Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA

1. CHAPTER 2 Financial Statements, Cash Flow,and Taxes • Balance sheet • Income statement • Statement of cash flows • Accounting income vs. cash flow • MVA and EVA • Personal taxes • Corporate taxes

2. Financial Statements • Accounting based, so by definition, historical. • Tells us where we are and have been, but not where we are going. • But… we have to know where we’ve been before we know the future. • This discussion is based on D’Leon case pages 82-85 (useful to look at) • Will be continued in Ch. 3

3. The Balance Sheet (on page 39): What is it? • A “snapshot” of the condition of a company at one instant in time. • Contains all financial information at that instant. • IS NOT a flow…can only tell you what is, not what happened. • The core equation: A=L+OE

4. First, Assets: • Left-Hand Side (LHS) of the B/S • Two general categories: • Current Assets: cash and those items which can be turned into cash within a year. • Fixed Assets: long term (plant, equipment, etc)

5. Balance Sheet: Assets 2000 1999 Cash 7,282 57,600 AR 632,160 351,200 Inventories 1,287,360 715,200 Total CA 1,926,802 1,124,000 Gross FA 1,202,950 491,000 Less: Deprec. 263,160 146,200 Net FA 939,790 344,800 Total Assets 2,866,592 1,468,800

6. Liabilities and Owners Equity • Right-Hand Side (RHS) of the B/S • Must equal assets (LHS) • Three general categories: • Current Liabilities: What must be paid within a year. • Long Term Liabilities: the Debt we owe beyond a year • Owners (S/H) Equity: What shareholders (S/H) have contributed (including retained earnings).

7. Liabilities and Equity 2000 1999 Accts payable 524,160 145,600 Notes payable 720,000 200,000 Accruals 489,600 136,000 Total CL 481,600 1,733,760 Long-term debt 1,000,000 323,432 Common stock 460,000 460,000 Retained earnings (327,168) 203,768 Total equity 132,832 663,768 Total L&E 2,866,592 1,468,800

8. Second, the Income Statement(page 43) • Information about sales, expenses and profits over a given period of time. • Only a partial picture • Eventually flows onto balance sheet.

9. Income Statement 2000 1999 Sales 5,834,400 3,432,000 COGS 5,728,000 2,864,000 Other expenses 680,000 340,000 (573,600) 228,000 EBITDA 116,960 18,900 Depr. & Amort. EBIT (690,560) 209,100 Interest exp. 176,000 62,500 EBT (866,560) 146,600 Taxes (40%) (346,624) 58,640 Net income (519,936) 87,960

10. These two are the basics • From the Income Statement and Balance Sheet (with some additional data), we can derive other information. • Most important of the other statements is the Statement of Cash Flows (to which we will come back later).

11. Other Data 2000 1999 No. of shares 100,000 100,000 EPS ($5.199) $0.88 DPS $0.110 $0.22 Stock price $2.25 $8.50 Lease pmts $40,000 $40,000

12. Statement of Retained Earnings (2000) Balance of retained earnings, 12/31/99 $203,768 Add: Net income, 2000 (519,936) Less: Dividends paid (11,000) Balance of retained earnings, 12/31/00 ($327,168)

13. Cash Flow Statement • This is the KEY statement for Finance: because it focuses on cash, and tells us what happened. • Takes data from both income statement and balance sheet. • Subdivided into operations, investments and financing.

14. Statement of Cash Flows (2000) OPERATING ACTIVITIES Net income (519,936) Add (Sources of cash): Depreciation 116,960 Increase in A/P 378,560 Increase in accruals 353,600 Subtract (Uses of cash): Increase in A/R (280,960) Increase in inventories (572,160) Net cash provided by ops. (523,936)

15. L-T INVESTING ACTIVITIES Investment in fixed assets (711,950) FINANCING ACTIVITIES Increase in notes payable 520,000 Increase in long-term debt 676,568 Payment of cash dividends (11,000) Net cash from financing 1,185,568 NET CHANGE IN CASH (50,318) Plus: Cash at beginning of year 57,600 Cash at end of year 7,282

16. What can you conclude about D’Leon’s financial condition from its statement of CFs? • Net cash from operations = -$523,936, mainly because of negative NI. • The firm borrowed $1,185,568 to meet its cash requirements. • Even after borrowing, the cash account fell by $50,318.

17. Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 – Tax rate) NOPAT00 = -$690,560(1 – 0.4) = -$690,560(0.6) = -$414,336. NOPAT99 = $125,460.

18. What effect did the expansion have on net operating working capital (NOWC)? Current assets Non-interest bearing CL NOWC = – NOWC00 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042. NOWC99 = $842,400.

19. What effect did the expansion have on capital used in operations? Operating capital = NOWC + Net fixed assets. = $913,042 + $939,790 = $1,852,832. = $1,187,200. Operating capital00 Operating capital99

20. What is your initial assessment of the expansion’s effect on operations? 2000 1999 Sales $5,834,400 $3,432,000 NOPAT ($414,336) $125,460 NOWC $913,042 $842,400 Operating capital $1,852,832 $1,187,200 Net Income ($519,936) $87,960

21. What effect did the company’s expansion have on its net cash flow and operating cash flow? NCF00 = NI + DEP = ($519,936) + $116,960 = ($402,976). NCF99 = $87,960 + $18,900 = $106,860. OCF00 = NOPAT + DEP = ($414,336) + $116,960 = ($297,376). OCF99 = $125,460 + $18,900 = $144,360.

22. What was the free cash flow (FCF) for 2000? FCF = NOPAT – Net capital investment = -$414,336 – ($1,852,832 – $1,187,200) = -$414,336 – $665,632 = -$1,079,968. Is negative free cash flow always a bad sign?

23. EVA and MVA: New Finance Buzzwords (or acronyms, actually!) • EVA = Economic Value Added = a measure of the effectiveness of management during the year: • EVA = [After tax operating profit ($)] less [After tax cost of capital ($)] … or computationally: • EVA = [EBIT(1-Tax Rate)] -[Capital(after tax cost of capital)

24. Economic Value Added (EVA) Operating IncomeAfter Tax After-TaxCapital Costs EVA = – = – = NOPAT – After-Tax Cost of Capital Cost ofCapital Used Funds Availableto Investors

25. EVA Concepts • In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. • EVA takes into account the total cost of capital (see Ch. 10), which includes the cost of equity.

26. What is the company’s EVA? Assume the firm’s after-tax cost of capital was 11% in 1999 and 13% in 2000. EVA00 = NOPAT – (A-T cost of capital)(Capital) = -$414,336 – (0.13)($1,852,832) = -$414,336 – $240,868 = -$655,204. EVA99 = $125,460 – (0.11)($1,187,200) = $125,460 – $130,592 = -$5,132.

27. MVA • MVA = Market Value Added = how much the market value of firm increased, apart from the effect of new capital infusions. • MVA = Mkt. Val. Equity - Equity supplied … or computationally: • MVA = [(share o/s)(price)]-Total common equity.

28. Would you conclude that the expansion increased or decreased MVA? Market value of equity Equity capital supplied MVA = – During the last year stock price has decreased 73%, so market value of equity has declined. Consequently, MVA has declined.

29. Leading Creators of Wealth in the U. S. Market Value Added in 1999 Company Market Value Added Microsoft $328,257 million General Electric $285,320 million Intel $166,902 million Wal-Mart Stores $159,444 million Coca-Cola $157,536 million Merck $153,170 million Pfizer $148,245 million Cisco Systems $135,650 million Lucent Technologies $127,265 million Bristol-Myers Squibb $119,350 million

30. What else do we need to learn?? • Are suppliers happy/unhappy? • What’s happening with their customers? • What’s the impact of the expansion; how did they pay for it??

31. Does D’Leon pay its suppliers on time? • Probably not. • A/P increased 260% over the past year, while sales increased by only 70%. • If this continues, suppliers may cut off D’Leon’s trade credit.

32. Does it appear that D’Leon’s sales price exceeds its cost per unit sold? • No, the negative NOPAT and decline in cash position shows that D’Leon is spending more on its operations than it is taking in.

33. What effect would each of these actions have on D’Leon’s cash account? 1. The company offers 60-day credit terms. The improved terms are matched by its competitors, so sales remain constant. • A/R would é • Cash would ê

34. 2. Sales double as a result of the change in credit terms. • Short run: Inventory and fixed assets é to meet increased sales. A/R é , Cash ê. Company may have to seek additional financing. • Long-run: Collections increase and the company’s cash position would improve.

35. How did D’Leon finance its expansion? • D’Leon financed its expansion with external capital. • D’Leon issued long-term debt which reduced its financial strength and flexibility.

36. Would D’Leon have required external capital if they had broken even in 2000 (Net Income = 0)? • YES, the company would still have to finance its increase in assets.

37. What happens if D’Leon depreciates its fixed assets over 7 years (as opposed to the current 10 years)? • No effect on physical assets. • Fixed assets on balance sheet would decline. • Net income would decline. • Tax payments would decline. • Cash position would improve.

38. Other policies that affect financial statements • Inventory valuation methods. • Capitalization of R&D expenses. • Policies for funding the company’s retirement plan.

39. Does the company’s positive stock price ($2.25), in the face of large losses, suggest that investors are irrational? • NO, it means that investors expect things to get better in the future.

40. Why did the stock fall after the dividend was cut? • Management was “signaling” that the firm’s operations were in trouble. • The dividend cut lowered expectations for future cash flows, which caused the stock price to decline.

41. What were some other sources of financing for D’Leon in 2000? • Bank loans: Notes payable increased by $520,000. • Credit from suppliers: A/P increased by $378,560. • Employees: Accruals increased by $353,600.

42. D’Leon received a tax credit of $346,624 in 2000. • This suggests the company paid at least $346,624 in taxes during the past 2 years. • If D’Leon’s payments over the past 2 years were less than $346,624 the firm would have had to carry forward the amount of its loss that was not carried back. • If the firm did not receive a full refund its cash position would be even worse.

43. INCOME TAXES

44. Taxes color everything we do in Finance • While not the prime motivation for actions, tax considerations cannot be ignored due to their size • Generally, we talk about the “after- tax” cash effects of a given decision…. • So, what do we need to know?? • First … how do taxes work? • On an individual basis...

45. April 2000 Single Individual Tax Rates Taxable Income Tax on Base Rate* 0 - 25,750 0 15% 25,750 - 62,450 3,862.50 28% 62,450 - 130,250 14,138.50 31% 130,250 - 283,150 35,156.50 36% Over 283,150 90,200.50 39.6% *Plus this percentage on the amount over the bracket base.

46. Assume your salary is $45,000, and you received $3,000 in dividends. You are single, so your personal exemption is $2,750 and your itemized deductions are $4,850. On the basis of the information above and the April 2000 tax rate schedule, what is your tax liability?

47. Calculation of Taxable Income Salary $45,000 Dividends 3,000 Personal exemptions (2,750) Deductions (4,850) Taxable Income $40,400

48. 40,400 - 25,750 • Tax Liability: TL = $3,862.50 + 0.28($14,650) = $7,964.50 »$7,965. • Marginal Tax Rate = 28%. • Average Tax Rate: Tax rate = = 19.71% »19.7%. $7,965 $40,400

49. Corporate Taxes • What we really care about (at least as far as this course is concerned) … • Work mostly the same way…with two major exceptions: • 1) Dividend Exclusion (companies can exclude from income 70% of the dividends they receive) • 2) Tax loss carry backs (2 years) and carry forwards (20 years) .

50. Corp. Taxes (continued) • IMPORTANT: interest expense is fully deductible for companies; not so for individuals. • Therefore, there is a distinct tax advantage to corporations to using debt financing.