6-1

CHAPTER 6
Accounting for Financial Management

 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income versus cash flow
 MVA and EVA
 Personal taxes
 Corporate taxes
 6-2
Income Statement
2002 2003
Sales 3,432,000 5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
EBT 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income 87,960 (95,136)
 6-3
What happened to sales and net
income?
 Sales increased by over $2.4 million.
 Costs shot up by more than sales.
 Net income was negative.
 However, the firm received a tax
refund since it paid taxes of more
than $63,424 during the past two
years.
 6-4
Balance Sheet: Assets
2002 2003
Cash 9,000 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets 1,468,800 2,886,592
 6-5
What effect did the expansion have on
the asset section of the balance sheet?
 Net fixed assets almost tripled in
size.
 AR and inventory almost doubled.
 Cash and short-term investments
fell.
 6-6
Statement of Retained Earnings: 2003
Balance of ret. earnings,
12/31/2002 203,768

Add: Net income, 2003 (95,136)

Less: Dividends paid, 2003 (11,000)

Balance of ret. earnings,

12/31/2003 97,632
 6-7
Balance Sheet: Liabilities & Equity
2002 2003
Accts. payable 145,600 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E 1,468,800 2,886,592
 6-8
What effect did the expansion have on
liabilities & equity?
 CL increased as creditors and
suppliers “financed” part of the
expansion.
 Long-term debt increased to help
finance the expansion.
 The company didn’t issue any stock.
 Retained earnings fell, due to the
year’s negative net income and
dividend payment.
 6-9
Statement of Cash Flows: 2003
Operating Activities
Net Income (95,136)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 178,400
Change in accruals 148,960
Net cash provided by ops. (503,936)
 6 - 10

Long-Term Investing Activities

Cash used to acquire FA (711,950)

Financing Activities
Change in S-T invest. 28,600
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash provided by fin. act. 1,214,168
 6 - 11

Summary of Statement of CF

Net cash provided by ops. (503,936)

Net cash to acquire FA (711,950)
Net cash provided by fin. act. 1,214,168

Net change in cash (1,718)

Cash at beginning of year 9,000
Cash at end of year 7,282
 6 - 12
What can you conclude from the
statement of cash flows?
 Net CF from operations = -$503,936,
because of negative net income and
increases in working capital.
 The firm spent $711,950 on FA.
 The firm borrowed heavily and sold
some short-term investments to meet
its cash requirements.
 Even after borrowing, the cash
account fell by $1,718.
 6 - 13
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 upon
the amount of FCF it can generate.
 6 - 14

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.)
 6 - 15

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.
 6 - 16

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.
 6 - 17

What effect did the expansion have on

net operating working capital (NOWC)?
Operating Operating
NOWC = -
CA CL
NOWC03 = ($7,282 + $632,160 + $1,287,360)
- ($324,000 + $284,960)
= $1,317,842.

NOWC02 = $793,800.
 6 - 18
What effect did the expansion have on total
net operating capital (also just called
operating capital)?
Operating
capital = NOWC + Net fixed assets.
Operating
capital03 = $1,317,842 + $939,790
= $2,257,632.

Operating
capital02 = $1,138,600.
 6 - 19

Did the expansion create additional net

operating profit after taxes (NOPAT)?

NOPAT = EBIT(1 - Tax rate)

NOPAT03 = $17,440(1 - 0.4)

= $10,464.

NOPAT02 = $125,460.
 6 - 20

What was the free cash flow (FCF)

for 2003?

FCF = NOPAT - Net investment in

operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.

How do you suppose investors reacted?

 6 - 21

Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital

ROIC03 = $10,464 / $2,257,632 = 0.5%.

ROIC02 = 11.0%.
 6 - 22
The firm’s cost of capital is 10%. Did
the growth add value?
 No. The ROIC of 0.5% 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.
For example, Home Depot has high
growth, negative FCF, but a high
ROIC.
 6 - 23

Calculate EVA. Assume the cost of

capital (WACC) was 10% for both years.
EVA = NOPAT- (WACC)(Capital)
EVA03 = $10,464 - (0.1)($2,257,632)
= $10,464 - $225,763
= -$215,299.
EVA02 = $125,460 - (0.10)($1,138,600)
= $125,460 - $113,860
= $11,600.
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Stock Price and Other Data

2002 2003
Stock price $8.50 $6
# of shares 100,000 100,000
EPS $0.88 -$0.95
DPS $0.22 $0.11
 6 - 25

What is MVA (Market Value Added)?

 MVA = Market Value of the Firm -

Book Value of the Firm
 Market Value = (# shares of stock)
(price per share) + Value of debt
 Book Value = Total common equity +
Value of debt

(More…)
 6 - 26

MVA (Continued)

 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
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Find 2003 MVA. (Assume market value

of debt = book value of debt.)
 Market Value of Equity 2003:
(100,000)($6.00) = $600,000.
 Book Value of Equity 2003:
$557,632.
MVA03 = $600,000 - $557,632 = $42,368.
MVA02 = $850,000 - $663,768 = $186,232.
 6 - 28

Key Features of the Tax Code

 Corporate Taxes
 Individual Taxes
 6 - 29

2002 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%
... ... ...
Over 18.3M 6.4M 35%
*Plus this percentage on the amount over the
bracket base.
 6 - 30

Features of Corporate Taxation

 Progressive rate up until $18.3

million taxable income.
Below $18.3 million, the marginal
rate is not equal to the average
rate.
Above $18.3 million, the marginal
rate and the average rate are 35%.
 6 - 31

Features of Corporate Taxes (Cont.)

 A corporation can:
deduct its interest expenses but not its
dividend payments;
carry-back losses for two years, carry-
forward losses for 20 years.*
exclude 70% of dividend income if it
owns less than 20% of the company’s
stock
*
Losses in 2001 and 2002 can be carried back for five years.
 6 - 32

Assume a corporation has $100,000 of

taxable income from operations, $5,000
of interest income, and $10,000 of
dividend income.

What is its tax liability?

 6 - 33

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.
 6 - 34

Key Features of Individual Taxation

 Individuals face progressive tax
rates, from 10% to 38.6%.
 The rate on long-term (i.e., more
than one year) capital gains is
20%. But capital gains are only
taxed if you sell the asset.
 Interest on municipal (i.e., state
and local government) bonds is
not subject to Federal taxation.
 6 - 35
Individual Rates for 2002
Taxable Income Tax on Base Rate*
0 - 6,000 0 10.0%
6,000 - 27,950 600.0 15.0%
27,950 - 67,700 3,892.5 27.0%
67,700 - 141,250 14,625.0 30.0%
141,250 - 307,050 36,690.0 35.0%
307,050 -  94,720.0 38.6%

*Plus this percentage on the amount over the

bracket base.
 6 - 36

Assume your salary is $45,000, and you

received $3,000 in dividends.
You are single, so your personal
exemption is $3,000 and your itemized
deductions are $7,100.

On the basis of the information

above and the 2002 tax year tax rate
schedule, what is your tax liability?
 6 - 37

Calculation of Taxable Income

Salary $45,000
Dividends 3,000
Personal exemptions (3,000)
Deductions (7,100)
Taxable Income $37,900
 6 - 38
 Tax Liability:
TL = $3,892.50 + 0.27($37,900-
$27,950)
= $6,579.
 Marginal Tax Rate = 27%.
 Average Tax Rate:
Tax rate = $6,579/$37,900 = 17.4%.
Or
Tax rate = $6,579 /$48,000 = 13.7%.
 6 - 39

Taxable versus Tax Exempt Bonds

State and local government bonds

(municipals, or “munis”) are
generally exempt from federal
taxes.
 6 - 40

 Exxon bonds at 10% versus California

muni bonds at 7%.
 T = Tax rate = 27.0%.
 After-tax interest income:
Exxon = 0.10($5,000)- 0.10($5,000)(0.27)
= 0.10($5,000)(0.73) = $365.
CAL = 0.07($5,000) - 0 = $350.
 6 - 41

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)

7.00% = 10.0%(1-T)
T = 30.0%.
 6 - 42

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.