2 Chapter 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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Determinants of Intrinsic Value: Calculating FCF
Sales revenues - Operating costs and taxes - Required investments in operating capital Free cash flow (FCF) =
FCF1 FCF2 ... Value = + + + (1 + WACC)1 (1 + WACC)2
Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity
FCF (1 + WACC)
Firm's debt/equity mix Firm's business risk
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Income Statement
2009 Sales COGS Other expenses Deprec. Tot. op. costs EBIT Int. expense EBT $3,432,000 2,864,000 340,000 18,900 3,222,900 209,100 62,500 146,600 2010 $5,834,400 4,980,000 720,000 116,960 5,816,960 17,440 176,000 (158,560) 4
What happened to sales and net income?
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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 Cash ST invest. AR Inventories Total CA Gross FA Less: Depr. Net FA $ 9,000 48,600 351,200 715,200 1,124,000 491,000 146,200 344,800
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2010 $ 7,282 20,000 632,160 1,287,360 1,946,802 1,202,950 263,160 939,790
Effect of Expansion on Assets
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Net fixed assets almost tripled in size. AR and inventory almost doubled. Cash and shortterm investments fell.
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Balance Sheet: Liabilities & Equity
2009 Accts. payable Notes payable Accruals Total CL Longterm debt Common stock Ret. earnings Total equity $ 145,600 200,000 136,000 481,600 323,432 460,000 203,768 663,768
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2010 $ 324,000 720,000 284,960 1,328,960 1,000,000 460,000 97,632 557,632
What effect did the expansion have on liabilities & equity?
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CL increased as creditors and suppliers "financed" part of the expansion. Longterm 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 Adjustments: Depreciation Change in AR Change in inventories Change in AP Change in accruals
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($ 95,136) 116,960 (280,960) (572,160) 178,400 148,960
Investing Activities Cash used to acquire FA Change in ST invest. Net cash prov. (used) by inv. act. ($711,950) 28,600 ($683,350)
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Financing Activities Change in notes payable Change in longterm debt Payment of cash dividends Net cash provided (used) by fin. act. $ 520,000 676,568 (11,000) $1,185,568
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Summary of Statement of CF
Net cash provided (used) by ops. Net cash to acquire FA Net cash prov. (used) by fin. act. Net change in cash Cash at beginning of year Cash at end of year ($ 503,936) (683,350) 1,185,568 (1,718) 9,000 $ 7,282
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What can you conclude from the statement of cash flows?
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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 shortterm 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?
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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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Step 1
Calculating Free Cash Flow in 5 Easy Steps
Step 2
Earning before interest and taxes (1 - Tax rate) Net operating profit after taxes X -
Operating current assets Operating current liabilities
Net operating working capital
Step 3
Net operating working capital + Operating longterm assets Total net operating capital
Step 4
Step 5
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Net operating profit after taxes Net investment in operating capital
Total net operating capital this year - Total net operating capital last year Net investment in operating capital
Free cash flow
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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?
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Operating current assets are the CA needed to support operations.
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Op CA include: cash, inventory, receivables. Op CA exclude: shortterm investments, because these are not a part of operations.
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What are operating current liabilities?
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Operating current liabilities are the CL resulting as a normal part of operations.
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Op CL include: accounts payable and accruals. Op CL exclude: notes payable, because this is a source of financing, not a part operations.
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Net of Operating Working Capital (NOWC)
NOWC
NOWC10 NOWC09
Operating Operating = CA CL
= ($7,282 + $632,160 + $1,287,360) ($324,000 + $284,960) = $1,317,842. = $793,800.
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Total net operating capital (also called operating capital)
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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
Aftertax interest payment = Reduction (increase) in debt = Payment of dividends = Repurchase (Issue) stock = Purch. (Sale) of ST investments = Total uses of FCF = $105,600 -$1,196,568 $11,000 $0 -$28,600 -$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?
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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)
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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) = $10,464 $225,763 = $215,299. EVA09 = $125,460 (0.10)($1,138,600) = $125,460 $113,860 = $11,600.
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EVA10 = $10,464 (0.1)($2,257,632)
Stock Price and Other Data
2009 Stock price # of shares EPS DPS $8.50 100,000 $0.88 $0.22
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2010 $6.00 100,000 $0.95 $0.11
Market Value Added (MVA)
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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)
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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.)
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Market Value of Equity 2010:
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Book Value of Equity 2010:
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(100,000)($6.00) = $600,000. $557,632.
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MVA10 = $600,000 $557,632 = $42,368. MVA09 = $850,000 $663,768 = $186,232.
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Key Features of the Tax Code
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Corporate Taxes Individual Taxes
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2009 Corporate Tax Rates
Taxable Income 0 50,000 50,000 75,000 75,000 100,000 100,000 335,000 335,000 10M 10M 15M 15M 18.3M Tax on Base 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000
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Rate on amount above base 15% 25% 34% 39% 34% 35% 38%
Features of Corporate Taxation
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Progressive rate up until $18.3 million taxable income.
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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.)
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A corporation can:
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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
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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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Example (Continued)
Operating income Interest income Taxable dividend income Taxable income
$100,000 5,000 3,000* $108,000
*Dividends Exclusion = $10,000 0.7($10,000) = $3,000. 38
Example (Continued)
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.
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Key Features of Individual Taxation
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Individuals face progressive tax rates, from 10% to 35%. The rate on longterm (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
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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%
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T = Tax rate = 25.0%. Aftertax 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
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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(1T) 7.00% = 10.0%(1T) T = 30.0%.
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Implications
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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.
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