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

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bmgt 440 introduction
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
on index cards
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
key concepts and skills
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
balance sheet
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
the balance sheet figure 2 1
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
net working capital and liquidity
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
us corporation balance sheet table 2 1
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

market vs book value
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?
income statement
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
us corporation income statement table 2 2
US Corporation Income Statement – Table 2.2

US Corporation

2002 Income Statement

For the year ended Dec. 31, 2002

($millions)

work the web example
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!
the concept of cash flow
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
cash flow from assets
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
example us corporation
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
cash flow summary table 2 5
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

example balance sheet and income statement information
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
example cash flows
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.
taxes
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
slide21

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.

deductions
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.)
slide23

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?

slide24

Calculation of Taxable Income

Salary

$45,000

Dividends

3,000

Personal exemptions

(2,800)

Deductions

(5,150)

Taxable Income

$40,050

slide25

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

slide26

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.

slide27

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?

slide28

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.)

example marginal vs average rates
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?
quick quiz
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?