Finance Short Response
jandreg
ch02_show.pptx1
Chapter 2
Financial Statements, Cash Flow, and Taxes
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Topics in Chapter
Income statement
Balance sheet
Statement of cash flows
Free cash flow
MVA and EVA
Corporate taxes
Personal taxes
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Value = + + +
FCF1
FCF2
FCF∞
(1 + WACC)1
(1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Sales revenues
Operating costs and taxes
Required investments in operating capital
−
−
=
Determinants of Intrinsic Value: Calculating FCF
...
Figure 1-6 in FM13.
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Income Statement
| 2009 | 2010 | |
| Sales | $3,432,000 | $5,834,400 |
| COGS | 2,864,000 | 4,980,000 |
| Other expenses | 340,000 | 720,000 |
| Deprec. | 18,900 | 116,960 |
| Tot. op. costs | 3,222,900 | 5,816,960 |
| EBIT | 209,100 | 17,440 |
| Int. expense | 62,500 | 176,000 |
| EBT | 146,600 | (158,560) |
| Taxes (40%) | 58,640 | (63,424) |
| Net income | $ 87,960 | ($ 95,136) |
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What happened to sales and net income?
Sales increased by over $2.4 million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax refund since it paid taxes of more than $63,424 during the past two years.
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Balance Sheet: Assets
| 2009 | 2010 | |
| Cash | $ 9,000 | $ 7,282 |
| S-T invest. | 48,600 | 20,000 |
| AR | 351,200 | 632,160 |
| Inventories | 715,200 | 1,287,360 |
| Total CA | 1,124,000 | 1,946,802 |
| Gross FA | 491,000 | 1,202,950 |
| Less: Depr. | 146,200 | 263,160 |
| Net FA | 344,800 | 939,790 |
| Total assets | $1,468,800 | $2,886,592 |
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Effect of Expansion on Assets
Net fixed assets almost tripled in size.
AR and inventory almost doubled.
Cash and short-term investments fell.
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Balance Sheet: Liabilities & Equity
| 2009 | 2010 | |
| Accts. payable | $ 145,600 | $ 324,000 |
| Notes payable | 200,000 | 720,000 |
| Accruals | 136,000 | 284,960 |
| Total CL | 481,600 | 1,328,960 |
| Long-term debt | 323,432 | 1,000,000 |
| Common stock | 460,000 | 460,000 |
| Ret. earnings | 203,768 | 97,632 |
| Total equity | 663,768 | 557,632 |
| Total L&E | $1,468,800 | $2,886,592 |
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What effect did the expansion have on liabilities & equity?
CL increased as creditors and suppliers “financed” part of the expansion.
Long-term debt increased to help finance the expansion.
The company didn’t issue any stock.
Retained earnings fell, due to the year’s negative net income and dividend payment.
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Statement of Cash Flows: 2010
| Operating Activities | |
| Net Income | ($ 95,136) |
| Adjustments: | |
| Depreciation | 116,960 |
| Change in AR | (280,960) |
| Change in inventories | (572,160) |
| Change in AP | 178,400 |
| Change in accruals | 148,960 |
| Net cash provided (used) by ops. | ($503,936) |
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| Investing Activities | |
| Cash used to acquire FA | ($711,950) |
| Change in S-T invest. | 28,600 |
| Net cash prov. (used) by inv. act. | ($683,350) |
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| Financing Activities | |
| Change in notes payable | $ 520,000 |
| Change in long-term debt | 676,568 |
| Payment of cash dividends | (11,000) |
| Net cash provided (used) by fin. act. | $1,185,568 |
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Summary of Statement of CF
| Net cash provided (used) by ops. | ($ 503,936) |
| Net cash to acquire FA | (683,350) |
| Net cash prov. (used) by fin. act. | 1,185,568 |
| Net change in cash | (1,718) |
| Cash at beginning of year | 9,000 |
| Cash at end of year | $ 7,282 |
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What can you conclude from the statement of cash flows?
Net CF from operations = -$503,936, because of negative net income and increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold some short-term investments to meet its cash requirements.
Even after borrowing, the cash account fell by $1,718.
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What is free cash flow (FCF)? Why is it important?
FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.
A company’s value depends on the amount of FCF it can generate.
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What are the five uses of FCF?
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)
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Earning before interest and taxes
(1 − Tax rate)
Net operating profit after taxes
X
Operating current assets
Operating current liabilities
Net operating working capital
−
Total net operating capital
Operating long-term assets
+
Net operating working capital
Free cash flow
−
Net investment in operating capital
Net operating profit after taxes
−
Total net operating capital this year
Total net operating capital last year
Net investment in operating capital
Calculating Free Cash Flow in 5 Easy Steps
Step 1
Step 2
Step 3
Step 4
Step 5
Figure 2-1 in FM13
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Net Operating Profit after Taxes (NOPAT)
NOPAT = EBIT(1 - Tax rate)
NOPAT10 = $17,440(1 - 0.4)
= $10,464.
NOPAT09 = $125,460.
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What are operating current assets?
Operating current assets are the CA needed to support operations.
Op CA include: cash, inventory, receivables.
Op CA exclude: short-term investments, because these are not a part of operations.
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What are operating current liabilities?
Operating current liabilities are the CL resulting as a normal part of operations.
Op CL include: accounts payable and accruals.
Op CL exclude: notes payable, because this is a source of financing, not a part of operations.
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Net Operating Working Capital (NOWC)
NOWC10 = ($7,282 + $632,160 + $1,287,360)
- ($324,000 + $284,960)
= $1,317,842.
NOWC09 = $793,800.
= -
Operating
CA
Operating
CL
NOWC
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Total net operating capital (also called operating capital)
Operating Capital= NOWC + Net fixed assets.
Operating Capital 2010 = $1,317,842 + $939,790 = $2,257,632.
Operating Capital 2009 = $1,138,600.
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Free Cash Flow (FCF) for 2010
FCF = NOPAT - Net investment in
operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.
How do you suppose investors reacted?
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Uses of FCF
| After-tax interest payment = | $105,600 |
| Reduction (increase) in debt = | −$1,196,568 |
| Payment of dividends = | $11,000 |
| Repurchase (Issue) stock = | $0 |
| Purch. (Sale) of ST investments = | −$28,600 |
| Total uses of FCF = | −$1,108,568 |
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Return on Invested Capital (ROIC)
ROIC = NOPAT / operating capital
ROIC10 = $10,464 / $2,257,632 = 0.5%.
ROIC09 = 11.0%.
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The firm’s cost of capital is 10%. Did the growth add value?
No. The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require.
Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, in 2008 Qualcomm had high growth, negative FCF, but a high ROIC.
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Economic Value Added (EVA)
WACC is weighted average cost of capital
EVA = NOPAT- (WACC)(Capital)
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Economic Value Added (WACC = 10% for both years)
EVA = NOPAT- (WACC)(Capital)
EVA10 = $10,464 - (0.1)($2,257,632)
= $10,464 - $225,763
= -$215,299.
EVA09 = $125,460 - (0.10)($1,138,600)
= $125,460 - $113,860
= $11,600.
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Stock Price and Other Data
| 2009 | 2010 | |
| Stock price | $8.50 | $6.00 |
| # of shares | 100,000 | 100,000 |
| EPS | $0.88 | -$0.95 |
| DPS | $0.22 | $0.11 |
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Market Value Added (MVA)
MVA = Market Value of the Firm - Book Value of the Firm
Market Value = (# shares of stock)(price per share) + Value of debt
Book Value = Total common equity + Value of debt
(More…)
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MVA (Continued)
If the market value of debt is close to the book value of debt, then MVA is:
MVA = Market value of equity – book value of equity
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2010 MVA (Assume market value of debt = book value of debt.)
Market Value of Equity 2010:
(100,000)($6.00) = $600,000.
Book Value of Equity 2010:
$557,632.
MVA10 = $600,000 - $557,632 = $42,368.
MVA09 = $850,000 - $663,768 = $186,232.
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Key Features of the Tax Code
Corporate Taxes
Individual Taxes
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2009 Corporate Tax Rates
| Taxable Income | Tax on Base | Rate on amount above base |
| 0 -50,000 | 0 | 15% |
| 50,000 - 75,000 | 7,500 | 25% |
| 75,000 - 100,000 | 13,750 | 34% |
| 100,000 - 335,000 | 22,250 | 39% |
| 335,000 - 10M | 113,900 | 34% |
| 10M - 15M | 3,400,000 | 35% |
| 15M - 18.3M | 5,150,000 | 38% |
| 18.3M and up | 6,416,667 | 35% |
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Features of Corporate Taxation
Progressive rate up until $18.3 million taxable income.
Below $18.3 million, the marginal rate is not equal to the average rate.
Above $18.3 million, the marginal rate and the average rate are 35%.
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Features of Corporate Taxes (Cont.)
A corporation can:
deduct its interest expenses but not its dividend payments;
carry back losses for two years, carry forward losses for 20 years.*
exclude 70% of dividend income if it owns less than 20% of the company’s stock
*Losses in 2001 and 2002 can be carried back for five years.
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Example
Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income.
What is its tax liability?
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Operating income
$100,000
Interest income
5,000
Taxable dividend
income
3,000*
Taxable income
$108,000
*Dividends - Exclusion
= $10,000 - 0.7($10,000) = $3,000.
Example (Continued)
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Taxable Income = $108,000
Tax on base = $22,250
Amount over base = $108,000 - $100,000
= $8,000
Tax = $22,250 + 0.39 ($8,000)
= $25,370.
Example (Continued)
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Key Features of Individual Taxation
Individuals face progressive tax rates, from 10% to 35%.
The rate on long-term (i.e., more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset.
Dividends are taxed at the same rate as capital gains.
Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.
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Taxable versus Tax Exempt Bonds
State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.
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ExxonMobil bonds at 10% versus California muni bonds at 7%
T = Tax rate = 25.0%.
After-tax interest income:
ExxonMobil = 0.10($5,000) - 0.10($5,000)(0.25)
ExxonMobil = 0.10($5,000)(0.75) = $375.
CAL = 0.07($5,000) - 0 = $350.
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Breakeven Tax Rate
At what tax rate would you be indifferent between the muni and the corporate bonds?
Solve for T in this equation:
Muni yield = Corp Yield(1-T)
7.00% = 10.0%(1-T)
T = 30.0%.
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Implications
If T > 30%, buy tax exempt munis.
If T < 30%, buy corporate bonds.
Only high income, and hence high tax bracket, individuals should buy munis.
