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Financial Statements, Taxes and Cash Flow Financial Statements, Taxes, and Cash Flow Chapter 2 2-‹#› 2.1 Describe the difference between accounting value (or “book” value) and market value Describe the difference between accounting income and cash flow Describe the difference between average and marginal tax rates Determine a firm’s cash flow from its financial statements Key Concepts and Skills 2-‹#› 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 decreasing liquidity. Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity Balance Sheet 2-‹#› 2.3 The Balance Sheet Figure 2.1 2-‹#› 2.4 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 typically earn a lower return. Trade-off to find balance between liquid and illiquid assets Net Working Capital and Liquidity 2-‹#› 2.5 U.S. Corporation Balance Sheet Table 2.1 To I/S Back to Example 2-‹#› 2.6 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? Market Value vs. Book Value 2-‹#› 2.7 Example 2.2 Klingon Corporation 2-‹#› 2.8 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 says to show revenue when it accrues and match the expenses required to generate the revenue Income Statement 2-‹#› 2.9 U.S. Corporation Income Statement – Table 2.2 To B/S Back to Example 2-‹#› 2.10 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. Visit EDGAR to search for company filings. Work the Web Example 2-‹#› 2.11 Marginal vs. average tax rates Marginal tax rate – the percentage paid on the next dollar earned Average tax rate – the tax bill / taxable income Taxes 2-‹#› 2.12 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. The Concept of Cash Flow 2-‹#› 2.13 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 Cash Flow From Assets 2-‹#› 2.14 OCF (I/S) = EBIT + depreciation - taxes = $628 NCS (B/S and I/S) = ending net fixed assets - beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC - beginning NWC = $391 CFFA = 628 - 130 - 391 = $107 Example: U.S. Corporation – Part I 2-‹#› 2.15 CF to Creditors (B/S and I/S) = interest paid - net new borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid - net new equity raised = $83 CFFA = 24 + 83 = $107 Example: U.S. Corporation – Part II 2-‹#› 2.16 Cash Flow Summary - Table 2.6 2-‹#› 2.17 Current Accounts 2018: CA = 3,625; CL = 1,787 2017: CA = 3,596; CL = 2,140 Fixed Assets and Depreciation 2018: NFA = 2,194; 2014: NFA = 2,261 Depreciation Expense = 500 Long-term Debt and Equity 2018: LTD = 538; Common stock & APIC = 462 2017: LTD = 581; Common stock & APIC = 372 Income Statement EBIT = 1,014; Taxes = 193 Interest Expense = 93; Dividends = 460 Example: Balance Sheet and Income Statement Info 2-‹#› 2.18 OCF = 1,014 + 500 - 193 = 1,321 NCS = 2,194 - 2,261 + 500 = 433 Changes in NWC = (3,625 - 1,787) - (3,596 - 2,140) = 382 CFFA = 1,321 - 433 - 382 = 506 CF to Creditors = 93 - (538 - 581) = 136 CF to Stockholders = 460 - (462 - 372) = 370 CFFA = 136 + 370 = 506 The CF identity holds. Example: Cash Flows 2-‹#› 2.19 Current Accounts 2018: CA = 4,400; CL = 1,500 2017: CA = 3,500; CL = 1,200 Fixed Assets and Depreciation 2018: NFA = 3,400; 2014: NFA = 3,100 Depreciation Expense = 400 Long-term Debt and Equity (R.E. not given) 2018: LTD = 4,000; Common stock & APIC = 400 2017: LTD = 3,950; Common stock & APIC = 400 Income Statement EBIT = 2,000; Taxes = 300 Interest Expense = 350; Dividends = 500 Compute the CFFA Comprehensive Problem 2-‹#› 2.20 END OF CHAPTER CHAPTER 2 2-‹#› 2-‹#› 2.21 Problem 1 (12 points) In Excel, create an income statement and balance sheet for 2018 for Klein Manufacturing from the following information. Cash$500 Accounts Receivable20% of Sales Accounts Payable20% of Cost of Goods Sold Notes Payable$800 Inventory$2,900 Gross Plant & Equipment$22,000 Long-term Debt$4,000 Common Stock$10,000 Sales$7,500 Cost of Goods Sold40% of Sales Depreciation Expense$1,200 Other Operating Expenses$1,000 Interest Expense8% of Long-term Debt Income Taxes25% of Taxable Income Since I did not give you retained earnings, you will need to calculate it. Retained earnings will be the amount necessary to balance your balance sheet. Accumulated depreciation for 2017 was $6,000. a.What is the firm’s operating cash flow for 2018? b.If gross plant & equipment for 2017 was $20,000, what is the amount of the net capital spending for 2018? c.If Klein’s current assets for 2017 were $4,750 and current liabilities for 2017 were $1,750 what is the change in the net working capital from 2017 to 2018? Problem 2 (8 points) You are planning to purchase a new car at $44,000 and you already saved $4,000 for the down payment and will apply for a car loan to finance the rest of the purchase price. Your bank offers a loan with monthly payments at 4% APR with a term of 36 months. Alternatively, a credit union has a promotional APR of 3% for new customers with a loan term of 48 months. Build amortization tables of both loan alternatives and calculate total interest paid in each loan. Calculate Effective Annual Rate (EAR) for each loan.