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Chapter

Tool Kit Chapter 2 11/20/18
Financial Statements, Cash Flow, and Taxes
2-1 Financial Statements and Reports
The annual report contains a verbal section plus four key statements: the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows.
Our spreadsheets use formulas rather than fixed numbers. For example, the cell for Total assets for the most recent year contains the Sum formula rather than just a fixed number. That way, if the data for any inputs (cash, for instance) change, the spreadsheet will automatically recalculate and provide the correct new value for Total assets.
In financial modeling, it is helpful to users when input data is grouped together, so you should follow this practice in your own models, too.
2-2 The Balance Sheet
INPUT DATA SECTION: Historical Data Used in the Analysis
2019 2018
Tax rate 25% 25%
Weighted average cost of captal (WACC) 11.50% 11.50%
Figure 2-1
MicroDrive Inc. December 31 Balance Sheets Older version in manuscript 4/20
(Millions of Dollars) Assets 2019 2018
Assets 2019 2018 Cash and equivalents $100 $110
Cash and equivalents $100 $102 Short-term investments 10 182
Short-term investments 10 40 Accounts receivable 500 410
Accounts receivable 500 384 Inventories 1,000 830
Inventories 1,000 774 Total current assets $1,610 $1,532
Total current assets $1,610 $1,300 Net plant and equipment 2,000 1,780
Net property, plant, and equipment (PP&E) 2,000 1,780 Note: Net plant and equipment is equal to cumulative purchases of fixed assets less cumulative depreciation and cumulative disposed assets. Total assets $3,610 $3,312
Total assets $3,610 $3,080
Liabilities and Equity
Liabilities and Equity Accounts payable $200 $190
Accounts payable $200 $180 Notes payable 150 100
Notes payable 150 28 Accruals 400 370
Accruals 400 370 Total current liabilities $750 $660
Total current liabilities $750 $578 Long-term bonds 520 500
Long-term bonds 520 350 Total liabilities $1,270 $1,160
Total liabilities $1,270 $928 Preferred stock (1,000,000 shares) 100 100
Preferred stock (1,000,000 shares) 100 100 Common stock (50,000,000 shares) 500 500
Common stock (50,000,000 shares) 500 500 Retained earnings 1,740 1,552
Retained earnings 1,740 1,552 Total common equity $2,240 $2,052
Total common equity $2,240 $2,052 Total liabilities and equity $3,610 $3,312
Total liabilities and equity $3,610 $3,080
2-2 The Income Statement
Figure 2-2
MicroDrive Income Statements (and Selected Additional Information) for Years Ending December 31
(Millions, Except for Per Share Data)
2019 2018 Older version in manuscript 4/20
Net sales $5,000 $4,800 Net sales 5000 4680
Costs of goods sold except depreciation 3,900 3,710 Costs of goods sold except depreciation $3,900 $3,618
Depreciation and amortizationa 200 180 Depreciation and amortizationa 200 180
Other operating expenses 500 470 Other operating expenses 500 470
Earnings before interest and taxes (EBIT) $400 $440 Earnings before interest and taxes (EBIT) 400 412
Less interest 60 40 Less interest $60 $56
Pre-tax earnings $340 $400 Pre-tax earnings 340 356
Taxes 85 100 Taxes $85 $89
Net Income before preferred dividends $255 $300 Net Income before preferred dividends 255 267
Preferred dividends 7 7 Preferred dividends $7 $7
Net Income available to common stockholders $248 $293 Net Income available to common stockholders 248 260
Additional Information Additional Information
Common dividends $60.0 $59.4 Common dividends $60 $57
Addition to retained earnings $188.0 $233.6 Addition to retained earnings $188 $203
Number of common shares 60 60 Number of common shares $60 $60
Stock price per share $31.00 $45.00 Stock price per share 31 38
Per Share Data Per Share Data
Earnings per share, EPSb $4.13 $4.88 Earnings per share, EPSb $4.13 $4.33
Dividends per share, DPSc $1.00 $0.99 Dividends per share, DPSc $1.00 $0.95
Book value per share, BVPSd $37.33 $34.20 Book value per share, BVPSd $37.33 $34.20
Notes:
a MicroDrive has no amortization charges.
b EPS = Net income available to common stockholders Common shares outstanding
c DPS = Dividends paid to common stockholders Common shares outstanding
d BVPS = Total common equity Common shares outstanding
2-4 Statement of Stockholders’ Equity
The statement of stockholders' equity takes the previous year's balance of common stock, retained earnings, and stockholders' equity and then adds the current year's net income and subtracts dividends paid to common stockholders. The end result is the new balance of common stock, retained earnings, and stockholders' equity.
Figure 2-3
MicroDrive Inc. Statement of Stockholders' Equity
(Millions of Dollars, Millions of Shares)
Preferred Stock Common Shares Common Stock Retained Earnings Total Equity
Balances, Dec. 31, 2018 $100 60 $500 $1,552 $2,152
Changes during year:
Net income $248 $248
Cash dividends (60) (60)
Issuance/repurchase of stock 0 0 0
Balances, Dec. 31, 2019 $100 60 $500 $1,740 $2,340
Note: In financial statements, parentheses and red colors denote a negative number.
2-5 Statement of Cash Flows
Information from the balance sheet and income statement can be used to construct the Statement of Cash Flows, which is shown below for MicroDrive, in millions of dollars.
Figure 2-4
MicroDrive Statement of Cash Flows for Year Ending Dec. 31
(Millions of Dollars)
Operating Activities 2019
Net Income before preferred dividends $255
Noncash adjustments
Depreciationa 200
Working capital adjustments
Increase in accounts receivableb (116)
Increase in inventories (226)
Increase in accounts payable 20
Increase in accruals 30
Net cash provided (used) by operating activities $163
Investing Activities
Cash used to acquire fixed assetsc ($420)
Sale of short-term investments 30
Net cash provided (used) by investing activities ($390)
Financing Activities
Increase in notes payable $122
Increase in bonds 170
Payment of common and preferred dividends (67)
Net cash provided (used) by financing activities $225
Summary
Net change in cash and equivalents ($2)
Cash and securities at beginning of the year 102
Cash and securities at end of the year $100
Notes:
aDepreciation is a noncash expense that was deducted when calculating net income. It must be added back to show the correct cash flow from operations.
bAn increase in a current asset decreases cash. An increase in a current liability increases cash. An increase in a current liability increases cash. See the text in this section for examples and explanations.
cThe net increase in fixed assets 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.
2-6 Net Cash Flow
2019 2018
Net income $248.0 $293.0
Depreciation $200.0 $180.0
Net cash flow $448.0 $473.0
2-7 Free Cash Flow: The Cash Flow Available for Distribution to Investors
Net Operating Profit After Taxes
NOPAT is the amount of profit MicroDrive would generate if it had no debt and held no financial assets.
NOPAT = EBIT x (1-T)
2019 2018
Tax rate 25% 25%
Earnings before interest and taxes (EBIT) $400 $440
x (1-T) 75% 75%
NOPAT $300 $330
Net Operating Working Capital
The current assets (CA) used in operations are called operating current assets. Operating CA include the cash needed for operations, accounts receivable and inventories. The current liabilities (CL) that are due to operations are called operating current liabilities. Operating CL include accounts payable and accruals. Net operating working capital (NOWC) is equal to operating CA minus operating CL. NOWC is the net amount that a company's operations tie up in current assets and current liabilities.
Calculating Operating Current Assets
2019 2018
Cash and equivalents $100 $102
+ Accounts receivable $500 $384
+Inventories $1,000 $774
Operating current assets $1,600 $1,260
Calculating Operating Current Liabilities
2019 2018
Accounts payable $200 $180
+ Accruals $400 $370
Operating current liabilities $600 $550
Calculating Net Operating Working Capital
2019 2018
Operating current assets $1,600 $1,260
− Operating current liabilities $600 $550
Net operating working capital $1,000 $710
Total Net Operating Capital (also just called Operating Capital or just Capital)
The Total Net Operating Capital is Net Operating Working Capital plus any long-term fixed assets or net plant, property, and equipment used in operations.
Calculating Total Net Operating Capital
2019 2018
Net operating working capital $1,000 $710
+ Net plant and equipment $2,000 $1,780
Total net operating capital $3,000 $2,490
Alternative Calculation of Total Net Operating Capital (also just called Operating Capital)
Total Funds Provided by Investors
2019 2018
Notes payable $150 $28
Long-term bonds $520 $350
Preferred stock $100 $100
Total common equity $2,240 $2,052
Total investor supplied funds $3,010 $2,530
Total Funds Provided by Investors for Operations
2019 2018
Total investor supplied capital $3,010 $2,530
Less short-term investments $10 $40
Total investor-supplied operating capital $3,000 $2,490
Free Cash Flow
MicroDrive's Free Cash Flow calculation is the cash flow actually availabe for distribution to investors after the company has made all necessary investments in fixed assets and working capital to sustain ongoing operations. Free cash flow is equal to NOPAT minus the investment made in total net operating capital. The investment in total net operating capital is equal to the current year's total net operating capital minus the previous year's total net operating capital.
Calculating the Investment in Total Net Operating Capital
2019 2018
Total net operating capital $3,000 $2,490
Investment in total net operating capital $510
Calculating Free Cash Flow
2019
NOPAT $300
− Investment in total net operating capital $510
Free cash flow −$210
Here is an alternative calculation of FCF that is sometimes used in the financial press.
2019 FCF = NOPAT + Depreciation − Gross investment in fixed assets − Investment in NOWC
= $500 − $420 − $290
= −$210
Uses of Free Cash Flow
1. After-tax interest payments
2019 After-tax interest expense = (Pre-tax interest expense) x (1-T)
= $60.0 x 75%
= $45.0
2. Net repayment (issuance) of debt
The 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 of 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 of FCF.
2019 Repayment (issuance) to debtholders = All debt at beginning of year - all debt at end of year
= $378.0 - $670.0
= −$292
3. Total dividend payments
This includes all dividends to preferred stockholders and dividends to common stockholders.
2019 Dividends = Prefered dividends + common dividends
= $7.0 + $60.0
= $67.0
4. Net repurchase (sale) of stock
The 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, 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.
2019 Repurchase stock = Preferred stock and common stock at beginning of year - Preferred stock and common stock at end of year
= $600.0 - $600.0
= $0.0
5. Net purchase (sale) of short-term investments
The amount of net purchases of ST 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 ending investments is greater than the beginning investments, 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 of FCF.
2019 Purchase ST investments = ST investents at end of year - ST investments at beginning of year
= $10.0 − $40.0
= -$30.0
Summary of uses of FCF
2019
1. After-tax interest payments $45.0
2. Net repayment (issuance) of debt -$292.0
3. Total dividend payments $67.0
4. Net repurchase (sale) of stock $0.0
5. Net purchase (sale) of short-term investments -$30.0
Total uses of FCF = −$210
Notice that the total uses of FCF equals the previously calculated value of FCF.
2-8 Performance Evaluation
The Return on Invested Capital (ROIC)
The Return on Invested Capital tells us the amount of NOPAT per dollar of operating capital.
2019 ROIC = NOPAT ÷ Total net operating capital
= $300.00 ÷ $3,000
= 10.00%
2018 ROIC = NOPAT ÷ Total net operating capital
= $330.00 ÷ $2,490
= 13.25%
The Operating Profitability Ratio (OP)
The operating profitability ratio show the amount of NOPAT per dollar of sales.
2019 OP = NOPAT ÷ Sales
= $300.00 ÷ $5,000
= 6.00%
2018 OP = NOPAT ÷ Sales
= $330.00 ÷ $4,800
= 6.88%
The Capital Requirement Ratio (CR)
The capital requirement ratio show the amount of operating capital that is needed to generate a dollar of sales.
2019 CR = Total net operating capital ÷ Sales
= $3,000 ÷ $5,000
= 60.00%
2018 CR = Total net operating capital ÷ Sales
= $2,490 ÷ $4,800
= 51.88%
Market Value Added
Market Value Added is the difference between the market value of MicroDrive's stock and the amount of equity capital supplied by shareholders.
2019 MVA = Stock price x # of shares − Total common equity
= $31.00 x 60 − $2,240.0
= $1,860 − $2,240.0
= −$380
2018 MVA = Stock price x # of shares − Total common equity
= $45.00 x 59.4 − $2,052.0
= $2,673 − $2,052.0
= $621
Economic Value Added
Economic Value Added represents MicroDrive's residual income that remains after the cost of all capital, including equity capital, has been deducted.
2019 EVA = NOPAT − Operating Capital x Weighted average cost of capital
= $300 − $3,000 x 11.5%
= $300 − $345
= −$45
2018 EVA = NOPAT − Operating Capital x Weighted average cost of capital
= $330 − $2,490 x 11.5%
= $330 − $286
= $44
Figure 2-6
Calculating Performance Measures for MicroDrive
(Millions of Dollars)
2019 2018 Ind. Avg.
Calculating NOPAT
EBIT $400 $440
x (1 − Tax rate) 75% 75%
NOPAT = EBIT(1 − T) $300 $330
Calculating Net Operating Working Capital (NOWC)
Operating current assets $1,600 $1,260
− Operating current liabilities 600 550
NOWC $1,000 $710
Calculating Total Net Operating Capital
NOWC $1,000 $710
+ Net plant and equipment 2,000 1,780
Total net operating capital $3,000 $2,490
Calculating Return on Invested Capital (ROIC)
NOPAT $300 $330
÷ Total net operating capital 3,000 2,490
ROIC = NOPAT/Total net operating capital 10.00% 13.25% 13.19%
Weighted average cost of capital (WACC) 11.50% 11.50% 11.20%
Calculating the Operating Profitability Ratio (OP)
NOPAT $300 $330
÷ Sales 5,000 4,800
OP = NOPAT/Sales 6.00% 6.88% 6.75%
Calculating Capital Requirement Ratio (CR)
Total net operating capital $3,000 $2,490
÷ Sales 5,000 4,800
CR = Total net operating capital/Sales 60.00% 51.88% 51.19%
Calculating Market Value Added (MVA)
Price per share $31.00 $45.00
x Number of shares (millions) 60.0 59.4
Market value of equity = P x (# of shares) $1,860 $2,673
− Book value of equity 2,240 2,052
MVA = Market value − Book value −$380 $621
Calculating Economic Value Added (EVA)
Total net operating capital $3,000.0 $2,490.0
x Weighted average cost of capital (WACC) 11.5% 11.5%
Dollar cost of capital $345.0 $286.4
NOPAT $300.0 $330.0
− Dollar cost of capital 345.0 286.4
EVA = NOPAT – Dollar cost of capital −$45.0 $43.7
2-9 Corporate Taxes
In 2017, Congress passed "An Act to Provide for the Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018." The Act is still widely known by the title in one of its preliminary versions, the Tax Cut and Jobs Act (TCJA). We will refer to it as the 2017 Tax Act or just the Act.
The 2017 Tax Act made major changes to the corporate and personal tax regulations. Following are descriptions and examples of several important items in the Act.
Tax Rates
The biggest change was to the actual tax rates. Prior to the the Act's passage, corporate taxes were progressive (i.e., the rate was higher for higher taxable income) 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.
Previous tax rate = 35%
Taxable income = $200 million
New tax rate = 21%
Tax on income = $42 million
2017 tax on same income = $70 million
Tax saving due to 2018 Act = $28
Percentage reduction in taxes = 40%
Interest Expense Deduction Limitation
Before the Act, corporations could deduct the entire amount of their interest expenses when calculating 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, and depreciation & amortization (EBITDA). For 2022 and subsequent years, the Act reduced the allowable interest expense deduction to 30% of earnings before interest and taxes (EBIT).
For example, consider a company with EBITDA of $160 million in 2019 and interest expenses of $80.
EBITDA = $160 million
Interest expense = $80 million
Percentage of allowable deduction = 30%
Allowable interest rate deduction = $48 million
Remaining interest expense to carry forward = $32 million
Loss Carryforward
For example, consider a company in the following situation.
Cumulative prior unused net operating lossess = $120 million
2019 taxable income prior to carryforward adjustment = $100 million
2020 taxable income prior to carryforward adjustment = $100 million
Carryforward: Limitation on offset of taxable income = 80%
Federal corporate tax rate = 21%
Table 2-1
Apex Corporation: Tax Loss Carryforward (Millions of Dollars)
Calculation of tax if ignore carryforward losses 2018 2019 2020
Taxable operating profit if no carryforward provision $100.0 $100.0
Tax (21%) if no carryforward provision $21.0 $21.0
Calculation of maximum allowed carryforward loss
Unadjusted taxable operating profit prior to carryforward $100.0 $100.0
Maximum allowed carryforward lossa $80.0 $80.0
Cumulative prior unused net operating lossesb $120 $40.0 $0.0
Calculation of maximum allowed carryforward loss
Unadjusted taxable profit prior to carryforward $100.0 $100.0
Allowed prior unused net operating losses carried forwardc $80.0 $40.0
Adjusted taxable profit $20.0 $60.0
Tax on adjusted profit (21%) $4.2 $12.6
Tax savings due to carryforward provision
Tax if carryforward losses are ignored $21.0 $21.0
Tax on adjusted profit (21%) after carryforward $4.2 $12.6
Tax savings due to carryforward $16.8 $8.4
Notes:
aThe maximum allowed carry forward loss is limited to 80% of the unadjusted taxable operating profit.
bThe cumulative prior unused net operating loss for Yeart is equal to its value in Yeart-1 minus the amount that is used in Yeart.
cThe 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.
Dividend Income Received by a Corporation
If a corporation receives dividends from another, it may exclude a portion of the dividends from taxation.
Amount of investible funds = $136.8 million
Coupon rate on preferred stock = 7.310%
Dividend exclusion rate = 50%
Tax rate = 21%
Pre-tax dividends received by a company = (Preferred coupon rate)(Amount invested)
= $10.000 million
Tax on dividends = (Dividends)(1 − Dividend exclusion rate)(Tax rate)
= ($10)(1 − 50%)(21%)
= $1.05 million
After-tax dividends = $8.950 million
Effective tax rate on dividends received = (After-tax dividends)/(Pre-tax dividends)
= 10.50%
Suppose the company in the previous example invests in debt rather than preferred stock because debt usually has a higher pre-tax rate of return than preferred stock. For example, suppose the company above invests the same amount in debt with an interest rate higher than the coupon rate on the preferred stock.
Amount of investible funds = $136.8 million
Interest rate on debt = 8.18%
Pre-tax interest income received by a company = $11.19 million
Tax rate = 21%
Tax on interest = (Interest income)(Tax rate)
= $2.35 million
After-tax interest = $8.84 million
Effective tax rate on interest received = (After-tax interest)/(Pre-tax interest)
= 21.0%
The net result is that corporations are taxed less on dividend income.
Effective tax rate on interest received = 21.0%
Effective tax rate on dividends received = 10.5%
Tax advantage of dividend versus interest income = 10.5%
Dividends and Interest Paid by a Corporation
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. If the combined federal + state tax rate is 24.8%, how much pre-tax income is needed to pay $1 of dividends?
Combined federal + state tax rate = 24.8%
Pre-tax income needed = $1/(1 - T)
= $1.33
Working backwards, suppose a company has $1.33 in pre-tax earnings and has a 24.8% combined federal + state tax rate. How much can it pay in dividends?
Pre-tax income = $1.33
After-tax income = (Pre-tax income)(1 - T)
= $1.00
2-10 Personal Taxes
Most of the changes to the personal tax code are actually suspensions of elements in the prior code and will revert to their former values for the 2026 tax year unless Congress intervenes. In other words, the most of the TCJA’s changes to the personal tax code are in effect only for tax years 2018-2025.
Tax brackets and rates
How much will a person owe on taxable income of $9,525? On $38,700?
For the 2018 tax year, individuals with less than $9,525 of taxable income are subject to a federal income tax rate of 10%.
Top of first bracket = $9,525
Tax rate for income less than the first bracket = 10%
Taxable income = $8,000
Tax = $800.00
How much will a taxpayer owe on taxable income of $29,525?
Top of first bracket = $9,525
Tax rate for income less than the first bracket = 10%
Top of second bracket = $38,700
Tax rate for income over the first bracket but under the second bracket = 12%
Taxable income = $29,525
Amount taxed at first bracket's rate = $9,525
Tax on amount in first bracket = $952.50
Amount taxed at second bracket's rate = $20,000
Tax on amount in first bracket = $2,400.00
Total tax = $3,352.50
Interest on municipal bonds versus interest on corporate bonds
Interest rate on municipal bond = 5.50%
Marginal tax rate on individual = 37.00%
How much must a corporate bond pay until it is a better deal than the municipal bond?
Pre-tax interest rate on corporate bond needed to provide same after-tax return as a municipal bond = (Rate on muni)/(1 − Marginal tax rate)
= 8.73%

2-2

SECTION 2-2
SOLUTIONS TO SELF-TEST
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 (i.e., the reported common equity)?
Total assets $8,000,000
Current liabilities $3,000,000
Long-term debt $2,000,000
Preferred stock $1,000,000
The net worth of shareholders, also called common equity, is equal to the total assets less all liabilities and preferred stock.
Net worth = common equity = $2,000,000

2-3

SECTION 2-3
SOLUTIONS TO SELF-TEST
A firm has $2,000,000 million in earnings before taxes. The firm has an interest expense of $300,000 and depreciation of $200,000; it has no amortization. What is its EBITDA?
Earnings before taxes $2,000,000
Interest $300,000
Depreciation $200,000
Amortization $0
EBITDA stands for earnings before interest, taxes, and depreciation. To calculate EBITDA using the given information, start with earnings before taxes and add back interest, depreciation, and amortization.
EBITDA $2,500,000
Now suppose a firm has the following information: $7 million in sales, $4 million of costs of goods sold excluding depreciation & amortization, $500,000 of other operating expenses. What is its EBITDA?
Sales $7,000,000
Costs of goods sold excluding depreciation and amortization $4,000,000
Other operating expenses $500,000
EBITDA stands for earnings before interest, taxes, and depreciation. To calculate EBITDA using the given information, start with sales and subtract costs of goods sold (excluding depreciation) and other operating costs:
EBITDA $2,500,000

2-4

SECTION 2-4
SOLUTIONS TO SELF-TEST
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 it its resulting retained earnings balance?
Previous retained earnings balance $3,000,000
Current net income $2,500,000
Common dividends $1,000,000
This year's addition to retained earnings is the amount of net income not paid out in dividends:
Addition to retained earnings $1,500,000
The new balance of retained earnings is the previous year's balance plus this year's addition to retained earnings:
Current retained earnings balance $4,500,000

2-5

SECTION 2-5
SOLUTIONS TO SELF-TEST
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?
Previous year's inventories $2,000,000
Current year's inventories $1,500,000
Inventories are assets that a company owns. When inventories increase (perhaps because the company bought more goods than it sold), cash goes down due to the increase in assets owned by the company. When inventories decrease (perhaps because the company sold more goods than it purchased), cash goes up due to the decrease in assets owned by the company. Therefore the cash flow due to a change in inventories is equal to the previous year's inventories minus the current year's inventories:
Cash flow due to inventories = Previous year's inventories −Current year's inventories
Change in net cash provided by operations $500,000

2-6

SECTION 2-6
SOLUTIONS TO SELF-TEST
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?
Net income $5,000,000
Depreciation $1,000,000
Net cash flow = Net income + Noncash expenses
Net cash flow $6,000,000

2-7

SECTION 2-7
SOLUTIONS TO SELF-TEST
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?
Sales $10,000,000
Costs of goods sold (excluding depreciation) $5,000,000
Depreciation $1,400,000
Other operating expenses $2,000,000
Interest expense $1,000,000
Tax rate 25%
The first step is to calculate the earnings before interest and taxes, EBIT. This is the amount of pre-tax operating earnings.
EBIT = Sales − Costs of goods sold excluding depreciation − Depreciation − Other operating expenses
Notice that interest expense is not subtracted because interest is not an operating expense.
EBIT = pre-tax operating earnings = $1,600,000
The second step is to calculate NOPAT, which is equal to after-tax operating earnings.
NOPAT = EBIT (1−T)
NOPAT = $1,200,000
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?
Cash $500,000
Short-term investments $2,500,000
Accounts receivable $1,200,000
Inventories $1,000,000
Net plant and equipment $4,000,000
Operating current assets are the short-term assets used in operations. They do not include an short-term investments or marketable securities that are not a part of normal operations. They do not include any long-term assets.
Operating CA = Cash + Accounts receivable + inventories
Operating current assets = $2,700,000
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?
Accounts payable $1,000,000
Notes payable $1,100,000
Short-term debt $1,400,000
Accruals $500,000
Long-term bonds $3,000,000
Operating current liabilities are the short-term liabilities arising from operating acivities. They do not include any form of debt, including notes payable, short-term debt, or long-term bonds.
Operating CL = Accounts payable + accruals
Operating current liabilities = $1,500,000
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? How much is tied up in total net operating capital?
Operating current assets $2,700,000
Operating current liabilities $1,500,000
Long-term bonds $3,000,000
Net plant and equipment $7,800,000
Other long-term operating assets $1,000,000
Net operating working capital (NOWC) is the net amount tied up in short-term operating assets after adjusting for the amount arising from short-term operating liabilities. It does not include any cash ties up in long-term assets and it is not adjusted for any cash provided by investors.
Net operating working capital = NOWC = Operating current assets − Operating current liabilities
Net operating working capital = NOWC = $1,200,000
Total net operating capital includes the net amount tied up in net operating working capital (NOWC) and the amount tied up in all long-term operating assets. It is not adjusted for any cash provided by investors.
Total net operating capital = Net operating working capital + Net plant and equipment + Other long-term operating assets
Total net operating capital = $10,000,000
A firm’s total net operating capital for the previous year was $2 million. For the current year, its total net operating capital is $2.5 million and its NOPAT is $1.2 million. What is its free cash flow for the current year?
Previous year's total net operating capital $9,300,000
Current year's total net operating capital $10,000,000
Current year's NOPAT $1,200,000
First, calculate the investment in total net operating capital.
Investment in total net operating capital = Current year's total net operating capital − previous year's total net operating capital
Investment in total net operating capital = $700,000
Second, calculate free cash flow.
Free cash flow = NOPAT − Investment in total net operating capital
Free cash flow = $500,000

2-8

SECTION 2-8
SOLUTIONS TO SELF-TEST
A company has sales of $200 million, NOPAT of $12 million, net income of $8 million, new operating working capital (NOWC) of $10 million, total net operating capital of $100 million, and total assets of $110 million. What is it operating profitability (OP) ratio? Its capital requirment (CF) ratio? Its return on invested capital (ROIC)?
Sales $200 million
NOPAT $12 million
Net income $8 million
Net operating working capital $10 million
Total net operating capital $100 million
Total assets $110 million
The operating profitability (OP) ratio measures the dollars of operating profit per dollar of sales.
OP = NOPAT / Sales
OP = 6%
The capital requirement (CR) ratio measures the dollars of total net operating capital tied up per dollar of sales.
CR = (Total net operating capital) / Sales
CR = 50%
The return on invested capital (ROIC) measures the dollars of operating profit per dollar of total net operating capital.
ROIC = NOPAT / (Total net operating capital) = OP / CR
ROIC = NOPAT / (Total net operating capital) = 12%
ROIC = OP / CR = 12.00%
A firm has $100 million in total net operating capital. Its return on invested capital is 14 percent, and its weighted average cost of capital is 10 percent. What is its EVA?
Total net operating working capital $100,000,000
ROIC 14%
WACC 10%
Free cash flow = $4,000,000

2-9

SECTION 2-9
SOLUTIONS TO SELF-TEST
If a corporation has $85,000 in taxable income, what is its tax liability?
Taxable income $85,000
Tax rate 21%
Tax liability $17,850

Mini Case Data

11/20/18
Chapter 2 Mini Case
Situation
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.
Computron's Balance Sheets (Millions of Dollars)
2019 2020
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 $ 1,990
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
Computron's Income Statement (Millions of Dollars) 2019 2020
Net sales $ 5,500 $ 6,000
Cost of goods sold (Excluding depr. & amort.) 4,300 4,800
Depreciation and amortizationa 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
Notes:
a Computron has no amortization charges.
Other Data 2020 2019
Stock price $57.00 $40.00
Shares outstanding (millions) 100 100
Common dividends (millions) $90 $84
Tax rate 25% 25%
Weighted average cost of capital (WACC) 10.00% 10.00%
Computron's Statement of Cash Flows (Millions of Dollars)
Bart Kreps: The statement of cash flows provides information about cash inflows and outflows during an accounting period.
2020
Operating Activities
Net Income before preferred dividends $ 264
Noncash adjustments
Depreciation and amortization 320
Due to changes in working capital
Change in accounts receivable (120)
Change in inventories (200)
Change in accounts payable 100
Change in accruals 40
Net cash provided by operating activities $ 404
Investing activities
Cash used to acquire fixed assets $ (920)
Bart Kreps: Make sure to add back annual Depreciation to Net PP&E.
Change in short-term investments 90
Net cash provided by investing activities $ (830)
Financing Activities
Change in notes payable $ 200
Change in long-term debt 300
Payment of cash dividends (84)
Net cash provided by financing activities $ 416
Net change in cash and equivalents $ (10)
Cash and securities at beginning of the year 60
Cash and securities at end of the year $ 50

Web 2A

Read this comment
Michael Ehrhardt: The rates shown are those available in spring 2018. They may change as inflation is incorporated into the dollar break points.		 11/20/18
Web Extension 2A: Tool Kit for Individual Taxes
Some of the examples here are simplified for the sake of clarity and do not necessarily reflect all the possible exceptions and minor adjustments in the actual tax code. Do not use these examples as a substitute for the actual IRS instruction or the advice of a profession tax preparer.
The rates shown are those available in spring 2018. They may change as inflation is incorporated into the dollar break points.
Table 2A-1
Individual Tax Table
If an individual's He/she pays this Plus this percentage Average tax
taxable income amount on the on the excess rate at
is between: base of the bracket over the base top of bracket
(1) (2) (3) (4) (5)
$0 $9,525 $0.00 10.0% 10.0%
$9,525 $38,700 $952.50 12.0% 11.5%
$38,700 $82,500 $4,453.50 22.0% 17.1%
$82,500 $157,500 $14,089.50 24.0% 20.4%
$157,500 $200,000 $32,089.50 32.0% 22.8%
$200,000 $500,000 $45,689.50 35.0% 30.1%
$500,000 and up $150,689.50 37.0% 37.0%
Married (Joint Return) Tax Table
If a couple's It pays this Plus this percentage Average tax
taxable income amount on the on the excess rate at
is between: base of the bracket over the base top of bracket
(1) (2) (3) (4) (5)
$0 $19,050 $0.00 10.0% 10.0%
$19,050 $77,400 $1,905.00 12.0% 11.5%
$77,400 $165,000 $8,907.00 22.0% 17.1%
$165,000 $315,000 $28,179.00 24.0% 20.4%
$315,000 $400,000 $64,179.00 32.0% 22.8%
$400,000 $600,000 $91,379.00 35.0% 26.9%
$600,000 and up $161,379.00 37.0% 37.0%
Application of tax table to single filers and married (joint return) filers.
Suppose an individual filer has taxable income (Form 1040 Line 44) of $60,000. All the earning are from wages (i.e., none are from dividend income or net long-term capital gains).
Individual filer:
Taxable income Tax Average Tax Rate
$60,000.00 $9,139.50 15.23%
Suppose a married couple filing jointly has taxable income (Form 1040 Line 44) of $120,000. All the earning are from wages (i.e., none are from dividend income or net long-term capital gains).
Married (joint) filer:
Taxable income Tax Average Tax Rate
$120,000.00 $18,279.00 15.23%
As shown below, the married joint filers have twice as much taxable income as the individual filer and they have twice as much tax as the indidvidual filer. Prior to the TCJA, this was not the case--married joint filers paid more in taxes than twice the individual filers with the same taxable income. This was called the marriage penalty, which was common if both spouses had similar incomes. The TCJA eliminated the marriage penalty.
Married taxable income / Individual taxable income = 2.00
Married tax / Individual tax = 2.00
Example: Using Tax Rates and Brackets to Calculate Personal Taxes
Exemption per person = $0 Read comment.
Michael Ehrhardt: When filing a tax return in 2018 for the 2017 tax year, each taxpayer received an exemption of $4,500 for each dependent, including the taxpayer, which reduced taxable income. However, the TCJA eliminated personal exemptions for 2018-2025.
Standard deduction (individual) = $12,000
Standard deduction (married filing joint) = $24,000
Social Security (SS) tax rate = 6.20%
Wage base level for capping SS tax = $128,700
Medicare tax rate = 1.45%
Additional Medicare Tax rate = 0.90%
Additional Medicare Tax for single filers begins at = $200,000
Additional Medicare Tax for married joint filers begins at = $250,000
Income tax on wage, salaries, tips, etc.
Find the marginal income tax rate, the U.S. income tax, and the average tax rate for a single person in the following situation.
Gross income    (all as wages reported on Form 1040 Line 7) = $70,700.00
Standard deduction = $12,000.00
Taxable Income = $58,700.00
Base taxable income = $38,700.00
Base tax = $4,453.50
Marginal tax rate = 22.0%
Tax = $8,853.50
Average tax rate = 15.08%
Payroll taxes: Social Security taxes and Medicare taxes
Using the example above, how much would remain after income taxes, Social Security taxes, and Medicare taxes?
Gross income (all as wages) = $70,700.00
Amount subject to Social Security rate = $70,700.00
Social Security tax rate = 6.2%
Social Security tax = $4,383.40
Medicare tax rate = 1.45%
Additional Medicare tax rate for high incomes = 0.90%
Total Medicare tax rate = 1.45%
Medicare tax = $1,025.15
Total payroll taxes (Social Security and Medicare) = $5,408.55
Remaining after income taxes, Social Security, and Medicare = $56,437.95
Suppose the person in the previous example receives a $1,000 raise. What are the additional income taxes and combined Social Security and Medicare taxes (assume the person is not self-employed).
Pay raise: $1,000.00
Gross income (all as wages) = $71,700.00
Standard deduction = $12,000.00
Taxable Income = $59,700.00
Base taxable income = $38,700.00
Base tax = $4,453.50
Marginal tax rate = 22.0%
Tax = $9,073.50
Average tax rate = 15.20%
Social Security payment rate = 6.2%
Amount subject to Social Security rate = $71,700.00
Social Security payment = $4,445.40
Medicare payment rate = 1.45%
Social Security payment = $1,039.65
Remaining income after income taxes, Social Security, and Medicare = $57,141.45
Additional income due to raise = $703.50
If the increase in income does not put the gross income into a new tax bracket and does not exceed the limit for Social Security taxes, then the additional after-tax raise is equal to the pre-tax raise multiplied by the marginal tax rate.
Marginal tax rate = 22%
Additional income tax = $220
Additional Social Security and Medicare tax = $76.50
Total after-tax raise = $703.50
Net Investment Income Tax
In addition to tax on various types of investment income, there is 3.8% Net Investment Income Tax levied on investment income that exceeds a limit, as shown below.
Net investment income tax rate = 3.80%
Net investment income tax threshold for single filers = $200,000
Net investment income tax threshold for joint filers = $250,000
Single filer's investment income = $80,000
Single filer's modified adjusted gross income = $300,000
Modified adjusted gross income minus the threshold = $100,000
Minimum of net investment income and excess of modified adjusted gross income over the threshold = $80,000
Net investment income tax = $3,040
Municipal bond after-tax interest
Suppose an individual is at the top tax bracket. This person is considering purchasing either a tax-exempt municipal bond or a a corporate bond. Total investment income is below the threshold that triggers the additional Net Income Investment Tax. Using the information below, which bond should the person buy?
Interest rate on corporate bond = 8.00%
Interest rate on municipal bond = 5.50%
Marginal tax rate on individual = 37.00%
After-tax return on corporate bond = (Interest rate)(1 − Marginal tax rate)
= 5.04%
How much must a corporate bond pay until it is a better deal than the municipal bond?
Pre-tax interest rate on corporate bond needed to provide same after-tax return as a municipal bond = (Rate on muni)/(1 − Marginal tax rate)
= 8.73%
If we know the pre-tax yield on the corporate bond, how much must a muni pay for it to be a better deal than the corporate bond?
Pre-tax interest rate on corporate bond = 8.73%
Marginal tax rate on individual = 37.00%
Required interest rate on muni = (Pre-tax rate on corporate bond)(1 − Marginal tax rate)
= 5.50%
Dividend and Capital Gains Taxation
First, there is no separate line of Form 1040 to record the tax on qualified dividends and net long-term gains. (The dividends we discuss will be qualied. Loosely speaking, a qualified dividend one that is actually paid by a domestic C corporation.) Instead, it is embedded in the caculations of 1040 line 44, Tax. So you have to use the "Qualified Dividends and Capital Gain Worksheet" in Form 1040. The following examples isolate the tax treatment of dividends and gains from the embedded calculations in the "Qualified Dividends and Capital Gain Worksheet" in Form 1040.
Dividends and net long-term capital gains are taxed exactly the same way, so we will usually refer to "combined dividends and gains" when discussing taxes. Combined dividends and gains are taxed differently from ordinary income. Combined dividends and gains have progressive brackets that differ from those for ordinary income. The following examples are based on the combined amount of dividends and capital gains. Note: At high incomes, there may be an additional Net Investment Income Tax, as we illustrated previously. We omit this from the following examples to better focus on the separate tax on combined dividend and gains.
Table  2A-2
Tax Brackets and Rates for Calculating Tax on Combined Dividends and Long-Term Capital Gains for the 2018 Tax Year (as available in March, 2018)
Single Filers
Brackets Rates Rates
$0 $38,600 0.00% 0.00%
$38,600 $425,800 15.00% 15.00%
$425,800 and up 20.00% 20.00%
Married Joint Filers
Brackets Rates Rates
$0 $77,200 0.00% 0.00%
$77,200 $479,000 15.00% 15.00%
$479,000 and up 20.00% 20.00%
Summary of Brackets
Single filers
1st bracket = $38,600
2nd bracket = $425,800
Amount between 1st and 2nd bracket = $387,200
Married joint filers
1st bracket = $77,200
2nd bracket = $479,000
Amount between 1st and 2nd bracket = $401,800
Suppose a married couple has ordinary income of $379,000 and dividends & gains of $200,000. How much tax do they owe on the dividends & gains?
Married joint filers
Ordinary income = $379,000
Dividends and gains = $150,000
Line 43 taxable income = $529,000
Total tax tax on dividends & gains using calcuations shown below = $25,000
Will there be taxable income only at the 20% rate? If so, how much?
Is ordinary income > 2nd bracket = FALSE
Tax on dividends & gain = FALSE
Is ordinary income between 1st and 2nd bracket? TRUE
Amount of bracket filled by ordinary income = $301,800
Remaining amount of bracket NOT filled by ordinary income = $100,000
Amount of bracket filled by dividends & gains = $100,000
Tax on dividends & gains between 1st and 2nd bracket = $15,000
Amount of remaining untaxed dividends & gains = $50,000
Tax on dividends & gains > over 2nd bracket = $10,000
Total Tax on div and gain if ordinary income is between 1st and 2nd brackets = $25,000
Is ordinary income in 1st bracket? FALSE
Amount of bracket filled by ordinary income = FALSE
Remaining amount of bracket NOT filled by ordinary income = FALSE
Amount of bracket filled by dividends & gains = FALSE
Tax on dividends & gains below 1st bracket = $0
Amount of remaining untaxed dividends & gains = FALSE
Amount of remaining dividends & gains below 2nd bracket = FALSE
Tax on dividends & gains between the brackets = $0
Amount of dividends and gains > 2nd bracket = FALSE
Tax on dividends & gains > over 2nd bracket = $0
Total tax on dividends & gains if ordinary < 1st bracket = $0
Single filers
Ordinary income = $20,000
Dividends and gains = $500,000
Line 43 taxable income = $520,000
Total tax tax on dividends & gains using calcuations shown below = $76,920
Will there be taxable income only at the 20% rate? If so, how much?
Is ordinary income > 2nd bracket = FALSE
Tax on dividends & gain = FALSE
Is ordinary income between 1st and 2nd bracket? FALSE
Amount of bracket filled by ordinary income = FALSE
Remaining amount of bracket NOT filled by ordinary income = FALSE
Amount of bracket filled by dividends & gains = FALSE
Tax on dividends & gains between 1st and 2nd bracket = $0
Amount of remaining untaxed dividends & gains = FALSE
Tax on dividends & gains > over 2nd bracket = $0
Total Tax on div and gain if ordinary income is between 1st and 2nd brackets = $0
Is ordinary income in 1st bracket? TRUE
Amount of bracket filled by ordinary income = $20,000
Remaining amount of bracket NOT filled by ordinary income = $18,600
Amount of bracket filled by dividends & gains = $18,600
Tax on dividends & gains below 1st bracket = $0
Amount of remaining untaxed dividends & gains = $481,400
Amount of remaining dividends & gains below 2nd bracket = $387,200
Tax on dividends & gains between the brackets = $58,080
Amount of dividends and gains > 2nd bracket = $94,200
Tax on dividends & gains > over 2nd bracket = $18,840
Total tax on dividends & gains if ordinary < 1st bracket = $76,920