Chapter 2
If you make an extra $1000 in income and your marginal tax rate is %30 while your average tax rate is %20, then you will pay ____ in taxes on this extra income.
$300 1000 x .30 = 300
If ending net fixed assets are $100, beginning net fixed assets are $60, and depreciation is $10, then the capital spending on fixed assets during the period is ____.
$50 Ending net fixed assets (100) - (beginning net fixed assets (60) + depreciation (10)
According to the originators of the current U.S. corporate tax code, the tax rates in effect for 2015 are:
%15 %25 %34 %35
If interest paid is $100 and net new borrowing is $150, then cash flow to creditors equals:
-50 interest paid (100) - net new borrowing (150)
Long-term liabilities represent obligations of the firm lasting over
1 year
If dividends are $100, stock sold is $10, and stock repurchased is $25, what is the cash flow to stockholders?
115 dividends paid (100) - net new equity (10-25)
If a firm's current assets are $100 and its current liabilities are $80, then its net working capital is:
20 CA - CL
The companies in biotechnology industry pay tax at the ____ (lowest/highest) average tax rate.
4.5
What is depreciation?
A systematic expensing of an asset based on the asset's estimated life
Which of the following are classified as liabilities on a firm's balance sheet?
Accounts payable Long term debt
A customer has yet to pay the bill for products purchased from Firm A on credit. This customer's trade credit is recorded in which of Firm A's balance sheet accounts?
Accounts receivable
Free cash flow
Another name for cash flow from assets Of course, there is no such thing as "free" cash (we wish!). Instead, the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments.
Which of the following is the balance sheet equation?
Assets = liabilities + stockholder's equity
Capital spending example
At the end of 2015, net fixed assets for U.S. Corporation (Table 2.1) were $1,644. During the year, we wrote off (depreciated) $65 worth of fixed assets on the income statement. So, if we didn't purchase any new fixed assets, net fixed assets would have been $1,644 − 65 = $1,579 at year's end. The 2016 balance sheet shows $1,709 in net fixed assets, so we must have spent a total of $1,709 − 1,579 = $130 on fixed assets during the year: Ending net fixed assets $1,709 − Beginning net fixed assets 1,644 + Depreciation 65 Net investment in fixed assets $ 130 This $130 is our net capital spending for 2016. Could net capital spending be negative? The answer is yes. This would happen if the firm sold off more assets than it purchased. The net here refers to purchases of fixed assets net of any sales of fixed assets.
Under GAAP, assets are generally carried on a firm's balance sheet at ____.
Book value and historical cost
Rank the ease (from easiest to hardest) of turning the following assets into cash.
Cash equivalents Accounts receivable Inventory Plant and equipment
in finance, the value of a firm depends on its ability to generate
Cash flows
Net capital spending is equal to the change in net fixed assets plus:
Depreciation
Cash Flows for Dole Cola: Operating cash flow
Earnings before interest and taxes $150 + Depreciation 150 − Taxes 41 Operating cash flow $259 As this example illustrates, operating cash flow is not the same as net income because depreciation and interest are subtracted out when net income is calculated. If you recall our earlier discussion, we don't subtract these out in computing operating cash flow because depreciation is not a cash expense and interest paid is a financing expense, not an operating expense.
Book Value
the difference between the cost of a depreciable asset and its related accumulated depreciation the balance sheet value of the assets, liabilities, and equity assets are "carried on the books" at what the firm paid for them (minus accumulated depreciation), no matter how long ago they were purchased or how much they are worth today.
Cash flow refers to
the difference between the number of dollars that came in and the number that went out
Shareholder's equity (common equity, owner's equity)
the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term) This feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all of its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders
Changes in capital spending can be negative if
the firm sold more assets than it purchased
On which side of the balance sheet do liability appear?
the right side
Flat rate tax
there is only one tax rate, and this rate is the same for all income levels With such a tax, the marginal tax rate is always the same as the average tax rate. As it stands now, corporate taxation in the United States is based on a modified flat-rate tax, which becomes a true flat rate for the highest incomes.
Tangible assets
those assets that can be appraised by value or seen or touched
What is the purpose of the income statement?
to measure performance over a set period of time
Free cash flow is Bettie described as
total distributable cash flow
Dividends Per Share (DPS)
total dividends/total shares outstanding
Average tax rate
total taxes paid divided by total taxable income in other words, the percentage of your income that goes to pay taxes
Financial leverage refers to a firm's ____
use of debt in its capital structure
Current assets ____exceed current liabilities in a healthy firm.
usually
Could net capital spending be negative?
yes. This would happen if the firm sold off more assets than it purchased. The net here refers to purchases of fixed assets net of any sales of fixed assets.
Operating cash flow example:
If we look at U.S. Corporation's income statement (Table 2.2), we see that earnings before interest and taxes (EBIT) are $694. This is almost what we want because it doesn't include interest paid. We need to make two adjustments. First, recall that depreciation is a noncash expense. To get cash flow, we first add back the $65 in depreciation because it wasn't a cash deduction. The other adjustment is to subtract the $212 in taxes because these were paid in cash. The result is operating cash flow: U.S. Corporation thus had a 2016 operating cash flow of $547. Operating cash flow is an important number because it tells us, on a very basic level, whether or not a firm's cash inflows from its business operations are sufficient to cover its everyday cash outflows. For this reason, a negative operating cash flow is often a sign of trouble.
Cash flow to creditors
Looking at the income statement in Table 2.2, we see that U.S. Corporation paid $70 in interest to creditors. From the balance sheets in Table 2.1, long-term debt rose by $454 − 408 = $46. So, U.S. Corporation paid out $70 in interest, but it borrowed an additional $46. Net cash flow to creditors is thus: U.S. CORPORATION 2016 Cash Flow to Creditors Interest paid $70 − Net new borrowing 46 Cash flow to creditors $24 Cash flow to creditors is sometimes called cash flow to bondholders; we will use these terms interchangeably.
Non-cash items are expenses that directly affect ____ but do not directly affect _____.
Net income; cash flow
Assets
On the left-hand side of the balance sheet In order of decreasing liquidity Everything that a company owns
Liabilities
On the right-hand side of the balance sheet What the company owes
Which of the following are components of cash flow from assets?
Operating cash flow Capital spending Change in net working capital
Net capital spending is equal to ending net fixed assets minus beginning net fixed assets _____
PLUS depreciation
Debt versus Equity
Shareholders' equity = Assets - Liabilities
Liquidity
Speed and ease of conversion to cash without significant loss of value Valuable in avoiding financial distress
Current assets
cash and other assets expected to be exchanged for cash or consumed within a year Inventory Accounts receivable Cash
Non-cash items do not affect
cash flow
Product costs are usually shown on the income statement under the heading of
cost of goods sold
The cash flow identity states that cash flow from assets equal cash flow to _____
creditors and stockholders
Assets can be categorized as
current and fixed assets tangible and intangible assets
Net Working Capital
current assets - current liabilities usually positive for a healthy firm
When a firm smooths earnings to please investors, it is called ________.
earnings management
Depreciation is the accountant's estimate of the cost ____ used in the production process matched with the benefits produced from owning it
fixed assets equipment
Costs that do not change in the short run arise because
fixed commitments
Cash flow to creditors equal
interest paid - net new borrowing
Balance sheet
is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm's equity) at a given point in time.
For a mature firm, operating cash flow:
is usually positive is a sign of trouble if negative over a long period of time
Current liabilities
liabilities due within a short time, usually within a year Accounts payable
The price at which willing buyers and sellers would trade is called ________ value.
market
The ____ principal of GAAP states that costs associated with a good or service should be recorded at the same time as the revenue from selling that good or service
matching
Income statement
measures performance over some period of time, usually a quarter or a year. Revenues - expenses
Earnings Per Share (EPS)
net income/total shares outstanding
Cash flow from assets involves three components:
operating cash flow capital spending, and change in net working capital.
Calculating cash flow from assets
operating cash flow less the amounts invested in fixed assets and net working capital. So, for U.S., we have: U.S. CORPORATION 2016 Cash Flow from Assets Operating cash flow $547 − Net capital spending 130 − Change in NWC 330 Cash flow from assets $ 87 From the cash flow identity above, this $87 cash flow from assets equals the sum of the firm's cash flow to creditors and its cash flow to stockholders. We consider these next. It wouldn't be at all unusual for a growing corporation to have a negative cash flow. As we shall see below, a negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders that year.
Liquidity has two dimensions which are the ability to:
quickly convert assets into cash without significant loss in value
Operating cash flow
refers to the cash flow that results from the firm's day-to-day activities of producing and selling. Expenses associated with the firm's financing of its assets are not included because they are not operating expenses. we want to calculate revenues minus costs, but we don't want to include depreciation because it's not a cash outflow, and we don't want to include interest because it's a financing expense. We do want to include taxes because taxes are, unfortunately, paid in cash.
Capital Spending
refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets).
Corporate tax rate
rise from 15 percent to 39 percent, but they drop back to 34 percent on income greater than $335,000. They then rise to 38 percent and subsequently fall to 35 percent. According to the originators of the current tax rules, there are only four corporate rates: 15 percent, 25 percent, 34 percent, and 35 percent. The 38 and 39 percent brackets arise because of "surcharges" applied on top of the 34 and 35 percent rates
Who is entitled to the residual value of a firm's cash flows?
shareholders
Change in net working capital
the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase or decrease in current assets over current liabilities.
Cash flow
the difference between cash coming in and cash going out of a business Cash flow from assets=Cash flow to creditors+ Cash flow to stockholders
The short-run is a period when there are _____ costs
both fixed and variable
Net working capital will be negative when current assets ____ current liabilities.
are less than
Fixed asset
asset with long-term use or value, such as land, buildings, and equipment
Noncash items
Expenses charged against revenue that do not affect cash flow Depreciation = most important Suppose a firm purchases a fixed asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period. The depreciation deduction is simply another application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So, the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.
For financial analysis, financial statements and accounting numbers are more important than cash flows.
False, relies on cash flows
Marginal tax rates are the most important tax rate because:
Financial decisions are usually based on new cash flows incremental cash flows are taxed at marginal tax rates
Algernon, Inc., has a taxable income of $85,000. What is its tax bill? What is its average tax rate? Its marginal tax rate?
From Table 2.3, the tax rate applied to the first $50,000 is 15 percent; the rate applied to the next $25,000 is 25 percent; and the rate applied after that up to $100,000 is 34 percent. So, Algernon must pay .15 × $50,000 + .25 × 25,000 + .34 × (85,000 − 75,000) = $17,150. The average tax rate is thus $17,150/85,000 = 20.18%. The marginal rate is 34 percent since Algernon's taxes would rise by 34 cents if it had another dollar in taxable income.
Cash flow to stockholders
From the income statement, dividends paid to stockholders amount to $103. To get net new equity raised, we need to look at the common stock and paid-in surplus account. This account tells us how much stock the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have: U.S. CORPORATION 2016 Cash Flow to Stockholders Dividends paid $103 − Net new equity raised 40 Cash flow to stockholders $ 63 The cash flow to stockholders for 2016 was thus $63.
What should you keep in mind when examining an income statement?
GAAP Cash versus non cash items Time and costs
When looking at an income statement, the financial manager needs to keep three things in mind:
GAAP, cash versus noncash items, and time and costs
What does GAAP stand for?
Generally Accepted Accounting Principles
Time and costs
If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (e.g., property taxes). Other costs, such as wages to laborers and payments to suppliers, are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas. The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide as to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs. Product costs include such things as raw materials, direct labor expense, and manufacturing overhead. These are reported on the income statement as costs of goods sold, but they include both fixed and variable costs. Similarly, period costs are incurred during a particular time period and might be reported as selling, general, and administrative expenses.
Shareholder's equity equals
assets - liabilities
Intangible assets
assets that do not have physical substance
On the balance sheet, assets are listed at their ____ value
book
Cash Flows for Dole Cola: Change in NWC and Cash Flow from Assets
Suppose Dole Cola started the year with $2,130 in current assets and $1,620 in current liabilities. The corresponding ending figures were $2,260 and $1,710. What was the change in NWC during the year? What was cash flow from assets? How does this compare to net income? Net working capital started out as $2,130 − 1,620 = $510 and ended up at $2,260 − 1,710 = $550. The change in NWC was thus $550 − 510 = $40. Putting together all the information for Dole Cola, we have: DOLE COLA 2016 Cash Flow From Assets Operating cash flow $259 − Net capital spending 400 − Change in NWC 40 Cash flow from assets −$181 Dole had cash flow from assets of −$181. Net income was positive at $79. Is the fact that cash flow from assets was negative a cause for alarm? Not necessarily. The cash flow here is negative primarily because of a large investment in fixed assets. If these are good investments, then the resulting negative cash flow is not a worry.
Cash Flows for Dole Cola: Net capital spending
Suppose beginning net fixed assets were $500 and ending net fixed assets were $750. What was the net capital spending for the year? From the income statement for Dole, depreciation for the year was $150. Net fixed assets rose by $250. Dole thus spent $250 along with an additional $150, for a total of $400.
Operating cash flow does not include depreciation or interest
TRUE
Market Value
The amount you could realistically sell an asset for today true value; the price at which the assets, liabilities, or equity can actually be bought or sold.
GAAP and Income Statement
The general rule (the recognition principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. revenue is recognized at the time of sale, which need not be the same as the time of collection.
Earnings management
The way that firms are required by GAAP to report financial results is intended to be objective and precise. In reality, there is plenty of wiggle room, and, as a result, companies have significant discretion over their reported earnings. For example, corporations frequently like to show investors that they have steadily growing earnings. To do this, they might take steps to overstate or understate earnings at various times to smooth out dips and surges.
Change in net working capital example
To determine the change in net working capital, the easiest approach is just to take the difference between the beginning and ending net working capital (NWC) figures. Net working capital at the end of 2016 was $1,403 − 389 = $1,014. Similarly, at the end of 2015, net working capital was $1,112 − 428 = $684. So, given these figures, we have: Ending NWC $1,014 − Beginning NWC 684 Change in NWC $ 330 Net working capital thus increased by $330. Put another way, U.S. Corporation had a net investment of $330 in NWC for the year.
Which of the following are classified as fixed assets on the balance sheet?
Trademark Building Equipment
Cash Flows for Dole Cola: Cash Flow to Creditors and Stockholders
We saw that Dole Cola had cash flow from assets of −$181. The fact that this is negative means that Dole raised more money in the form of new debt and equity than it paid out for the year. For example, suppose we know that Dole didn't sell any new equity for the year. What was cash flow to stockholders? To creditors? Because it didn't raise any new equity, Dole's cash flow to stockholders is just equal to the cash dividend paid: DOLE COLA 2016 Cash Flow to Stockholders Dividends paid $30 − Net new equity 0 Cash flow to stockholders $30 Now, from the cash flow identity, the total cash paid to creditors and stockholders was −$181. Cash flow to stockholders is $30, so cash flow to creditors must be equal to −$181 − 30 = −$211: Cash flow to creditors + Cash flow to stockholdersCash flow to creditors+$30Cash flow to creditors===−$181−$181−$211 Because we know that cash flow to creditors is −$211 and interest paid is $30 (from the income statement), we can now determine net new borrowing. Dole must have borrowed $241 during the year to help finance the fixed asset expansion: DOLE COLA 2016 Cash Flow to Creditors Interest paid $ 30 − Net new borrowing 241 Cash flow to creditors −$211
Which of these questions can be answered by reviewing a firm's balance sheet?
What is the total amount of assets the firm owns How much debt is used to finance the firm
According to GAAP, when is revenue recognized on an income statement?
When the value of an exchange of goods or services is known or reliably determined when the earnings process is virtually completed
Long term debt
a liability that falls due beyond one year from the date of the financial statements
A balance sheet reflects a firm's
accounting value on a specific date
net earnings refers to income earned
after interest and taxes
Marginal tax rate
amount of tax payable on the next dollar earned It will normally be the marginal tax rate that is relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect on our tax bill.