Chapter 3- Financial Statements, Cash Flow and Taxes
How does the deductibility of interest and dividend by the paying corporations affect the choice of financing ( i.e use of debt vs. equity)
3-12 Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in Chapters 10 and 14.
What are some of the basic users of financial statements and how do they use them?
3-2 Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or in which to invest, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way.
IF a "typical" fit reports $20 million of retained earnings on its balance sheets, could its directors declare a $20 million cash dividend without having any qualms about what they were doing?
3-3 No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm over its life. Consequently, the $20 million would be an investment in all of the firm's assets.
Explain: Although the balance sheet can be thought of as a snapshot of a firms financial position at a point in time, the income state meant reports on operations over a period of tine
3-4 The balance sheet shows the firm's financial position on a specific date, for example, December 31, 2012. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2012. The income statement, on the other hand, reports on the firm's operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2012, would represent the firm's sales over the period from January 1, 2012, through December 31, 2012, not just sales for December 31, 2012.
Can a company have neg. cash flow and still be highly valued bit investors?
3-8 Yes. Negative free cash flow is not necessarily bad. Most rapidly growing companies have negative free cash flows because the fixed assets and working capital needed to support rapid growth generally exceed cash flows from existing operations. This is not bad, provided the new investments will eventually be profitable and they contribute to free cash flow.
How are managements actions incorporated iN EVA and MVA? How are EVA and MVA related?
3-9 MVA, the difference between book and market value, measures management's ability to maximize shareholder value. EVA accounts for the true economic profit of a firm, including the firm's cost of equity capital. When management invests in projects that return excess profit over the cost of debt and equity capital, EVA is positive. A positive EVA increases shareholder value and contributes to keeping MVA positive.
Current Liabilities eq
Current liabilities = Accounts payable and accruals + Notes payable
Depreciation eq
EBITDA-EBIT
EBIT Eq
EBT+ Interest
What is free cash flow? Why mighty be entered in free cash flow than net income?
Free cash flow is the amount of cash that could be withdrawn from the firm without harming its ability to operate and to produce future cash flows. It is calculated as after-tax operating income plus depreciation less capital expenditures and the change in net operating working capital. It is more important than net income because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company's operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.
Financial stamens are based on GAAP and are audited by CPS firms. Do investors need to worry about validity of these statements?
Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating 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 way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting practices.
Market value added eq
MVA = (P0 x Number of common shares) - BV of equity
Net operating working capital
Net operating working capital = Current assets - (Current liabilities - Notes payable)
Net working capital eq
Net working capital = Current assets - Current liabilities
Rate of returned earnings eq
R/EB/Y (previous year retained earnings)+ NI(Net income) - Div = R/EY/E
Total Assets eq
Total assets= current assets + net plants/ equipment
Total liabilities and equity
Total liabilities and equity = Current liabilities + Long-term debt + Total common equity
EVA eq
[Operating income x (1- tax rate %)] - [Total invested capital x % cost of capital]
Double taxation of corporate income and can be triple taxed?
double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received. In fact, because of double taxation Congress was motivated to reduce the tax rate on dividends to the same rate (15%) as long-term capital gains (at least through 2012). However, the tax rate is scheduled to rise on January 1, 2013. Income could even be subject to triple taxation. Triple taxation occurs when (1) the original corporation is first taxed, (2) the second corporation is then taxed on the dividends it received, and (3) the individuals who receive the final dividends are taxed again. Therefore, corporations that receive dividend income can exclude some of the dividends from its taxable income. This provision in the Tax Code minimizes the amount of triple taxation that would otherwise occur.
What four financial statements are contained in most annual reports?
he four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows.
Interest expense eq
net income / (1-T)=(tax rate)
What does total liabilities and equity equal
total assets
