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synopsis for chapter 2

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Financial Statements, Cash Flow, and Taxes

CHAPTER 2

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Topics in Chapter
Income statement
Balance sheet
Statement of cash flows
Free cash flow
Performance measures
Corporate taxes
Personal taxes

Determinants of Intrinsic Value: Calculating FCF

Computron Inc.
Computron expanded operations in 2019. Following slides show key information and financial statements to evaluate the expansions.
2018 2019
Stock price $50.00 $30.00
Shares outstanding (millions) 100 100
Common dividends (millions) $90 $84
Tax rate 25% 25%
Cost of capital (WACC) 10.00% 10.00%

Income Statement (Millions of Dollars)
2018 2019
Sales $ 5,500 $ 6,000
COGS 4,300 4,800
Deprec. 290 320
Other expenses 350 420
Tot. op. costs $ 4,940 $ 5,540
EBIT $ 560 $ 460
Int. expense 68 108
Pre-tax earnings $ 492 $ 352
Taxes (25%) 123 88
Net income $ 369 $ 264

What happened to sales and net income?
Sales increased by $500 million (9% growth).
59% increase in interest payments.
Net income fell by $105 million.

Balance Sheet: Assets (Millions of Dollars)
2018 2019
Cash $ 60 $ 50
S-T invest. 100 10
AR 400 520
Inventories 620 820
Total CA $ 1,180 $ 1,400
Gross FA $ 3,900 $ 4,820
Less: Depr. 1,000 1,320
Net FA $ 2,900 $ 3,500
Total assets $ 4,080 $ 4,900

Effect of Expansion on Assets
Current assets and net fixed assets each grew by over 20%, much more than sales grew.
AR and inventory almost doubled.
Taking longer to collect
Unsold products (or unused raw materials) in warehouses
Cash and short-term investments fell.

Balance Sheet: Liabilities & Equity
(Millions of Dollars)

What effect did the expansion have on liabilities & equity?
Debt increased to help finance the expansion.
The company didn’t issue any stock.

Statement of Cash Flows for 2019: Operating Activities (Millions of Dollars)
Operating Activities
Net Income $ 264
Adjustments:
Depreciation 320
Change in AR (120)
Change in inventories (200)
Change in AP 100
Change in accruals 40
Net cash provided (used) by ops. $ 404

Statement of Cash Flows: Investing Activities (Millions of Dollars)
Investing Activities
Cash used to acquire FA $ (920)
Change in S-T invest. 90
Net cash prov. (used) by inv. act. $ (830)

Statement of Cash Flows: Financing Activities (Millions of Dollars)
Financing Activities 2020
Change in notes payable $ 200
Change in long-term debt 300
Payment of cash dividends (84)
Net cash provided (used) by fin. act. $ 416

Statement of Cash Flows: Summary
(Millions of Dollars)
Net cash provided (used) by ops. $ 404
Net cash prov. (used) by inv. act. (830)
Net cash prov. (used) by fin. act. 416
Net change in cash (10)
Cash at beginning of year 60
Cash at end of year $ 50

What can you conclude from the statement of cash flows?
Positive net CF from operations:
Dragged down by big net increase in working capital.
Negative net CF from investing:
Small increase due to selling ST investments
Bigger decrease due to large FA expenditures.
Net CF from financing:
Big increase in borrowing.
Even after borrowing, the cash account fell.

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.

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.)

Calculating Free Cash Flow in 5 Easy Steps

Net Operating Profit after Taxes (NOPAT)

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.

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.

Net Operating Working Capital (NOWC)

Total net operating capital
(also called operating capital)
Operating Capital= NOWC + Net fixed assets.
Operating Capital 2019:
OpCap19 = $750 + $3,500
= $4,250.
Operating Capital 2018:
OpCap18 = $3,480.

Free Cash Flow (FCF) for 2019
FCF NOPAT – Net investment in operating capital

How do you suppose investors reacted?

Uses of FCF
After-tax interest payment $81
Reduction (increase) in debt −$500
Payment of dividends $84
Repurchase (Issue) stock $0
Purch. (Sale) of ST investments −$90
Total uses of FCF −$425

Operating Profitability (OP) Ratio

Operating profitability (the amount of operating profit generated by a dollar of sales) fell.

Capital Requirement (CR) Ratio

Capital requirements (the amount of operating capital required to generate a dollar of sales) went up, which means capital utilization worsened.

Return on Invested Capital (ROIC)

ROIC fell due to a decline in operating profitability and an increase in the operating capital required to generate a dollar of sales.

The firm’s cost of capital is 10%. Did the growth add value?
No. The ROIC of 8.1% 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.

Economic Value Added (EVA)
WACC is weighted average cost of capital
EVA = NOPAT − (WACC)(Capital)

Economic Value Added
(WACC 10% for both years)

Market Value Added (MVA) (1 of 2)
MVA = Market Value of the Firm
− Book Value of the Firm

Mkt Value = (# shares)(Price)
+ Mkt Val of Debt
Book Value = Total common equity + Debt

Market Value Added (MVA) (2 of 2)
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

2019 MVA (Assume market value of debt book value of debt.)
Market Value of Equity 2019:
(100)($30.00) = $3,000.
Book Value of Equity 2019:
$2,910.
MVA19 = $3,000 − $2,910 = $90.
MVA18 =$5,000 − $2,730 = $2,270.

Corporate Taxes and the 2017 Tax Cut and Jobs Act
First major rewrite since 1986 Tax Reform Act.
Corporate tax code permanent until Congress passes new law.
21% flat rate on taxable income.
Replaced progressive rates.
Replaced 35% top marginal rate.

Interest and Dividend Income Received by Corporation
Interest income received:
21% flat rate.
Dividend income received:
Can exclude 50% from taxable income.
Remainder is taxed at 21%.

Cumulative Prior Operating Losses
Carry forward losses:
Applies to cumulative past operating losses.
Carry forward to offset future taxable income and taxes
Carry forward indefinitely (prior to TCJA was 20 years).
Carry back losses:
Not allowed in TCJA.
Prior to TCJA:
Carry back 2 years.
Received tax refund from previously paid taxes.

Dividends Paid and Interest Expenses
Dividend payments to shareholders:
Not deductible as expense.
Interest expenses:
Can deduct interest expenses if below limit:
30% of EBITDA for 2019, 2020, and 2021.
30% of EBIT thereafter.

Corporate Capital Gains and Losses
Capital gains arise when a company sells an asset for more than it paid for the asset.
Capital losses are the opposite: the company sells the asset for less than it paid.
Capital gains and losses are treated like other income or losses.

Foreign Profits and the TCJA (1 of 2)
Foreign profits:
Earned by overseas subsidiary of U.S. company.
Taxed at subsidiary’s legal residence (e.g., Ireland because it has favorable tax laws)
Prior to TCJA:
No U.S. taxes due if reinvested overseas:
New or expanded operations.
Financial assets such as deposits at foreign bank.
U.S. taxes due only if profits returned to parent.

Foreign Profits and the TCJA (2 of 2)
Profits earned 2018 and after:
No U.S. tax
Profits earned before 2018:
15.5% due on profits held in cash and cash equivalents;
8% due on remainder.
Payments to be spread out between 2018 and 2025.

Corporate Tax on Interest and Dividends: Example (1 of 2)
Assume a corporation has:
$87 million of taxable income from operations
$8 million of interest income
$10 million of dividend income
21% tax rate
50% dividend exclusion rate
How much does it pay in taxes?

Corporate Tax on Interest and Dividends: Example (2 of 2)
Taxable dividends received (Divtaxable):
Divtaxable = (1 − Excl. rate)Dividends
= (1 − 0.5)($10) = $5
Taxable income
Taxable inc.= Op. inc. + Int. + Divtaxable
= $87 + $8 + $5 = $100
Tax = 21%($100) = $21

Personal Taxes and the 2017 Tax Cut and Jobs Act: Key Features
Individuals face progressive tax rates:
7 brackets (unchanged).
Bracket thresholds have been increased so that more income is taxed at lower levels.
Tax rates from 10% to 37% instead of 10% to 39.6%. Rest were either decreased or remained the same.

TCJA: Exemptions and Standard Deductions
Personal exemptions are eliminated.
Were $4,050 for 2017.
The standard deduction increased:
$12,000 for individual filers (was $6,350 in 2017)
$24,000 for married joint filers (was $12,700 in 2017)

TCJA: Itemized Deductions
Phase-out of itemized deductions as adjusted gross income (AGI) increases
TCJA and 2017 code are similar
Mortgage interest:
Deductible only for interest on first $750,000 of mortgages used for home purchases after 2017 (down from $1 million in 2017).
Home Equity Line of Credit
Interest no longer deductible
Charitable contributions
Limited to 60% of Adjusted Gross Income, up from the previous 50% limit.

TCJA: Investment Income
Net Investment Income Tax (NIIT)
New 3.8% tax on total investment income.
Is in addition to other income taxes paid on investment income.
Only applies to high-income filers.
Dividends and capital gains
Taxable amount is total of dividends and net capital gains (gain on sale of assets more than 1 year after purchase)
Tax rates are progressive
3 brackets
Top rate is 20%. Note: the rules to determine the tax bracket and the taxable dividends & gains are very complicated.
Interest on municipal (i.e., state and local government) bonds is exempt from Federal taxation

TCJA: Pass-through Entities
Proprietorships, partnerships, limited liability corporations, S corporations, and several other types of businesses.
Not taxed at business level—income “passed through” to owners

TCJA: Tax on Owners of Pass-through Entities
Owners of qualifying businesses may deduct 20% of pass-through income from personal taxable income.
Deduction is not available to most businesses that provide services:
Accounting, consulting, legal services.
Dental and medical practices.
However, it is available to architects and engineers.

TCJA: Estate Taxes and Gift Taxes
Estate taxes
Value of assets left by decedent.
Rules are complex.
Generally exempt from taxes if estate is worth less than $11.2 million (increased from $5.49 million in 2017).
Estates over exemption threshold:
Taxed at progressive rates up to 40%.
Estate pays tax prior to disbursement to inheritors

Example: Tax on muni versus corporate bond
Data:
Tax rate 25.0%.
$20,000 to invest.
10% interest rate on corporate bond
7% interest rate on muni
After-tax interest income:
Corporate bond: 0.10($20,000) − 0.10($20,000)(0.25) = $1,500.
Muni: 0.07($20,000) − $0 = $1,400
A-T income on corporate is higher.

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)
T = 1 − (Muni yield /Corp yield )
T = 1 − (7.00%/10.0%) = 30.0%.

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. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ( ) NOPATEBIT1Taxrate - ( ) 19 18 NOPAT$46010.25 $345. NOPAT$420. =- = = NOWCOperating CAOperating CL =- ( ) ( ) 19 18 NOWC$50$520820$400$240 $750. NOWC$580. =++-+ = = FCF $345$4,250$3,480 $345$770 $425. () =-- =- =- 19 18 OP NOPATSales OP $345$6,0008.1%. OP 12.1%. = == = 19 18 CR Total operating capitalSales CR $4,250$6,00070.8%. CR 58.0%. = == = 19 18 ROIC NOPATTotal operating capital ROIC $345$4,2508.1%. ROIC 12.1%. = == = ( ) ( ) ( ) ( ) 20 19 EVA NOPATWACCCapital EVA $3450.1$4,250 $345$425 $80. EVA $4200.10$3,480 $420$348 $72. () () =- =- =- =- =- =- =

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