Finance Short Response

Forum Topic Responses: One comprehensive forum topic response is assigned weekly. Students are required to select and research one of the forum topics listed below using a minimum of 3 reference sources in addition to the textbook and then write a 1,000-word or more response to the forum topic. Post the topic response in this forum no later than Day 2 of this week. APA format is required. Also submit your forum topic response to Turnitin through the Weekly Materials/Week 2/Assignment Submission folder for grading.
Comprehensive forum topic response contributions will be critically graded on the thought quality of the response, work effort, research, APA format, and analysis. Refer to the rubric for this assignment in the Syllabus section of Blackboard.
Select one of the following forum topics to research and write about.

Forum Topics – Chapter 2: Financial Statements, Cash Flow, and Taxes; Chapter 3: Analysis of Financial Statements

-The Income Statement

-The Balance Sheet

-The Importance of Cash Flow to a Corporation

-The Federal Income Tax System (Web Extension 2A)

-Ratios and Ratio Analysis

Comprehensive forum topic response contributions will be critically graded on the thought quality of the response, work effort, research, APA format, and analysis. Refer to the rubric for this assignment in the Syllabus section of Blackboard.

Select one of the following forum topics to research and write about.

Week 2 Forum Topics – Chapter 2:
Financial Statements, Cash Flow, and Taxes; Chapter 3: Analysis of Financial Statements

-The Income Statement

-The Balance Sheet

-The Importance of Cash Flow to a Corporation

-The Federal Income Tax System (Web Extension 2A)

-Ratios and Ratio Analysis

W E B E X T E N S I O N 2A
The Federal Income Tax
System for Individuals

Our tax laws can be changed by Congress, and in recent years changes have occurred
frequently. Indeed, a major change has occurred, on average, every 3 to 4 years since

913, when our federal income tax system began. Further, certain parts of our tax system
are tied to the inflation rate, so changes occur automatically each year, depending on the
rate of inflation during the previous year. Therefore, although this section will give you
a good background on the basic nature of our tax system, you should consult current rate
schedules and other data published by the Internal Revenue Service (available in some
U.S. post offices and on the Web) before you file your personal or business tax returns.

Currently (January 2009), federal income tax rates for individuals go up to 35%;
when Social Security, Medicare, and state and city income taxes are included, the
marginal tax rate on an individual’s income can easily exceed 50%. Business income
is also taxed heavily. The income from partnerships and proprietorships is reported
by the individual owners as personal income and, consequently, is taxed at federal-
plus-state rates going up to 50% or more. Corporate profits are subject to federal
income tax rates of up to 39%, plus state income taxes. Furthermore, corporations
pay taxes and then distribute after-tax income to their stockholders as dividends,
which are also taxed (although at a lower rate than ordinary income, as explained be-
low). So, corporate income is really subject to double taxation. Because of the magni-
tude of the tax bite, taxes play a critical role in many financial decisions.

As this text is being written, Congress and the administration are debating the
merits of different changes in the tax laws. Even in the unlikely event that no explicit
changes are made in the tax laws, changes will still occur because certain aspects of
the tax calculation are tied to the inflation rate. Thus, by the time you read this, tax
rates and other factors will almost certainly be different from those we provide. Still,
if you understand this section, you will understand the basics of our tax system, and
you will know how to operate under the revised Tax Code.

Taxes are so complicated that university law schools offer master’s degrees in taxation
to lawyers, many of whom are also CPAs. In a field complicated enough to warrant such
detailed study, only the highlights can be covered in a book such as this. This is really
enough, though, because business managers and investors should and do rely on tax spe-
cialists rather than trusting their own limited knowledge. Still, it is important to know
the basic elements of the tax system as a starting point for discussions with tax experts.

Individuals pay taxes on wages and salaries, on investment income (dividends,
interest, and profits from the sale of securities), and on the profits of proprietorships
and partnerships. Our tax rates are progressive—that is, the higher one’s income,
the larger the percentage paid in taxes. Table 2A-1 gives the tax rates for single in-
dividuals and married couples filing joint returns under the rate schedules that were
in effect for the 2009 tax year.

WWW
H&R Block provides infor-
mation for the current and
next year at http://www
.hrblock.com/taxes/tax_
calculators. A Web site
explaining federal tax law
is http://www.taxsites
.com. From this home page
one can visit other sites
that provide summaries of
recent tax legislation or
current information on
corporate and individual
tax rates. The official gov-
ernment site is http://www
.irs.gov.

resource

See Ch02 Tool Kit.xls for
details.

Individual Tax Rates for the 2009 Tax YearTABLE 2A-1

INDIVIDUAL TAX TABLE

IF AN INDIVIDUAL’S
TAXABLE INCOME IS

BETWEEN:

HE/SHE PAYS THIS
AMOUNT ON THE

BASE OF THE
BRACKET

PLUS THIS
PERCENTAGE

ON THE EXCESS
OVER THE BASE

AVERAGE
TAX RATE AT

TOP OF
BRACKET

(1) (2) (3) (4) (5)
$ 0 $ 8,350 $ 0.00 10.0% 10.0%
$ 8,350 $ 33,950 $ 835.00 15.0% 13.8%
$ 33,950 $ 82,250 $ 4,675.00 25.0% 20.4%
$ 82,250 $171,550 $ 16,750.00 28.0% 24.3%
$171,550 $372,950 $ 41,754.00 33.0% 29.0%
$372,950 and up $108,216.00 35.0% 35.0%

MARRIED ( JOINT RETURN) TAX TABLE

IF A COUPLE’S
TAXABLE INCOME IS

BETWEEN:

THEY PAY THIS
AMOUNT ON THE

BASE OF THE
BRACKET
PLUS THIS
PERCENTAGE
ON THE EXCESS
OVER THE BASE

AVERAGE TAX
RATE AT TOP
OF BRACKET

(1) (2) (3) (4) (5)
$ 0 $ 16,700 $ 0.00 10.0% 10.0%
$ 16,700 $ 67,900 $ 1,670.00 15.0% 13.8%
$ 67,900 $137,050 $ 9,350.00 25.0% 19.4%
$137,050 $208,850 $ 26,637.50 28.0% 22.4%
$208,850 $372,950 $ 46,741.50 33.0% 27.1%
$372,950 and up $100,894.50 35.0% 35.0%

Notes:
1. These are the tax rates for the 2009 tax year as of January 2009. Congress may change these rates later in the year.

Also, the income ranges at which each tax rate takes effect—as well as the ranges for the additional taxes discussed

later—are indexed with inflation each year, so they will change from those shown in the table. See http://hrblock
.com/taxes/tax_calculators/rate_tables/filing_status.html.
2. The average tax rate approaches 35% as taxable income rises without limit. At $1 million of taxable income, the av-

erage tax rates for single individuals and married couples filing joint returns are 33.1% and 32.5%, respectively, while

at $10 million they are 34.8% for individuals and married couples.

3. In 2009, a personal exemption of $3,650 per person or dependent could be deducted from gross income to deter-
mine taxable income. Thus, a husband and wife with two children would have a 2009 exemption of 4 × $3,650 =

$14,600. The amount of the exemption is scheduled to increase with inflation. However, if gross income exceeds cer-

tain limits ($250,200 for joint returns and $166,800 for single individuals in 2009), the exemption is phased out, and

this has the effect of raising the effective tax rate on incomes over the specified limit by about 0.5% per family mem-

ber, or 2.0% for a family of four. See http://hrblock.com/taxes/tax_calculators/rate_tables/exemption_allowance
.html for details.

Taxpayers can claim itemized deductions for charitable contributions and certain other items, but these deductions
are reduced if the gross income exceeds $166,800 (for both single individuals and joint returns; see http://hrblock
.com/taxes/tax_calculators/rate_tables/itemized_deductions.html), and this raises the effective tax rate for high-
income taxpayers by another 1% or so. The combined effect of the loss of exemptions and the reduction of item-

ized deductions is about 3%, so the marginal federal tax rate for high-income individuals goes up to about 38%.

In addition, there is the Social Security tax, which amounts to 6.2% (12.4% for a self-employed person) on up to

$106,800 of earned income, plus a 1.45% Medicare payroll tax (2.9% for self-employed individuals) on all earned
income. See http://hrblock.com/taxes/tax_calculators/rate_tables/social_security_rates.html. Finally, older high-
income taxpayers who receive Social Security payments must pay taxes on 85% of their Social Security receipts, up

from 50% in 1994. All of this pushes the effective tax rate up even further.

2 Web Extension 2A: The Federal Income Tax System for Individuals

1. Taxable income is defined as gross income less a set of exemptions and deductions
that are spelled out in the instructions to the tax forms individuals must file. When
filing a tax return in 2010 for the tax year 2009, each taxpayer receives an exemption
of $3,650 for each dependent, including the taxpayer, which reduces taxable income.
However, this exemption is indexed to rise with inflation, and the exemption is
phased out (taken away) for high-income taxpayers. Also, certain expenses including
mortgage interest paid, state and local income taxes, and charitable contributions can
be deducted and thus be used to reduce taxable income; again, however, high-income
taxpayers lose most of these deductions.

2. The marginal tax rate is defined as the tax rate on the last unit of income. Marginal
rates begin at 10% and rise to 35%. Note, though, that when consideration is given
to the phase-out of exemptions and deductions, to Social Security and Medicare
taxes, and to state taxes, the marginal tax rate can exceed 50%.

3. One can calculate average tax rates from the data in Table 2A-1. For example, if
Jill Smith, a single individual, had taxable income of $35,000, then her tax bill
would be $4,675 + ($35,000 − $33,950)(0.25) = $4,937.50. Her average tax rate
would be $4,937.50/$35,000 = 14.1% versus a marginal rate of 25%. If Jill
received a raise of $1,000, bringing her income to $36,000, she would have to
pay $250 of it as taxes, so her after-tax raise would be $750. In addition, her So-
cial Security and Medicare taxes would increase by $76.50, which would cut her
net raise to $673.50.

2.1 TAXES ON DIVIDEND AND INTEREST INCOME
Interest income received by individuals is added to their other income and thus is
taxed at rates going up to about 50%.1 Because corporations pay dividends out of
earnings that have already been taxed, there is double taxation of corporate income:
Income is first taxed at the corporate rate; then, when what is left is paid out as divi-
dends, it is taxed again at the personal rate. Under the 2003 tax law changes, divi-
dends are now taxed as though they were capital gains (which are explained below).
As stated earlier, corporations may deduct interest payments but not dividends when
computing their corporate tax liability, which means that dividends are taxed twice,
once at the corporate level and again at the personal level. This differential treatment
motivates corporations to use debt relatively heavily, and to pay small (or even no)
dividends. The 2003 tax law did not eliminate the differential treatment of dividends
and interest payments from the corporate perspective, but it did make the tax treat-
ment of dividends more similar to that of capital gains from investors’ perspectives.
To see this, consider a company that doesn’t pay a dividend but instead reinvests
the cash it could have paid. The company’s stock price should increase, leading to a
capital gain, which would be taxed at the same rate as the dividend. Of course, the
stock price appreciation isn’t exactly taxed until the stock is sold, whereas the divi-
dend is taxed in the year it is paid, so dividends will be more costly than capital gains
for many investors.

It should be noted that under U.S. tax laws, interest on most state and local gov-
ernment bonds, called municipals or munis, is not subject to federal income taxes.
Thus, investors get to keep all of the interest received from most municipal bonds
but only a fraction of the interest received from bonds issued by corporations or by

1You do not pay Social Security and Medicare taxes on interest, dividends, and capital gains, only on
earned income. However, state taxes are generally imposed on interest, dividends, and capital gains.

Web Extension 2A: The Federal Income Tax System for Individuals 3

the U.S. government. This means that a lower-yielding muni can provide the same
after-tax return as a higher-yielding corporate bond. For example, a taxpayer in the
35% marginal tax bracket who could buy a muni that yielded 5.5% would have to
receive a before-tax yield of 8.46% on a corporate or U.S. Treasury bond to have
the same after-tax income:

Equivalent pre-tax yield
on taxable bond

¼ Yield on muni
1 − Marginal tax rate

¼ 5:5%
1 − 0:35

¼ 8:46%

If we know the yield on the taxable bond, we can use the following equation to
find the equivalent yield on a muni:

Equivalent yield
on muni

�

Pre-tax yield on
taxable bond

��
1−

Marginal
tax rate

�

¼ 8:46%ð1 − 0:35Þ ¼ 8:46%ð0:65Þ ¼ 5:5%
The exemption from federal taxes stems from the separation of federal and state
powers, and its primary effect is to help state and local governments borrow at lower
rates than they otherwise could.

Munis always yield less than corporate bonds with similar risk, maturity, and liquidity.
Because of this, it would make no sense for someone in a zero or very low tax bracket to
buy munis. Therefore, most munis are owned by high-bracket investors.

2.2 CAPITAL GAINS VERSUS ORDINARY INCOME
Assets such as stocks, bonds, and real estate are defined as capital assets. If you buy a
capital asset and later sell it for more than your purchase price, the profit is called a
capital gain; if you suffer a loss, it is called a capital loss. An asset sold within one
year of the time it was purchased produces a short-term gain or loss, and one held for
more than a year produces a long-term gain or loss. Thus, if you buy 100 shares of
Disney stock for $42 per share and sell them for $52 per share, you make a capital gain
of 100($10) = $1,000. However, if you sell the stock for $32 per share, you will have a
$1,000 capital loss. Depending on how long you hold the stock, you will have a short-
term or long-term gain or loss.2 If you sell the stock for exactly $42 per share, you have
neither a gain nor a loss; you simply get your $4,200 back, and no tax is due.

Short-term capital gains are added to such ordinary income as wages, dividends, and
interest and are then taxed at the same rate as ordinary income. However, long-term
capital gains are taxed differently. The top rate on long-term gains for most situations
is 15%. Thus, if in 2009 you were in the 35% tax bracket, we congratulate you. Any
short-term gains you earned would be taxed just like ordinary income, but your long-
term gains would be taxed at 15%. Thus, capital gains on assets held for more than 12
months are better than ordinary income for many people because the tax bite is smaller.3

Capital gains tax rates have varied over time, but they have generally been lower
than rates on ordinary income. The reason is simple: Congress wants the economy to

2If you have a net capital loss (capital losses exceed capital gains) for the year, then you can currently de-
duct only up to $3,000 of this loss against your other income (e.g., salary, interest, and dividends). This
$3,000 loss limitation is not applicable to losses on the sale of business assets, which by definition are not
capital assets.
3The capital gains rate is only 5% if you are in the 10% bracket. The Tax Code governing capital gains is
very complex, and we have illustrated only the most common provision.

4 Web Extension 2A: The Federal Income Tax System for Individuals

grow; for growth we need investment in productive assets; and low capital gains tax
rates encourage investment. To see why, suppose you owned a company that earned
$1 million after corporate taxes. Because it is your company, you could have it pay
out the entire $1 million profit as dividends, or you could have it retain and reinvest
all or part of the income to expand the business. If it paid dividends, they would be
taxable to you at a rate of 35%. However, if the company reinvests its income, that
reinvestment should cause the company’s earnings and stock price to increase. Then,
if you wait for one year and one day and then sell some of your stock at a now-higher
price, you will have earned a capital gain, but it will be taxed at only 15%. Further-
more, you can postpone the capital gains tax indefinitely by simply not selling the
stock.

It should be clear that the lower tax rate on capital gains encourages investment.
The owners of small businesses will want to reinvest income to get capital gains, as
will stockholders in large corporations. Individuals with money to invest will under-
stand the tax advantages associated with investing in newly formed companies versus
buying bonds, so new ventures will have an easier time attracting equity capital. All in
all, lower capital gains tax rates stimulate capital formation and investment.4

4Fifty percent of any capital gains on the newly issued stock of certain small companies is excluded from
taxation, provided the small-company stock is held for 5 years or longer. The remaining 50% of the gain
is taxed at a rate of 20% for most taxpayers. Thus, if one bought newly issued stock from a qualifying
small company and held it for at least 5 years, any capital gains would be taxed at a maximum rate of
10% for most taxpayers. This provision was designed to help small businesses attract equity capital.

Web Extension 2A: The Federal Income Tax System for Individuals 5

Chapter

Financial Statements, Cash Flow, and Taxes

Topics in Chapter

Income statement

Balance sheet

Statement of cash flows

Free cash flow

MVA and EVA

Corporate taxes

Personal taxes

Value = + + +
FCF1
FCF2
FCF∞
(1 + WACC)1
(1 + WACC)∞
(1 + WACC)2

Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Sales revenues
Operating costs and taxes
Required investments in operating capital
−
−
=
Determinants of Intrinsic Value: Calculating FCF
…

Figure 1-6 in FM13.

4
Income Statement
2009 2010
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)

5
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
Balance Sheet: Assets
2009 2010
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

7
Effect of Expansion on Assets
Net fixed assets almost tripled in size.
AR and inventory almost doubled.
Cash and short-term investments fell.

8
Balance Sheet: Liabilities & Equity
2009 2010
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

9
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.

10
Statement of Cash Flows: 2010
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 (used) by ops. ($503,936)

Investing Activities
Cash used to acquire FA ($711,950)
Change in S-T invest. 28,600
Net cash prov. (used) by inv. act. ($683,350)

Financing Activities
Change in notes payable $ 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash provided (used) by fin. act. $1,185,568

13
Summary of Statement of CF
Net cash provided (used) by ops. ($ 503,936)
Net cash to acquire FA (683,350)
Net cash prov. (used) by fin. act. 1,185,568
Net change in cash (1,718)
Cash at beginning of year 9,000
Cash at end of year $ 7,282

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.

15
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.

16
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.)

17
Earning before interest and taxes
(1 − Tax rate)
Net operating profit after taxes
X

Operating current assets
Operating current liabilities
Net operating working capital
−

Total net operating capital
Operating long-term assets
+
Net operating working capital
Free cash flow
−

Net investment in operating capital
Net operating profit after taxes
−
Total net operating capital this year
Total net operating capital last year
Net investment in operating capital
Calculating Free Cash Flow in 5 Easy Steps
Step 1
Step 2
Step 3
Step 4
Step 5

Figure 2-1 in FM13

18
Net Operating Profit after Taxes (NOPAT)
NOPAT = EBIT(1 – Tax rate)
NOPAT10 = $17,440(1 – 0.4)
= $10,464.
NOPAT09 = $125,460.

19
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.

20
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.

21
Net Operating Working Capital (NOWC)
NOWC10 = ($7,282 + $632,160 + $1,287,360)
– ($324,000 + $284,960)
= $1,317,842.
NOWC09 = $793,800.
= –
Operating
CA
Operating
CL
NOWC

22
Total net operating capital (also called operating capital)
Operating Capital= NOWC + Net fixed assets.
Operating Capital 2010
= $1,317,842 + $939,790
= $2,257,632.
Operating Capital 2009 = $1,138,600.

23
Free Cash Flow (FCF) for 2010
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?

24
Uses of FCF
After-tax interest payment = $105,600
Reduction (increase) in debt = −$1,196,568
Payment of dividends = $11,000
Repurchase (Issue) stock = $0
Purch. (Sale) of ST investments = −$28,600
Total uses of FCF = −$1,108,568

25
Return on Invested Capital (ROIC)
ROIC = NOPAT / operating capital
ROIC10 = $10,464 / $2,257,632 = 0.5%.
ROIC09 = 11.0%.

26
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, in 2008 Qualcomm had high growth, negative FCF, but a high ROIC.

27
Economic Value Added (EVA)
WACC is weighted average cost of capital
EVA = NOPAT- (WACC)(Capital)

28
Economic Value Added
(WACC = 10% for both years)
EVA = NOPAT- (WACC)(Capital)
EVA10 = $10,464 – (0.1)($2,257,632)
= $10,464 – $225,763
= -$215,299.
EVA09 = $125,460 – (0.10)($1,138,600)
= $125,460 – $113,860
= $11,600.

29
Stock Price and Other Data
2009 2010
Stock price $8.50 $6.00
# of shares 100,000 100,000
EPS $0.88 -$0.95
DPS $0.22 $0.11

30
Market Value Added (MVA)
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…)

31
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

32
2010 MVA (Assume market value of debt = book value of debt.)
Market Value of Equity 2010:
(100,000)($6.00) = $600,000.
Book Value of Equity 2010:
$557,632.
MVA10 = $600,000 – $557,632 = $42,368.
MVA09 = $850,000 – $663,768 = $186,232.

33
Key Features of the Tax Code
Corporate Taxes
Individual Taxes

34
2009 Corporate Tax Rates
Taxable Income Tax on Base Rate on amount above base
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 – 10M 113,900 34%
10M – 15M 3,400,000 35%
15M – 18.3M 5,150,000 38%
18.3M and up 6,416,667 35%

35
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%.

36
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.

37
Example
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?

38
Operating income
$100,000
Interest income
5,000
Taxable dividend
income
3,000*
Taxable income
$108,000
*Dividends – Exclusion
= $10,000 – 0.7($10,000) = $3,000.

Example (Continued)

39
Taxable Income = $108,000
Tax on base = $22,250
Amount over base = $108,000 – $100,000
= $8,000
Tax = $22,250 + 0.39 ($8,000)
= $25,370.
Example (Continued)

40
Key Features of Individual Taxation
Individuals face progressive tax rates, from 10% to 35%.
The rate on long-term (i.e., more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset.
Dividends are taxed at the same rate as capital gains.
Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.

Taxable versus Tax Exempt Bonds
State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.

ExxonMobil bonds at 10% versus California muni bonds at 7%
T = Tax rate = 25.0%.
After-tax interest income:
ExxonMobil = 0.10($5,000) – 0.10($5,000)(0.25)
ExxonMobil = 0.10($5,000)(0.75) = $375.
CAL = 0.07($5,000) – 0 = $350.

Breakeven Tax Rate
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%.

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.

CHAPTER 3

Analysis of Financial Statements

Topics in Chapter

Ratio analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

Value = + + +
FCF1
FCF2
FCF∞
(1 + WACC)1
(1 + WACC)∞
(1 + WACC)2

Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
Determinants of Intrinsic Value:
Using Ratio Analysis

…

For value box in Ch 3 ratios FM13.

4
Overview
Ratios facilitate comparison of:
One company over time
One company versus other companies
Ratios are used by:
Lenders to determine creditworthiness
Stockholders to estimate future cash flows and risk
Managers to identify areas of weakness and strength

5
Income Statement
2010 2011E
Sales $5,834,400 $7,035,600
COGS 4,980,000 5,800,000
Other expenses 720,000 612,960
Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income ($ 95,136) $ 253,584

6
Balance Sheets: Assets
2010 2011E
Cash $ 7,282 $ 14,000
S-T invest. 20,000 71,632
AR 632,160 878,000
Inventories 1,287,360 1,716,480
Total CA 1,946,802 2,680,112
Net FA 939,790 836,840
Total assets $2,886,592 $3,516,952

7
Balance Sheets: Liabilities & Equity
2010 2011E
Accts. payable $ 324,000 $ 359,800
Notes payable 720,000 300,000
Accruals 284,960 380,000
Total CL 1,328,960 1,039,800
Long-term debt 1,000,000 500,000
Common stock 460,000 1,680,936
Ret. earnings 97,632 296,216
Total equity 557,632 1,977,152
Total L&E $2,886,592 $3,516,952

8
Other Data
2010 2011E
Stock price $6.00 $12.17
# of shares 100,000 250,000
EPS -$0.95 $1.01
DPS $0.11 $0.22
Book val. per sh. $5.58 $7.91
Lease payments $40,000 $40,000
Tax rate 0.4 0.4

9
Liquidity Ratios
Can the company meet its short-term obligations using the resources it currently has on hand?

10
Forecasted Current and Quick Ratios for 2011.
CR10 = = = 2.58.
QR10 =
= = 0.93.
CA
CL
$2,680
$1,040
$2,680 – $1,716
$1,040
CA – Inv.
CL

11
Comments on CR and QR
2011E 2010 2009 Ind.
CR 2.58 1.46 2.3 2.7
QR 0.93 0.5 0.8 1.0

Expected to improve but still below the industry average.
Liquidity position is weak.

12
Asset Management Ratios
How efficiently does the firm use its assets?
How much does the firm have tied up in assets for each dollar of sales?

13
Inventory Turnover Ratio vs. Industry Average
Inv. turnover =
= = 4.10.
Sales
Inventories
$7,036
$1,716
2011E 2010 2009 Ind.
Inv. T. 4.1 4.5 4.8 6.1

14
Comments on Inventory Turnover
Inventory turnover is below industry average.
Firm might have old inventory, or its control might be poor.
No improvement is currently forecasted.

15
DSO =

= =
= 45.5 days.
Receivables
Average sales per day

$878
$7,036/365
Receivables
Sales/365
DSO: average number of days from sale until cash received.

16
Appraisal of DSO
Firm collects too slowly, and situation is getting worse.
Poor credit policy.
2011 2010 2009 Ind.
DSO 45.5 39.5 37.4 32.0

17
Total assets
turnover
=
= = 2.00.
Sales
Total assets
$7,036
$3,517
Fixed assets
turnover
Sales
Net fixed assets
=
= = 8.41.
$7,036
$837
(More…)
Fixed Assets and Total Assets
Turnover Ratios

18
Fixed Assets and Total Assets
Turnover Ratios
FA turnover is expected to exceed industry average. Good.
TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).
2011E 2010 2009 Ind.
FA TO 8.4 6.2 10.0 7.0
TA TO 2.0 2.0 2.3 2.5

19
Debt Management Ratios
Does the company have too much debt?
Can the company’s earnings meet its debt servicing requirements?

Total liabilities
Total assets
Debt ratio =
= = 43.8%.
$1,040 + $500
$3,517
EBIT
Int. expense
TIE =
= = 6.3.
$502.6
$80
(More…)
Calculate the debt, TIE, and EBITDA coverage ratios.

= = 5.5.
EBIT + Depr. & Amort. + Lease payments
Interest Lease
expense pmt.
+ + Loan pmt.
$502.6 + $120 + $40
$80 + $40 + $0
EBITDA Coverage (EC)

22
Recapitalization improved situation, but lease payments drag down EC.
2011E 2010 2009 Ind.
D/A 43.8% 80.7% 54.8% 50.0%
TIE 6.3 0.1 3.3 6.2
EC 5.5 0.8 2.6 8.0

Debt Management Ratios vs. Industry Averages

23
Profitability Ratios
What is the company’s rate of return on:
Sales?
Assets?

24
Profit Margins
PM = = = 3.6%.
NI
Sales
$253.6
$7,036
OM = = = 7.1%.
EBIT
Sales
$503
$7,036
Net profit margin (PM):
Operating profit margin (OM):
(More…)

25
Sales − COGS
Sales
Profit Margins (Continued)
GPM = =
GPM = = 17.6%.
$1,236
$7,036
Gross profit margin (GPM):
$7,036 − $5,800
$7,036

26
Very bad in 2010, but projected to
meet or exceed industry average in 2011.
2011E 2010 2009 Ind.
PM 3.6% -1.6% 2.6% 3.6%
OPM 7.1 0.3 6.1 7.1
GPM 17.6 14.6 16.6 15.5

Profit Margins vs. Industry Averages

27
BEP =
= = 14.3%.
EBIT
Total assets
$502.6
$3,517
(More…)
Basic Earning Power (BEP)

28
Basic Earning Power vs. Industry Average
BEP removes effect of taxes and financial leverage. Useful for comparison.
Projected to be below average.
Room for improvement.
2011E 2010 2009 Ind.
BEP 14.3% 0.6% 14.2% 17.8%

29
ROA =
= = 7.2%.
NI
Total assets
$253.6
$3,517
(More…)
Return on Assets (ROA)
and Return on Equity (ROE)

30
ROE =
= = 12.8%.
NI
Common Equity
$253.6
$1,977
(More…)
Return on Assets (ROA)
and Return on Equity (ROE)

31
2011E 2010 2009 Ind.
ROA 7.2% -3.3% 6.0% 9.0%
ROE 12.8% -17.1% 13.3% 18.0%

Both below average but improving.
ROA and ROE vs. Industry Averages

32
Effects of Debt on ROA and ROE
ROA is lowered by debt–interest expense lowers net income, which also lowers ROA.
However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

33
Market Value Ratios
Market value ratios incorporate the:
High current levels of earnings and cash flow increase market value ratios
High expected growth in earnings and cash flow increases market value ratios
High risk of expected growth in earnings and cash flow decreases market value ratios

34
Price = $12.17.
EPS = = = $1.01.

P/E = = = 12.
NI
Shares out.
$253.6
250
Price per share
EPS
$12.17
$1.01
Calculate and appraise the
P/E, P/CF, and M/B ratios.

35
Industry P/E Ratios:
Industry Ticker* P/E
Banking STI 1.32
Software MSFT 6.14
Drug PFE 5.87
Electric Utilities DUK 10.14
Semiconductors INTC 4.01
Steel NUE 0.33
Tobacco MO 1.30
S&P 500 14.22
*Ticker is for typical firm in industry, but P/E ratio is for the industry, not the individual firm; www.investor.reuters.com, January 2009.

36
NI + Depr.
Shares out.
CF per share =
= = $1.49.
$253.6 + $120.0
250
Price per share
Cash flow per share
P/CF =
= = 8.2.
$12.17
$1.49
Market Based Ratios

37
Com. equity
Shares out.
BVPS =
= = $7.91.
$1,977
250
Mkt. price per share
Book value per share
M/B =
= = 1.54.
$12.17
$7.91
Market Based Ratios (Continued)

38
Interpreting Market Based Ratios
P/E: How much investors will pay for $1 of earnings. Higher is better.
M/B: How much paid for $1 of book value. Higher is better.
P/E and M/B are high if ROE is high, risk is low.

39
2011E 2010 2009 Ind.
P/E 12.0 -6.3 9.7 14.2
P/CF 8.2 27.5 8.0 7.6
M/B 1.5 1.1 1.3 2.9

Comparison with Industry Averages

40
Common Size Balance Sheets:
Divide all items by Total Assets
Assets 2009 2010 2011E Ind.
Cash 0.6% 0.3% 0.4% 0.3%
ST Inv. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%

41
Divide all items by Total Liabilities & Equity
Assets 2009 2010 2011E Ind.
AP 9.9% 11.2% 10.2% 11.9%
Notes pay. 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total CL 32.8% 46.0% 29.6% 23.7%
LT Debt 22.0% 34.6% 14.2% 26.3%
Total eq. 45.2% 19.3% 56.2% 50.0%
Total L&E 100.0% 100.0% 100.0% 100.0%

42
Analysis of Common Size Balance Sheets
Computron has higher proportion of inventory and current assets than Industry.
Computron now has more equity (which means LESS debt) than Industry.
Computron has more short-term debt than industry, but less long-term debt than industry.

43
Common Size Income Statement:
Divide all items by Sales
2009 2010 2011E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
Other exp. 9.9% 12.3% 8.7% 4.4%
Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%

44
Analysis of Common Size Income Statements
Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

45
Percentage Change Analysis: % Change from First Year (2009)
Income St. 2009 2010 2011E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
Other exp. 0.0% 111.8% 80.3%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%
NI 0.0% -208.2% 188.3%

46
Analysis of Percent Change Income Statement
We see that 2011 sales grew 105% from 2009, and that NI grew 188% from 2009.
So Computron has become more profitable.

47
Percentage Change Balance Sheets: Assets
Assets 2009 2010 2011E
Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -58.8% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 73.2% 138.4%
Net FA 0.0% 172.6% 142.7%
TA 0.0% 96.5% 139.4%

48
Percentage Change Balance Sheets: Liabilities & Equity
Liab. & Eq. 2009 2010 2011E
AP 0.0% 122.5% 147.1%
Notes pay. 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total CL 0.0% 175.9% 115.9%
LT Debt 0.0% 209.2% 54.6%
Total eq. 0.0% -16.0% 197.9%
Total L&E 0.0% 96.5% 139.4%

49
Analysis of Percent Change Balance Sheets
We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

50
Explain the Du Pont System
The Du Pont system focuses on:
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
It shows how these factors combine to determine the ROE.

51
( )( )( ) = ROE

Profit
margin
TA
turnover
Equity
multiplier
NI
Sales
Sales
TA
TA
CE
x
x
= ROE
The Du Pont System

52
2008: 2.6% x 2.3 x 2.2 = 13.2%
2009: -1.6% x 2.0 x 5.2 = -16.6%
2010: 3.6% x 2.0 x 1.8 = 13.0%
Ind.: 3.6% x 2.5 x 2.0 = 18.0%
NI
Sales
Sales
TA
TA
CE
x
x
= ROE
The Du Pont System

53
Potential Problems and Limitations of Ratio Analysis
Comparison with industry averages is difficult if the firm operates many different divisions.
Seasonal factors can distort ratios.
Window dressing techniques can make statements and ratios look better.
Different accounting and operating practices can distort comparisons.

54
Qualitative Factors
There is greater risk if:
revenues tied to a single customer
revenues tied to a single product
reliance on a single supplier?
High percentage of business is generated overseas?
What is the competitive situation?
What products are in the pipeline?
What are the legal and regulatory issues?

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