Finc Chapter 2 Mini

Assume that you are in the 25% marginal tax bracket and that you have $20,000 to invest. You have narrowed your investment choices down to municipal bonds yielding 7% or equally risky corporate bonds with a yield of 10%. Which one should you choose and why? At what marginal tax rate would you be indifferent?

After-tax return income at T = 25%: After-tax interest on corporate bond = 0.10($20,000) - (0.25)(0.10)($20,000) = $2,000 - $500 = $1,500. After-tax interest on muni = 0.07($20,000) - $0 = $1,400. Alternatively, calculate after-tax yields: A-T yieldCorporate = 10.0%(1 - T) = 10%(1 - 0.25) = 7.5%. A-T yieldMuni = 7.0%. At what marginal tax rate would you be indifferent? Solve for T in this equation: Muni yield = Corp Yield(1-T) T = 1 - (Muni yield /Corp yield ) T = 1 - (7.00%/10.0%) = 30.0%.

Assume that a corporation has $87 million of taxable income from operations. It also received interest income of $8 million and dividend income of $10 million. The federal tax rate is 21% and the dividend exclusion rate is 50%. What is its taxable income and federal tax liability?

Calculation of the company's tax liability: Taxable dividend income = Dividends(1 - Exclusion rate) = $10(1 - 0.5) = $5. Taxable operating income = $87 Taxable interest income = $8 Taxable dividend income = 5 Total taxable income = $100 Tax = 21%($100)= $21.

Cochran also has asked you to estimate Computron's EVA. She estimates that the after-tax cost of capital was 10 percent in both years.

EVA = NOPAT- (WACC)(CAPITAL). Current year: EVA = $345 - (0.1)($4,250) = $345 - $425 = -$80. Previous year: EVA = $420 - (0.10)($3,480) = $420 - $348 = $72.

What is Computron's free cash flow (FCF)? What are Computron's "net uses" of its FCF?

FCF = NOPAT - Net investment in capital = $345 - ($4,250 - $3,480) = $345 - $770 = -$425. Uses of FCF: After-tax interest payment = $81 Reduction (increase) in debt = −$500 Payment of dividends = $84 Repurchase (Issue) stock = $0 Purchase (Sale) of short-term investments = −$90 Total uses of FCF = −$425

What is free cash flow? Why is it important? What are the five uses of FCF?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A company's value depends upon the amount of FCF it can generate. 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

What happened to Computron's market value added (MVA)?

MVA = market value of the firm - book value of the firm. Market value = (# shares of stock)(price per share) + value of debt. Book value = total common equity + value of debt. If the market value of debt is close to the book value of debt, then MVA is market value of equity minus book value of equity. Assume market value of debt equals book value of debt. Current year: Market value of equity = (100)($30.00) = $3,000. Book value of equity = $2,910. MVA = $3,000 - $2,910 = $90. Previous year: MVA = 100($50.00) - $2,730 = $2,270.

What is Computron's net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have

NOPAT = EBIT(1 - TAX RATE) Current year: NOPAT = 460(1 - 0.25) = $345. Previous year: NOPAT = $420. Operating current assets are the CA needed to support operations. OP CA include: cash, inventory, receivables. OP CA exclude: short-term investments, because these are not a part of operations. Operating current liabilities are the CL resulting as a normal part of operations. OP CL include: accounts payable and accruals. OP CA exclude: notes payable, because this is a source of financing, not a part of operations. NOWC = operating CA - operating CL Current year: NOWC = ($50 + $520 + 820) - ($400 + $240) = $1,390 - $640 = $750. Previous year: NOWC = $580, Total operating working capital = NOWC + net fixed assets. Current year: Operating capital = $750 + $3,500 = $4,250. Previous year: Operating capital = $3,480.

What do you conclude from the statement of cash flows?

Net CF from operations was positive, but was dragged down by a large net increase in working capital. Net CF from investing was negative even though the firm sold short- term investments. This was because the expenditures in fixed assets were so high. Net CF from financing shows heavy borrowing. Even after borrowing, the cash account fell.

Calculate Computron's return on invested capital (ROIC). Computron has a 10% cost of capital (WACC). What caused the decline in the ROIC? Was it due to operating profitability or capital utilization? Do you think Computron's growth added value?

ROIC = NOPAT / TOTAL NET OPERATING CAPITAL. Current year: ROIC = $345 / $4,250 = 8.1%. Previous year: ROIC = 12.1%. Current year: OP = $345/$6,000 = 5.8%. Previous year: OP = 7.0%. Current year: CR = $4,250 / $6,000 = 70.8%. Previous year: CR = 58.0%. The current ROIC dropped from the previous year. This decline was due to worse operating profitability (5.8% versus 7.0%) and worse capital utilization (CR ratio of 70.8% versus a CR ratio of 58.0%). The ROIC is less than the WACC of 10%. Investors did not get the return they require. Note: high growth usually causes negative FCF (due to investment in capital), but that's OK if ROIC > WACC.

What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity?

Sales increased by $500 million (9% growth), but net income fell by $105 million. Current assets and net plant & equipment each grew by over 20%. Large increases in debt funded the expansion, causing a 59% increase in interest payments.

Briefly describe the TCJA's key provisions for personal taxes.

The TCJA specifies the previous tax code for personal taxes is suspended and that TCJA's changes to personal taxes are for 2018-2025, after which they expire and the personal tax code reverts to its pre-TCJA form. Following are explanations for some of the TCJA's major changes and features. Personal tax code: 1. There are still seven brackets, but the bracket thresholds are reduced from previous levels. In addition, the marginal tax rates for some of the brackets have been reduced, with the top rate decreasing from 37% to 35%. The previous top rate was 39.6% 2. Personal exemptions are eliminated. 3. The standard deduction is increased to $12,000 for individual filers and $24,000 for married joint filers. 4. The amount of mortgage interest that may be deducted from federal taxable income is reduced. 5. The amount of state and local taxes (including income taxes, property taxes, and sales taxes) that may be deducted from federal taxable income is reduced. 6. The Act increases the amount of charitable contributions filers may deduct to 60% of Adjusted Gross Income, up from the previous 50% limit. 7. For those with high taxable income, there is now a 3.8% Net Investment Income Tax on total investment income in addition to ordinary taxes paid on investment income. 8. There is a progressive tax (three brackets) on the total net combination of dividends and capital gains on assets held for more than 1 year. The top rate is 20%. Note: the rules to determine the tax bracket and the taxable dividends & gains are very complicated. 9. Investors may deduct 20% of income earned by pass-through entities such as partnership, limited liability corporations, and S corporations. 10. There are no estate taxes due if the estate is worth less than $11.2 million. Estates over that value are taxed at progressive rates up to 40%. The estate taxes are paid prior to disbursement to the inheritors.

The Tax Cut and Jobs Act (TCJA) was signed into law in 2017. Briefly describe its key provisions for corporate taxes.

The Tax Cut and Jobs Act (TCJA) made major changes to corporate taxes. The changes will remain in place until Congress passes a new tax bill. Following are explanations for some of the TCJA's major changes and features. Corporate tax code: 1. The U.S. corporate tax code has a 21% flat rate that is fixed for corporate payers. It does not go up as taxable income increases. The previous top rate was 35%. 2. Interest income received by a corporation is taxed at the 21% flat rate. A corporation my exclude from taxable income 50% of dividend income that it receives. 3. A company may indefinitely carry forward cumulative past operating losses to offset future taxable income, thereby reducing future taxes (the previous tax code's carry-forward provision limited the period to 20 years). A company may not carry back current losses to reduce taxes previous paid and thereby receive a tax refund. 4. A corporation may not deduct from pre-tax income the dividends it pays to its shareholder. In contrast, the company may deduct interest expenses paid to its creditors and investors. However, the amount of interest expense it may deduct is limited to 30% of EBITDA for 2019, 2020, and 2021. For subsequent years, the limit is 30% of EBIT. 5. Capital gains and losses are treated like other ordinary income. 6. U.S. firms with accumulated foreign deferred earnings between 1986 and 2017 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. The payments be spread out between 2018 and 2025. U.S. companies with foreign earnings in 2018 and subsequent years are not liable for tax on those earnings.