current assets - Operating current liabilities == (Cash + Accounts receivable + Inventories)

- (Accounts payable + Accruals) == ($100 + $500 + $1,000) - ($200 + $400) = $1,000 million

For the previous year, net operating working capital was:

NOWC = ($102 + $384 + $774) - ($180 + $370) = $710 million

From past experience with our students, we know the terminology can be confus ing. Accounting and supply chain management tend to use the term net working capital, defined as all current assets minus all current liabilities. This is quite different from net operating working capital, which excludes the impact of items not directly related to oper ations (e.g., short-term investments and notes payable). Keep this important distinction in mind as you read the rest of this book.

2-7c Total Net Operating Capital

In addition to working capital, most companies also use long-term assets to support their operations. These include land, buildings, factories, equipment, and the like. Total net operating capital, also just called net operating capital or operating capital, is the sum ofNOWC and operating long-term assets such as net plant and equipment:

Total net operating capital = NOWC + Operating long-term assets ■ Because MicroDrive's operating long-term assets consist only of net plant and equip

ment, its total net operating capital at year-end 2019 was:

Total net operating capital = $1,000 + $2,000 = $3,000 million

For the previous year, its total net operating capital was:

Total net operating capital = $710 + $1,780 = $2,490 million

Notice that we have defined total net operating capital as the sum of net operat ing working capital and operating long-term assets. In other words, our definition is in terms of operating assets and liabilities. However, we can also calculate total net operat ing capital by looking at the sources of funds. Total investor-supplied capital is defined as the total of funds provided by investors, such as notes payable, long-term bonds, pre ferred stock, and common equity. For most companies, total investor-supplied capital is:

Total investor-supplied = Notes +

Long-term +

Preferred +

Common

I ·

capital payable bonds stock equity

(

Chapter 2 Financial Statements, Cash Flow, and Taxes 73

For MicroDrive, the total capital provided by investors at year-end 2019 was $150 + $520 + $100 + $2,240 = $3,010 million. Of this amount, $10 million was tied up in short-term investments, which are not directly related to MicroDrive's operations. Therefore, we define total investor-supplied operating capital as:

Total investor-supplied Total investor-supplied Short-term operating capital = capital

- investments I

MicroDrive had $3,010 - $10 = $3,000 million of investor-supplied operating cap ital in 2019. Notice that this is exactly the same value as our earlier calculation of total net operating capital for that year. Therefore, we can calculate total net operat ing capital either from net operating working capital and operating long-term assets or from the investor-supplied funds. We usually base our calculations on operating data because this approach allows us to analyze a division, factory, or work center. In contrast, the approach based on investor-supplied capital is applicable only for the entire company.

The expression "total net operating capital" is a mouthful, so we often call it operating capital or even just capital. Also, unless we specifically say "investor-supplied capital," we are referring to total net operating capital.

2-7d Net Investment in Operating Capital

As calculated previously, MicroDrive had $2,490 million of total net operating capital at the end of 2018 and $3,000 million at the end of 2019. Therefore, during 2019, it made a net investment in operating capital of:

Net investment in operating capital = $3,000 - $2,490 = $510 million

Much of this investment was made in net operating working capital, which rose from $710 million to $1,000 million, or by $290 million. This 41% increase in net operating working capital is very worrying considering that sales grew by only 4.2% (to $5 billion from $4.8 billion), should set off warning bells in your head: Why did MicroDrive tie up so much additional cash in working capital? Is the company gear ing up for a big increase in sales, or are inventories not moving and receivables not being collected? We will address these questions in detail in Chapter 3, when we cover ratio analysis.

2-7e Calculating Free Cash Flow

Free cash flow is defined as:

FCF = NOPAT - Net investment in total operating capital

MicroDrive's free cash flow in 2019 was:

FCF = $300 - ($3,000 - $2,490) = $300 - $510 = -$210 million

■

74 Part I The Company and Its Environment

Although we prefer the approach we just explained, sometimes the financial press calculates FCF differently: FCF = - -[ EBIT(l - T) ] [Gross investment] [Investment]

+ Depreciation in fixed assets in NOWC For MicroDrive, this calculation is: FCF = ($300 + $200) - $420 - ($1 ,000 - $710) = -$210

I Notice that the results are the same for either calculation. To see this, replace EBIT(l - T) with NOPAT in the first bracket of Equation 2-11, and replace Gross investment in fixed assets with Net investment in fixed assets + Depreciation in the second bracket:

[ ] [ Net investment] [ ] NOPAT fix d Investment FCF = - in e assets -+ Depreciation . . in NOWC + Depreciation

Both the first and second brackets have depreciation, so depreciation can be canceled out, leaving: FCF = NOP AT _ [Net investment] _ [Investment]in fixed assets in NOWC

The last two bracketed terms are equal to the net investment in operating capital, so Equation 2-llb simplifies to Equation 2-10. We usually use Equation 2-10 because it saves us the step of adding depreciation both to NO PAT and to the net investment in fixed assets and also because frequently only net fixed assets and not gross fixed assets are reported on the firm's financial statements.

Financial Statement Fraud

The Securities Exchange Commission (SEC) has a Division of

Enforcement that investigates companies and individuals

regarding noncompliance with securities laws. Within the Di

vision, the Financial Reporting and Audit (FRAud) Group fo

cuses on financial statement misreporting. Among its tools,

the FRAud group utilizes data analytics and advanced algo

rithms to identify financial reporting that needs additional

investigation. When the FRAud Group identifies a violation, it

can file a civil suit in a federal court, but usually the matter is

settled through an Administrative procedure. The settlement

often involves fines, cease-and-desist injunctions, and dis

gorgement of profits.

For example, the SEC claimed that Bankrate, Inc., its

CFO, and other senior executives misreported financial in

formation to the public for the purpose of matching or sur

passing analysts' expectations. The company and its officers

agreed to pay more than $15 million in fines. However, the

story didn't end here. The Justice Department charged the

CFO, Hyunjin Lerner, and others for crimes connected with

financial fraud. In May 2018, Lerner was sentenced to 5 years

in prison and was ordered to pay $21 million in restitution.

Sources: For SEC actions, see www.sec.gov/dlvlslons/enforce/clalms

/bankrate-lnc.htm. For Justice Department actions, see www.Justlce.gov

/crlmlnal-vns/case/hyunjln-lerner/update.

(

Chapter 2 Financial Statements, Cash Flow, and Taxes

2-7f The Uses of FCF

Recall that free cash flow (FCF) is the amount of cash that is available for distribution to all investors, including shareholders and debtholders. There are five good uses for FCF:

1. Pay interest to debtholders, keeping in mind that the net cost to the company is the after-tax interest expense.

2. Repay debtholders; that is, pay off some of the debt. Issuing new debt is a "negative use." 3. Pay dividends to shareholders. 4. Repurchase stock from shareholders. Issuing new stock is a "negative use." 5. Buy short-term investments or other nonoperating assets. Selling is a "negative use."

C onsider MicroDrive, with its FCF of -$210 million in 2019. How did MicroDrive "use" the FCF?

MicroDrive's income statement shows an interest expense of $60 million. With a tax rate of 25%, the after-tax interest payment for the year is:

After-tax interest payment = $60(1 - 25%) = $45 million

The net amount of debt that is repaid is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes notes payable and long-term debt. If the amount of ending debt is less than the beginning debt, the company paid down some of its debt. But if the ending debt is greater than the beginning debt, the company actually borrowed additional funds from creditors. In that case, it would be a negative use ofFCF. For MicroDrive, the net debt repayment for 2019 is equal to the amount at the beginning of the year minus the amount at the end of the year:

Net debt repayment (issuance) = ($28 + $350) - ($150 + $520) = -$292 million

This is a "negative use" of FCF because it increased the debt balance. This is typical of most companies because growing companies usually add debt each year.

MicroDrive paid $7 million in preferred dividends and $60 in common dividends for a total of:

Dividend payments = $7 + $60 = $67 million

The net amount of stock that is repurchased is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes preferred stock and common stock. If the amount of ending stock is less than the beginning stock, then the company made net repurchases. But if the ending stock is greater than the beginning stock, the company actually made net issuances. In that case, it would be a negative use of FCF. Even though MicroDrive neither issued nor repurchased stock during the year, many companies use FCF to repurchase stocks as a replacement for or supplement to dividends, as we discuss in Chapter 14.

The amount of net purchases of short-term investments is equal to the amount at the end of the year minus the amount at the beginning of the year. If the amount of end ing investments is greater than the beginning investments, then the company made net purchases. But if the ending investments are less than the beginning investments, the company actually sold investments. In that case, it would be a negative use ofFCF. Micro Drive's net purchases of short-term investments in 2019 are:

Net purchases (sales) of short-term investments = $10 - $40 = -$30 million

Notice that this is a negative use because MicroDrive sold short-term investments instead of purchasing them.

76 Part 1 The Company and Its Environment

We combine these individual uses ofFCF to find the total uses:

I. After-tax interest 2. Net debt repayments (issuance) 3. Dividends 4. Net stock repurchases (sales) 5. Net purchases (sales) of ST investments

Total uses of FCF

$45

-$292 $67 $0

-$30 -$210

As it should be, the -$210 total for uses of FCF is identical to the value of FCF from operations that we calculated previously.

Observe that a company does not use FCF to acquire operating assets, because the cal culation ofFCF already takes into account the purchase of operating assets needed to sup port growth. Unfortunately, there is evidence to suggest that some companies with high FCF tend to make unnecessary investments that don't add value, such as paying too much to acquire another company. Thus, high FCF can cause waste if managers fail to act in the best interests of shareholders. As discussed in Chapter l, this is called an agency cost because managers are hired as agents to act on behalf of stockholders. We discuss agency costs and ways to control them in Chapter 13 (where we discuss corporate governance) and in Chapter 15 (where we discuss the choice of capital structure).

2-7g FCF and Corporate Value

Free cash flow is the amount of cash available for distribution to investors; so the funda mental value of a company to its investors depends on the present value of its expected future FCFs, discounted at the company's weighted average cost of capital (WACC). Sub sequent chapters will develop the tools needed to forecast FCFs and evaluate their risk. Chapter 7 ties all this together with a model used to calculate the value of a company. Even though you do not yet have all the tools to apply the model, you must understand this basic concept: PCP is the cash flow available for distribution to investors. Therefore, a company's fundamental value depends primarily on its expected future PCP.

SELF-TEST

What is net operating working capital? Why does it exclude most short-term investments and notes payable?

What is total net operating capital? Why is it important for managers to calculate a company's capital requirements?

Why is NOPAT a better performance measure than net income?

What is free cash flow? What are its five uses? Why is FCF important?

Suppose a firm has the following information: Sales = $10 million; costs of goods sold (excluding depreciation) = $5 million; depreciation = $1.4 million; other operating expenses = $2 million; interest expense= $1 million. If the tax rate is 25%, what is NOPAT, the net operating profit after taxes? ($1.2 million)

Suppose a firm has the following information: Cash = $500,000; short-term investments = $2.5 million; accounts receivable = $1.2 million; inventories = $1 million; and net plant and equipment= $7.8 million. How much is tied up in operating current assets? ($2.7 million)

Suppose a firm has the following information: Accounts payable = $1 million; notes payable = $1.1 million; short-term debt = $1.4 million; accruals = $500,000; and long-term bonds = $3 million. What is the amount arising from operating current liabilities? ($1.5 million)

(

Chapter 2 Financial Statements, Cash Flow, and Taxes 77

Suppose a firm has the following information: Operating current assets = $2. 7 million; operating current liabilities = $1.5 million; long-term bonds = $3 million; net plant and equipment= $7.8 million; and other long-term operating assets = $1 million. How much is tied up in net operating working capital (NOWC)? ($1.2 million) How much is tied up in total net operating capital? ($10 million)

A firm's total net operating capital for the previous year was $9.3 million. For the current year, its total net operating capital is $10 million, and its NOPAT is $1.2 million. What is its free cash flow for the current year? ($500,000)

2-8 Performance Evaluation

Because free cash flow has such a big impact on value, managers and investors can use FCF and its components to measure a company's performance. The following sections explain three performance measures: return on invested capital, market value added, and economic value added.

2-Sa The Return on Invested Capital

Even though MicroDrive had a positive NOPAT, its very high investment in operating as sets caused a negative FCF. Is a negative free cash flow always bad? The answer is, "Not necessarily; it depends on why the free cash flow is negative." It's a bad sign if FCF is negative because NOPAT is negative, which probably means the company is experiencing operating problems. However, many high-growth companies have positive NOPAT but negative FCF because they are making large investments in operating assets to support growth. For example, Fabrinet manufactures optical and electromechanical systems and sensors. In 2016, its sales grew 26%, its NOPAT increased by over 30% from 2015, but its FCF was negative $5 million. This was an increase from the prior year's FCF, which was negative $15 million. These negative FCFs were due largely to a $40 million investment in working capital in 2015 and a $90 million investment in working capital in 2016 that were required to support sales growth.

There is nothing wrong with value-adding growth, even if it causes negative free cash flows in the short term, but it is vital to determine whether growth is actually adding value. For this, we use the return on invested capital (ROIC), which shows how much NOPAT is generated by each dollar of operating capital:

ROIC = NOPAT

Operating capital I As shown in Figure 2-6, MicroDrive's 2019 ROIC is $300/$3,000 = 10%. To determine

whether this ROIC is high enough to add value, compare it to the weighted average cost of capital (WACC). Chapter 9 explains how to calculate the WACC; for now, accept that the WACC considers a company's individual risk, as well as overall market conditions. Figure 2-6 shows that MicroDrive's 10% ROIC is less than its 11.5% WACC. Thus, MicroDrive did not generate a sufficient rate of return to compensate its investors for the risk they bore in 2019. This is markedly different from the previous year, in which MicroDrive's 13.25% ROIC was greater than its 11.5% WACC. Not only is the current ROIC too low, but the trend is in the wrong direction. Finally, MicroDrive's ROIC is less than the 13.19% industry average.

78 Part 1 The Company and Its Environment

FIGURE2-6

Calculating Performance Measures for MicroDrive, Inc. (Millions of Dollars and Millions of Shares)

A B C D E F G H 395 2019 2018 Ind.Avg .

396 Calculating NOPAT 397 EBIT $400 $440

398 x (1-Tax rati:) 75% 75% 399 NOPAT = EBIT{l -T) $300 $330

400 401 Calculating Net Operating Working Capital (NOWC) 402 Operating current assets $1,600 $1,260

403 -Qpi:ratine i;yrci:nt liabilitii:5 600 550

404 NOWC $1,000 $710

405 406 Calculating Total Net Operating Capital 407 NOWC $1,000 $710

408 + l'lli:t plant and i:qyipmi:nt 2,000 1,780

409 Total net operating capital $3,000 $2,490

410 411 Calculating Return on Invested Capital (ROIC) 412 NOPAT $300 $330

413 + Iati!I ni:t api:ratine i;api!.11 3,000 2,490

414 ROIC = NOP AT /Total net operating capital 10.00% 13.25% 13.19%

415 Weighted average cost of capital (W ACC) 11.50% 11.50% 11.20%

416 417 Calculating the Operating Profitability Ratio (OP) 418 NOPAT $300 $330

419 � 5,000 4,800

420 OP= NOPAT/Sales 6.00% 6.88% 6.75%

421 422 Calculating Capital Requirement Ratio (CR) 423 Total net operating capital $3,000 $2,490

424 ±..Silru 5,000 4,800

425 CR= Total net operating capital/Sales 60.00% 51.88% 51.19%

426 427 Calculating Market Value Added (MVA) 428 Price per share $31.00 $45.00

429 x l'lIYmbi:c 2(11haci:11 (millian5) 60.0 59.4

430 Market value of equity= P x (# of shares) $1,860 $2,673

431 - ll!!!!k xalyi: gf !:QYitt 2,240 2,052

432 MVA = Market value Book value -$380 $621

433 434 Calculating Economic Value Added (EVA) 435 Total net operating capital $3,000.0 $2,490.0

436 X Wi:iehti:d i!Y:!:raei: 1,;g5t gf i;apit!.!l (WACC) 11.5% 11.5%

437 Dollar cost of capital $345.0 $286.4

438 439 NOPAT $300.0 $330.0

440 -Uallar r;g5t gf r;apill!I 345.0 286.4

441 EVA= NOPAT- Dollar cost of ca ital -$45.0 $43.7

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity but are calculated using Excel's full precision. Thus,

intermediate calculations using the figure's rounded values may be inexact.

(

Chapter 2 Financial Statements, Cash Flow, and Taxes 79

Is MicroDrive's ROIC low due to low operating profitability, poor capital utilization, or both? To answer that question, begin with the operating profitability ratio (OP), which measures the percentage operating profit per dollar of sales:

0 . f' b'l' .

(OP) NOPAT

peratmg pro 1ta 1 1ty ratio = al S es

MicroDrive's current operating profitability ratio is:

$300 OP=--=6%

$5,000

and its previous operating profitability ratio was 6.6%. The average operating profitability ratio for companies in MicroDrive's industry is 6.75%, so MicroDrive's operating prof itability is trending in the wrong direction and is a bit lower than the 6.75% industry's average.

Let's take a look at how effectively MicroDrive uses its capital. The capital requirement ratio (CR) measures how much operating capital is tied up in generating a dollar of sales:

Total net operating capital Capital requirement ratio (CR) = --------

Sales

MicroDrive's current capital requirement ratio is:

$3,000 CR = -- = 60.0%

$5,000

and its previous capital requirement ratio was 51.88%. This shows that MicroDrive tied up much more in operating capital needed to generate sales in the current year than it did in the previous year. Even more alarming, MicroDrive's capital requirement ratio is much worse than the industry average of 51.19%.

Although not the case for MicroDrive, in many situations a negative FCF is not neces sarily bad. For example, Fabrinet, previously discussed, had a negative FCF in 2016, but its ROIC was about 22.7%. Because its WACC was only 8.5%, Fabrinet's growth was add ing value.9 At some point, its growth will slow, and it will not require such large capital investments. If it maintains a high ROIC, then its FCF will become positive and very large as growth slows.

Neither traditional accounting data nor return on invested capital incorporates stock prices, even though the primary goal of management should be to maximize the firm's intrinsic stock price. In contrast, Market Value Added (MVA) and Economic Value Added (EVA) do attempt to compare intrinsic measures with market measures.10

9lf g is the growth rate in capital, then with a little (or a lot of!) algebra, free cash flow is: FCF = Capital (ruoc - _g_)l+g

With a little more algebra, this shows that if g > ROIC/(1 - ROIC), then FCF will be negative. '0The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of the consulting firm Stern Stewart & Company. Stern Stewart trademarked the term "EVA," so other consulting firmshave given other names to this value, as they have to MVA. Still, EVA and MVA are the terms most commonlyused in practice.

WWW

For on updated estimate

of Coco-Colo's MVA, go to

http://finance.yahoo

.com, enter KO, ond click

Search. This shows the

market value of equity,

called Mkt Cap. To get

the book value of equity,

select Financials and then

Balance Sheet.

Part 1 The Company and Its Environment

2-Sb Market Value Added (MVA)

One measure of shareholder wealth is the difference between the market value of the firm's stock and the cumulative amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA):

MVA = Market value of stock - Equity capital supplied by shareholders

= (Shares outstanding)(Stock price) - Total common equity I To illustrate, consider Coca-Cola. In September 2017, its total market equity value,

commonly called market capitalization, was $192 billion, while its balance sheet showed that stockholders had put up only $22 billion. Thus, Coca-Cola's MVA was $192 - $22 = $170 billion. This $170 billion represents the difference between the money that Coca-Cola's stockholders have invested in the corporation since its found ing-including indirect investment by retaining earnings-and the cash they could get if they sold the business. The higher its MVA, the better the job that management is doing for the firm's shareholders.

MicroDrive's MVA is -$396 million:

MicroDrive's MVA = (Shares outstanding)(Stock price) - Total common equity = (60 million)($31.00) - $2,240 million = $1,844 million - $2,240 million = -$380 million.

As Figure 2-6 shows, MicroDrive's MVA went from a positive value in 2018 to a negative value in 2019. In other words, MicroDrive's current market value is less than the cumula tive amount of equity that its shareholders have invested during the company's life.

Sometimes MVA is defined as the total market value of the company minus the total amount of investor-supplied capital:

MVA = Total market value - Total investor-supplied capital = (Market value of stock + Market value of debt)

- Total investor-supplied capital

For most companies, the total amount of investor-supplied capital is the sum of equity, debt, and preferred stock. We can calculate the total amount of investor-supplied capital directly from their reported values in the financial statements. The total market value of a company is the sum of the market values of common equity, debt, and preferred stock. It is easy to find the market value of equity because stock prices are readily available, but it is not always easy to find the market value of debt. Hence, many analysts use the value of debt reported in the financial statements, which is the debt's book value, as an estimate of the debt's market value.

2-Sc Economic Value Added (EVA)

Whereas MVA measures the effects of managerial actions since the inception of a com pany, Economic Value Added (EVA) focuses on managerial effectiveness in a given year. The EVA formula is:

Chapter 2 Financial Statements, Cash Flow, and Taxes

EVA = (Net operating profit)- (After-tax dollar cost of capital)after taxes used to support operations = NOPAT - (Total net operating capital)(WACC)

Economic Value Added is an estimate of a business's true economic profit for the year,and it differs sharply from accounting profit.11 EVA represents the residual income thatremains after the cost of all capital, including equity capital, has been deducted, whereasaccounting profit is determined without imposing a charge for equity capital. As we willdiscuss in Chapter 11, equity capital has a cost because shareholders give up the opportunity to invest and earn returns elsewhere when they provide capital to the firm. This costis an opportunity cost rather than an accounting cost, but it is real nonetheless. Note that when calculating EVA we do not add back depreciation. Although it is nota cash expense, depreciation is a cost because worn-out assets must be replaced, and it istherefore deducted when determining both net income and EVA. Our calculation of EVAassumes that the true economic depreciation of the company's fixed assets exactly equalsthe depreciation used for accounting and tax purposes. If this were not the case, adjustments would have to be made to obtain a more accurate measure of EVA. Economic Value Added measures the extent to which the firm has increased shareholder value. Therefore, if managers focus on EVA, they will more likely operate in a manner consistent with maximizing shareholder wealth. Note too that EVA can be determinedfor divisions as well as for the company as a whole, so it provides a useful basis for determining managerial performance at all levels. Consequently, many firms include EVA as acomponent of compensation plans. We can also calculate EVA in terms of ROIC: EVA= (Total net operating capital)(ROIC - WACC) ■

As this equation shows, a firm adds value-that is, has a positive EVA-if its ROIC is greaterthan its WACC. IfWACC exceeds ROIC, then growth can actually reduce a firm's value. Using Equation 2-18, Figure 2-6 shows that MicroDrive's EVA is: EVA= $300 - ($3,000)(11.5%} = $300 - $345 = -$45 million

This negative EVA reinforces our earlier conclusions that MicroDrive lost value in2019 due to an erosion in its operating performance. In Chapters 7 and 12, we will determine MicroDrive's intrinsic value and explore ways in which MicroDrive can reverse itsdownward trend. 2-Sd Intrinsic Value, MVA, and EVA

We will have more to say about both MVA and EVA later in the book, but we can closethis section with two observations. First, there is a relationship between MVA and EVA,but it is not a direct one. If a company has a history of negative EV As, then its MVA will 11The most important reason EVA differs from accounting profit is that the cost of equity capital is deducted when EVA is calculated. Other factors that could lead to differences include adjustments that might be made to depreciation, to research and development costs, to inventory valuations, and so on. These other adjustments also can affect the calculation of investor-supplied capital, which affects both EVA and MVA. See G. Bennett Stewart, III, The Quest for Value (New York: HarperCollins, 1991).

82 Part 1 The Company and Its Environment

probably be negative; conversely, its MVA probably will be positive if the company has a history of positive EVAs. However, the stock price, which is the key ingredient in the MVA calculation, depends more on expected future performance than on historical per formance. Therefore, a company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future.

The second observation is that when EVAs or MVAs are used to evaluate manage rial performance as part of an incentive compensation program, EVA is the measure that is typically used. The reasons are as follows: (1) EVA shows the value added during a given year, whereas MVA reflects performance over the company's entire life, perhaps even including times before the current managers were born. (2) EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.

SELF-TEST

A company has sales of $200 million, NOPAT of $12 million, net income of $8 million, net operating working capital (NOWC) of $10 million, total net operating capital of $100 million, and total assets of $110 million. What is its operating profitability ratio (OP)? (6%) Its capital requirement ratio (CR)? (50%) Its return on invested capital (ROIC)? (12%)

Define "Market Value Added (MVA}" and "Economic Value Added (EVA}."

How does EVA differ from accounting profit?

A firm has $100 million in total net operating capital. Its return on invested capital is 14%, and its weighted average cost of capital is 10%. What is its EVA? ($4 million)

2-9 Corporate Income Taxes

The value of any financial asset (including stocks, bonds, and mortgages), as well as most real assets such as plants or even entire firms, depends on the after-tax stream of cash flows produced by the asset. The following sections describe the key features of corporate and individual taxation.

In December 2017, Congress passed a tax act that is still widely known by the title of its preliminary version, the 2017 Tax Cut and Jobs Act (TCJA).12 We will refer to it as the Tax Cut and Jobs Act, the TCJA, or just the Act. The TCJA made major changes to corporate and personal tax codes. Following are descriptions and example applications of the most important items in the Act that affect corporate taxes.

2-9a The Corporate Tax Rate

Prior to the Act's passage, corporate tax rates were progressive (i.e., the tax rate increased as taxable income increased) up to $18,333,333. Beyond this amount, the tax rate was 35%. The new tax code is not progressive but instead applies a flat 21% rate to taxable income.

For example, consider a company with taxable income of $200 million. Prior to the Act, the tax would have been $70 million. However, the tax on this income is now (0.21)($200) = $42 million. This is a 40% reduction in taxes: ($70 - $42)/$70 = 0.4 = 40%.

"Congress actually passed An Act to Provide for the Reconciliation Pursuant to Titles II and V of the Concur• rent Resolution on the Budget for Fiscal Year 2018. It is still widely known by its preliminary version, the Tax Cut and Jobs Act (TC)A), so that is how we will refer to it.

(

Chapter 2 Financial Statements, Cash Flow, and Taxes

2-9b Limitation on Interest Expense Deduction

Before the Act, interest expense was a fully deductible expense because it reduced taxable income. However, the Act put a limit on the amount of interest that could be deducted. For 2018, 2019, 2020, and 2021, the Act reduced the allowable interest expense deduction to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). For 2022 and subsequent years, the Act reduced the allowable interest expense deduction to 30% of earnings before interest and taxes (EBIT).13

For example, consider a company with EBITDA of $160 million in a year prior to 2022. Even though the company had interest expenses of $80 million, the deductible interest expense for the year is only (0.30)($160) = $48 million. This leaves $80 - $48 = $32 mil lion of unused interest expenses for the current year. However, the company may "carry forward" the unused interest expenses and deduct them in a subsequent year, subject to the 30% limitation. The following section describes the carryforward provision.

2-9c Corporate Loss Carryforward

A corporation's actual tax liability in a current year depends on its current profit and its past losses. The Act's tax loss carryforward provision allows a company to use prior or dinary operating losses to offset up to 80% of its current taxable income.14 Any remaining prior operating losses can be carried forward indefinitely and used to offset future taxable income. The purpose of this loss treatment is to avoid penalizing corporations whose in comes fluctuate substantially from year to year.

To illustrate, suppose Apex Corporation lost a cumulative amount of $120 million in 2018 and prior years. (See Table 2-1.) Apex had unadjusted pre-tax operating profits of $100 million in 2019 and 2020. Because its 2018 pre-tax income is positive, it may use prior operating losses to offset up to 80% of this income. This limit for Apex is 80%($100) = $80 million. This reduces its 2019 taxable income from $100 million to $20 million and reduces its tax liability from 21%($100) = $21 million to 21%($20) = $4.2 million. Note that Apex has $40 million left in unused prior losses: $120 - $80 = $40 million.

Apex's 2020 pre-tax income is $100 million, and operating losses could offset up to $80 million. However, Apex has only $40 million remaining from cumulative prior oper ating losses. This is less than the $80 million limit, so Apex can carry forward the full $40 million and reduce its 2020 taxable income.

2-9d Interest and Dividends Received by a Corporation

Interest income received by a corporation is taxed as ordinary income at regular corpo rate tax rates. The situation is different for dividends. Consider a corporation that receives dividends from another firm. If the corporation subsequently pays a dividend to its own

"There are situations in which the 30% limitation does not apply. For example, the limitation does not apply

to small companies with average annual revenues less than $25 million, based on the current and previous two years. Nor does it apply to investment interest expense, which might be incurred if an investor uses borrowed

funds to purchase financial investments, such as stocks and bonds.

Interest on floor financing, which is incurred when auto dealers obtain loans to purchase the vehicles on

their lots, is not subject to the limitation. Real estate and farming companies can choose not to be subject to the 30% limitation. However, additional restrictions may be triggered in these situations.

14Prior to 2018, firms could carry an operating loss in the current year back to reduce the taxes paid in the prior

two years, receiving a tax refund in the current year for taxes paid in the two prior years. The 2017 Act elimi nated this carryback provision.

r.esource See Ch02 Tool Kit.xlsx for details.

Part 1 The Company and Its Environment

TABLE2-1

Apex Corporation: Application of $120 Million Loss Carryforward

Calculation of tax if carryforward losses are ignored

Taxable operating profit if no carryforward provision

Tax (21%) if no carryforward provision

Calculation of maximum allowed carryforward Joss

Unadjusted taxable operating profit prior to carryforward

Maximum allowed carryforward loss•

Cumulative prior to unused net operating lossesb

Calculation of maximum allowed carryforward loss

Unadjusted taxable profit prior to carryforward

Allowed prior unused net operating losses carried forward'

Adjusted taxable profit after carryforward

Tax on adjusted profit (21%) after carryforward

Tax savings due to carryforward provision

Tax if carryforward losses are ignored

Tax on adjusted profit (21%) after carryforward

Tax savings due to carryforward

Notes:

2018

$120.0

2019

$ 100.0

$ 21.0

$100.0

$ 80.0

$ 40.0

$100.0

$ 80.0

$ 20.0

$ 4.2

$ 21.0

$ 4.2

$ 16.8

'The maximum allowed carryforward loss is limited to 80% of the unadjusted taxable operating profit.

2020

$100.0

$ 21.0

$100.0

$ 80.0

$ 0.0

$100.0

$ 40.0

$ 60.0

$ 12.6

$ 21.0

$ 12.6

$ 8.4

"The cumulative prior unused net operating loss for Year, is equal to its value in Year, 1 minus the amount that is

used in Year,.

'The operating loss that is carried forward is equal to the minimum of the prior unused operating losses and 80% of the current unadjusted operating loss.

investors, then their dividend income is subject to triple taxation: (1) The first corporation is taxed on its income before it pays a dividend to the second company. (2) The second cor poration is then taxed on the dividends it receives from the first firm. (3) The second firm's investors are taxed on the dividends they receive. To reduce the impact of triple taxation, corporations are allowed to exclude a portion of dividends received, as explained next.

For a company receiving dividends, 50% of the dividends are excluded from taxable income, but the remaining 50% are taxed at the ordinary tax rate.15 For example, sup pose a company has $136.8 million to invest. If it is invested in preferred stock with a 7.31% coupon rate, the dividend payment would be $10 million: 7.31%($136.8 million) = $10 million. The taxes on the dividends would be $1.05 million:

Taxes on dividend = (Dividend payment)(l - Exclusion rate)(Tax rate) = ($10 million)(l - 0.50)(0.21) = $1.05 million

"The size of the dividend exclusion actually depends on the degree of ownership. Before the 2017 TCJA, corpo rations owning 20% or less of the paying company could exclude 70% of dividends received, but the exclusion is now only 50%. Corporations owning more than 20% but less than 80% of a dividend-paying company can exclude 65% of the dividends, down from 80%. Corporations owing more than 80% can exclude the entire divi dend payment. We will assume a 50% dividend exclusion for all subsequent examples.

Chapter 2 Financial Statements, Cash Flow, and Taxes 85

The after-tax dividend would be $10 - $1.05 = $8.95 million and the effective tax rate on the dividends would be only $10.5/$100 = 10.5%.

Suppose the company in the previous example instead invests in debt with an 8.18% inter est rate, which is higher than the preferred stock's 7.31 % coupon rate. The company would receive $11.19 million in interest income. The company would pay taxes of $11.19(0.21) = $2.35 million. Its after-tax interest would be $11.19 - $2.35 = $8.84 million. Notice that this is less than the $8.95 million after-tax dividends calculated earlier. Therefore, a corporation with surplus funds might choose to invest in preferred stock rather than interest-paying investments even though the pre-tax rate of return on the preferred stock is lower.16

2-9e Interest and Dividends Paid by a Corporation

A firm's operations can be financed with either debt or equity capital. If the firm uses debt, then it must pay interest on this debt. The interest paid by a corporation is deducted from its operating income to obtain its taxable income. Therefore, a firm needs $1 of pre tax income to pay $1 of interest.

In contrast, dividends paid are not deductible. Suppose a firm is in the 24.8% federal plus-state tax bracket. It must earn $1.33 of pre-tax income for it to have enough after-tax income to pay $1 of dividends:

Pre-tax income needed $1 $1 = = -- = $1.33

to pay $1 of dividends 1 - Tax rate 0.752

Working backward, if a company has $1.33 in pre-tax income, it must pay $0.33 in taxes: (0.248)($1.33) = $0.33. This leaves the firm with after-tax income of $1.00.

As this example suggests, companies have a tax incentive to finance with debt and not stock. See Chapter 15 for a more detailed analysis of debt versus equity financing.

2-9f Corporate Capital Gains

A capital gain occurs when an asset is sold for more than its book value, and a capital loss occurs when the reverse happens. Under current law, corporations' capital gains are taxed at the same rates as their operating income.

2-9g Improper Accumulation to Avoid Payment of Dividends

Corporations could refrain from paying dividends and thus permit their stockholders to avoid personal income taxes on dividends. To prevent this, the Tax Code contains an improper accumulation provision stating that earnings accumulated by a corporation are subject to penalty rates if the purpose of the accumulation is to enable stockholders to avoid personal income taxes. A cumulative total of $250,000 (the balance sheet item "retained earnings") is by law exempted from the improper accumulation tax for most corporations. This is a benefit primarily to small corporations.

The improper accumulation penalty applies only if the retained earnings in excess of $250,000 are shown by the IRS to be unnecessary to meet the reasonable needs of the business.

16 Note that corporations are restricted in their use of borrowed funds to purchase other firms' preferred or

common stocks. Without such restrictions, firms could engage in tax arbitrage by borrowing and then us ing the proceeds to purchase preferred stock. As this example shows, the after-tax dividends would be greater

than the after-tax interest expense, and the excess amount would be pure after-tax profit. If not for the restric tion, firms could generate huge after-tax profits without investing any of their own money: Borrow very large amounts and purchase equally large amounts of preferred stock.

86 Part I The Company and Its Environment

A great many companies do indeed have legitimate reasons for retaining more than $250,000 of earnings. For example, firms may retain and use earnings to pay off debt, finance growth, or provide the corporation with a cushion against possible cash drains caused by losses. How much a firm should be allowed to accumulate for uncertain contin gencies is a matter of judgment. We shall consider this matter again in Chapter 14, which deals with corporate dividend policy.

2-9h Consolidated Corporate Tax Returns

If a corporation owns 80% or more of another corporation's stock, then it can aggregate income and file one consolidated tax return; thus, the losses of one company can be used to offset the profits of another. {Similarly, one division's losses can be used to offset an other division's profits.) No business ever wants to incur losses (you can go broke losing $1 to save 21¢ in taxes), but tax offsets do help make it more feasible for large, multidivisional corporations to undertake risky new ventures or ventures that will suffer losses during a developmental period.

2-9i Taxes on Overseas Income

Many U.S. corporations have overseas subsidiaries, and those subsidiaries must pay taxes in the countries where they operate. Often, foreign tax rates are lower than U.S. rates. Prior to 2018, no U.S. tax was immediately due on foreign earnings if they were reinvested overseas, even though the "investment" might be a financial asset rather than a physical asset. However, when foreign earnings were repatriated to the U.S. parent for investment here or for dividend payments, they were taxed at the applicable U.S. rate, less a credit for taxes paid to the foreign country. Over the years, this procedure has stimulated over seas investments by U.S. multinational firms; they continued the deferral indefinitely by continuing to reinvest the earnings in their overseas operations (or in overseas bank ac counts). As a result, many U.S. corporations such as Google, Coca-Cola, and Microsoft have been able to defer billions of dollars of taxes.

The TCJA made major changes to the taxation of foreign income. U.S. firms with accumulated foreign deferred earnings since 1986 must pay a tax of 15.5% on those earn ings that are held in cash and cash equivalents; they must pay 8% on the remainder.17 After this one-time tax, the United States will not tax any new foreign earnings. The good news is that U.S. tax revenues will increase and that companies with past deferred foreign earn ings might now invest them here rather than abroad.

The bad news is that the Act increases incentives for companies to locate production offshore in low-tax countries. After paying the new taxes, companies may choose to rein vest overseas in countries that have lower tax rates than the United States. Doing so will generate higher after-tax profits and free cash flows but won't increase investments and jobs here. If manufacturing in a foreign country is more cost-effective than in the United States, then the Act may not stimulate employment growth for blue-collar workers.

2-9j Taxation of Pass-Through Entities

A pass-through entity is a business whose income is not taxed at the business level but is instead passed through to its owners and then is taxed at their individual personal tax rates. (This is true even if the actual cash generated by the pass-through is used by the pass through rather than being distributed to its owners.) Such businesses include sole propri etorships and partnerships. Another type of pass-through entity is an S corporation, which

"These payments are not all due immediately but may be spread out over 8 years.

(

�source

See Web Extension 2A

on the textbook's Web

site for details concerning

personal taxation.

Chapter 2 Financial Statements, Cash Flow, and Taxes 87

receives benefits from the corporate form of organization-especially limited liability-yet is taxed as a proprietorship or partnership. See Web Extension 2A for a description of how the TCJA affects the personal taxes of those receiving pass-through income.

2-9k The Corporate Alternative Minimum Tax

In addition to the changes described in the following sections, the TCJA eliminated the corporate Alternative Minimum Tax (AMT). The AMT was an additional method of cal culating corporate taxable income that reduced or eliminated some of the various tax credits and deductions used in calculating the normal tax. The corporate AMT's objective was to make it less likely that a company would pay no income taxes.

SELF -TEST

If a corporation has $85,000 in taxable income, what is its tax liability? ($17,150)

How does the federal income tax system treat dividends received by a corporation?

What is the difference in the tax treatment of interest and dividends paid by a corporation? Does this factor favor debt or equity financing?

Briefly explain how tax loss carryback and carryforward procedures work.

2-10 Personal Taxes

Web Extension 2A provides a more detailed treatment of personal taxes, but the key ele ments are presented here based on the 2017 Tax Cut and Job Creation Act. Keep in mind that the TCJA's changes in the corporate tax code will not change unless Congress passes a new tax act. However, most of the changes to the personal tax code are actually suspen sions of elements in the prior code and will revert to their former values for the 2026 tax year unless Congress intervenes. In other words, most of the TCJA's changes to the per sonal tax code are in effect only for tax years 2018-2025.

Ordinary income consists primarily of wages or profits from a proprietorship or part nership, plus investment income other than qualified dividends and net long-term capital gains. We describe taxation of qualified dividends and net long-term capital gains in a fol lowing section, but for now we will assume that a taxpayer has no qualified dividends or net long-term capital gains. Therefore, the taxable income is just ordinary income.

For the 2018 tax year, individuals with less than the first bracket of $9,525 of taxable income are subject to a federal income tax rate of 10%. Therefore, for someone earning $8,000, the tax is 10%($8,000) = $800. For someone with income of $29,525, which is above the first bracket but below the second of $38,700, the first $9,525 (i.e., the amount less than the first bracket) is taxed at 10% and the remaining $29,525 - $9,525 = $20,000 is taxed at 12%. Because 12% is the rate on each additional dollar between $9,524 and $38,700, it is called a marginal tax rate. Total taxes are 10%($9,525) + 12%($20,000) = $3,352.5. As income increases, there are more brackets at higher rates until income exceeds the highest bracket of $500,000 for individuals ($600,000 for married joint filers), at which point the additional income is taxed at 37%. This is called a progressive tax because the higher one's income, the larger the percentage paid in taxes.

Prior to the TCJA in 2017, the top bracket was $418,400 for individuals {$470,700 for joint filers), and the top tax rate was 39.6%. In general, the TCJA cut the marginal rates for the brackets and reduced the bracket thresholds. For example, in 2017, the tax on $29,525 of income (the same amount we just used) would be $3,962.50, over $600 more than it would be under the rates and brackets of the TCJA.

As noted, individuals are taxed on investment income as well as earned income, with a few exceptions and modifications. For example, interest received from most municipal

88 Part 1 The Company and Its Environment

bonds issued by state and local government bonds is not subject to federal taxation. How ever, interest earned on most other bonds or lending is taxed as ordinary income. This means that a lower-yielding muni can provide the same after-tax return as a higher yielding corporate bond. For a taxpayer in the 37% marginal tax bracket, a muni yielding 5.5% provides the same after-tax return as a corporate bond with a pre-tax yield of 8.73%: 8.73%(1 - 0.37) = 5.5%.

Assets such as stocks, bonds, and real estate are defined as capital assets. If you own a capital asset and its price goes up, then your wealth increases, but you are not liable for any taxes on your increased wealth until you sell the asset. If you sell the asset for more than you originally paid, the profit is called a capital gain; if you sell it for less, then you suffer a capi tal loss. The length of time you owned the asset determines the tax treatment. If held for less than 1 year, it is a short-term capital gain or loss and is included as part of ordinary income. If held for more than a year, it is a long-term capital gain or loss and is taxed at a lower rate. Dividends are taxed as though they are capital gains, so we will use the term "dividends & gains" when we refer to the combined dividends and net long-term capital gains.18

Portions of a capital gain may be taxed at 0%, 15%, and 20%. For an investor with total income (ordinary income plus long-term capital gains) less than $36,800 (the first brack et's threshold), none of the capital gain is taxed. For an investor with ordinary income greater than $425,800, all of the capital gains are taxed at 20%. The long-term capital gains rate is 15% for many other situations, but the details are complicated.

Web Extension 2A explains in more detail how to calculate taxes on gains and divi dends. It also describes the standard deduction, itemized deductions, personal exemptions (which are not allowed under the TCJA), tax credits, payroll taxes, the net investment income tax, income from pass-through entities, the alternative minimum tax (AMT), gifts, estates, and generation-skipping transfers.

SELF -TEST

Explain what is meant by this statement: "Our tax rates are progressive."

Explain the difference between marginal tax rates and average tax rates.

What are municipal bonds, and how are these bonds taxed?

What are capital gains and losses, and how are they taxed?

• The four basic statements contained in the annual report are the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows.

• The balance sheet shows assets and liabilities and equity, or claims against assets. The balance sheet may be thought of as a snapshot of the firm's financial position at a particular point in time.

• The income statement reports the results of operations over a period of time, and it shows earnings per share as its "bottom line."

• The statement of stockholders' equity shows the change in stockholders' equity, including the change in retained earnings, between balance sheet dates. Retained earnings represent a claim against assets, not assets per se.

• The statement of cash flows reports the effect of operating, investing, and financing activities on cash flows over an accounting period.

"See Web Extension 2A for details on how net long-term capital gains are calculated. It also explains which dividends are eligible for treatment as though they are capital gains.

Chapter 2 Financial Statements, Cash Flow, and Taxes

• Net cash flow differs from accounting profit because some of the revenues and expenses reflected in accounting profits may not have been received or paid out in cash during the year. Depreciation is typically the largest noncash item, so net cash flow is often expressed as net income plus depreciation.

• Operating current assets are the current assets that are used to support operations, such as cash, inventory, and accounts receivable. They do not include short-term investments.

• Operating current liabilities are the current liabilities that occur as a natural con sequence of operations, such as accounts payable and accruals. They do not include notes payable or any other short-term debts that charge interest.

• Net operating working capital (NOWC) is the difference between operating current assets and operating current liabilities. Thus, it is the working capital acquired with investor-supplied funds.

• Operating long-term assets are the long-term assets used to support operations, such as net plant and equipment. They do not include any long-term investments that pay interest or dividends.

• Total net operating capital (which means the same as operating capital) is the sum of net operating working capital and operating long-term assets. It is the total amount of capital needed to run the business.

• NOPAT is net operating profit after taxes. It is the after-tax profit a company would have if it had no debt and no investments in nonoperating assets. Because NOPAT excludes the effects of financial decisions, it is a better measure of operating perfor mance than is net income.

• Return on invested capital (ROIC) is equal to NOPAT divided by total net operating capital. It measures the rate of return that the operations are generating. It is the best measure of operating performance.

• Free cash flow (FCF) is the cash flow available for distribution to all of a company's investors after the company has made all investments necessary to sustain ongoing operations. Therefore, the intrinsic value of a company is directly related to its ability to generate free cash flow. FCF is defined as NOPAT minus the investment in total net operating capital.

• Market Value Added (MVA) represents the difference between the total market value of a firm and the total amount of investor-supplied capital. If the market values of debt and preferred stock equal their values as reported on the financial statements, then MVA is the difference between the market value of a firm's stock and the amount of equity its shareholders have supplied.

• Economic Value Added (EVA) is the difference between after-tax operating profit and the total dollar cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially from accounting profit because no charge for the use of equity capital is reflected in accounting profit.

• Interest income received by a corporation is taxed as ordinary income; however, 50% of the dividends received by one corporation from another are excluded from taxable income.

• Interest paid by a corporation is a deductible expense, subject to limits established by the 2017 Tax Cut and Jobs Act. However, dividends are not a deductible expense, caus ing our tax system to favor debt over equity financing.

• The corporate tax code's carryforward provision allows certain losses and expenses to be carried forward indefinitely to offset future taxable income.

• S corporations are businesses that have the limited-liability benefits of the corporate form of organization yet are taxed as partnerships or proprietorships.

• In the United States, tax rates are progressive-the higher one's income, the larger the percentage paid in taxes.

90 Part 1 The Company and Its Environment

• Assets such as stocks, bonds, and real estate are defined as capital assets. If a capital asset is sold for more than its cost, the profit is called a capital gain; if the asset is sold for a loss, it is called a capital loss. Assets held for more than a year provide long-term gains or losses.

• Dividends are taxed as though they were capital gains in most situations. • Personal taxes are discussed in more detail in Web Extension 2A.

QUESililONS

{2-1) Define each of the following terms:

{2-2)

{2-3)

{2-4)

{2-5)

{2-6)

{2-7)

{2-8)

a. Annual report; balance sheet; income statement b. Common stockholders' equity, or net worth; retained earnings c. Statement of stockholders' equity; statement of cash flows d. Depreciation; amortization; EBITDA e. Operating current assets; operating current liabilities; net operating working capital;

total net operating capital f. Accounting profit; net cash flow; NOPAT; free cash flow; return on invested capital g. Market Value Added; Economic Value Added h. Progressive tax; taxable income; marginal and average tax rates i. Capital gain or loss; tax loss carryforward j. Improper accumulation; S corporation

What four statements are contained in most annual reports?

If a "typical" firm reports $20 million of retained earnings on its balance sheet, can the firm definitely pay a $20 million cash dividend?

Explain the following statement: "Whereas the balance sheet can be thought of as a snapshot of the firm's financial position at a point in time, the income statement reports on opera- tions over a period of time."

What is operating capital, and why is it important?

Explain the difference between NO PAT and net income. Which is a better measure of the performance of a company's operations?

What is free cash flow? Why is it the most important measure of cash flow?

If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

SELF-TEST PROBLEM SOLUTION SHOWN IN APPFNDIX A

{ST-1) Net Income, Cash

Flow, and EVA

Last year Cole Furnaces had $4 million in operating income (EBIT). The company had a net depreciation expense of $1 million and an interest expense of $1 million; its com bined federal and state corporate tax rate is 25%. The company has $14 million in operat ing current assets and $4 million in operating current liabilities; it has $15 million in net plant and equipment. It estimates that it has an after-tax cost of capital of 10%. Assume that Cole's only noncash item was depreciation.

a. What was the company's net income for the year? b. What was the company's net cash flow? c. What was the company's net operating profit after taxes (NOPAT)? d. Calculate net operating working capital and total net operating capital for the

current year.

Chapter 2 Financial Statements, Cash Flow, and Taxes

e. If total net operating capital in the previous year was $24 million, what was the company's free cash flow (FCF) for the year?

f. What was the return on invested capital? g. What was the company's Economic Value Added (EVA)?

P R O B L E M S A f\J S W E R S A f� E I f\J /\ P P E 1,1 D I X B

(2-1) Personal After

Tax Yield

(2-2) Personal After

Tax Yield

(2-3) Income Statement

(2-4) Income Statement

(2-5) Net Cash Flow

(2-6} Statement of

Retained Earnings

(2-7) Net Operating Profit after Taxes (NOPAT)

(2-8) Total Net Operating

Capital

(2-9) Free Cash Flow

(FCF)

(2-10) Corporate Tax

Liability

Note: By the time this book is published, Congress may have changed rates and/or other provi sions of current tax law. Work all problems on the assumption that the information in the chapter is applicable.

EASY PROBLEMS 1-9

An investor recently purchased a corporate bond that yields 7.68%. The investor is in the 25% federal-plus-state tax bracket. What is the bond's after-tax yield to the investor?

Corporate bonds issued by Johnson Corporation currently yield 8.0%. Municipal bonds of equal risk currently yield 5.5%. At what personal tax rate would an investor be indif ferent between these two bonds?

Holly's Art Galleries recently reported $7.9 million of net income. Its EBIT was $13 mil lion, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was its interest expense? (Hint: Write out the headings for an income statement and then fill in the known values. Then divide $7.9 million net income by 1 - T = 0.79 to find the pre-tax income. The difference between EBIT and taxable income must be the interest expense. Use this procedure to work some of the other problems.)

Nicholas Health Systems recently reported an EBITDA of $25.0 million and net income of $15.8 million. It had $2.0 million of interest expense, and its federal tax rate was 21 % (ignore any possible state corporate taxes). What was its charge for depreciation and amortization?

Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $500,000. What was its net cash flow? Assume it had no amortization expense.

In its most recent financial statements, Del-Castillo Inc. reported $70 million of net in come and $900 million of retained earnings. The previous retained earnings were $855 million. How much in dividends did the firm pay to shareholders during the year?

Zucker Inc. recently reported $4 million in earnings before interest and taxes (EBIT). Its federal-plus-state tax rate is 25%. What is the free cash flow?

Jenn Translation (JT) Inc. reported $10 million in operating current assets, $15 million in net fixed assets, and $3 million in operating current liabilities. How much total net operating capital does JT have?

Carter Swimming Pools has $16 million in net operating profit after taxes (NOPAT) in the current year. Carter has $12 million in total net operating assets in the current year and had $10 million in the previous year. What is its free cash flow?

INTERMEDIATE PROBLEMS 10-17

The Talley Corporation had taxable operating income of $365,000 (i.e., earnings from operating revenues minus all operating costs). Talley also had (1) interest charges of $50,000, (2) dividends received of $15,000, and (3) dividends paid of $25,000. Its federal

(2-11) Corporate Tax

Liability

(2-12) Corporate After

Tax Yield

(2-13) Net Cash Flows

(2-14) Income and Cash

Flow Analysis

(2-15) Net Operating Profit

after Tax (NOPAT)

Part I The Company and Its Environment

tax rate was 21 % (ignore any possible state corporate taxes). Recall that 50% of dividends received are tax exempt. What is the taxable income? What is the tax expense? What is the after-tax income?

The Wendt Corporation reported $50 million of taxable income. Its federal tax rate was 21 % (ignore any possible state corporate taxes).

a. What is the company's federal income tax bill for the year? b. Assume the firm receives an additional $1 million of interest income from some

bonds it owns. What is the additional tax on this interest income? c. Now assume that Wendt does not receive the interest income but does receive an

additional $1 million as dividends on some stock it owns. Recall that 50% of divi dends received are tax exempt. What is the additional tax on this dividend income?

The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds (which yield 6.6%), AT&T preferred stock (with a divi dend yield of 6.0%), and state of Florida muni bonds (which yield 5% but are not taxable). The federal tax rate is 21% (ignore any possible state corporate taxes). Recall that 50% of dividends received are tax exempt. Find the after-tax rates of return on all three securi ties after paying federal corporate taxes.

The Moore Corporation has operating income (EBIT) of $750,000. Its depreciation expense is $200,000. Moore is 100% equity financed. The federal tax rate is 21% (ignore any possible state corporate taxes). What is the company's net income? What is its net cash flow?

The Berndt Corporation expects to have sales of $12 million. Costs other than deprecia tion are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. The federal tax rate is 21% (ignore any possible state corporate taxes). Berndt has no debt.

a. Set up an income statement. What is Berndt's expected net income? Its expected net cash flow?

b. Suppose Congress changed the tax laws so that Berndt's depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?

c. Now suppose that Congress changed the tax laws such that, instead of doubling Berndt's depreciation, it was reduced by 50%. How would profit and net cash flow be affected?

d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?

Use the following income statement of Elliott Game Theory Consulting to determine its net operating profit after taxes (NOPAT). Use 25% as the tax rate.

Elliott Game Theory Consulting Income Statement for Year Ending December 31

2020

Sales $800,000

Operating costs excluding depreciation

Depreciation and amortization

Earnings before interest and taxes

Less interest

Pre-tax income

Taxes (25%) Net income available to common stockholders

700,000

20,000

$ 80,000 2,000

$ 78,000

19,500

$ 58,500

(2-16) Net Operating

Working Capital (NOWC)

(2-17) Investment in Total Net

Operating Capital

Chapter 2 Financial Statements, Cash Flow, and Taxes 93

Using the following balance sheets of Mimi's Gymnastics Inc., what is the net operating working capital (NOWC) for 2020?

Mimi's Gymnastics Inc.: Balance Sheets as of December 31 (Millions of Dollars)

Assets

Cash Short-term investments Accounts receivable Inventories

Total current assets Net plant and equipment Total assets Liabilities and Equity

Accounts payable Accruals Notes payable

Total current liabilities Long-term debt

Total liabilities Common stock Retained earnings

Total common equity Total liabilities and equity

2020

$ 90 llO

1,200 900

$2,300 2,200

$4,500

$ 600 200 180

$ 980 800

$1,780 2,200

520 $2,720 $4,500

Athenian Venues Inc. just reported the following selected portion of its financial statements for the end of 2020. Your assistant has already calculated the 2020 end-of-year net operating working capital (NOWC) from the full set of financial statements (not shown here), which is $13 million. The total net operating capital for 2019 was $50 million. What was the 2020 net investment in operating capital?

Athenian Venues Inc.: Selected Balance Sheet Information as of December 31 (Millions of Dollars)

Assets Cash Short-term investments Accounts receivable Inventories

Total current assets Net plant and equipment Total assets

2020

$1 4 8

ll $24 51

lli

(2-18) Free Cash Flows

Part 1 The Company and Its Environment

CHALLENGING PROBLEMS 18-19

Rhodes Corporation's financial statements are shown after part f. Suppose the federal plus-state tax corporate tax is 25%. Answer the following questions.

a. What is the net operating profit after taxes (NOPAT) for 2020? b. What are the amounts of net operating working capital for both years? c. What are the amounts of total net operating capital for both years? d. What is the free cash flow for 2020? e. What is the ROIC for 2020? f. How much of the FCF did Rhodes use for each of the following purposes: after-tax

interest, net debt repayments, dividends, net stock repurchases, and net purchases of short-term investments? (Hint: Remember that a net use can be negative.)

Rhodes Corporation: Income Statements for Year Ending December 31 (Millions of Dollars)

2020 2019

Sales $11,000 $10,000

Operating costs excluding depreciation 9,612 8,728

Depreciation and amortization 380 360

Earnings before interest and taxes $ 1,008 $ 912

Less interest 120 100

Pre-tax income $ 888 $ 812

Taxes (25%) 222 203

Net income available to common stockholders $ 666 $ 609

Common dividends $ 202 $ 200

Rhodes Corporation: Balance Sheets as of December 31 (Millions of Dollars)

Assets Cash Short-term investments Accounts receivable Inventories

Total current assets Net plant and equipment Total assets

Liabilities and Equity Accounts payable Accruals Notes payable

Total current liabilities

Long-term debt Total liabilities

Common stock Retained earnings

Total common equity Total liabilities and equity

2020 2019

$ 550 $ 500 110 100

2,750 2,500

1,650 1,500

$5,060 $4,600 3,850 3,500

$8,910 $8,100

$1,100 $1,000 550 500 384 200

$2,034 $1,700 1,100 1,000

$3,134 $2,700 4,312 4,400 1,464 1,000

$5,776 $5,400 $8,910 $8.100

(2-19) Loss Carryforward

(2-20) Build a Model:

Financial Statements

resource

Chapter 2 Financial Statements, Cash Flow, and Taxes 95

The Bookbinder Company had $500,000 cumulative operating losses prior to the beginning of last year. It had $100,000 in pre-tax earnings last year before using the past operating losses and has $300,000 in the current year before using any past operating losses. It projects $350,000 pre-tax earnings next year.

a. How much taxable income was there last year? How much, if any, cumulative losses remained at the end of the last year?

b. What is the taxable income in the current year? How much, if any, cumulative losses remain at the end of the current year?

c. What is the projected taxable income for next year? How much, if any, cumulative losses are projected to remain at the end of next year?

Begin with the partial model in the file Ch02 P20 Build a Model.xlsx on the textbook's Web site.

a. Britton String Corp. manufactures specialty strings for musical instruments and tennis racquets. Its most recent sales were $880 million; operating costs (excluding depreciation) were equal to 85% of sales; net fixed assets were $300 million; depreciation amounted to 10% of net fixed assets; interest expenses were $22 million; the state-plus-federal corporate tax rate was 25%; and it paid 40% of its net income out in dividends. Given this information, construct Britton String's income statement. Also calculate total dividends and the addition to retained earnings. Report all dollar figures in millions.

b. Britton String's partial balance sheets follow. Britton issued $36 million of new common stock in the most recent year. Using this information and the results from part a, fill in the missing values for common stock, retained earnings, total common equity, and total liabilities and equity.

Britton Strings Corp: Balance Sheets as of December 31 (Millions of Dollars)

Assets Cash and cash equivalents Short-term investments Accounts receivable Inventories Total current assets

Net fixed assets Total assets

Liabilities and Equity Accounts payable Accruals Notes payable Total current liabilities

Long-term debt Total liabilities

Common stock Retained earnings Total common equity

Total liabilities and equity

Construct the statement of cash flows for 2020.

2020 2019

$ 70 $ 60 46 42

120 140 $264 $196 $500 $438 300 262

$800 $700

$ 73 $ 64 49 60 30 39

$ 152 $ 163 217 178

$ 369 $ 341 285 $249 146 110

$431 $359 $800 $700

(2-21) Build a Model:

Free Cash Flows, EVA, andMVA

resource

Part 1 The Company and Its Environment

Begin with the partial model in the file Ch02 P21 Build a Model.xlsx on the textbook's Web site.

a. Using the financial statements shown here for Lan & Chen Technologies, calculate net operating working capital, total net operating capital, net operating profit after taxes, free cash flow, and return on invested capital for 2020. The federal-plus-state tax rate is 25%.

b. Assume there were 15 million shares outstanding at the end of 2019, the year-end closing stock price was $65 per share, and the after-tax cost of capital was 10%. Calculate EVA and MVA for 2020.

Lan & Chen Technologies: Income Statements for Year Ending December 31 (Millions of Dollars)

2020 2019

Sales $945,000 $900,000

Expenses excluding depreciation and amortization 812,700 774,000

EBITDA $132,300 $126,000

Depreciation and amortization 33,100 31,500

EBIT $ 99,200 $ 94,500

Interest expense 10,400 8,900

Pre-tax earnings $ 88,800 $ 85,600

Taxes (25%) 22,200 21,400

Net income $ 66,600 $ 64,200

Common dividends $ 43,300 $ 41,230

Addition to retained earnings $ 23,300 $ 22,970

Lan & Chen Technologies: December 31 Balance Sheets (Thousands of Dollars)

Assets Cash and cash equivalents Short-term investments Accounts receivable Inventories

Total current assets Net fixed assets

Total assets

Liabilities and Equity Accounts payable Accruals Notes payable

Total current liabilities Long-term debt

Total liabilities Common stock Retained earnings

Total common equity Total liabilities and equity

2020 2019

$ 47,250 $ 45,000 3,800 3,600

283,500 270,000 141,750 135,000

$476,300 $453,600 330,750 315,000

$ 807,050 $768,600

$ 94,500 $ 90,000 47,250 45,000 17,400 9,000

$ 159,150 $144,000 90,000 90,000

$ 249,150 $234,000 $444,600 $444,600

113,300 90,000 $ 557,900 $534,600 $807,050 $768,600

(

The following financial

statements are available

in the file Ch02 Tool Kit.

xlsx In the Mini Case tab.

Because the statements

will be used to project

future years, they are

organized with the most

recent year at the for right.

Chapter 2 Financial Statements, Cash Flow, and Taxes 97

Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components.

During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data.

Balance Sheets {Millions of Dollars) 2018 2019

Assets

Cash and equivalents $ 60 $ 50 Short-term investments 100 10 Accounts receivable 400 520 Inventories 620 820

Total current assets $1,180 $1,400 Gross fixed assets $3,900 $4,820

Less: Accumulated depreciation 1,000 1,320 Net fixed assets $2,900 $3,500 Total assets $4,080 $4,900

Liabilities and Equity Accounts payable $ 300 $ 400 Notes payable 50 250 Accruals 200 240

Total current liabilities $ 550 $ 890 Long-term bonds 800 1,100

Total liabilities $1,350 Common stock 1,000 1,000 Retained earnings 1,730 1,910

Total equity $2,730 $2,910

Total liabilities and equity $4,080 $4,900

Income Statement (Millions of Dollars) 2018 2019

Net sales $5,500 $6,000 Cost of goods sold (excluding depr. & amort.) 4,300 4,800 Depreciation and amortization• 290 320 Other operating expenses 350 420

Total operating costs $4,940 $5,540 Earnings before interest and taxes (EBIT) $ 560 $ 460 Less interest 68 108

Pre-tax earnings $ 492 $ 352 Taxes (25%) 123 88 Net Income $ 369 $ 264

Note:

•computron has no amortization charges.

98 Part 1 The Company and Its Environment

Other Data

Stock price Shares outstanding (millions) Common dividends (millions) Tax rate Weighted average cost of capital (WACC)

Statement of Cash Flows (Millions of Dollars)

Operating Activities Net income before preferred dividends

Noncash Adjustments Depreciation and amortization

Due to Changes in Working Capital Change in accounts receivable Change in inventories Change in accounts payable Change in accruals

Net cash provided by operating activities

Investing Activities Cash used to acquire fixed assets Change in short-term investments

Net cash provided by investing activities

Financing Activities Change in notes payable Change in long-term debt Payment of cash dividends

Net cash provided by financing activities

Net change in cash and equivalents Cash and securities at beginning of the year Cash and securities at end of the year

2018

$50.00 100 $90 25%

10.00%

2019

$30.00 100 $84 25%

10.00%

2019

$ 264

320

(120) (200)

100 40

$ 404

$(920) 90

$(830)

$ 200 300

� $ 416

$ (10) 60

$ 50

Assume that you are Cochran's assistant and that you must help her answer the fol lowing questions:

a. What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity?

b. What do you conclude from the statement of cash flows? c. What is free cash flow? Why is it important? What are FCF's five uses? d. What is Computron's net operating profit after taxes (NOPAT)? What are operat

ing current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?

e. What is Computron's free cash flow? What are Computron's "net uses" of its FCF? f. Calculate Computron's return on invested capital (ROIC). Computron has a

10% cost of capital (WACC). What caused the decline in the ROIC? Was it due to operating profitability or capital utilization? Do you think Computron's growth added value?

Chapter 2 Financial Statements, Cash Flow, and Taxes 99

g. Cochran also has asked you to estimate Computron's Economic Value Added (EVA). She estimates that the after-tax cost of capital was 10% in both years.

h. What happened to Computron's Market Value Added (MVA)? i. The Tax Cut and Jobs Act (TCJA) was signed into law in 2017. Briefly describe its

key provisions for corporate taxes. j. Assume that a corporation has $87 million of taxable income from operations. It

also received interest income of $8 million and dividend income of $10 million. The federal tax rate is 21 %, and the dividend exclusion rate is 50%. What is its taxable income and federal tax liability?

k. Briefly describe the TCJA's key provisions for personal taxes. 1. Assume that you are in the 25% marginal tax bracket and that you have $20,000 to

invest. You have narrowed your investment choices down to municipal bonds yield ing 7% or equally risky corporate bonds with a yield of 10%. Which one should you choose and why? At what marginal tax rate would you be indifferent?