Chapter 2 Financial Statements, Taxes & Cash Flow

1. Chapter 2Financial Statements, Taxes & Cash Flow .

2. BMGT 440 introduction • Elinda Fishman Kiss, Ph.D. • Professor - Rutgers, Temple, Wharton, Wellesley, PSU, TCNJ, Drexel • Treasurer - Custom Equipment Mfg., Inc. • RTC (Resolution Trust Corp.) • PSFS (Philadelphia Savings Fund Soc.) • Citicorp Investment Bank • First Pennsylvania Bank (now Wachovia) • Federal Reserve - Board of Governors; US Treasury • e-mail EFKiss@AOL.com • web page http://www.rhsmith.umd.edu/finance/elinda-kiss • Blackboard http://bb.rhsmith.umd.edu • Rutgers web page http://www.elinda-kiss.rutgers.edu/ • Office 301-405-7538; (cell) 215-962-9071 • Fax 301- 405-0359

3. on index cards • Course & section number (e.g., BMGT440 – 0101) • name • phone number (Home) (Office) (cell) • e-mail address - very important - will send you class announcements in email • Include as many emails as you wish – home, office, university, etc. – PLEASE PRINT YOUR EMAIL ADDRESS IN CAPS • past Finance courses • employment - what do? where? • social security number or student ID • Are you registered? yes/no • Are you completing incomplete? yes/no • Sign the back of the card

4. Key Concepts and Skills • Know the difference between book value and market value • Know the difference between accounting income and cash flow • Know the difference between average and marginal tax rates • Know how to determine a firm’s cash flow from its financial statements Chapter Outline • The Balance Sheet • The Income Statement • Taxes • Cash Flow

5. Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity

6. The Balance Sheet, figure 2.1 Remember Accounting identity Total Assets = Total Liabilities + shareholders’ equity On the left Total Assets = Current Assets + Fixed Assets Tangible Fixed Assets Intangible Fixed Assets On the right Total Liabilities = Current Liabilities + Long Term Debt Shareholders’ Equity = Stock + Retained Earnings • Net Working Capital = • Current Assets – Current Liabilities

7. Net Working Capital and Liquidity • Net Working Capital • Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm • Liquidity • Ability to convert to cash quickly without a significant loss in value • Liquid firms are less likely to experience financial distress • But, liquid assets earn a lower return • Trade to find balance between liquid and illiquid assets

8. US Corporation Balance Sheet-Table 2.1 US Corporation Balance Sheets as of December 31, 2001 & 2002 ($ in Millions) 2002 2001 2002 2001 Assets Liabilities & Owners Equity Current assets $160 $104 Current liabilities Cash Acc’ts pay’bl $ 266 $ 232 Accounts rec’ble 688 455 Notes pay’bl 123 196 Inventory 555 553 Total $ 389 $ 428 Total $1,403 $1,112 Fixed Assets Long-term Net plant & debt $ 454 $ 408 equipment $1,709$1,644 Owners equity Common stock & paid-in surplus 640 600 Retain’d earn’g 1,6291,320 Total $2,269 $1,920 Total liabilities & Total assets $3,112$2,756 owners equity $3,112$2,756

9. Market Vs. Book Value • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process?

10. Example 2.2 Klingon Corporation

11. Income Statement • The income statement is more like a video of the firm’s operations for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue

12. US Corporation Income Statement – Table 2.2 US Corporation 2002 Income Statement For the year ended Dec. 31, 2002 ($millions)

13. Work the Web Example • Publicly traded companies must file regular reports with the Securities and Exchange Commission • These reports are usually filed electronically and can be searched at the SEC public site called EDGAR • http://www.edgar-online.comhttp://www.freedgar.com • Click on the web surfer, pick a company and see what you can find!

14. The Concept of Cash Flow • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • The statement of cash flows does not provide us with the same information that we are looking at here • We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

15. Cash Flow From Assets • Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders • Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

16. Example: US Corporation • OCF (I/S) = EBIT + depreciation – taxes = 694+65-212 =$547 • NCS = Net Capital Spending ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation =1,709-1,644+65 = $130 • Changes in NWC (B/S) = ending NWC – beginning NWC = 1,014-684 = $330 • CFFA = OCF-NCS-DNWC = 547 – 130 – 330 = $87 • CF to Creditors (B/S and I/S) = interest paid – net new LT borrowing = 70 – (46) = $24 • CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = 103 – 40 =$63 • CFFA = 24 + 63 = $87

17. Cash Flow Summary Table 2.5 I. The cash flow identity CFA = CFC + CFS Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners) II. Cash flow from assets Cash flow from assets = Operating cash flow (OCF) - Net capital spending (NCS) - change in new working capital (NWC) where: Operating cash flow = EBIT + Depreciation – Taxes Net capital spending = Ending net fixed assets –Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC III. Cash flow to creditors (Bondholders) (CFC) CFC = Interest paid – Net new borrowing IV. Cash flow to stockholders (owners) (CFS) CFS = Dividends paid – Net new equity raised

18. Example: Balance Sheet and IncomeStatement Information • Current Accounts • 1998: CA = 1500; CL = 1300 • 1999: CA = 2000; CL = 1700 • Fixed Assets and Depreciation • 1998: NFA = 3000; 1999: NFA = 4000 • Depreciation expense = 300 • LT Liabilities and Equity • 1998: LTD = 2200; Common Equity = 500; RE = 500 • 1999: LTD = 2800; Common Equity = 750; RE = 750 • Income Statement Information • EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250

19. Example: Cash Flows • OCF = 2700 + 300 – 1000 = 2000 • NCS = 4000 – 3000 + 300 = 1300 • Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100 • CFFA = 2000 – 1300 – 100 = 600 • CF to Creditors = 200 – (2800 – 2200) = -400 • CF to Stockholders = 1250 – (750 – 500) = 1000 • CFFA = -400 + 1000 = 600 • The CF identity holds.

20. Taxes • The one thing we can rely on with taxes is that they are always changing • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average – the tax bill / taxable income • Other taxes

21. April 2001 Single Individual Tax Rates Taxable Income Tax on Base Rate* 0 - 26,250 0 15% 26,250 - 63,550 3,937.50 28% 63,550 - 132,600 14,381.50 31% 132,600 - 288,350 35,787.00 36% Over 288,350 91,857.00 39.6% *Plus this percentage on the amount over the bracket base.

22. Deductions • Standard Deductions • Joint $7,350 • Single $4,400 • Itemized Deductions • Medical • Taxes - real estate, state & local government • Interest on mortgage • Contributions to charity • Miscellaneous (e.g., 2106 - employee business expenses, moving expenses, etc.)

23. Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,800 and your itemized deductions are $5,150. 1. On the basis of the information above and the 2000 (April 2001) tax rate schedule, what is your tax liability? 2. What are your average & marginal tax rates?

24. Calculation of Taxable Income Salary $45,000 Dividends 3,000 Personal exemptions (2,800) Deductions (5,150) Taxable Income $40,050

25. 40,050 - 26,250 • Tax Liability: TL = $3,937.50 + 0.28($13,800) = $7,801.50 »$7,802. • Marginal Tax Rate = 28%. • Average Tax Rate: Tax rate = = 19.48% »19.5%. $7,802 $40,050

26. January 2001 Corporate Tax Rates Taxable Income Tax on Base Rate* 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 - 10.0M 113,900 34% ... ... ... 6.4M 35% Over 18.3M *Plus this percentage on the amount over the bracket base.

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

28. Operating income $100,000 Interest income 5,000 Taxable dividend income 3,000* Taxable income $108,000 Tax = $22,250 + 0.39 ($8,000) =$25,370. *Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000. 70% of dividends received by one Corporation from another is excluded from taxable income, while the remaining 30% is taxed at the ordinary tax rate. (If the corporation owns >20% of the stock of the dividend-paying company, it can exclude 80% -100% of dividends received from taxable income.)

29. Example: Marginal Vs. Average Rates • Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • What is the average tax rate? • What is the marginal tax rate? • If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

30. Quick Quiz • What is the difference between book value and market value? Which should we use for decision making purposes? • What is the difference between accounting income and cash flow? Which do we need to use when making decisions? • What is the difference between average and marginal tax rates? Which should we use when making financial decisions? • How do we determine a firm’s cash flows? What are the equations and where do we find the information?