Chapter Three Finance Questions

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.

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 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 (that is, 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 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Free cash flow is the amount of cash that could be withdrawn without harming the firm's ability to operate and to produce future cash flows. Net income reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.

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

While 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, It shows each account balance at that particular point in time. The income statement reports on the firm's operations over a period of time. It reports revenues and expenses that the firm has incurred over a particular time period.

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?

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

What four financial statements are contained in most annual reports?

balance sheet, income statement, statement of stockholders equity, and statement of cash flows

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. Beginning in 2013, the maximum tax rate on qualified dividends and long-term capital gains increased to 20% for single taxpayers with incomes over $400,000 and married taxpayers with incomes over $450,000. However, for most tax payers the top tax rate on qualified dividends and long-term capital gains is 15%. 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.

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.