Finance Test Chapter 3
b.
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 in March 2015 indicate that aggregate household balance sheets have strengthened somewhat. These improvements reflect that many households have made progress in reducing their debt level. Household levels of net worth have also improved because of the surge in home prices and the large run-up in the stock market during this time period. As of August 2015, the unemployment rate had declined to 5.1%, which is the lowest unemployment rate since April 2008.
Who are some of the basic users of financial statements, and how do they use them?
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.
How does the deductibility of interest and dividends by the paying corporation affect the choice of financing (i.e., the use of debt versus equity)?
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 13.
What does double taxation of corporate income mean? Could income ever be subject to triple taxation? Explain your answer.
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 as long-term capital gains. In 2015, the maximum tax rate on qualified dividends and long-term capital gains is 20% for taxpayers in the 39.6% tax bracket. However, for most taxpayers the top tax rate on qualified dividends and long-term capital gains remains at 15%.However, numbers released in March 2015 indicate that aggregate household balance sheets have strengthened somewhat since 2010. Household net worth from 2010-2014 increased by almost 33%. 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 is free cash flow? If you were an investor, why might you be more interested in free cash flow than net income?
Free cash flow is the amount of cash that could be withdrawn without harming the firm's 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 statements are based on generally accepted accounting principles (GAAP) and are audited by CPA firms. Do investors need to worry about the validity of those statements? Explain your answer.
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.
How are management's actions incorporated in EVA and MVA? How are EVA and MVA interconnected?
MVA is the difference between a firm's market value and the book value of its equity. The higher a firm's MVA, the better the job management is doing for the firm's shareholders. EVA is the difference between a firm's after-tax net operating profit and the annual dollar cost of capital. Companies (through their managers) create value and realize positive EVA if the benefits of their investments exceed the cost of raising the necessary 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.
If a "typical" firm reports $20 million of retained earnings on its balance sheet, could its directors declare a $20 million cash dividend without having any qualms about what they were doing? Explain your answer.
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 the following statement: Although the balance sheet can be thought of as a snapshot of a firm's financial position at a point in time, the income statement reports on operations over a period of time.
The balance sheet shows the firm's financial position on a specific date, for example, December 31, 2016. 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, 2016. 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, 2016, would represent the firm's sales over the period from January 1, 2016, through December 31, 2016, not just sales for December 31, 2016.
What four financial statements are contained in most annual reports?
The four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows.
Explain the following statement: Our tax rates are progressive.
This statement means that the higher one's income, the larger the percentage paid in taxes.
Would it be possible for a company to report negative free cash flow and still be highly valued by investors; that is, could a negative free cash flow ever be viewed optimistically by investors? Explain your answer.
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 contribute to free cash flow.
Refer to the box titled, "The Balance Sheet of an 'Average' American Household" when answering parts a and b. Based on this evidence, did the financial position of the average household improved during 2004-2007? During 2007-2010? During 2010-2014? Explain your answers. What do you think the average household balance sheet looks like today? Explain your answer.
a. The average American household's financial position increased slightly from 2004-2007, but declined sharply from 2007-2010. Over this period of time, mortgage and installment loan balances increased, total assets decreased due to the decline in cash in bank accounts and the values of retirement savings and personal homes, and income declined slightly. At the end of 2010, the average family's net worth stood at the same level that was observed in 1992—so, in effect, the recent decline wiped out about 18 years' worth of savings and retirement.
