Fin 340

corp capital gains

-A capital gain occurs when an asset is sold for more than its book value, and a capital loss occurs when the reverse happens. Under current law, corporations' capital gains are taxed at the same rates as their operating income.

financial reports

-A company's annual report usually begins with the chairperson's description of the firm's operating results during the past year and a discussion of new developments that will affect future operations. The annual report also presents four basic financial statements—the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows. -The financial statements report what has actually happened to assets, earnings, dividends, and cash flows during the past few years, whereas the written materials attempt to explain why things turned out the way they did.

the corporate tax rate

-Prior to the Act's passage, corporate tax rates were progressive (i.e., the tax rate increased as taxable income increased) up to $18,333,333. Beyond this amount, the tax rate was 35%. The new tax code is not progressive but instead applies a flat 21% rate to taxable income.

personal taxes

-if personal taxes, but the key elements are presented here based on the 2017 Tax Cut and Job Creation Act. Keep in mind that the TCJA's changes in the corporate tax code will not change unless Congress passes a new tax act. However, most of the changes to the personal tax code are actually suspensions of elements in the prior code and will revert to their former values for the 2026 tax year unless Congress intervenes. In other words, most of the TCJA's changes to the personal tax code are in effect only for tax years 2018-2025. -Ordinary income consists primarily of wages or profits from a proprietorship or partnership, plus investment income other than qualified dividends and net long-term capital gains. We describe taxation of qualified dividends and net long-term capital gains in a following section, but for now we will assume that a taxpayer has no qualified dividends or net long-term capital gains. Therefore, the taxable income is just ordinary income. -For the 2018 tax year, individuals with less than the first bracket of $9,525 of taxable income are subject to a federal income tax rate of 10%. Therefore, for someone earning $8,000, the tax is 10%($8,000)=$800. For someone with income of $29,525, which is above the first bracket but below the second of $38,700, the first $9,525 (i.e., the amount less than the first bracket) is taxed at 10% and the remaining $29,525-$9,525=$20,000 is taxed at 12%. Because 12% is the rate on each additional dollar between $9,524 and $38,700, it is called a marginal tax rate. Total taxes are 10%($9,525)+12%($20,000)=$3,352.5. As income increases, there are more brackets at higher rates until income exceeds the highest bracket of $500,000 for individuals ($600,000 for married joint filers), at which point the additional income is taxed at 37%. This is called a progressive tax because the higher one's income, the larger the percentage paid in taxes. -In general, the TCJA cut the marginal rates for the brackets and reduced the bracket thresholds. F -As noted, individuals are taxed on investment income as well as earned income, with a few exceptions and modifications. -For example, interest received from most municipal bonds issued by state and local government bonds is not subject to federal taxation. However, interest earned on most other bonds or lending is taxed as ordinary income. This means that a lower-yielding muni can provide the same after-tax return as a higher-yielding corporate bond. -assets such as stocks, bonds, and real estate are defined as capital assets. If you own a capital asset and its price goes up, then your wealth increases, but you are not liable for any taxes on your increased wealth until you sell the asset. If you sell the asset for more than you originally paid, the profit is called a capital gain; if you sell it for less, then you suffer a capital loss. The length of time you owned the asset determines the tax treatment. If held for less than 1 year, it is a short-term capital gain or loss and is included as part of ordinary income. If held for more than a year, it is a long-term capital gain or loss and is taxed at a lower rate. Dividends are taxed as though they are capital gains, so we will use the term "dividends & gains" when we refer to the combined dividends and net long-term capital gains. Portions of a capital gain may be taxed at 0%, 15%, and 20%. For an investor with total income (ordinary income plus long-term capital gains) less than $36,800 (the first bracket's threshold), none of the capital gain is taxed. For an investor with ordinary income greater than $425,800, all of the capital gains are taxed at 20%. The long-term capital gains rate is 15% for many other situations, but the details are complicated. Web Extension 2A explains in more detail how to calculate taxes on gains and dividends. It also describes the standard deduction, itemized deductions, personal exemptions (which are not allowed under the TCJA), tax credits, payroll taxes, the net investment income tax, income from pass-through entities, the alternative minimum tax (AMT), gifts, estates, and generation-skipping transfers.

corporate loss carry forward

-A corporation's actual tax liability in a current year depends on its current profit and its past losses. The Act's tax loss carryforward provision allows a company to use prior ordinary operating losses to offset up to 80% of its current taxable income. Any remaining prior operating losses can be carried forward indefinitely and used to offset future taxable income. The purpose of this loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

interest and dividends paid by corp

-A firm's operations can be financed with either debt or equity capital. If the firm uses debt, then it must pay interest on this debt. The interest paid by a corporation is deducted from its operating income to obtain its taxable income. Therefore, a firm needs $1 of pre-tax income to pay $1 of interest. In contrast, dividends paid are not deductible.

taxation of pass-through entities

-A pass-through entity is a business whose income is not taxed at the business level but is instead passed through to its owners and then is taxed at their individual personal tax rates. (This is true even if the actual cash generated by the pass-through is used by the pass-through rather than being distributed to its owners.) Such businesses include sole proprietorships and partnerships. Another type of pass-through entity is an S corporation, which receives benefits from the corporate form of organization—especially limited liability—yet is taxed as a proprietorship or partnership.

performance evaluation

-Because free cash flow has such a big impact on value, managers and investors can use FCF and its components to measure a company's performance.

limitation on interest expense deduction

-Before the Act, interest expense was a fully deductible expense because it reduced taxable income. However, the Act put a limit on the amount of interest that could be deducted. For 2018, 2019, 2020, and 2021, the Act reduced the allowable interest expense deduction to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). For 2022 and subsequent years, the Act reduced the allowable interest expense deduction to 30% of earnings before interest and taxes (EBIT). For example, consider a company with EBITDA of $160 million in a year prior to 2022. Even though the company had interest expenses of $80 million, the deductible interest expense

Assets

-Cash, short-term investments, accounts receivable, and inventories are listed as current assets -All assets are stated in dollars, but only cash represents actual money that can be spent. Some marketable securities mature very soon, and these can be converted quickly into cash at prices close to their book values. Such securities are called cash equivalents and are included with cash. -MicroDrive reports the total of any other cash, cash equivalents, and marketable securities that are not used to support operation in a separate account called short-term investments. -We will always distinguish between the cash that is used to support operations and the cash, cash equivalents, and marketable securities that are held for other purposes. -When MicroDrive sells its products to customers but doesn't demand immediate payment, the customers then have obligations to make the payment, which MicroDrive reports as accounts receivable. -fIFO (first-in, first-out) inventory accounting method to estimate production costs and the value of remaining inventory. The FIFO method assumes, for accounting purposes only, that the first items placed in inventory are the first ones used in production. -the LIFO (last-in, first-out) method assumes that the items most recently placed in inventory are the first ones used in production. (No matter which method a company chooses for accounting purposes, the company actually can use inventory in any order it wishes.) -During an inflationary period of rising prices, older purchases of materials have lower costs than newer purchases. This means that FIFO will report lower costs of goods sold on the income statement than LIFO (because FIFO assumes that the older items are used first) but will report higher values for remaining inventory on the balance sheet. B -MicroDrive uses FIFO and because inflation has been occurring: (1)Its balance sheet inventories are higher than they would have been had it used LIFO. (2)Its cost of goods sold is lower than it would have been under LIFO. (3)Its reported profits are therefore higher. -inventory valuation method can have a significant effect on financial statements, -Rather than treat the entire purchase price of a long-term asset (such as a factory, plant, or equipment) as an expense in the purchase year, accountants "spread" the purchase cost over the asset's useful life. The amount they charge each year is called the depreciation expense. Some companies report an amount called gross plant and equipment, which is the total cost of the long-term assets they have in place, and another amount called accumulated depreciation, which is the total amount of depreciation that has been charged on those assets. Some companies, such as MicroDrive, report only net plant and equipment, which is gross plant and equipment less accumulated depreciation.

statement of stockholders' equity

-Changes in stockholders' equity during the accounting period are reported in the statement of stockholders' equity. -The last column shows the beginning stockholders' equity, any changes, and the end-of-year stockholders' equity. -Note that "Retained earnings" is not a pile of money just waiting to be used; it does not represent assets but is instead a claim against assets. -Thus, retained earnings, as reported on the balance sheet, does not represent cash and is not "available" for the payment of dividends or anything else.

improper accumulation to avoid payment of dividends

-Corporations could refrain from paying dividends and thus permit their stockholders to avoid personal income taxes on dividends. To prevent this, the Tax Code contains an improper accumulation provision stating that earnings accumulated by a corporation are subject to penalty rates if the purpose of the accumulation is to enable stockholders to avoid personal income taxes. A cumulative total of $250,000 (the balance sheet item "retained earnings") is by law exempted from the improper accumulation tax for most corporations. This is a benefit primarily to small corporations. The improper accumulation penalty applies only if the retained earnings in excess of $250,000 are shown by the IRS to be unnecessary to meet the reasonable needs of the business.

statement of cash flows

-Even if a company reports a large net income during a year, the amount of cash reported on its year-end balance sheet may be the same or even lower than its beginning cash. The reason is that the company can use its net income in a variety of ways, not just keep it as cash in the bank. -Indeed, many factors affect a company's cash position as reported on its balance sheet. The statement of cash flows separates a company's activities into three categories—operating, investing, and financing—and summarizes the resulting cash balance.

finance activities

-Financing activities include raising cash by issuing short-term debt, long-term debt, or stock. Because dividend payments, stock repurchases, and principal payments on debt reduce a company's cash, such transactions are included here as negative cash flows.

intrinsic value,mva,eva

-First, there is a relationship between MVA and EVA, but it is not a direct one. If a company has a history of negative EVAs, then its MVA will probably be negative; conversely, its MVA probably will be positive if the company has a history of positive EVAs. However, the stock price, which is the key ingredient in the MVA calculation, depends more on expected future performance than on historical performance. Therefore, a company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future. The second observation is that when EVAs or MVAs are used to evaluate managerial performance as part of an incentive compensation program, EVA is the measure that is typically used. The reasons are as follows: (1)EVA shows the value added during a given year, whereas MVA reflects performance over the company's entire life, perhaps even including times before the current managers were born. (2)EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.

fcf and corporate value

-Free cash flow is the amount of cash available for distribution to investors; so the fundamental value of a company to its investors depends on the present value of its expected future FCFs, discounted at the company's weighted average cost of capital (WACC). -FCF is the cash flow available for distribution to investors. Therefore, a company's fundamental value depends primarily on its expected future FCF-

free cash flow

-However, the intrinsic value of a company is determined by the stream of cash flows that investors expect to receive now and in the future. A company generates these cash flows through its operating activities. These are called free cash flows (FCFs). -We can calculate FCF in two different ways, by how it is used and by how it is generated. In terms of how it is used, FCF is the cash flow available for distribution to all the company's investors after the company has made all investments necessary to sustain ongoing operations. In terms of how it is generated, FCF is equal to after-tax operating profit minus the amount of new expenditures necessary to sustain the business. Always keep in mind that the way for managers to make their companies more valuable is to increase free cash flow now and in the future

consolidated corp tax returns

-If a corporation owns 80% or more of another corporation's stock, then it can aggregate income and file one consolidated tax return; thus, the losses of one company can be used to offset the profits of another. (Similarly, one division's losses can be used to offset another division's profits.) No business ever wants to incur losses (you can go broke losing $1 to save 21¢ in taxes), but tax offsets do help make it more feasible for large, multidivisional corporations to undertake risky new ventures or ventures that will suffer losses during a developmental period.

net operating profit after taxes

-If two companies have different amounts of debt, thus different amounts of interest charges, they could have identical operating performances but different net incomes: The one with more debt would have a lower net income. Net income is important, but it does not always reflect the true performance of a company's operations or the effectiveness of its managers. A better measure for comparing managers' performance is net operating profit after taxes (NOPAT), which is the amount of profit a company would generate if it had no debt and held no financial assets. -NOPAT=EBIT(1-Tax rate)

the corp alternative minimum tax

-In addition to the changes described in the following sections, the TCJA eliminated the corporate Alternative Minimum Tax (AMT). The AMT was an additional method of calculating corporate taxable income that reduced or eliminated some of the various tax credits and deductions used in calculating the normal tax. The corporate AMT's objective was to make it less likely that a company would pay no income taxes.

interest and dividends recieved by corporation

-Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. The situation is different for dividends. Consider a corporation that receives dividends from another firm. If the corporation subsequently pays a dividend to its own investors, then their dividend income is subject to triple taxation: (1)The first corporation is taxed on its income before it pays a dividend to the second company. (2)The second corporation is then taxed on the dividends it receives from the first firm. (3)The second firm's investors are taxed on the dividends they receive. To reduce the impact of triple taxation, corporations are allowed to exclude a portion of dividends received, as explained next. -For a company receiving dividends, 50% of the dividends are excluded from taxable income, but the remaining 50% are taxed at the ordinary tax rate. Fo -Taxes on dividend=(Dividend payment)(1-Exclusion rate)(Tax rate)Taxes on dividend=($10 million)(1-0.50)(0.21)Taxes on dividend=$1.05 million -company would pay taxes of $11.19(0.21)=$2.35 million. Its after-tax interest would be $11.19-$2.35=$8.84 million. Notice that this is less than the $8.95 million after-tax dividends calculated earlier. Therefore, a corporation with surplus funds might choose to invest in preferred stock rather than interest-paying investments

investing activities

-Investing activities include transactions involving fixed assets or short-term financial investments. For example, if a company buys new IT infrastructure, its cash goes down at the time of the purchase. On the other hand, if it sells a building or a Treasury bond, its cash goes up.

putting pieces together

-The statement of cash flows is used to help answer questions such as these: Is the firm generating enough cash to purchase the additional assets required for growth? Is the firm generating any extra cash it can use to repay debt or to invest in new products? -MicroDrive's statement of cash flows as it would appear in the company's annual report. -The top section shows cash generated by and used in operations: -Therefore, if you are ever analyzing a company and are pressed for time, look first at the trend in cash provided by operating activities because it will tell you more than any other single number. -the second section shows investing activities. -The third section, financing activities, includes borrowing from banks (notes payable), selling new bonds, and paying dividends on common and preferred stock.

taxes on overseas income

-Many U.S. corporations have overseas subsidiaries, and those subsidiaries must pay taxes in the countries where they operate. Often, foreign tax rates are lower than U.S. rates. Prior to 2018, no U.S. tax was immediately due on foreign earnings if they were reinvested overseas, even though the "investment" might be a financial asset rather than a physical asset. However, when foreign earnings were repatriated to the U.S. parent for investment here or for dividend payments, they were taxed at the applicable U.S. rate, less a credit for taxes paid to the foreign country. Over the years, this procedure has stimulated overseas investments by U.S. multinational firms; they continued the deferral indefinitely by continuing to reinvest the earnings in their overseas operations (or in overseas bank accounts). -The TCJA made major changes to the taxation of foreign income. U.S. firms with accumulated foreign deferred earnings since 1986 must pay a tax of 15.5% on those earnings that are held in cash and cash equivalents; they must pay 8% on the remainder. After this one-time tax, the United States will not tax any new foreign earnings. The good news is that U.S. tax revenues will increase and that companies with past deferred foreign earnings might now invest them here rather than abroad. The bad news is that the Act increases incentives for companies to locate production offshore in low-tax countries. After paying the new taxes, companies may choose to reinvest overseas in countries that have lower tax rates than the United States. Doing so will generate higher after-tax profits and free cash flows but won't increase investments and jobs here. If manufacturing in a foreign country is more cost-effective than in the United States, then the Act may not stimulate employment growth for blue-collar workers.-

net operating working capital

-Most companies need some current assets to support their operating activities. -For example, all companies must carry some cash to "grease the wheels" of their operations. -Companies must also have other current assets, such as inventory and accounts receivable, which are required for normal operations. The short-term assets normally used in a company's operating activities are called operating current assets. -Not all current assets are operating current assets. For example, holdings of short-term marketable securities generally result from investment decisions made by the treasurer and not as a natural consequence of operating activities. Therefore, short-term investments are nonoperating assets and normally are excluded when calculating operating current assets. A useful rule of thumb is that if an asset pays interest, it should not be classified as an operating asset. -The reverse situation is possible, too, where a company reports very little cash but many short-term investments. In such a case, we would classify some of the short-term investments as operating cash when calculating operating current assets. Some current liabilities—especially accounts payable and accruals—arise in the normal course of operations. Such short-term liabilities are called operating current liabilities. Not all current liabilities are operating current liabilities. -The company could have raised an equivalent amount as long-term debt or could have issued stock, so the choice to borrow from the bank was a financing decision and not a consequence of operations. Again, the rule of thumb is that if a liability charges interest, it is not an operating liability. -gain, the rule of thumb is that if a liability charges interest, it is not an operating liability. -If you are ever uncertain about whether an item is an operating asset or operating liability, ask yourself whether the item is a natural consequence of operations or if it is a discretionary choice, such as a particular method of financing or an investment in a particular financial asset. If it is discretionary, then the item is not an operating asset or liability. Notice that each dollar of operating current liabilities is a dollar that the company does not have to raise from investors in order to conduct its short-term operating activities. Therefore, we define net operating working capital (NOWC) as operating current assets minus operating current liabilities. In other words, net operating working capital is the working capital acquired with investor-supplied funds. Here is the definition in equation form: -Notice that each dollar of operating current liabilities is a dollar that the company does not have to raise from investors in order to conduct its short-term operating activities. Therefore, we define net operating working capital (NOWC) as operating current assets minus operating current liabilities. In other words, net operating working capital is the working capital acquired with investor-supplied funds. -Net operatingworking capital=Operating currentassets-Operating currentliabilities -NOWC=Operating current assets-Operating current liabilities=(Cash+Accounts receivable+Inventories)-(Accounts payable+Accruals)=($100+$500+$1,000)-($200+$400)=$1,000million -from past experience with our students, we know the terminology can be confusing. Accounting and supply chain management tend to use the term net working capital, defined as all current assets minus all current liabilities. This is quite different from net operating working capital, which excludes the impact of items not directly related to operations (e.g., short-term investments and notes payable

operating activities

-Net income is not a cash flow! -Not all revenues and expenses reported on the income statement are received or paid in cash during the year. The most common item is depreciation. -depreciation is reported as an expense but is not a cash flow—the cash flow occurred when the asset was purchased, not in the subsequent years. -Other items on the income statement can differ significantly from actual cash flows -Therefore, a company's reported tax expense can differ significantly from its actual tax payments. -For example, growing companies report lower depreciation expenses to the public than to the IRS. This makes publicly reported taxable income higher than actual taxable income, resulting in higher reported taxes than actual taxes paid. -A firm's investment in current assets—cash, marketable securities, inventory, and accounts receivable—is called working capital. Increases in current assets other than cash (such as inventories and accounts receivable) decrease cash, whereas decreases in these accounts increase cash. For example, if inventories are to increase, then the firm must use cash to acquire the additional inventory. Conversely, if inventories decrease, this generally means the firm is selling inventories and not replacing all of them, hence generating cash. -If the amount we own goes up (like getting a new laptop computer), it means we have spent money, and our cash goes down. On the other hand, if something we own goes down (like selling a car), our cash goes up. -how consider a current liability, such as accounts payable. If accounts payable increase, then the firm has received additional credit from its suppliers, which saves cash; however, if payables decrease, this means it has used cash to pay off its suppliers. Therefore, increases in current liabilities such as accounts payable increase cash, whereas decreases in current liabilities decrease cash. To keep track of the cash flow's direction, think about the impact of getting a student loan. The amount you owe goes up, and your cash goes up. Now think about paying off the loan: The amount you owe goes down, but so does your cash.

market value added-

-One measure of shareholder wealth is the difference between the market value of the firm's stock and the cumulative amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA): MVA=Market value of stock -Equity capital supplied by shareholdersMVA=(Shares outstanding)(Stock price)- Total common equity -Micro Drive's MVA=(Shares outstanding)(Stock price)-Total common equityMicro Drives MVA=(60 million)($31.00)-$2,240 million Micro Drives MVA=$1,844 million -$2,240 million =-$380 million. -Sometimes MVA is defined as the total market value of the company minus the total amount of investor-supplied capital: MVA=Total market value-Total investor-supplied capitalMVA=(Market value of stock+Market value of debt)MVA-Total investor-supplied capital -For most companies, the total amount of investor-supplied capital is the sum of equity, debt, and preferred stock. We can calculate the total amount of investor-supplied capital directly from their reported values in the financial statements. The total market value of a company is the sum of the market values of common equity, debt, and preferred stock. It is easy to find the market value of equity because stock prices are readily available, but it is not always easy to find the market value of debt. Hence, many analysts use the value of debt reported in the financial statements, which is the debt's book value, as an estimate of the debt's market value.

the uses of fcf

-Recall that free cash flow (FCF) is the amount of cash that is available for distribution to all investors, including shareholders and debtholders. There are five good uses for FCF: Pay interest to debtholders, keeping in mind that the net cost to the company is the after-tax interest expense. Repay debtholders; that is, pay off some of the debt. Issuing new debt is a "negative use." Pay dividends to shareholders. Repurchase stock from shareholders. Issuing new stock is a "negative use." Buy short-term investments or other nonoperating assets. Selling is a "negative use." -The net amount of debt that is repaid is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes notes payable and long-term debt. If the amount of ending debt is less than the beginning debt, the company paid down some of its debt. But if the ending debt is greater than the beginning debt, the company actually borrowed additional funds from creditors. In that case, it would be a negative use of FCF. -This is a "negative use" of FCF because it increased the debt balance. This is typical of most companies because growing companies usually add debt each year. -The net amount of stock that is repurchased is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes preferred stock and common stock. If the amount of ending stock is less than the beginning stock, then the company made net repurchases. But if the ending stock is greater than the beginning stock, the company actually made net issuances. In that case, it would be a negative use of FCF. -The amount of net purchases of short-term investments is equal to the amount at the end of the year minus the amount at the beginning of the year. If the amount of ending investments is greater than the beginning investments, then the company made net purchases. But if the ending investments are less than the beginning investments, the company actually sold investments -Observe that a company does not use FCF to acquire operating assets, because the calculation of FCF already takes into account the purchase of operating assets needed to support growth. Unfortunately, there is evidence to suggest that some companies with high FCF tend to make unnecessary investments that don't add value, such as paying too much to acquire another company. Thus, high FCF can cause waste if managers fail to act in the best interests of shareholders.

economic value added

-Whereas MVA measures the effects of managerial actions since the inception of a company, Economic Value Added (EVA) focuses on managerial effectiveness in a given year. The EVA formula is: EVA=(Net operating profit after taxes)-(After tax dollar cost of capital used to support operations)EVA=NOPAT-(Total net operating capital)(WACC) -economic Value Added is an estimate of a business's true economic profit for the year, and it differs sharply from accounting profit. EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted, whereas accounting profit is determined without imposing a charge for equity capital. -equity capital has a cost because shareholders give up the opportunity to invest and earn returns elsewhere when they provide capital to the firm. This cost is an opportunity cost rather than an accounting cost, but it is real nonetheless. -when calculating EVA we do not add back depreciation. Although it is not a cash expense, depreciation is a cost because worn-out assets must be replaced, and it is therefore deducted when determining both net income and EVA. Our calculation of EVA assumes that the true economic depreciation of the company's fixed assets exactly equals the depreciation used for accounting and tax purposes. If this were not the case, adjustments would have to be made to obtain a more accurate measure of EVA. -Economic Value Added measures the extent to which the firm has increased shareholder value. Therefore, if managers focus on EVA, they will more likely operate in a manner consistent with maximizing shareholder wealth. Note too that EVA can be determined for divisions as well as for the company as a whole, so it provides a useful basis for determining managerial performance at all levels. Consequently, many firms include EVA as a component of compensation plans. We can also calculate EVA in terms of ROIC: EVA=(Total net operating capital)(ROIC-WACC) -that is, has a positive EVA—if its ROIC is greater than its WACC. If WACC exceeds ROIC, then growth can actually reduce a firm's value. -This negative EVA reinforces our earlier conclusions that MicroDrive lost value in 2019 due to an erosion in its operating performance.

Liabilities and equity

-accounts payable, notes payable, and accruals are listed as current liabilities because MicroDrive is expected to pay them within a year. When MicroDrive purchases supplies but doesn't immediately pay for them, it takes on obligations called accounts payable. Similarly, when MicroDrive takes out a loan that must be repaid within a year, it signs an IOU called a note payable -Most companies use the Accrual Accounting Method, which attempts to match revenues to the periods in which they are earned and expenses to the periods in which the effort to generate income occurred. -Long-term bonds are also liabilities because they reflect a claim held by someone other than a stockholder. They are not reported as a current liability because the maturity date is more than one year away. -Preferred stock is a hybrid, or a cross between common stock and debt. In the event of bankruptcy, preferred stock ranks below debt but above common stock. Also, the preferred dividend is fixed, so preferred stockholders do not benefit if the company's earnings grow. Most firms do not use much, if any, preferred stock, so "equity" usually means "common equity" unless the words "total" or "preferred" are included. -When a company sells shares of stock, it records the proceeds in the common stock account. Retained earnings are the cumulative amount of earnings that have not been paid out as dividends. The sum of common stock and retained earnings is called common equity, or just equity. If a company could actually sell its assets at their book value, and if the liabilities and preferred stock were actually worth their book values, then a company could sell its assets, pay off its liabilities and preferred stock, and the remaining cash would belong to common stockholders. Therefore, common equity is sometimes called the net worth of shareholders—it's the assets minus (or "net of") the liabilities and preferred stock.

calculating free cash flow

-free cash flow is defined as: FCF=NOPAT-Net investment in total operating capital -FCF=[EBIT(1-T)+Depreciation]-[Gross investmentin fixed assets]-[Investmentin NOWC] -FCF=[NOPAT+Depreciation]-[Net investmentin fixed assets+Depreciation]-[Investmentin NOWC] -FCF=NOPAT-[Net investmentin fixed assets]-[Investmentin NOWC]

corporate income taxes

-he value of any financial asset (including stocks, bonds, and mortgages), as well as most real assets such as plants or even entire firms, depends on the after-tax stream of cash flows produced by the asset -In December 2017, Congress passed a tax act that is still widely known by the title of its preliminary version, the 2017 Tax Cut and Jobs Act (TCJA). We will refer to it as the Tax Cut and Jobs Act, the TCJA, or just the Act. The TCJA made major changes to corporate and personal tax codes. Following are descriptions and example applications of the most important items in the Act that affect corporate taxes.

the income statement

-income statements can cover any period of time, but they are usually prepared monthly, quarterly, and annually. Unlike the balance sheet, which is a snapshot of a firm at a point in time, the income statement reflects performance during the period. -Net sales are the revenues less any discounts or returns. Depreciation and amortization reflect the estimated costs of the assets that wear out in producing goods and services. -the reported depreciation expense on the income statement is the sum of all the assets' annual depreciation charges. -Depreciation applies to tangible assets, such as plant and equipment, whereas an amortization expense applies to intangible assets. For example, if a company acquires another company but pays more than the tangible assets, then the difference is called goodwill. Other intangible assets include patents, copyrights, trademarks, and similar items. -The cost of goods sold (COGS) includes labor, raw materials, and other expenses directly related to the production or purchase of the items or services sold in that period. As reported in most financial statements, the COGS includes depreciation because accounting logic defines depreciation as the cost of assets wearing out by producing goods. In contrast, we report depreciation separately so that analysis later in the chapter will be more transparent. -Subtracting COGS (including depreciation) and other operating expenses results in earnings before interest and taxes (EBIT). Many analysts add back depreciation to EBIT to calculate EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Because neither depreciation nor amortization is paid in cash, some analysts claim that EBITDA is a better measure of financial strength than is net income. MicroDrive's EBITDA is: EBITDA=EBIT+Depreciation -EBITDA=Sales-COGS excluding depreciation-Other expenses -EBITDA is not as useful to managers and analysts as free cash flow, so we usually focus on free cash flow instead of EBITDA. Subtracting interest expense from EBIT results in pre-tax income, which is also called earning before tax (EBT), or taxable income. The net income available to common shareholders, which equals revenues less expenses, taxes, and preferred dividends (but before paying common dividends), is generally referred to as net income. Net income is also called accounting income, accounting profit, earnings, or profit, particularly in financial news reports. Dividing net income by the number of shares outstanding gives earnings per share (EPS), often called the bottom line.

Total Net Operating Capital

-investor-supplied capital is defined as the total of funds provided by investors, such as notes payable, long-term bonds, preferred stock, and common equity. For most companies, total investor-supplied capital is: -Total investor-suppliedcapital=Notespayable+Long-termbonds+Preferredstock+Commonequity(2-8) For MicroDrive, the total capital provided by investors at year-end 2019 was $150+$520+$100+$2,240=$3,010million. Of this amount, $10 million was tied up in short-term investments, which are not directly related to MicroDrive's operations. Therefore, we define total investor-supplied operating capital as: -investor-supplied operating capital as: Total investor-suppliedoperating capital=Total investor-suppliedcapital-Short-terminvestments -Notice that this is exactly the same value as our earlier calculation of total net operating capital for that year. Therefore, we can calculate total net operating capital either from net operating working capital and operating long-term assets or from the investor-supplied funds. We usually base our calculations on operating data because this approach allows us to analyze a division, factory, or work center. In contrast, the approach based on investor-supplied capital is applicable only for the entire company. -The expression "total net operating capital" is a mouthful, so we often call it operating capital or even just capital. Also, unless we specifically say "investor-supplied capital," we are referring to total net operating capital.

the return on invested capital

-its very high investment in operating assets caused a negative FCF. Is a negative free cash flow always bad? The answer is, "Not necessarily; it depends on why the free cash flow is negative." It's a bad sign if FCF is negative because NOPAT is negative, which probably means the company is experiencing operating problems. However, many high-growth companies have positive NOPAT but negative FCF because they are making large investments in operating assets to support growth. -There is nothing wrong with value-adding growth, even if it causes negative free cash flows in the short term, but it is vital to determine whether growth is actually adding value. For this, we use the return on invested capital (ROIC), which shows how much NOPAT is generated by each dollar of operating capital -ROIC=NOPATOperating capital -ROIC low due to low operating profitability, poor capital utilization, or both? To answer that question, begin with the operating profitability ratio (OP), which measures the percentage operating profit per dollar of sales: -Operating profitability ratio (OP)=NOPATSales -The capital requirement ratio (CR) measures how much operating capital is tied up in generating a dollar of sales: Capital requirement ratio(CR)=Total net operating capitalSales -At some point, its growth will slow, and it will not require such large capital investments. If it maintains a high ROIC, then its FCF will become positive and very large as growth slows. -Neither traditional accounting data nor return on invested capital incorporates stock prices, even though the primary goal of management should be to maximize the firm's intrinsic stock price. In contrast, Market Value Added (MVA) and Economic Value Added (EVA) do attempt to compare intrinsic measures with market measures.-

Balance sheet

-most recent balance sheets, which represent "snapshots" of its financial position on the last day of each year. -Although most companies report their balance sheets only on the last day of a given period, the "snapshot" actually changes daily as inventories are bought and sold, as fixed assets are added or retired, or as loan balances are increased or paid down. -The balance sheet begins with assets, which are the "things" the company owns. Assets are listed in order of liquidity, or length of time it typically takes to convert them to cash at fair market values. The balance sheet also lists the claims that various groups have against the company's value; these are listed in the order in which they must be paid. -suppliers may have claims called accounts payable that are due within 30 days, banks may have claims called notes payable that are due within 90 days, and bondholders may have claims that are not due for 20 years or more. -Stockholders' claims represent ownership (or equity) and need never be "paid off." These are residual claims in the sense that stockholders may receive payments only if there is value remaining after other claimants have been paid. The nonstockholder claims are liabilities from the stockholders' perspective. The amounts shown on the balance sheets are called book values because they are based on the amounts recorded by bookkeepers when assets are purchased or liabilities are issued. -book values may be very different from market values, which are the current values as determined in the marketplace.

net cash flow

-use net cash flow, which is defined as: Net cash flow=Net income-Noncash revenues+Noncash expenses -where net income is the net income available for distribution to common shareholders. Depreciation and amortization usually are the largest noncash items, and in many cases the other noncash items roughly net out to zero -Net cash flow=Net income+Depreciation and amortization