CHAPTER 2 Financial Statements, Cash Flow, and TaxesThe Annual ReportBalance Sheet: AssetsBalance sheet: Liabilities and EquityIncome statementOther dataStatement of Retained Earnings (2002)Statement of Cash Flows (2002)Slide 9What can you conclude about D’Leon’s financial condition from its statement of CFs?Did the expansion create additional net operating after taxes (NOPAT)?What effect did the expansion have on net operating working capital?What effect did the expansion have on operating capital?What is your assessment of the expansion’s effect on operations?What effect did the expansion have on net cash flow and operating cash flow?What was the free cash flow (FCF) for 2002?Economic Value Added (EVA)EVA ConceptsWhat is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2000 and 13% in 2001.Did the expansion increase or decrease MVA?Does D’Leon pay its suppliers on time?Does it appear that D’Leon’s sales price exceeds its cost per unit sold?What if D’Leon’s sales manager decided to offer 60-day credit terms to customers, rather than 30-day credit terms?How did D’Leon finance its expansion?Would D’Leon have required external capital if they had broken even in 2001 (Net Income = 0)?What happens if D’Leon depreciates fixed assets over 7 years (as opposed to the current 10 years)?Federal Income Tax SystemCorporate and Personal TaxesTax treatment of various uses and sources of fundsMore tax issues2-1CHAPTER 2Financial Statements, Cash Flow, and TaxesBalance sheet Income statementStatement of cash flowsAccounting income vs. cash flowMVA and EVAFederal tax system2-2The 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.2-3Balance Sheet: Assets CashA/RInventoriesTotal CAGross FALess: Dep.Net FATotal Assets 20027,282 632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592 200157,600351,200 715,2001,124,000491,000 146,200 344,8001,468,8002-4Balance sheet: Liabilities and EquityAccts payableNotes payableAccrualsTotal CLLong-term debtCommon stockRetained earningsTotal EquityTotal L & E 2002524,160 636,808 489,6001,650,568723,432460,000 32,592 492,5922,866,592 2001145,600200,000 136,000481,600323,432460,000 203,768 663,7681,468,8002-5Income statementSalesCOGSOther expensesEBITDADepr. & Amort.EBITInterest Exp.EBTTaxesNet income 20026,034,000 5,528,000 519,988(13,988) 116,960(130,948) 136,012(266,960) (106,784) (160,176) 20013,432,0002,864,000 358,672209,328 18,900190,428 43,828146,600 58,640 87,9602-6Other dataNo. of sharesEPSDPSStock priceLease pmts2002100,000-$1.602$0.11$2.25$40,0002001100,000$0.88$0.22$8.50$40,0002-7Statement of Retained Earnings (2002)Balance of retainedearnings, 12/31/01Add: Net income, 2002Less: Dividends paidBalance of retained earnings, 12/31/02$203,768(160,176) (11,000)$32,5922-8Statement of Cash Flows (2002)OPERATING ACTIVITIESNet incomeAdd (Sources of cash):DepreciationIncrease in A/PIncrease in accrualsSubtract (Uses of cash):Increase in A/RIncrease in inventoriesNet cash provided by ops.(160,176)116,960378,560353,600(280,960)(572,160)(164,176)2-9Statement of Cash Flows (2002)L-T INVESTING ACTIVITIESInvestment in fixed assetsFINANCING ACTIVITIESIncrease in notes payableIncrease in long-term debtPayment of cash dividendNet cash from financingNET CHANGE IN CASHPlus: Cash at beginning of yearCash at end of year(711,950)436,808400,000 (11,000)825,808(50,318) 57,6007,2822-10What can you conclude about D’Leon’s financial condition from its statement of CFs?Net cash from operations = -$164,176, mainly because of negative NI.The firm borrowed $825,808 to meet its cash requirements.Even after borrowing, the cash account fell by $50,318.2-11Did the expansion create additional net operating after taxes (NOPAT)?NOPAT = EBIT (1 – Tax rate)NOPAT02= -$130,948(1 – 0.4)= -$130,948(0.6)= -$78,569NOPAT01= $114,2572-12What effect did the expansion have on net operating working capital?NOWC = Current - Non-interest assets bearing CLNOWC02 = ($7,282 + $632,160 + $1,287,360) – ( $524,160 + $489,600)= $913,042NOWC01 = $842,4002-13What effect did the expansion have on operating capital?Operating capital = NOWC + Net Fixed AssetsOperating Capital02 = $913,042 + $939,790 = $1,852,832Operating Capital01 = $1,187,2002-14What is your assessment of the expansion’s effect on operations? SalesNOPATNOWCOperating capitalNet Income 2002 $6,034,000-$78,569$913,042$1,852,832-$160,1762001 $3,432,000$114,257$842,400$1,187,200$87,9602-15What effect did the expansion have on net cash flow and operating cash flow?NCF02 = NI + Dep = ($160,176) + $116,960 = -$43,216NCF01 = $87,960 + $18,900 = $106,860OCF02 = NOPAT + Dep = ($78,569) + $116,960 = $38,391OCF01 = $114,257 + $18,900 = $133,1572-16What was the free cash flow (FCF) for 2002?FCF = OCF – Gross capital investment- OR -FCF02 = NOPAT – Net capital investment= -$78,569 – ($1,852,832 - $1,187,200)= -$744,201Is negative free cash flow always a bad sign?2-17Economic 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 Capital2-18EVA 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.2-19What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2000 and 13% in 2001.EVA02= NOPAT – (A-T cost of capital) (Capital)= -$78,569 – (0.13)($1,852,832)= -$78,569 - $240,868= -$319,437EVA01= $114,257 – (0.10)($1,187,200)= $114,257 - $118,720= -$4,4632-20Did the expansion increase or decrease MVA?MVA = Market value __ Equity capital of equity suppliedDuring the last year, the stock price has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has