Chapter 3 & Web Appendix 3A

Financial Statements, Cash Flows, and Taxes

Topic Overview

Key Financial Statements (See Best Buy Spreadsheet for Example)

Balance sheet Income statements Statement of retained earnings Statement of cash flows

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

The annual report

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

Income statement summarizes a firms revenues and expenses over a given period of time. (Please review section 3.4) Statement of retained earnings shows how much of the firms earnings were retained, rather than paid out as dividends. (Please
review section 3.7)

Statement of cash flows reports the impact of a firms activities on cash flows over a given period of time.

Homer & Son Balance Sheet: Assets

2006 Assets Current Assets Net Fixed Assets Total Assets 900 1500 2400 800 1300 2100 100 200 2005 20062005

Homer & Son Balance Sheet: Liabilities

Liabilities Acct Pay Accruals Notes Payable Total CL Long-term Debt Total Liab 2006 450 200 150 800 600 1400 2005 350 150 150 650 600 1250 2006-2005 100 50

Homer & Son Balance Sheet: Equity and Total Liabilities and Equity
2006 Total Liab Common Stock Retained Earnings Total Equity Total Liab & Equity 1400 700 300 1000 2400 2005 1250 700 150 850 2100

2006 Homer & Son Income Statement

Sales Cost of good sold Gross Profit SGA Expense Depreciation Operating Inc. Interest Exp EBT Taxes (40%) Net Income 3000 1800 1200 720 100 380 80 300 120 180

Some Balance Sheet Comments

Net Working Capital = Current Assets Current Liabilities Assets (particularly Long-term) and Equity on Balance Sheet are Book (or historical-based) Values. Market Value of Assets and Equity (# of shares x market price/share) can be vastly different for a given firm.

For Best Buy: 2/25/2006 Book Value of Equity = $5.247 billion, 2/25/2006 Market Value= $26.6 billion

Accounting Income vs. Cash Flow

An Income Statement Sales Cost of Goods Sold Selling & Gen. Adm. Exp Depreciation Interest Exp Taxable Income Taxes Net Income

Do all items reflect all cash collected and paid? NO!!! Income statement is on an accrued basis. What is and who is depreciation?

Net Cash Flow or Simple Income Statement Cash Flow

If all other revenues and expenses are in cash or non-cash revenues and expenses net to zero, then Net Cash Flow(NCF) = Net Income + Depreciation(& Amortization) 2006 Homer & Son, Depreciation = 100; Net Income = 180 NCF = 180 + 100 = 280 Otherwise, Net Cash Flow = Cash Revenues - Cash Expenses

Statement of Cash Flows

Shows how the firm used and raised cash during the year. Reconciles the Income Statement by the changes in the Balance Sheet from the beginning of the year to the end of the year

Statement of Cash Flows: General Concepts

Overall: Inflows(or sources) of cash are net income, depreciation, decreases in assets, and increases in liabilities Outflows(or uses) of cash are increases in assets, decreases in liabilities, and dividends

Parts of Statement of Cash Flows

Operating Cash Flow = net cash income from income statement: net income, Depreciation,change in A/R, Inv, Other CA, A/P, Accruals (Wages & Taxes), Other CL Investing Cash Flow = Purchases and Sales of long-term real assets and investments (Marketable Securities) Financing Cash Flow = issuances and payments of debt and stock: L-T Debt, Common and Preferred Stock, Notes Payable & Dividends Paid

Best Buy Statement of Cash Flow Information (millions$)

2,000 1,500 1,000 500 0 -500 -1,000 -1,500 2006 2005 2004 Operating Investing Financing Change in Cash

Using Accounting Data to Measure Other Cash Flows for Investors

Operating Cash Flow = total cash available for new asset investment, and for debt & equity investors. Free Cash Flow = cash available for debt & equity investors. This measure is often use to value a firm.

Operating Cash Flow (OCF)

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

NOPAT = Earnings Before Interest & Taxes (EBIT) x (1 Tax Rate)

OCF = EBIT(1 tax rate) + Depreciation & Amortization

What is Homer & Sons 2006 Operating Cash Flow?

Free Cash Flow (FCF)

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

Investment in Operating Capital = Increase in Gross Fixed Assets (Capital Expenditures) + Increase in Net Operating Working Capital
Increase in Gross Fixed Assets = Increase in Net Fixed Assets + Depreciation Increase in Net Operating Working Capital = Increase in Current Assets Increase in non-interest bearing current liabilities

Alternate FCF Definition

This definition is not developed or presented in the chapter itself but is used in some of the problem solutions. The term Investment in Net Operating Capital is created which is Increase in Net Fixed Assets + Increase in Net Operation Working Capital. Since depreciation is deducted in the Net Operating Capital term it must be deducted from the OCF term. FCF = NOPAT Investment in Net Operating Capital

What is Homer & Sons 2006 Free Cash Flow?

INCOME TAXES

2006 Single Individual Tax Rates

Note: Appendix 3A provides 2004 brackets.

Taxable Income
0 7,550 7,550 - 30,650 30,650 - 74,200 74,200 - 154,800 154,800 - 336,550 Over O 336,550

Tax on Base
0 755.00 4,220.00 15,107.50 37,675.50 97.653.00

Rate*
10% 15% 25% 28% 33% 35%

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

Personal Income Taxes

Marginal tax rate = the tax rate on the next dollar of income. Wages, tips, and interest income are considered ordinary taxable income. Deductions: charitable donations, mortgage interest, a portion of student loan interest, personal exemptions, and medical expenses to an extent(> 7.5% of gross income).

Personal Investment Taxes

Interest Income taxed at individuals marginal tax rate. Dividend Income tax rate: 15% or less Financial and Real assets held for less than 12 MONTHS and then sold for a gain are considered short-term capital gains and taxed at the taxpayers marginal tax rate. Long-term (held more than 12 months) capital gains are taxed at a max rate of 15%.

Corporate Income Taxes

Corporate deductions from income: operating expenses, depreciation, interest expense. Dividends paid are NOT deductible. Interest and capital gain income is fully taxable. 30% (in general) of Dividend income is taxable. Losses can be carried back 2 years and carried forward up to 20 years

Corporate Tax Rates

Taxable Income

Tax on Base

Rate*

0 - 50,000 50,000 - 75,000 75,000 - 100,000 100,000 - 335,000 ... Over 18.3M

0 7,500 13,750 22,250 ... 6.4M

15% 25% 34% 39% ... 35%

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

Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income.
Whats its tax liability?

Taxable vs. Tax Exempt Bonds

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

After-tax Investment Returns

After-tax Return=Before-tax Return(1-T) After-tax Corporate Dividend Return = Before-tax Dividend Yield (1 - .3T) Municipal Bond Interest is tax exempt on the federal level Equivalent pretax return = Muni Return/(1-T)

After-Tax Return Example

Which of the following would you prefer if your marginal tax rate is 28%? Exxon bonds at 10% or California municipal bonds at 7%. At what marginal tax rate would you be indifferent be these two bonds?