Business Law Question

1st assignment is :

Answer the following questions:

1. What is a Balance Sheet and what information it provides? What is the importance for a company.

MINIMUM ONE PAGE REQUIREMENT.

2. What is an Income Statement and what information it provides? What is the importance for a company? MINIMUM ONE PAGE REQUIREMENT.

3. What is EBITDA? Discuss. MINIMUM ONE PAGE REQUIREMENT.

REFERENCES ARE MANDATORY.

Writing Requirement:

APA format,
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• Use the APA template located in the Student Resource Center to complete the assignment.

2nd different assignment is:

I NEED YOU TO WRITE A BRIEF SUMMARY OF THE IMPORTANT CONCEPTS LEARNED FROM THE FILE BELOW.

MINIMUM ONE PAGE REQUIREMENT.

Writing Requirements

Use the APA template located in the Student Resource Center to complete the assignment. Chapter 3
Introduction
Unlocking the Valuable Information in Financial Statements
In Chapter 1, we said that managers should make decisions that enhance long-term
shareholder value, and they should be less concerned about short-term accounting
measures such as earnings per share. With that important point in mind, you might
reasonably wonder why are we now going to talk about accounting and financial statements.
The simple answer is financial statements convey a lot of useful information that helps
corporate managers assess the company’s strengths and weaknesses and gauge the
expected impact of various proposals. Good managers must have a solid understanding of
the key financial statements. Outsiders also rely heavily on financial statements when
deciding whether they want to buy the company’s stock, lend money to the company, or
enter into a long-term business relationship with the company.
At first glance, financial statements can be overwhelming—but if we know what we are
looking for, we can quickly learn a great deal about a company after a quick review of its
financial statements. Looking at the balance sheet we can see how large a company is, the
types of assets it holds, and how it finances those assets. Looking at the income statement,
we can see if the company’s sales increased or declined and whether the company made a
profit. Glancing at the statement of cash flows, we can see if the company made any new
investments, if it raised funds through financing, repurchased debt or equity, or paid
dividends.
For example, in early 2020, McDonald’s released its fourth quarter financial statements for
2019. The news was good. The company announced higher than expected revenue and
earnings per share. Notably, the company’s U.S. same-store sales rose 5.1% in the fourth
quarter, despite a 1.9% drop in the number of customer visits. The sales growth reflected
higher prices and robust sales of some of its key menu items.
The company’s 2019 annual report at the end of its fiscal year (December 31, 2019) showed
total assets of $47.5 billion and total liabilities of $55.72 billion on its balance sheet—
indicating that the book value of the company’s equity was negative. Finally, looking at the
statement of cash flows, we see that McDonald’s generated $8.12 billion from its operating
activities and used a little more than $3 billion in cash for its investing activities, which
included the continued establishment of kiosk technology in the stores and resources
needed for new product lines. The company also used nearly $5 billion in cash to support its
financing activities—the large bulk of this money was used to pay dividends and to
repurchase some shares of common stock. It follows that the company’s overall cash
position increased by
$
32.5
million
during 2019.
While we can learn a lot from a quick tour of the financial statements, a good financial
analyst does not just accept these numbers at face value. The analyst digs deeper to see
what’s really driving the numbers and uses his or her intuition and knowledge of the
industry to help assess the company’s future direction. Keep in mind that just because a
company reports great numbers doesn’t mean that you should purchase the stock. In the
case of McDonald’s, its stock price did rise after it announced its better than expected
financial numbers for the fourth quarter. However, as is always the case, analysts have mixed
feelings about the stock’s future direction. It’s these types of disagreements that make
finance interesting, and as always, time will tell whether the optimists (the bulls) or the
pessimists (the bears) are correct.
Sources: Heather Haddon and Micah Maidenberg, “McDonald’s Global Sales Rise, but U.S.
Guest Count Falls,” The Wall Street Journal (wsj.com), January 29, 2020; Amelia Lucas,
“McDonald’s Earnings Beat Wall Street Estimates, Helped By Price Hikes as U.S. Foot Traffic
Declined,” CNBC (cnbc.com), January 29, 2020; and “McDonald’s Reports Fourth Quarter
and Full Year 2019 Results and Quarterly Cash Dividend,” news.mcdonalds.com, January 29,
2020.
Putting Things in Perspective
A manager’s primary goal is to maximize shareholder value, which is based on the firm’s
future cash flows. But how do managers decide which actions are most likely to increase
those flows, and how do investors estimate future cash flows? The answers to both
questions lie in a study of financial statements that publicly traded firms must provide to
investors. Here investors include both institutions (banks, insurance companies, pension
funds, and the like) and individuals like you.
Much of the material in this chapter deals with concepts you covered in a basic accounting
course. However, the information is important enough to warrant a review. Also, in
accounting you probably focused on how accounting statements are made; the focus here is
on how investors and managers interpret and use them. Accounting is the basic language of
business, so everyone engaged in business needs a good working knowledge of it. It is used
to “keep score”; if investors and managers do not know the score, they won’t know whether
their actions are appropriate. If you took midterm exams but were not told your scores, you
would have a difficult time knowing whether you needed to improve. The same idea holds in
business. If a firm’s managers—whether they work in marketing, human resources,
production, or finance—do not understand financial statements, they will not be able to
judge the effects of their actions, which will make it hard for the firm to survive, much less to
have a maximum value.
When you finish this chapter you should be able to do the following:
List each of the key financial statements and identify the kinds of information they provide
to corporate managers and investors.
Estimate a firm’s free cash flow and explain why free cash flow has such an important effect
on firm value.
Discuss the major features of the federal income tax system and changes due to the passage
of the “Tax Cuts and Jobs Act” (TCJA).
3-1. Financial Statements and Reports
The annual report is the most important report that corporations issue to stockholders, and
it contains two types of information. First, there is a verbal section, often presented as a
letter from the chairperson, which describes the firm’s operating results during the past year
and discusses new developments that will affect future operations. Second, the report
provides these four basic financial statements:
The balance sheet, which shows what assets the company owns and who has claims on
those assets as of a given date—for example, December 31, 2021.
The income statement, which shows the firm’s sales and costs (and thus profits) during some
past period—for example, 2021.
The statement of cash flows, which shows how much cash the firm began the year with, how
much cash it ended up with, and what it did to increase or decrease its cash.
The statement of stockholders’ equity, which shows the amount of equity the stockholders
had at the start of the year, the items that increased or decreased equity, and the equity at
the end of the year.
These statements are related to one another, and, taken together, they provide an
accounting picture of the firm’s operations and financial position.
The quantitative and verbal materials are equally important. The firm’s financial statements
report what has actually happened to its assets, earnings, and dividends over the past few
years, whereas management’s verbal statements attempt to explain why things turned out
the way they did and what might happen in the future.
For discussion purposes, we use data for Allied Food Products, a processor and distributor of
a wide variety of food products, to illustrate the basic financial statements. Allied was
formed in 1985, when several regional firms merged; it has grown steadily while earning a
reputation as one of the best firms in its industry. Allied’s earnings dropped from
$
152.3
million
in 2020 to
$
146.3
million
in 2021. Management reported that the drop resulted from losses associated with a
drought as well as increased costs due to a 3-month strike. However, management then
went on to describe a more optimistic picture for the future, stating that full operations had
been resumed, that several unprofitable businesses had been eliminated, and that 2022
profits were expected to rise sharply. Of course, an increase in profitability may not occur,
and analysts should compare management’s past statements with subsequent results. In any
event, the information contained in the annual report can be used to help forecast future
earnings and dividends. Therefore, investors are very interested in this report.
We should note that Allied’s financial statements are relatively simple and straightforward;
we also omitted some details often shown in the statements. Allied finances with only debt
and common stock—it has no preferred stock, convertibles, or complex derivative securities.
Also, the firm has made no acquisitions that resulted in goodwill that must be carried on the
balance sheet. We deliberately chose such a company because this is an introductory text;
as such, we want to explain the basics of financial analysis, not wander into arcane
accounting matters that are best left to accounting and security analysis courses. We do
point out some of the pitfalls that can be encountered when trying to interpret accounting
statements, but we leave it to advanced courses to cover the intricacies of accounting.
Global Perspectives Global Accounting Standards: Will It Ever Happen?
Until 2017, global accounting standards to improve financial reporting to investors and users
of that information seemed all but certain. In 2005, the EU required the adoption of
International Financial Reporting Standards (IFRS), and in 2007, the SEC eliminated the
requirement for companies reporting under IFRS to reconcile their financial statements to
U.S. Generally Accepted Accounting Principles (GAAP). To date, 120 countries have adopted
IFRS. However, on July 13, 2012, the SEC staff issued a report that failed to recommend IFRS
for U.S. adoption. The ultimate decision will be up to the SEC. On December 6, 2014, at an
American Institute of Certified Public Accountants (AICPA) national conference, the SEC chief
accountant at that time, James Schnurr, stated that he was open to dialogue about the best
way to achieve high-quality financial information and comparability, but there is currently no
sign that the United States will be adopting IFRS anytime soon.
The effort to internationalize accounting standards began in 1973 with the formation of the
International Accounting Standards Committee. However, in 1998, it became apparent that a
full-time rule-making body with global representation was necessary; so the International
Accounting Standards Board (IASB) was established. The IASB was charged with the
responsibility for creating a set of IFRS. The “convergence” process began in earnest in
September 2002 with the “Norwalk Agreement,” in which the Financial Accounting
Standards Board (FASB) and IASB undertook a short-term project to remove individual
differences between the FASB’s U.S. GAAP and IFRS and agreed to coordinate their activities.
The process was meant to narrow gaps between the two standards, with the intention of
making the transition for companies simpler and less expensive. Some progress has been
made, but differences still remain.
Obviously, the globalization of accounting standards is a huge endeavor—one that involves
compromises between the IASB and FASB. However, in recent years the momentum behind
this goal has diminished. Despite the best of intentions, progress toward consolidation was
slowed by the 2007–2008 financial crisis and the resulting global recession. In addition, it
has become apparent that the cost to companies, both large and small, for switching from
GAAP to IFRS will be significant. Another reason for resistance to convergence is the
principles-based IFRS approach fails to offer guidance as compared to the rules-based U.S.
standards. In addition, the SEC has been given the task of implementing the Dodd-Frank
financial reform law and the Consumer Protection Act—limiting its ability to focus on
adopting global accounting standards. Finally, the appointment in 2017 of Jay Clayton as SEC
chairman has caused the project to come to a grinding halt. The SEC chairman has made it
clear it is not a primary focus for him.
The United States is an important economy, and without its participation it will be difficult to
truly have global accounting standards. In the meantime, it is important for companies and
analysts that evaluate businesses in different countries to have a full understanding of the
key differences between the various global accounting standards. While there doesn’t seem
to be a one-size-fits-all global accounting rulebook coming in the foreseeable future, the
FASB and IASB will continue to work together to make sure that financial reporting guidance
is as comparable as possible.
Sources: Weaver Assurance, Tax & Advisory Firm, “Global Convergence Project: U.S. GAAP Is
Alive and Well,” weaver.com/blog/global-convergence-project-us-gaap-alive-and-well,
January 11, 2019; Nicolas Pologeorgis, “The Impact of Combining the U.S. GAAP and IFRS,”
Investopedia (investopedia.com), March 12, 2018; David M. Katz “The Path to Global
Standards?” CFO (cfo.com), January 28, 2011; “Global Accounting Standards: Closing the
GAAP,” The Economist, vol. 404, July 21, 2012; Joe Adler, “Is Effort to Unify Accounting
Regimes Falling Apart?” American Banker, vol. 177, no. 145, July 30, 2012; Kathleen
Hoffelder, “SEC Report Backs Away from Convergence,” CFO (cfo.com), September 1, 2012;
Ken Tysiac, “Still in Flux: Future of IFRS in U.S. Remains Unclear after SEC Report,” Journal of
Accountancy (journalofaccountancy.com), September 2012; and Tammy Whitehouse, “Ten
Years on, Convergence Movement Starting to Wane,” Compliance Week
(complianceweek.com), October 2, 2012.
SelfTest
What is the annual report, and what two types of information does it provide?
What four financial statements are typically included in the annual report?
Why is the annual report of great interest to investors?
3-2. The Balance Sheet
The balance sheet is a “snapshot” of a firm’s position at a specific point in time. Figure 3.1
shows the layout of a typical balance sheet. The left side of the statement shows the assets
that the company owns, and the right side shows the firm’s liabilities and stockholders’
equity, which are claims against the firm’s assets. As Figure 3.1 shows, assets are divided into
two major categories: current assets and fixed, or long-term, assets. Current assets consist
of assets that should be converted to cash within one year, and they include cash and cash
equivalents, accounts receivable, and inventory. Long-term assets are assets expected to be
used for more than one year; they include plant and equipment in addition to intellectual
property such as patents and copyrights. Plant and equipment is generally reported net of
accumulated depreciation. Allied’s long-term assets consist entirely of net plant and
equipment, and we often refer to them as “net fixed assets.”
Figure 3.1 A Typical Balance Sheet
Details
Note: This is the typical layout of a balance sheet for one year. When balance sheets for two
or more years are shown, assets are listed in the top section, and liabilities and equity in the
bottom section. See Table 3.1 for an illustration.
The claims against assets are of two basic types—liabilities (or money the company owes to
others) and stockholders’ equity. Current liabilities consist of claims that must be paid off
within one year, including accounts payable, accruals (total of accrued wages and accrued
taxes), and notes payable to banks and other short-term lenders that are due within one
year. Long-term debt includes bonds that mature in more than a year.
Stockholders’ equity can be thought of in two ways. First, it is the amount that stockholders
paid to the company when they bought shares the company sold to raise capital, in addition
to all of the earnings the company has retained over the years:
Stockholders
‘
equity
=
Paid-in capital
+
Retained earnings
The retained earnings are not just the earnings retained in the latest year—they are the
cumulative total of all of the earnings the company has earned and retained during its life.
Stockholders’ equity can also be thought of as a residual:
Stockholders
‘
equity
=
Total assets
Total liabilities
If Allied had invested surplus funds in bonds whose value subsequently fell below their
purchase price, the true value of the firm’s assets would have declined. The amount of its
liabilities would not have changed—the firm would still owe the amount it had promised to
pay its creditors. Therefore, the reported value of the common equity must decline. The
accountants would make a series of entries, and the result would be a reduction in retained
earnings—and thus in common equity. In the end, assets would equal liabilities and equity,
and the balance sheet would balance. This example shows why common stock is more risky
than bonds—any mistake that management makes has a big impact on the stockholders. Of
course, gains from good decisions also go to the stockholders; so with risk come possible
rewards.
Assets on the balance sheet are listed by the length of time before they will be converted to
cash (inventories and accounts receivable) or used by the firm (fixed assets). Similarly, claims
are listed in the order in which they must be paid: Accounts payable must generally be paid
within a few days, accruals must also be paid promptly, notes payable to banks must be paid
within 1 year, and so forth, down to the stockholders’ equity accounts, which represent
ownership and need never be “paid off.”
3-2A. Allied’s Balance Sheet
Resource
Students can download the Excel chapter models from the textbook’s student companion
site on cengage.com. Once downloaded onto your computer, retrieve the Chapter 3 Excel
model and follow along as you read this chapter.
Table 3.1 shows Allied’s year-end balance sheets for 2021 and 2020. From the 2021
statement, we see that Allied had $2 billion of assets—half current and half long term. These
assets were financed with
$
310
million
of current liabilities,
$
750
million
of long-term debt, and
$
940
million
of common equity. Comparing the balance sheets for 2021 and 2020, we see that Allied’s
assets grew by
$
320
million
and its liabilities and equity necessarily grew by that same amount. Assets must, of course,
equal liabilities and equity; otherwise, the balance sheet does not balance.
Several additional points about the balance sheet should be noted:
1.
Cash versus other assets. Although assets are reported in dollar terms, only the cash and
equivalents account represents actual spendable money. Accounts receivable represent
credit sales that have not yet been collected. Inventories show the cost of raw materials,
work in process, and finished goods. Net fixed assets represent the cost of the buildings and
equipment used in operations minus the depreciation that has been taken on these assets.
At the end of 2021, Allied has
$
10
million
of cash; hence, it could write checks totaling that amount. The noncash assets should
generate cash over time, but they do not represent cash in hand. And the cash they would
bring in if they were sold today could be higher or lower than the values reported on the
balance sheet.
2.
Working capital. Current assets are often called working capital because these assets “turn
over”; that is, they are used and then replaced throughout the year. When Allied buys
inventory items on credit, its suppliers, in effect, lend it the money used to finance the
inventory items. Allied could have borrowed from its bank or sold stock to obtain the money,
but it received the funds from its suppliers. These loans are shown as accounts payable, and
they typically are “free” in the sense that they do not bear interest. Similarly, Allied pays its
workers every 2 weeks and pays taxes quarterly; so Allied’s labor force and taxing authorities
provide it with loans equal to its accrued wages and taxes. In addition to these “free”
sources of short-term credit, Allied borrows from its bank on a short-term basis. These bank
loans are shown as notes payable. Although accounts payable and accruals do not bear
interest, Allied pays interest on funds obtained from the bank. The total of accounts payable,
accruals, and notes payable represent current liabilities on its balance sheet. If we subtract
current liabilities from current assets, the difference is called net working capital:
Net working capital
=
Current assets
Current liabilities
=
$
1,000
$
310
=
$
690
million
Table 3.1 Allied Food Products: December 31 Balance Sheets (Millions of Dollars)
Details
Notes:
Inventories can be valued by several different methods, and the method chosen can affect
both the balance sheet value and the cost of goods sold, and thus net income, as reported
on the income statement. Similarly, companies can use different depreciation methods for
financial reporting. The methods used must be reported in the notes to the financial
statements, and security analysts can make adjustments when they compare companies if
they think the differences are material.
Book value per share:
Total common equity
/
Shares outstanding
=
$
940
/
75
=
$
12.53
.
A relatively few firms use preferred stock, which we discuss in Chapter 9. Preferred stock can
take several different forms, but it is generally like debt because it pays a fixed amount each
year. However, it is like common stock because a failure to pay the preferred dividend does
not expose the firm to bankruptcy. If a firm does use preferred stock, it is shown on the
balance sheet between total debt and common stock. There is no set rule on how preferred
stock should be treated when financial ratios are calculated—it could be considered as debt
or as equity. Bondholders often think of it as equity, while stockholders think of it as debt
because it is a fixed charge. In truth, preferred stock is a hybrid, somewhere between debt
and common equity.
Current liabilities include accounts payable, accruals, and notes payable to the bank.
Financial analysts often make an important distinction between net working capital (NWC)
and net operating working capital (NOWC). NOWC differs from NWC in two important ways.
First, NOWC makes a distinction between cash that is used for operating purposes and
“excess” cash that is being held for other purposes. Thus, when calculating NOWC, analysts
make an estimate of excess cash and subtract this from the company’s current assets to get
the company’s operating current assets. Second, when looking at a company’s current
liabilities, analysts distinguish between its “free” liabilities (accruals and accounts payable)
and its interest-bearing notes payable. These interest-bearing liabilities are typically treated
as a financing cost, rather than an operating cost, which explains why they are not included
as part of the company’s operating current liabilities. Given these two adjustments, NOWC is
calculated as follows:
3.1
Net operating
working capital
(
NOWC
)
=
Operating current
assets
Operating
current liabilities
=
(
Current
assets
Excess
cash
)
(
Current
liabilities
Notes
payable
)
=
(
$
1,000
$
0
)
(
$
310
$
110
)
=
$
800
million
Note that since Allied’s cash holdings in 2021 are fairly small (
$
10
million
), we are assuming that all of its cash is being held for operating purposes and that it has no
excess cash. If we had instead assumed that all of Allied’s
$
10
million
in cash is held for nonoperating purposes, then this
$
10
million
in excess cash would be subtracted from its current assets, and its NOWC would be
calculated as
$
790
million
instead of the
$
800
million
calculated earlier. Although the difference for Allied is fairly small, assumptions about the
level of excess cash become much more important when analyzing companies with very
large cash holdings. For example, on December 31, 2019, both Alphabet and Apple had
more than $100 billion in cash and short-term investments. In these cases, it matters
considerably whether the cash is treated as operating cash or excess cash. To keep things
simple, when relevant, we will indicate what portion of the cash is assumed to be excess
cash.
Quick Question
Question:
Refer to Allied’s balance sheets shown in Table 3.1 to answer the following questions:
What was Allied’s net working capital on December 31, 2020?
What was Allied’s net operating working capital on December 31, 2020? Once again, assume
Allied has no excess cash in 2020.
Answer:
Net working capital
2020
=
Current assets
2020
Current liabilities
2020
Net working capital
2020
=
$
810
$
220
=
$
590
million
Net operating
working capital
2020
=
(
Current
assets
2020
Excess
cash
2020
)
(
Current
liabilities
2020
Notes
payable
2020
)
Net operating
working capital
2020
=
(
$
810
$
0
)
(
$
220
$
60
)
Net operating
working capital
2020
=
$
810
$
160
=
$
650
million
3.
Total debt versus total liabilities. A company’s total debt includes both its short-term and
long-term interest-bearing liabilities. Total liabilities equal total debt plus the company’s
“free” (noninterest bearing) liabilities. Allied’s short-term debt is shown as notes payable on
its balance sheet:
Total debt
=
Short-term debt
+
Long-term debt
=
$
110
+
$
750
=
$
860
million
Total liabilities
=
Total debt
+
(
Accounts payable
+
Accruals
)
=
$
860
+
(
$
60
+
$
140
)
=
$
1,060
million
=
$
1.06
billion
4.
Other sources of funds. Most companies (including Allied) finance their assets with a
combination of short-term debt, long-term debt, and common equity. Some companies also
use “hybrid” securities such as preferred stock, convertible bonds, and long-term leases.
Preferred stock is a hybrid between common stock and debt, while convertible bonds are
debt securities that give the bondholder an option to exchange their bonds for shares of
common stock. In the event of bankruptcy, debt is paid off first, and then preferred stock.
Common stock is last, receiving a payment only when something remains after the debt and
preferred stock are paid off.
5.
Depreciation. Most companies prepare two sets of financial statements—one is based on
Internal Revenue Service (IRS) rules and is used to calculate taxes; the other is based on
GAAP and is used for reporting to investors. Firms often use straight-line depreciation for
stockholder reporting because the financial statements will report higher earnings to
shareholders than would accelerated depreciation methods. Firms use the prescribed IRS
depreciation method for taxes. Prior to the Tax Cuts and Jobs Act (TCJA), firms used MACRS
depreciation, an accelerated depreciation method to calculate depreciation—which lowered
taxable income, lowered taxes, and increased cash flows. However, under the TCJA that
Congress passed in 2017, 100% of the costs of certain new and used assets can be
immediately expensed. There is a sunset to this provision; we will discuss depreciation in
greater detail later in Section 3-9 when we discuss taxes and later in the book when we
discuss capital budgeting. Allied uses its tax depreciation method for both sets of financial
statements.
Quick Question
Question:
Refer to Allied’s balance sheets shown in Table 3.1. What was Allied’s total debt on
December 31, 2020?
Answer:
Total debt
2020
=
Short-term debt
2020
+
Long-term debt
2020
Total debt
2020
=
$
60
+
$
580
=
$
640
million
6.
Market values versus book values. Companies generally use GAAP to determine the values
reported on their balance sheets. In most cases, these accounting numbers (or “book
values”) are different from what the assets would sell for if they were offered for sale (or
“market values”). For example, Allied purchased its headquarters in Chicago in 1991. Under
GAAP, the company must report the value of this asset at its historical cost (what it originally
paid for the building in 1991) less accumulated depreciation. Given that Chicago real estate
prices have increased over the last 26 years, the market value of the building is higher than
its book value. Other assets’ market values also differ from their book values.
We can also see from Table 3.1 that the book value of Allied’s common equity at the end of
2021 was
$
940
million
. Because 75 million shares were outstanding, the book value per share was
$
940
/
75
=
$
12.53
. However, the market value of the common stock was $23.06. As is true for most
companies in 2021, shareholders are willing to pay more than book value for Allied’s stock.
This occurs in part because the values of assets have increased due to inflation and in part
because shareholders expect earnings to grow. Allied, like most other companies, has
learned how to make investments that will increase future profits.
Apple provides an example of a company with very strong future prospects, and as a result,
in early March 2020, its market value was more than 14 times its book value. On the other
hand, if a company has problems, its market value can fall below its book value. For
example, at this same point in time, Genworth Financial, an insurance company that has
been struggling in recent years, saw its stock trading around $4.50 a share when its book
value per share approximated $26.
7.
Time dimension. The balance sheet is a snapshot of the firm’s financial position at a point in
time—for example, on December 31, 2021. Thus, we see that on December 31, 2020, Allied
had
$
80
million
of cash, but that balance fell to
$
10
million
by year-end 2021. The balance sheet changes every day as inventories rise and fall, as bank
loans are increased or decreased, and so forth. A company such as Allied, whose business is
seasonal, experiences especially large balance sheet changes during the year. Its inventories
are low just before the harvest season but high just after the fall crops have been harvested
and processed. Similarly, most retailers have large inventories just before Christmas but low
inventories (and high accounts receivable) just after Christmas. We will examine the effects
of these changes in Chapter 4, when we compare companies’ financial statements and
evaluate their performance.
A Quick Glance at the Aggregate Balance Sheets of Households and Nonprofits, 2000–2019
Balance sheets are not unique to corporations. Every entity—including state and local
governments, nonprofit agencies, and individual households—has a balance sheet. Although
not broken down on a per-household level, updated information on aggregate household
finances is on the Federal Reserve website. For example, numbers released following the
third quarter of 2019 indicate that aggregate household net worth has increased by 162%
since the end of 2000 and by over 80% since the end of 2009.
The following chart shows these trends in more detail over the time period, 2004–2019. It
plots household assets, liabilities, and net worth all as fractions of aggregate disposable
income. We see that the financial crisis of 2007 and 2008 produced a sustained drop in the
value of household assets along with a corresponding decline in net worth. Since then,
household net worth levels have improved because of the surge in home prices in certain
parts of the country and the large run-up in the stock market during this time period.
At the same time, it is very important to realize that these aggregate improvements in net
worth have not been shared equally across households. Indeed, many are concerned that
the gains over the past few decades have accrued largely to those who are already quite
wealthy. According to Pew Research Center, in 2018, the richest 20% of American
households earn 48% of overall income; however, the 20% wealthiest U.S. households have
79% of all the wealth in America. Thus, when evaluating the current state of American
households, it is important to consider both the level of overall wealth as well as the
distribution of household income and wealth.
Details
Sources: ”Financial Accounts of the United States: Household Balance Sheet, Changes in Net
Worth,” Federal Reserve Statistical Release
(federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/chart/), December 12, 2019;
“Financial Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated
Macroeconomic Accounts, Third Quarter 2019,” Federal Reserve Statistical Release
(federalreserve.gov/releases/z1/20191212/z1.pdf), December 12, 2019; and Juliana
Menasce Horowitz, Ruth Igielnik, and Rakesh Kochhar, “Trends in Income and Wealth
Inequality,” Pew Research Center Social & Demographic Trends (pewsocialtrends.org),
January 9, 2020.
SelfTest
What is the balance sheet, and what information does it provide?
How is the order in which items are shown on the balance sheet determined?
Explain in words the difference between net working capital and net operating working
capital.
Explain in words the difference between total debt and total liabilities.
What items on Allied’s December 31 balance sheet would probably be different from its June
30 values? Would these differences be as large if Allied were a grocery chain rather than a
food processor? Explain.
3-3. The Income Statement
Table 3.2 shows Allied’s 2020 and 2021 income statements. Net sales are shown at the top
of the statement; then operating costs, interest, and taxes are subtracted to obtain the net
income available to common shareholders. We also show earnings and dividends per share,
in addition to some other data, at the bottom of Table 3.2. Earnings per share (EPS) is often
called “the bottom line,” denoting that of all items on the income statement, EPS is the one
that is most important to stockholders. Allied earned $1.95 per share in 2021, down from
$2.03 in 2020. In spite of the decline in earnings, the firm still increased the dividend from
$1.06 to $1.15.
Table 3.2 Allied Food Products: Income Statements for Years Ending December 31 (Millions
of Dollars, Except for Per-Share Data)
Details
A typical stockholder focuses on the reported EPS, but professional security analysts and
managers differentiate between operating and nonoperating income. Operating income is
derived from the firm’s regular core business—in Allied’s case, from producing and selling
food products. Moreover, it is calculated before deducting interest expenses and taxes,
which are considered to be nonoperating costs. Operating income is also called EBIT, or
earnings before interest and taxes. Here is its equation:
3.2
Operating income
(
or EBIT
)
=
Sales revenues
Operating costs
=
$
3,000
$
2,722
=
$
278
million
This figure must, of course, match the one reported on the income statement.
Different firms have different amounts of debt, different tax carryforwards, and different
amounts of nonoperating assets such as marketable securities. These differences can cause
two companies with identical operations to report significantly different net incomes. For
example, suppose two companies have identical sales, operating costs, and assets. However,
one company uses some debt, and the other uses only common equity. Despite their
identical operating performances, the company with no debt (and therefore no interest
expense) would report a higher net income because no interest was deducted from its
operating income. Consequently, if you want to compare two companies’ operating
performances, it is best to focus on their operating income.
From Allied’s income statement, we see that its operating income increased from
$
263
million
in 2020 to
$
278
million
in 2021, or by
$
15
million
. However, its 2021 net income declined. This decline occurred because it increased its debt
in 2021, and the
$
23
million
increase in interest lowered its net income.
Taking a closer look at the income statement, we see that depreciation and amortization are
important components of operating costs. Recall from accounting that depreciation is an
annual charge against income that reflects the estimated dollar cost of the capital
equipment and other tangible assets that were depleted in the production process.
Amortization amounts to the same thing except that it represents the decline in value of
intangible assets such as patents, copyrights, trademarks, and goodwill. Because
depreciation and amortization are so similar, they are generally lumped together for
purposes of financial analysis on the income statement and for other purposes. They both
write off, or allocate, the costs of assets over their useful lives.
Even though depreciation and amortization are reported as costs on the income statements,
they are not cash expenses—cash was spent in the past, when the assets being written off
were acquired, but no cash is paid out to cover depreciation and amortization. Therefore,
managers, security analysts, and bank loan officers who are concerned with the amount of
cash a company is generating often calculate EBITDA, an acronym for earnings before
interest, taxes, depreciation, and amortization. Allied has no amortization charges, so Allied’s
depreciation and amortization expense consists entirely of depreciation. In 2021, Allied’s
EBITDA was
$
378
million
.
Although the balance sheet represents a snapshot in time, the income statement reports on
operations over a period of time. For example, during 2021, Allied had sales of $3 billion and
its net income was
$
146.3
million
. Income statements are prepared monthly, quarterly, and annually. The quarterly and
annual statements are reported to investors, while the monthly statements are used
internally by managers for planning and control purposes.
Finally, note that the income statement is tied to the balance sheet through the retained
earnings account on the balance sheet. Net income as reported on the income statement
less dividends paid is the retained earnings for the year (e.g., 2021). Those retained earnings
are added to the cumulative retained earnings from prior years to obtain the year-end 2021
balance for retained earnings. The retained earnings for the year are also reported in the
statement of stockholders’ equity. All four of the statements provided in the annual report
are interrelated.
SelfTest
Why is earnings per share called “the bottom line”? What is EBIT, or operating income?
What is EBITDA?
Which is more like a snapshot of the firm’s operations—the balance sheet or the income
statement? Explain your answer.
3-4. Statement of Cash Flows
Net income as reported on the income statement is not cash, and in finance, “cash is king.”
Management’s goal is to maximize the firm’s intrinsic value, and the value of any asset,
including a share of stock, is based on the cash flows the asset is expected to produce.
Therefore, managers strive to maximize the cash flows available to investors. The statement
of cash flows, as shown in Table 3.3, is the accounting report that shows how much cash the
firm is generating. The statement is divided into four sections, and we explain it on a line-byline basis.
Table 3.3 Allied Food Products: Statement of Cash Flows for 2021 (Millions of Dollars)
Details
Note: Here and throughout the book, parentheses are sometimes used to denote negative
numbers.
Here is a line-by-line explanation of the statement shown in Table 3.3:
Operating activities. This section deals with items that occur as part of normal ongoing
operations.
Net income. The first operating activity is net income, which is the first source of cash. If all
sales were for cash, if all costs required immediate cash payments, and if the firm were in a
static situation, net income would equal cash from operations. However, these conditions
don’t hold, so net income is not equal to cash from operations. Adjustments shown in the
remainder of the statement must be made.
Depreciation and amortization. The first adjustment relates to depreciation and
amortization. Allied’s accountants subtracted depreciation (it has no amortization expense),
which is a noncash charge, when they calculated net income. Therefore, depreciation must
be added back to net income when cash flow is determined.
Increase in inventories. To make or buy inventory items, the firm must use cash. It may
receive some of this cash as loans from its suppliers and workers (payables and accruals),
but ultimately, any increase in inventories requires cash. Allied increased its inventories by
$
200
million
in 2021. That amount is shown in parentheses on line d because it is negative (i.e., a use of
cash). If Allied had reduced its inventories, it would have generated positive cash.
Increase in accounts receivable. If Allied chooses to sell on credit when it makes a sale, it will
not immediately get the cash that it would have received had it not extended credit. To stay
in business, it must replace the inventory that it sold on credit, but it won’t yet have
received cash from the credit sale. So if the firm’s accounts receivable increase, this will
amount to a use of cash. Allied’s receivables rose by
$
60
million
in 2021, and that use of cash is shown as a negative number on line e. If Allied had reduced
its receivables, this would be shown as a positive cash flow. (Once cash is received for the
sale, the accompanying accounts receivable will be eliminated.)
Increase in accounts payable. Accounts payable represent a loan from suppliers. Allied
bought goods on credit, and its payables increased by
$
30
million
this year. That is treated as a
$
30
million
increase in cash on line f. If Allied had reduced its payables, that would have required, or
used, cash. Note that as Allied grows, it will purchase more inventories. That will give rise to
additional payables, which will reduce the amount of new outside funds required to finance
inventory growth.
Increase in accrued wages and taxes. The same logic applies to accruals as to accounts
payable. Allied’s accruals increased by
$
10
million
this year, which means that in 2021, it borrowed an additional
$
10
million
from its workers and taxing authorities. So this represents a
$
10
million
cash inflow.
Net cash provided by operating activities. All of the previous items are part of normal
operations—they arise as a result of doing business. When we sum them, we obtain the net
cash flow from operations. Allied had positive flows from net income, depreciation, and
increases in payables and accruals, but it used cash to increase inventories and to carry
receivables. The net result was that operations led to a
$
26.3
million
net cash inflow.
Investing activities. All activities involving long-term assets are covered in this section. It also
includes the purchase and sale of short-term investments, other than trading securities, and
lending and collecting on notes receivables. Allied had only one investment activity—the
acquisition of some fixed assets, as shown on line j. If Allied had sold some fixed assets, its
accountants would have reported it in this section as a positive amount (i.e., as a cash
inflow).
Additions to property, plant, and equipment. Allied spent
$
230
million
on fixed assets during the current year. This is an outflow; therefore, it is shown in
parentheses. If Allied had sold some of its fixed assets, this would have been a cash inflow.
Net cash used in investing activities. Because Allied had only one investment activity, the
total on this line is the same as that on the previous line.
Financing activities. Allied’s financing activities are shown in this section.
Increase in notes payable. Allied borrowed an additional
$
50
million
from its bank this year, which was a cash inflow. When Allied repays the loan, this will be an
outflow.
Increase in bonds (long-term debt). Allied borrowed an additional
$
170
million
from long-term investors this year, issuing bonds in exchange for cash. This is shown as an
inflow. When the bonds are repaid by the firm some years hence, this will be an outflow.
Payment of dividends to stockholders. Dividends are paid in cash, and the
$
86.3
million
that Allied paid to stockholders is shown as a negative amount.
Net cash provided by financing activities. The sum of the three financing entries, which is a
positive
$
133.8
million
, is shown here. These funds, along with the small positive operating cash flow, were used to
help pay for the
$
230
million
of new plant and equipment.
Summary. This section summarizes the change in cash and cash equivalents over the year.
Net decrease in cash. The net sum of the operating activities, investing activities, and
financing activities is shown here. These activities resulted in a
$
70
million
net decrease in cash during 2021, mainly due to expenditures on new fixed assets.
Cash and equivalents at the beginning of the year. Allied began the year with
$
80
million
of cash, which is shown here.
Cash and equivalents at the end of the year. Allied ended the year with
$
10
million
of cash, the
$
80
million
it started with minus the
$
70
million
net decrease that occurred during the year. Clearly, Allied’s cash position is weaker than it
was at the beginning of the year.
Allied’s statement of cash flows should be of concern to its managers and investors. The
company had a small positive operating cash flow that didn’t begin to cover its fixed assets
investment requirements. So the large investment in fixed assets was covered by borrowing
and reducing its beginning balances of cash and equivalents. However, the firm can’t
continue to do this indefinitely. In the long run, Section I needs to show larger positive
operating cash flows. In addition, we would expect Section II to show expenditures on fixed
assets that are about equal to
(1)
its depreciation charges (to replace worn out fixed assets), along with
(2)
some additional expenditures to provide for growth.
Section III would normally show some net borrowing in addition to a “reasonable” amount
of dividends. Finally, Section IV should show a reasonably stable year-to-year cash balance.
These conditions don’t hold for Allied, so some actions should be taken to correct the
situation. We will consider corrective actions in Chapter 4, when we analyze the firm’s
financial statements.
SelfTest
What is the statement of cash flows, and what are some questions it answers?
Identify and briefly explain the four sections shown in the statement of cash flows.
If during the year a company has high cash flows from its operations, does this mean that
cash on its balance sheet will be higher at the end of the year than it was at the beginning of
the year? Explain.
3-5. Statement of Stockholders’ Equity
Changes in stockholders’ equity during the accounting period are reported in the statement
of stockholders’ equity. Table 3.4 shows that Allied earned
$
146.3
million
during 2021, paid out
$
86.3
million
in common dividends, and plowed
$
60
million
back into the business. Thus, the balance sheet item “Retained earnings” increased from
$
750
million
at year-end 2020 to
$
810
million
at year-end 2021.
Table 3.4 Allied Food Products: Statement of Stockholders’ Equity, December 31, 2021
(Millions of Dollars)
Details
Note that “retained earnings” represents a claim against assets, not assets per se.
Stockholders allow management to retain earnings and reinvest them in the business, use
retained earnings for additions to plant and equipment, add to inventories, and the like.
Companies do not just pile up cash in a bank account. Thus, retained earnings as reported
on the balance sheet do not represent cash and are not “available” for dividends or anything
else.
SelfTest
What information does the statement of stockholders’ equity provide?
Why do changes in retained earnings occur?
Explain why the following statement is true: The retained earnings account reported on the
balance sheet does not represent cash and is not “available” for dividend payments or
anything else.
3-6. Uses and Limitations of Financial Statements
As we mentioned in the opening vignette to this chapter, financial statements provide a
great deal of useful information. You can inspect the statements and answer a number of
important questions such as these: How large is the company? Is it growing? Is it making or
losing money? Is it generating cash through its operations, or are operations actually losing
cash?
At the same time, investors need to be cautious when they review financial statements.
Although companies are required to follow GAAP, managers still have a lot of discretion in
deciding how and when to report certain transactions.
Consequently, two firms in exactly the same situation may report financial statements that
convey different impressions about their financial strength. Some variations may stem from
legitimate differences of opinion about the correct way to record transactions. In other
cases, managers may choose to report numbers in a manner that helps them present either
higher or more stable earnings over time. As long as they follow GAAP, such actions are
legal, but these differences make it difficult for investors to compare companies and gauge
their true performances. In particular, watch out if senior managers receive bonuses or other
compensation based on earnings in the short run—they may try to boost short-term
reported income to boost their bonuses.
Unfortunately, there have also been cases where managers disregarded GAAP and reported
fraudulent statements. One blatant example of cheating involved WorldCom, which reported
asset values that exceeded their true value by about $11 billion. This led to an
understatement of costs and a corresponding overstatement of profits. Enron is another
high-profile example. It overstated the value of certain assets, reported those artificial value
increases as profits, and transferred the assets to subsidiary companies to hide the true
facts. Enron’s and WorldCom’s investors eventually learned what was happening, and the
companies were forced into bankruptcy. Many of their top executives went to jail, the
accounting firm that audited their books was forced out of business, and investors lost
billions of dollars.
After the Enron and WorldCom fiascos, Congress in 2002 passed the Sarbanes-Oxley Act
(SOX), which required companies to improve their internal auditing standards and required
the CEO and CFO to certify that the financial statements were properly prepared. The SOX
bill also created a new watchdog organization to help make sure that the outside accounting
firms were doing their jobs.
Finally, keep in mind that even if investors receive accurate accounting data, it is cash flows,
not accounting income, that matters most. Similarly, as we shall see in Chapters 11, 12 and
13, when managers make capital budgeting decisions on which projects to accept, their
focus should be on cash flow.
SelfTest
Can investors be confident that if the financial statements of different companies are
accurate and are prepared in accordance with GAAP, the data reported by one company will
be comparable to the data provided by another?
Why might different companies account for similar transactions in different ways?
3-7. Free Cash Flow
Thus far, we have focused on financial statements as they are prepared by accountants.
However, accounting statements are designed primarily for use by creditors and tax
collectors, not for managers and stock analysts. Therefore, corporate decision makers and
security analysts often modify accounting data to meet their needs. The most important
modification is the concept of free cash flow (FCF), defined as “the amount of cash that
could be withdrawn without harming a firm’s ability to operate and to produce future cash
flows.” Here is the equation used to calculate free cash flow:
3.3
FCF
=
[
EBIT
(
1
T
)
+
Depreciation
and amortization
]
[
Capital
expenditures
+
Δ
Net operating
working capital
]
The first term represents the amount of cash that the firm generates from its current
operations. EBIT (1 − T) is often referred to as NOPAT, or net operating profit after taxes.
Depreciation and amortization are added back because these are noncash expenses that
reduce EBIT but do not reduce the amount of cash the company has available to pay its
investors. The second bracketed term indicates the amount of cash that the company is
investing in its fixed assets (capital expenditures) and operating working capital in order to
sustain ongoing operations. A positive level of FCF indicates that the firm is generating more
than enough cash to finance current investments in fixed assets and working capital. By
contrast, negative free cash flow means that the company does not have sufficient internal
funds to finance investments in fixed assets and working capital, and that it will have to raise
new money in the capital markets in order to pay for these investments.
Consider the case of Home Depot. The first bracketed term in Equation 3.3 represents the
amount of cash that Home Depot is generating from its existing stores. The second
bracketed term represents the amount of cash that the company is spending this period to
construct new stores. When Home Depot opens a new store, it needs cash to purchase the
land and construct the building—these are capital expenditures, and they lead to a
corresponding increase in the firm’s fixed assets on the balance sheet. However, when it
opens a new store, the company also needs to increase its net operating working capital. In
particular, the company needs to stock the store with new inventory. Part of this inventory
may be financed through accounts payable—for example, a supplier might ship Home Depot
some flashlights today and allow Home Depot to pay for them later. In this case, there would
be no increase in net operating working capital because the increase in current assets
exactly equals the increase in current liabilities. Other portions of their inventory may not
have offsetting accounts payable, so there will be an increase in net operating working
capital, and the company must come up with the cash today in order to pay for this increase.
Putting everything together, the company as a whole is generating positive free cash flow if
the money generated from operating existing stores exceeds the money required to build
new stores.
Looking at Allied’s key financial statements, we can collect the pieces that we need to
calculate its free cash flow. First, we can obtain Allied’s EBIT and depreciation and
amortization expense from the income statement. Looking at Table 3.2, we see that Allied’s
2021 operating income (EBIT) was
$
278
million
. Because Allied’s tax rate is 25%, it follows that its
NOPAT
=
EBIT
(
1
T
)
=
$
278
(
1
0.25
)
=
$
208.5
million
. We also see that Allied’s depreciation and amortization expense in 2021 was
$
100
million
.
Allied’s capital expenditures (the cash used to purchase new fixed assets) can be found
under the investment activities on the Statement of Cash Flows. Looking at Table 3.3, we see
that Allied’s capital expenditures in 2021 totaled
$
230
million
. Finally, we need to calculate the change in net operating working capital (ΔNOWC). Recall
that NOWC is operating current assets (where operating current assets equal current assets
minus excess cash) minus operating current liabilities (where operating current liabilities are
calculated as current liabilities minus notes payable). We showed earlier that Allied’s NOWC
for 2021 was:
NOWC
2021
=
(
$
1,000
$
0
)
(
$
310
$
110
)
=
$
800
million
Likewise, assuming once again that Allied had no excess cash in 2020, its NOWC for 2020 can
be calculated as:
NOWC
2020
=
(
$
810
$
0
)
(
$
220
$
60
)
=
$
650
million
Thus, Allied’s change in net operating working capital
(
Δ
NOWC
)
=
$
150
million
(
$
800
million
$
650
million
)
. Putting everything together, we can now calculate Allied’s 2021 free cash flow:
FCF
=
[
EBIT
(
1
T
)
+
Depreciation
and amortization
]
[
Capital
expenditures
+
Δ
Net operating
working capital
]
FCF
2021
=
[
$
208.5
+
$
100
]
[
$
230
+
$
150
]
=
$
71.5
million
Allied’s FCF is negative, which is not good. Note, though, that the negative FCF is largely
attributable to the
$
230
million
expenditure for a new processing plant. This plant is large enough to meet production for
several years, so another new plant will not be needed until 2025. Therefore, Allied’s FCF for
2022 and the next few years should increase, which means that Allied’s financial situation is
not as bad as the negative FCF might suggest.
Most rapidly growing companies have negative FCFs—the fixed assets and working capital
needed to support a firm’s rapid growth generally exceed cash flows from its existing
operations. This is not bad, provided a firm’s new investments are eventually profitable and
contribute to its FCF.
Many analysts regard FCF as being the single most important number that can be developed
from accounting statements, even more important than net income. After all, FCF shows
how much cash the firm can distribute to its investors. We discuss FCF again in Chapter 9,
which covers stock valuation, and in Chapters 11, 12 and 13, which cover capital budgeting.
Quick Question
Question:
A company has EBIT of
$
30
million
, depreciation of
$
5
million
, and a 25% tax rate. It needs to spend
$
10
million
on new fixed assets and
$
15
million
to increase its operating current assets. It expects its accounts payable to increase by
$
2
million
, its accruals to increase by
$
3
million
, and its notes payable to increase by
$
8
million
. The firm’s current liabilities consist of only accounts payable, accruals, and notes payable.
What is its free cash flow?
Answer:
First, you need to determine the ΔNet operating working capital (ΔNOWC):
Δ
NOWC
=
Δ
Operating current assets
Δ
Operating current liabilities
Δ
NOWC
=
Δ
Operating current assets
(
Δ
Current liabilities
Δ
Notes payable
)
Δ
NOWC
=
$
15
(
$
13
$
8
)
Δ
NOWC
=
$
15
$
5
$
10
million
Now, you can solve for free cash flow (FCF):
FCF
=
[
EBIT
(
1
T
)
+
Depreciation and amortization
]
[
Capital expenditures
+
Δ
NOWC
]
FCF
=
[
$
30
(
1
0.25
)
+
$
5
]
[
$
10
+
$
10
]
FCF
=
[
$
22.5
+
$
5
]
$
20
FCF
=
$
7.5
million
Free Cash Flow Is Important for Businesses Both Small and Large
Free cash flow is important to large companies like Allied Food Products. Security analysts
use FCF to help estimate the value of the stock, and Allied’s managers use it to assess the
value of proposed capital budgeting projects and potential merger candidates. Note, though,
that the concept is also relevant for small businesses.
Assume that your aunt and uncle own a small pizza shop and that their accountant prepares
their financial statements. The income statement shows their annual accounting profits.
Although they are certainly interested in this number, what they probably care more about is
how much money they can take out of the business each year to maintain their standard of
living. Let’s assume that the shop’s net income for 2021 was $75,000. However, your aunt
and uncle had to spend $50,000 to refurbish the kitchen and restrooms.
So although the business is generating a great deal of “profit,” your aunt and uncle can’t take
much money out because they have to put money back into the pizza shop. Stated another
way, their free cash flow is much less than their net income. The required investments could
be so large that they even exceed the money made from selling pizza. In this case, your aunt
and uncle’s free cash flow would be negative. If so, this means they must find funds from
other sources just to maintain their pizza business.
As astute business owners, your aunt and uncle recognize that their restaurant investments,
such as updating the kitchen and restrooms, are nonrecurring, and if nothing else happens
unexpectedly, your aunt and uncle should be able to take more cash out of the business in
future years, when their free cash flow increases. But some businesses never seem to
produce cash for their owners—they consistently generate positive net income, but this net
income is swamped by the amount of cash that has to be plowed back into the business.
Thus, when it comes to valuing the pizza shop (or any business small or large), what really
matters is the amount of free cash flow that the business generates over time. Looking
ahead, your aunt and uncle face competition from national chains that are moving into the
area. To meet the competition, your aunt and uncle will have to modernize the dining room.
This will again drain cash from the business and reduce its free cash flow, although the hope
is that it will enable them to increase sales and free cash flow in the years ahead. As we will
see in Chapters 11, 12 and 13, which cover capital budgeting, evaluating projects require us
to estimate whether the future increases in free cash flow are sufficient to more than offset
the initial project cost. Therefore, the free cash flow calculation is critical to a firm’s capital
budgeting analysis.
SelfTest
What is free cash flow (FCF)?
Why is FCF an important determinant of a firm’s value?
3-8. MVA and EVA
Items reported on the financial statements reflect historical, in-the-past values, not current
market values, and there are often substantial differences between the two. Changes in
interest rates and inflation affect the market value of the company’s assets and liabilities but
often have no effect on the corresponding book values shown in the financial statements.
Perhaps, more importantly, the market’s assessment of value takes into account its ongoing
assessment of current operations as well as future opportunities. For example, it cost
Microsoft very little to develop its first operating system, but that system turned out to be
worth many billions that were not shown on its balance sheet. For a given level of debt,
these increases in asset value also lead to a corresponding increase in the market value of
equity.
To illustrate, consider the following situation. A firm was started with
$
1
million
of assets at book value (historical cost), $500,000 of which was provided by bondholders,
and $500,000 by stockholders (50,000 shares purchased at $10 per share). However, this
firm became very successful; the market value of the firm’s equity is now worth
$
19.5
million
, and its current stock price is
$
19,500,000
/
50,000
=
$
390
per share
. Clearly the firm’s managers have done a marvelous job for the stockholders.
The accounting statements do not reflect market values, so they are not sufficient for
purposes of evaluating managers’ performance. To help fill this void, financial analysts have
developed two additional performance measures, the first of which is MVA, or market value
added. MVA is simply the difference between the market value of a firm’s equity and the
book value as shown on the balance sheet, with market value found by multiplying the stock
price by the number of shares outstanding. For our hypothetical firm, MVA is
$
19.5
million
$
0.5
million
=
$
19
million
.
For Allied, which has 75 million shares outstanding and a stock price of $23.06, the market
value of the equity is
$
1,729.5
million
versus a book value, as shown on the balance sheet in Table 3.1, of
$
940
million
. Therefore, Allied’s MVA is
$
1,729.5
$
940
=
$
789.5
million
. This
$
789.5
million
represents the difference between the money Allied’s stockholders have invested in the
corporation since its founding—including retained earnings—versus the cash they could
receive if they sold the business. The higher its MVA, the better the job management is
doing for the firm’s shareholders. Boards of directors often look at MVA when deciding on
the compensation a firm’s managers deserve. Note, though, that just as all ships rise in a
rising tide, most firms’ stock prices rise in a rising stock market, so a positive MVA may not
be entirely attributable to management performance.
A related concept, economic value added (EVA), sometimes called “economic profit,” is
closely related to MVA and is found as follows:
3.4
EVA
=
Net operating profit
after taxes
(
NOPAT
)
Annual dollar
cost of
capital
=
EBIT
(
1
T
)
(
Total
invested
capital
×
After-tax
percentage
cost of capital
)
Companies create value (and realize positive EVA) if the benefits of their investments exceed
the cost of raising the necessary capital. Total invested capital represents the amount of
money that the company has raised from debt, equity, and any other sources of capital (such
as preferred stock). The annual dollar cost of capital is total invested capital multiplied by the
after-tax percentage cost of this capital. So, for example, if the company has raised
$
1
million
in capital, and the current cost of capital is 10%, the annual dollar cost of capital would be
$100,000. The funds raised from this capital are invested in a variety of net fixed assets and
net operating working capital. In any given year, NOPAT is the amount of money that these
investments have generated for the company’s investors after paying for operating costs and
taxes—in this regard it represents the benefits of capital investments.
EVA is an estimate of a business’s true economic profit for a given year, and it often differs
sharply from accounting net income. The main reason for this difference is that although
accounting income takes into account the cost of debt (the company’s interest expense), it
does not deduct for the cost of equity capital. By contrast, EVA takes into account the total
dollar cost of all capital, which includes both the cost of debt and equity capital.
If EVA is positive, then after-tax operating income exceeds the cost of the capital needed to
produce that income, and management’s actions are adding value for stockholders. Positive
EVA on an annual basis will help ensure that MVA is also positive. Note that whereas MVA
applies to the entire firm, EVA can be determined for divisions as well as for the company as
a whole, so it is useful as a guide to “reasonable” compensation for divisional as well as top
corporate managers.
SelfTest
Define the terms market value added (MVA) and economic value added (EVA).
How does EVA differ from accounting net income?
3-9. Income Taxes
The IRS website is irs.gov. Here you can find current filing information and current credits
and deductions information, and order needed forms and publications.
Individuals and corporations pay out a significant portion of their income as taxes, so taxes
are important in both personal and corporate decisions. We summarize the key aspects of
the U.S. tax system for individuals in this section and for corporations in the next section,
using 2020 data. The details of our tax laws change fairly often, and indeed President Trump
signed the Tax Cuts and Jobs Act (TCJA) into law on December 22, 2017. Some of the
provisions in the law are set to sunset, and it remains possible that key features discussed in
this section may change over time.
Congress Passes Sweeping Tax Reform Act in 2017
In December 2017, Congress passed and President Trump signed the Tax Cuts and Jobs Act
(TCJA), which enacted the most sweeping changes to the tax code since 1986. The TCJA
impacts both individuals and corporations. Here is a quick summary of the bill’s key
provisions, and we provide sources at the end of this box so that you may read the bill’s
provisions in greater detail.
Major Changes to the Individual Tax Code
First, we provide a summary of the bill’s major changes to the individual tax code. It is
important to recognize that all of the individual provisions listed here will sunset at the end
of 2025. Moreover, there is a significant chance that future Congresses may change at least
some of these provisions.
The bill lowered the maximum tax rate from 39.6% to 37%.
The bill eliminated the personal exemption for taxpayers and their dependents.
The bill sharply raised the standard deduction for all individuals and married couples. The
standard deduction is the amount that taxpayers can apply as a deduction against their
taxable income. Typically, households have two choices: They can either take the standard
deduction and file a very simple tax form with no other deductions allowed, or they can
itemize their deductions in a more complicated tax form. Most households take the standard
deduction, and itemizers tend to be those who have very large allowable deductions such as
large mortgage payments, charitable donations, and medical expenses. In tax year 2020, the
standard deduction for individuals is $12,400 and $24,800 for married couples filing jointly.
The bill limited mortgage interest deductions. Taxpayers may only deduct interest on up to
$750,000 of principal. In addition, taxpayers can no longer deduct interest on home equity
loans.
The bill limited deductions for state and local taxes.
The individual alternative minimum tax (AMT) was kept; although the AMT exemption
amounts were increased and continue to be indexed for inflation.
The bill eliminated miscellaneous itemized deductions.
The bill doubles the estate tax exclusion amount to
$
10
million
, and this amount will continue to be indexed for inflation.
Implications of These Changes
Most households received a tax cut, either due to the increase in the standard deduction
and/or due to the drop in marginal tax rates. Analysts disagree about what portion of this
increase in after-tax income will be spent or saved. The answer will influence the TCJA’s
overall economic impact and its effect on interest rates.
The Congressional Budget Office reported that the TCJA will increase the federal deficit over
time, which is likely to lead to further upward pressure on interest rates.
The increase in the standard deduction will likely cause many taxpayers to stop itemizing
their deductions, which would simplify the filing of taxes for many households.
The TCJA could potentially lead to higher taxes for itemizing households living in high-taxrate states, where the curtailment of the state and local tax deductions may more than
offset the increase in the standard deduction. A likely spillover effect is that households
living in higher-tax-rate states will experience an increase in the cost of state and local
government, which may put pressure on those state governments to cut expenditures and
tax rates.
There are likely to be a large number of other (in many cases unintended) spillover effects.
For example, charitable organizations may see an increase in giving because of the overall
increase in after-tax income. But at the same time, fewer households are likely to itemize,
which may cause them to curtail giving because they will no longer be able to deduct their
charitable expenses (because they have opted for the standard deduction).
Major Changes to the Corporate Tax Code
Next, we summarize the TCJA’s major changes to the corporate tax code. While most of
these provisions will not automatically sunset over time, as we discuss next, some will
evolve or be eliminated over time. Once again, there is also the chance that they may be
altered over time by future Congresses.
The TCJA established a flat 21% corporate tax rate. The impetus for lowering the corporate
tax rate was to make U.S. companies more competitive—with the hope of creating jobs.
The TCJA permits an immediate 100% expensing of certain new and used business assets
placed into service after September 27, 2017, and before January 1, 2023. This “bonus”
percentage declines to 80% after January 1, 2023, and before January 1, 2027. This provision
sunsets on January 1, 2027. The main reason for this provision was to spur new investment
in plant and equipment.
The TCJA repealed the corporate alternative minimum tax (AMT).
The TCJA eliminated the net operating loss (NOL) carryback provision and changed the
carryforward provision so that NOLs can be carried forward indefinitely. However, the
carryforward in any one year is limited to the lower of the NOL or 80% of the firm’s taxable
income for that year.
The TCJA limits the corporate interest deduction on debt to 30% of income (measured as
EBITDA for 2018–2021 and as EBIT thereafter). The reason for this provision was to
discourage companies from taking on too much debt. Companies with average sales of
$
25
million
or less during the past 3 years are exempt from this provision.
The TCJA will provide a one-time repatriation tax holiday for firms with money parked
overseas. Firms will be taxed 15.5% on cash and equivalents and 8% on noncash and liquid
assets such as equipment abroad purchased with foreign profits. The lower rate is meant to
motivate firms to bring cash home and to use it here in the United States.
The TCJA changed the corporate dividend exclusion from 70% to 50% for less than 20%owned subsidiaries and from 80% to 65% for less than 80%-owned subsidiaries.
Implications of These Changes
The lower corporate tax rates will make U.S. companies more globally competitive, and they
may also spur some companies to repatriate their income back to the United States.
The lower tax rate also reduces the value of the tax deduction associated with debt
financing. This effect will likely reduce the percentage of debt financing and lead to an
increase in the average company’s cost of capital.
The lower corporate tax rate increases most companies’ after-tax free cash flows.
The combination of higher after-tax free cash flows and the expensing of business assets
mean that more projects have a positive net present value (NPV), which will encourage more
investment.
The TCJA took away many corporate deductions but lowered the tax rate, so companies
were impacted differently. Those companies with fewer deductions were more favorably
impacted by the new lower corporate tax rate than those with more deductions.
This is just a summary of the TCJA’s key features. In Chapters 12 and 14, we will consider in
more detail how these changes will affect firms’ capital budgeting and capital structure
decisions.
Sources: “Analysis of the Final Tax Reform Bill,” (cooley.com), December 20, 2017; Phillip
Daves, “Web Extension 1C: The 2017/18 Tax Reform and Its Impact on Corporate Finance,”
Intermediate Financial Management, 13th edition (Mason: OH, Cengage Learning, 2019);
Kimberly Amadeo, “Trump’s Tax Plan and How It Affects You,” The Balance (thebalance.com),
April 9, 2018; Wendy Connick, “What’s in the Final Version of the Tax Cuts and Jobs Act,” The
Motley Fool (fool.com), January 3, 2018; and Ben Casselman, “Federal Tax Cuts Leave States
in a Bind,” The New York Times (nytimes.com), May 12, 2018. Refer to Congress.gov
(congress.gov/bill/115th-Congress/house-bill/1) for the actual bill and all its provisions.
3-9A. Individual Taxes
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.
The tax rates are progressive—that is, the higher one’s income, the larger the percentage
paid in taxes. Table 3.5 provides the 2020 tax rates that taxpayers will pay for tax returns due
April 15, 2021.
Table 3.5 2020 Individual Tax Rates
Details
Notes:
These are the 2020 tax rates that will be paid on tax returns due April 15, 2021. The income
ranges at which each tax rate takes effect are indexed with inflation, so they change each
year.
The average tax rates are always below the marginal rates, but in 2020 the average at the
top of the brackets approaches 37% as taxable income rises without limit.
In 2018, the personal exemption for the taxpayer and dependents was eliminated. With the
deduction limitation on state and local property, income, and sales taxes and the existence
of payroll taxes (Social Security and Medicare taxes), the 2020 effective tax rate will be
higher than 37%.
Taxable income is defined as “gross income less a set of exemptions and deductions.” When
filing a tax return in 2021 for the tax year 2020, taxpayers no longer receive an exemption for
each dependent, including the taxpayer because the personal exemption was eliminated
with the passage of the Tax Cuts and Jobs Act (TCJA). Certain expenses can still be deducted
and thus be used to reduce taxable income—but some have been either reduced or
eliminated. For example, for mortgages begun after December 31, 2017, taxpayers can only
deduct interest on up to $750,000 of principal, but the interest deduction for home equity
loans has been eliminated. Also, the TCJA eliminates most itemized deductions; however,
deductions for charitable contributions, retirement savings, and student loan interest
remain. Taxpayers may now only claim an itemized deduction up to $10,000 (for couples
filing jointly) and $5,000 (for single taxpayers) for a combination of state and local property,
income, and sales taxes. Finally, the standard deduction (which is taken if itemized
deductions are below this amount) in 2020 is $12,400 for single individuals and $24,800 for
married couples filing jointly.
The marginal tax rate is defined as “the tax rate on the last dollar of income.” Marginal rates
begin at 10% and rise to 37%. Note, though, that when consideration is given to Social
Security and Medicare taxes, and to state taxes, the marginal tax rate may actually exceed
45%. Average tax rates can be calculated from the data in Table 3.5. For example, if a single
individual had taxable income of $45,000, his or her tax bill would be
$
4,617.50
+
(
$
45,000
$
40,125
)
(
0.22
)
=
$
4,617.50
+
$
1,072.50
=
$
5,690.00
. Her average tax rate would be
$
5,690
/
$
45,000
=
12.64
%
versus a marginal rate of 22%. If she received a raise of $1,000, bringing her income to
$46,000, she would have to pay $220 of it as taxes, so her after-tax raise would be $780.
Note too that interest income received by individuals from corporate securities is added to
other income and thus is taxed at federal rates going up to 37%, plus state taxes. Capital
gains and losses, on the other hand, are treated differently. Assets such as stocks, bonds,
and real estate are defined as capital assets. When you buy a capital asset and later sell it for
more than you paid, you earn a profit that is called a capital gain; when you suffer a loss, it is
called a capital loss. If you held the asset for a year or less, you will have a short-term capital
gain or loss, while if you held it for more than a year, you will have a long-term capital gain or
loss. Thus, if you buy 100 shares of Disney stock for $100 per share and sell them for $110
per share, you have a capital gain of 100 × $10, or $1,000. However, if you sell the stock for
$90 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 capital gain or loss. If you sell the stock for
exactly $100 per share, you make neither a gain nor a loss, so no tax is due.
A short-term capital gain is taxed at the same rate as ordinary income. However, long-term
capital gains are taxed differently. For most taxpayers, the rate on long-term capital gains is
only 15%. Thus, if in 2020, you were an individual taxpayer with an income of $300,000, any
short-term capital gains you earned would be taxed just like ordinary income, but your longterm capital gains would only be taxed at 15%. However, the tax rate on long-term capital
gains is 20% for single taxpayers with income greater than $441,450 and married couples
filing jointly with income greater than $496,600. In addition, high-income taxpayers may
incur a 3.8% surtax applied to their capital gains and other net investment income, the net
investment income tax (NIIT). So, the highest tax rate that could apply on short-term capital
gains that are taxed at ordinary rates is 40.8%, compared to 23.8% on long-term capital
gains. Even for individuals at these high income levels, the tax rate on long-term capital gains
remains considerably lower than the tax rate on ordinary income.
Beginning in 2013, the maximum tax rate on qualified dividends increased to 20% for
taxpayers in the 39.6% tax bracket. However, for most taxpayers the top tax rate on qualified
dividends is 15%. 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 dividends, it is taxed again. This double taxation
motivated Congress to tax dividends at a lower rate than the rate on ordinary income.
Tax rates on dividends and capital gains have varied over time, but they have generally been
lower than rates on ordinary income. Congress wants the economy to grow. For growth, we
need investment in productive assets, and low capital gains and dividend tax rates
encourage investment. Individuals with money to invest understand the tax advantages
associated with making equity investments in newly formed companies versus buying bonds,
so new ventures have an easier time attracting capital under the tax system. All in all, lower
capital gains and dividend tax rates stimulate capital formation and investment.
As you might imagine, over the years Congress has frequently adjusted the tax code for
individuals to promote certain activities. For example, Individual Retirement Accounts (IRAs)
have encouraged individuals to save more for retirement. There are two main types of IRAs,
Traditional IRAs and Roth IRAs. In each case, investors receive valuable tax benefits as long
as the money is held in their account until age
59
1
2
. Qualified contributions to a Traditional IRA are tax deductible, and the income and capital
gains on the investments within the account are not taxed until the money is withdrawn
after age
59
1
2
. On the other hand, contributions to a Roth IRA are not tax deductible (they come out of
after-tax dollars), but from that point forward, neither the future income nor the capital
gains from the investments are taxed. In each case, investors in IRAs face penalties if they
withdraw funds before age
59
1
2
, unless there is a qualifying exception—for example, investors in a Roth IRA can withdraw
up to $10,000 from their account to help pay for a first-time home without facing a penalty.
As a very rough rule of thumb, Roth IRAs are more attractive for those individuals who
believe that their tax rates will increase over time—either because they think their income
will increase as they age and/or because they think Congress will raise overall tax rates in the
future. For this reason, many younger investors who expect higher pay (and therefore higher
tax rates!) over time tend to select Roth IRAs. Indeed, a Vanguard analyst in a recent article
in The Wall Street Journal estimates that investors under 30 years old allocate 92% of their
IRA funds into Roth accounts. But as you might expect, one size doesn’t fit all, and it is
important to review the specific eligibility requirements, potential penalties, and distribution
policies before making any investments. Fortunately, there are a lot of great online resources
that summarize the relative benefits and drawbacks with both Traditional and Roth IRAs.
One other tax feature should be addressed—the Alternative Minimum Tax (AMT). The AMT
was created in 1969 because Congress learned that 155 millionaires with high incomes paid
no taxes because they had so many tax shelters from items such as depreciation on real
estate and municipal bond interest. Under the AMT law, people must calculate their tax
under the “regular” system and then under the AMT system, where many deductions are
added back to income and then taxed at a special AMT rate. For many years, the AMT was
not indexed for inflation, and literally millions of taxpayers found themselves subject to this
very complex tax.
Single taxpayers earning more than $200,000 and married taxpayers earning more than
$250,000 will incur an additional 0.9% Medicare tax and a 3.8% net investment income tax
(NIIT) on certain types of investment income. These taxes, originally enacted by the
Affordable Care Act, were left untouched by the TCJA.
3-9B. Corporate Taxes
The corporate tax structure is simple. The new tax law lowered the corporate tax rate to one
single flat rate of 21%. Because of state and local tax rates, in this textbook we will use a
federal-plus-state corporate tax rate of 25%. To illustrate, if a firm had $65,000 of taxable
income and we assume a federal-plus-state corporate tax rate of 25%, its tax bill would be
$16,250:
Taxes
=
$
65,000
(
0.25
)
=
$
16,250
.
Interest and Dividends Received by a Corporation
Corporations earn most of their income from operations, but they may also own securities—
bonds and stocks—and receive interest and dividend income. Interest income received by a
corporation is taxed as ordinary income at the lower corporate flat rate. However, dividends
are taxed more favorably: 50% of dividends received is excluded from taxable income,
whereas the remaining 50% is taxed at the flat corporate tax rate. Thus, a corporation would
normally pay only
(
0.5
)
(
0.25
)
=
0.125
=
12.5
%
of its dividend income as taxes. If this firm had $10,000 in pretax dividend income, its aftertax dividend income would be $8,750:
After-tax income
=
Pretax income
(
1
T
)
=
$
10,000
(
1
0.125
)
=
$
8,750
Corporate Tax Rates around the World
In the text, we describe some key elements of the TCJA. The impetus for passing this
legislation was to lower tax rates for both individuals and corporations and to spur the
creation of jobs with the lower corporate tax rate. The concern was that U.S. companies pay
much higher rates than their global competitors—and they did prior to the passage of the
TCJA. The new lower flat rate of 21% is much more in line with other corporate tax rates
around the world, as shown in the following table. This table shows the full impact of
effective corporate tax rates that consider federal and state and local tax rates for 2016
through 2019, so that’s why the U.S. rate is above 21% in 2018 and 2019. As you can see,
after 2017, the U.S. corporate tax rate is no longer one of the highest shown.
Sample of Corporate Tax Rates around the World
Country
2016 Tax Rate
2017 Tax Rate
2018 Tax Rate
2019 Tax Rate
Australia
30.00%
30.00%
30.00%
30.00%
Canada
26.50
26.50
26.50
26.50
Denmark
22.00
22.00
22.00
22.00
France
33.30
33.33
33.00
31.00
Germany
29.72
29.79
30.00
30.00
Hong Kong
16.50
16.50
16.50
16.50
Ireland
12.50
12.50
12.50
12.50
Japan
30.86
30.86
30.86
30.62
Mexico
30.00
30.00
30.00
30.00
Russia
20.00
20.00
20.00
20.00
Saudi Arabia
20.00
20.00
20.00
20.00
South Africa
28.00
28.00
28.00
28.00
Spain
25.00
25.00
25.00
25.00
United Kingdom
20.00
19.00
19.00
19.00
United States
40.00
40.00
27.00
27.00
Source: “Corporate Tax Rates Table,” (home.kpmg.com/xx/en/home/services/tax/tax-toolsand-resources/tax-rates-online/corporate-tax-rates-table.html).
The rationale behind this exclusion is that when a corporation receives dividends and then
pays out its own after-tax income as dividends to its stockholders, the dividends received are
subjected to triple taxation:
(1)
The original corporation is taxed.
(2)
The second corporation is taxed on the dividends it receives.
(3)
The individuals who receive the final dividends are taxed again.
This explains the 50% intercorporate dividend exclusion.
Suppose a firm has excess cash that it does not need for operations, and it plans to invest
this cash in marketable securities. The tax factor favors stocks, which pay dividends, rather
than bonds, which pay interest. For example, suppose Allied had $100,000 to invest, and it
could buy bonds that paid 8% interest, or $8,000 per year, or stock that paid 7% in dividends,
or $7,000. Remember, Allied’s federal-plus-state corporate tax rate is 25%. Therefore, if
Allied bought bonds and received interest, its tax on the $8,000 of interest would be
0.25
(
$
8,000
)
=
$
2,000
, and its after-tax income would be $6,000. If it bought stock, its tax would be
$
7,000
(
0.125
)
=
$
875
, and its after-tax income would be $6,125. Other factors might lead Allied to invest in
bonds, but when the investor is a corporation, the tax factor favors stock investments.
Interest and Dividends Paid by a Corporation
A firm like Allied can finance its operations with either debt or stock. If a firm uses debt, it
must pay interest, whereas if it uses stock, it is expected to pay dividends. Interest paid can
be deducted from operating income to obtain taxable income, but the deduction is limited
to 30% of earnings before interest, taxes, and depreciation (EBITDA) for the years from 2018
through 2021—and starting in 2022 the deduction is limited to 30% of earnings before
interest and taxes (EBIT). Companies with average annual gross receipts of
$
25
million
or less for the prior 3 years are exempt from this limitation. However, dividends paid cannot
be deducted. Therefore, Allied would need $1 of pretax income to pay $1 of interest, but
because it has a 25% federal-plus-state corporate tax rate, it must earn $1.33 of pretax
income to pay $1 of dividends:
Pretax income needed
to pay
$
1
of dividends
=
$
1
1
Tax rate
=
$
1
0.75
=
$
1.33
Working backward, if Allied has $1.33 in pretax income, it must pay $0.33 in taxes
[
(
0.25
)
(
$
1.33
)
=
$
0.33
]
. This leaves it with after-tax income of $1.00.
Table 3.6 shows the situation for a firm with
$
10
million
of assets, sales of
$
5
million
, and
$
1.5
million
of earnings before interest and taxes (EBIT). The company’s average annual gross receipts
are less than
$
25
million
and have been for the prior 3 years, so the firm is exempt from the interest deduction
limitation. As shown in column 1, if the firm were financed entirely by bonds and if it made
interest payments of
$
1.5
million
, its taxable income would be zero, taxes would be zero, and its investors would receive the
entire
$
1.5
million
. (The term investors includes both stockholders and bondholders.) However, as shown in
column 2, if the firm had no debt and was therefore financed entirely by stock, all of the
$
1.5
million
of EBIT would be taxable income to the corporation, the tax would be
$
1,500,000
(
0.25
)
=
$
375,000
, and investors would receive only
$
1.125
million
versus
$
1.5
million
under debt financing. Therefore, the rate of return to investors on their
$
10
million
investment is much higher when debt is used.
Table 3.6 Returns to Investors under Bond and Stock Financing
Details
Of course, it is generally not possible to finance exclusively with debt, and the risk of doing
so would offset the benefits of the higher expected income. Still, the fact that interest is a
deductible expense—even though the deduction may be limited—has a profound effect on
the way businesses are financed—the corporate tax system favors debt financing over equity
financing. This point is discussed in more detail in Chapters 10 and 14.
Corporate Capital Gains
Before 1987, corporate long-term capital gains were taxed at lower rates than corporate
ordinary income; so the situation was similar for corporations and individuals. Currently,
though, corporations’ capital gains are taxed at the same flat corporate tax rate as their
operating income.
Corporate Loss Carryforward
Ordinary corporate operating losses can be carried forward (carryforward) indefinitely. The
carryforward deduction is limited to the lessor of the total available net operating loss (NOL)
or 80% of the taxable income for the year to which the carryforward will be applied.
To illustrate, suppose in 2021, Company X lost
$
12
million
. Also, assume that in 2022 and 2023, Company X is profitable and has taxable income of
$
10
million
in each year. (Of course, we won’t have this information ahead of time, we’re simply
illustrating how carryforwards will be applied in future years for this company.) As shown in
Table 3.7, Company X would use the carryforward feature in 2022 to adjust its profits and
calculate its adjusted tax liability. The loss that can be carried forward in 2022 is the lesser of
the actual loss,
$
12
million
in this case, or 80% of the 2022 taxable income. Because 80% of the 2022 taxable income is
$
8
million
, Company X can carry forward
$
8
million
of its 2021 loss to adjust its 2022 profits. Taxes owed for 2022 would be calculated as
$500,000 ([0.25][$2,000,000]). Because not all of the 2021 loss has been used, Company X
can carry forward the remaining
$
4
million
loss to use in future years. In 2023, the firm has taxable income of
$
10
million
, so we can use the remaining carryforward to adjust the firm’s 2023 profits. Because all of
the carryforward available is less than 80% of the 2023 taxable income, Company X’s profits
will be reduced by
$
4
million
, so its adjusted 2023 profit is
$
6
million
and its tax liability is
$
1.5
million
. At this point, the entire 2021 loss carryforward has been used, so no carryforward remains
in our example. However, carryforwards can be extended indefinitely, so if an amount
remained, it would be applied to the next year using the same steps as we did here to adjust
the firm’s profits and lower its tax liability for that year. The purpose of permitting this loss
treatment is to avoid penalizing corporations whose incomes fluctuate substantially from
year to year.
Table 3.7 Calculation of Loss Carryforward for 2022–2023 Using a
$
12
million
2021 Loss
Consolidated Corporate Tax Returns
If a corporation owns 80% or more of another corporation’s stock, it can aggregate income
and file one consolidated tax return. This allows the losses of one company to be used to
offset the profits of another. (Similarly, one division’s losses can be used to offset another
division’s profits.) No business wants to incur losses, but tax offsets make it more feasible for
large, multidivisional corporations to undertake risky new ventures or ventures that will
suffer losses during a developmental period.
Taxation of Small Businesses: S Corporations
As we noted in Chapter 1, the Tax Code allows small businesses that meet certain conditions
to be set up as corporations and thus receive the benefits of the corporate form of
organization—especially limited liability—but they are still taxed as proprietorships or
partnerships rather than as corporations. These corporations are called S corporations.
(Regular corporations are called C corporations.) If a corporation elects to set up as an S
corporation, all of its income is reported as personal income by its stockholders, on a pro
rata basis, and thus is taxed at the stockholders’ individual rates. Because the income is
taxed only once, this is an important benefit to the owners of small corporations in which all
or most of the income earned each year will be distributed as dividends. The situation is
similar for LLCs.
Depreciation
Depreciation plays an important role in income tax calculations—the larger the depreciation,
the lower the taxable income, the lower the tax bill, and thus the higher the operating cash
flow. Under the TCJA, 100% of the cost of certain new and used business assets may be
immediately expensed if placed into service after September 27, 2017, and before January 1,
2023. For assets placed into service after January 1, 2023, but before January 1, 2027, only
80% of the asset’s cost may be immediately expensed. Immediate expensing is eliminated
after January 1, 2027. This “bonus” depreciation is typically for assets with lives less than 20
years. Nonresidential real property not subject to “bonus” depreciation falls under the
alternative depreciation system and is depreciated straight line over 40 years. We will
discuss depreciation in greater detail and how depreciation affects income and cash flows
when we study capital budgeting.
SelfTest
Explain this statement: “Our tax rates are progressive”.
What’s the difference between individual marginal and average tax rates?
What’s the AMT, and what is its purpose?
What’s a muni bond, and how are these bonds taxed?
What are long-term capital gains? Are they taxed like other income? Explain.
How does our tax system influence the use of debt financing by corporations?
What is the logic behind allowing tax loss carryforwards?
Differentiate between S and C corporations.
Tying It All Together
The primary purposes of this chapter were to describe the basic financial statements, to
present background information on cash flows, to differentiate between cash flow and
accounting income, and to provide an overview of the federal income tax system. In the next
chapter, we build on this information to analyze a firm’s financial statements and to
determine its financial health.