Chapter 2 Buiness Finanxce

Business Finance
FN-340
Dr Muhammad Ather Ashraf

University of Management and
Technology
CHAPTER 2
Financial Statements, Cash
Flow, and Taxes
 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income vs. cash flow
 MVA and EVA
 Federal tax system
The Annual Report
 Balance sheet – provides a snapshot of a firm’s

financial position at one point in time.
 Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
 Statement of retained earnings – shows how
much of the firm’s earnings were retained,
rather than paid out as dividends.
 Statement of cash flows – reports the impact of
a firm’s activities on cash flows over a given
period of time.
Balance Sheet: Assets
Accounting Equation
• Amounts shown are book values

• Different than market values
• Net Worth(Common Equity=Common stock+
Retained Earnings)= assets - liabilities
Income statement
Statement of Stockholder’s
Equity/Retained Earnings
Net Cash Flow
Net cash flow = Net income − Noncash

revenues + Noncash charges
Net cash flow = Net income + Depreciation

and amortization
Net cash flow = $113.5 + $100.0 = $213.5 million

Statement of Cash Flows
 Net income before preferred dividends,

Noncash adjustments to net income, Changes
in working capital,
 Investments, Security transactions and dividend
payments
 Statement Separates into
 Operating
 Investing &
 Financing activities
Statement of Cash Flows
What can you conclude about
MicroDrive Inc. financial
condition from its statement of
CFs?
 Net cash from operations = -$2,500,000
mainly because of new Investments.
 The firm borrowed $165,000,000 to meet
its cash requirements.
 Even after borrowing, the cash account
fell by $5,000,000
Modifying Accounting Data for
Managerial Decisions:
Free Cash Flow
Net operating Profit after taxes
(NOPAT)?
NOPAT = EBIT (1 – Tax rate)
NOPAT10 = $283.8(1 – 0.4)

= $283.8(0.6)
= $170.3 million
NOPAT09 = $157.8 million

Net operating working capital
(NOWC)?
Net operating capital?
Net Investment in Operating Capital =1800-1455=$345

What is your assessment of
the expansion’s effect on
operations?
2010 2009
Sales $3,000 $2,850
NOPAT $170.3 $157.8
NOWC $800 $585
Operating capital $1,800 $1,455
Net Income $113.5 $117.8
Net cash flow and operating cash flow?
NCF10 = NI + Dep = $113.5 + $100

= $213.5
NCF09 = $117.8 + $90 = $207.8
OCF10 = NOPAT + Dep
= $170.3 + $100
= $270.3
OCF09 = $157.8 + $90
= $247.8
What was the free cash flow
(FCF) for 2010?
FCF10 = OCF – Gross capital investment
= ($170.3 + $100) – ($345+100) = -$174.7
million
- OR -
FCF10 = NOPAT – Net capital investment
= $170.3 –($1,800 – $1,455)
= -$174.7 million
Both calculations show same results
Is negative free cash flow always a bad sign?
Uses of FCF
 Pay interest to debtholders, keeping in mind that

the net cost to the companyis the after-tax
interest expense.
 Repay debtholders; that is, pay off some of the
debt.
 Pay dividends to shareholders.
 Repurchase stock from shareholders.
 Buy short-term investments or other
nonoperating assets.
FCF cont’d
 Interest Payment
 Total $88 mil
 After Tax 88*(1-40%) = $52.8 million
 Debt Payment
 Net Reduction in Debt
 = ($60 + $580) – ($754 + $110) = -$224 million
 Dividend Payment
 $4 + $ 57.5 = $61.5 million
 Short term Investment
 Net Purchase = $0 - $ 65 = -$65 million
 Total -$174.7 million
Value Addition to the
Company
 Return on Invested Capital
 ROIC = NOPAT/ Operating Capital
 If ROIC >WACC Adding value to the company
Market Value Added (MVA)
Coca-Cola 2009
 The higher its MVA, the better the job management is doing for the firm’s
shareholders.
 MV = $103.2, Balance Sheet = $23.7, MVA= $79.5 billion
 Debt = $24.4, Total Market Value = $103.2 + $24.4 = $127.6 billion
 Total Funds = $23.7 + $24.4 = $ 48.1, MVA = $79.5 billion
Economic Value Added (EVA)
EVA = After-tax __ After-tax

Operating Income Capital costs
= Funds Available __ Cost of

to Investors Capital Used
= NOPAT – After-tax Cost of Capital

MVA and EVA
 EVA shows the value added during a given year.

 MVA reflects performance over the company’s entire life,
perhaps even including times before the current managers
were born; and
 EVA can be applied to individual divisions or other units of a
large corporation.
 MVA must be applied to the entire corporation.
MVA and EVA
EVA Concepts
 In order to generate positive EVA, a firm

has to more than just cover operating
costs. It must also provide a return to
those who have provided the firm with
capital.
 EVA takes into account the total cost of
capital, which includes the cost of equity.
Does MicroDrive Inc pay its
suppliers on time?
 Can be checked from increase or
decrease of A/P and sales.
What if MicroDrive Inc. sales manager
decided to offer 60-day credit terms to
customers, rather than 30-day credit
terms?
 If competitors match terms, and sales remain
constant …
 A/R would 
 Cash would 
 If competitors don’t match, and sales double …
 Short-run: Inventory and fixed assets  to meet
increased sales. A/R , Cash . Company
may have to seek additional financing.
 Long-run: Collections increase and the
company’s cash position would improve.
How company finance its
expansion?
 External capital.
 Long-term debt.
 Stock Offering
 Retained Earnings
What happens if MicroDrive Inc.
depreciates fixed assets over 7 years
(as opposed to the current 10 years)?
 No effect on physical
assets.
 Fixed assets on the
balance sheet would
decline.
 Net income would
decline.
 Tax payments would
decline.
 Cash position would
improve.
Federal Income Tax System
Corporate and Personal Taxes
 Both have a progressive structure (the higher the income,

the higher the marginal tax rate).
 Corporations
 Rates begin at 15% and rise to 35% for corporations
with income over $10 million.
 Also subject to state tax (around 5%).
 Individuals
 Rates begin at 10% and rise to 38.6% for individuals
with income over $307,050.
 May be subject to state tax.
Tax treatment of various uses
and sources of funds
 Interest paid – tax deductible for corporations (paid
out of pre-tax income), but usually not for individuals
(interest on home loans being the exception).
 Interest earned – usually fully taxable (an exception
being interest from a (muni”).
 Dividends paid – paid out of after-tax income.
 Dividends received – taxed as ordinary income for
individuals (“double taxation”). A portion of
dividends received by corporations is tax
excludable, in order to avoid “triple taxation”.
Tax treatment of various uses
and sources of funds
 Marginal Tax rate is rate paid on last dollar of
income.
 Average Tax rate is average of all brackets. (15%,
20%)
Taxes = $7,500 + 0.25($65,000 − $50,000)
= $7,500 + $3,750 = $11,250
Interest
 Interest Income is considered as ordinary income.

 Interest Expense is deducted and saving is equal to
the tax rate.
Dividend
 70% of dividend income received from other

corporation is excluded from taxable income.
 Remaining 30% is taxed at ordinary tax rate.
 Ordinary Tax rate is 35%
 To avoid Improper accumulation of Dividends
$250,000
More tax issues
 Tax Loss Carry-Back and Carry-Forward – since
corporate incomes can fluctuate widely, the tax code
allows firms to carry losses back to offset profits in
previous years or forward to offset profits in the future.
 Carryback 2 yrs, Carryforward 20,--
More tax issues
 Capital gains – defined as the profits from the
sale of assets not normally transacted in the
normal course of business, capital gains for
individuals are generally taxed as ordinary
income if held for less than a year, and at the
capital gains rate if held for more than a year.
Corporations face somewhat different rules.
 Consolidated Corporate Tax Return > 80%
 Overseas Income
 Personal Taxes, Munis, Capital Gain and Loss
Thanks for your Attention
Questions?
Discussion Please!!!

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Business Finance

Dr Muhammad Ather Ashraf

 Balance sheet – provides a snapshot of a firm’s

• Amounts shown are book values

Net cash flow = Net income − Noncash

Net cash flow = Net income + Depreciation

Net cash flow = $113.5 + $100.0 = $213.5 million

 Net income before preferred dividends,

NOPAT10 = $283.8(1 – 0.4)

NOPAT09 = $157.8 million

Net Investment in Operating Capital =1800-1455=$345

NCF10 = NI + Dep = $113.5 + $100

 Pay interest to debtholders, keeping in mind that

EVA = After-tax __ After-tax

= Funds Available __ Cost of

= NOPAT – After-tax Cost of Capital

 EVA shows the value added during a given year.

 In order to generate positive EVA, a firm

 Both have a progressive structure (the higher the income,

 Interest Income is considered as ordinary income.

 70% of dividend income received from other

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