CHAPTER 2 Financial Statements，Cash Flow，and Taxes

CHAPTER 2 Financial Statements，Cash Flow，and Taxes Financial Statements,2Cash Flow, and TaxesCHAPTERSOURCE:'Bill O’Connell/Black Star4 DOING YOURHOMEWORK WITH FINANCIALSTATEMENTS$uppose you are a small investor who knows aThe trick is to find a product that will boom, yetlittle about finance and accounting. Could youwhose manufacturer’s stock is undervalued. If thisScompete successfully against large institutionalsounds too easy, you are right. Lynch argues that onceinvestors with armies of analysts, high-poweredyou have discovered a good product, there is still muchcomputers, and state-of-the-art trading strategies?homework to be done. This involves combing throughThe answer, according to one Wall Street legend, is athe vast amount of financial information that isresounding yes! Peter Lynch, who had an outstandingregularly provided by companies. It also requires takingtrack record as manager of the $10 billion Fidelitya closer and more critical look at how the companyMagellan fund and then went on to become the best-conducts its business—Lynch refers to this as “kickingselling author of One Up on Wall Streetand Beating thethe tires.”Street,has long argued that small investors can beatTo illustrate his point, Lynch relates his experiencethe market by using common sense and informationwith Dunkin’ Donuts. As a consumer, Lynch wasavailable to all of us as we go about our day-to-dayimpressed with the quality of the product. Thislives.impression led him to take a closer look at theFor example, a college student may be more adept atcompany’s financial statements and operations. He likedscouting out the new and interesting products that willwhat he saw, and Dunkin’ Donuts became one of thebecome tomorrow’s success stories than is anbest investments in his portfolio.investment banker who works 75 hours a week in a NewThe next two chapters discuss what financialYork office. Parents of young children are likely to knowstatements are and how they are analyzed. Once youwhich baby foods will succeed, or which diapers arehave identified a good product as a possible investment,best. Couch potatoes may have the best feel for whichthe principles discussed in these chapters will help youtortilla chips have the brightest future, or whether a“kick the tires.” new remote control is worth its price.35 A manager’s primary goal is to maximize the value of his or her firm’s stock. Valueis based on the stream of cash flows the firm will generate in the future. But howdoes an investor go about estimating future cash flows, and how does a managerdecide which actions are most likely to increase cash flows? The answers to bothquestions lie in a study of the financial statements that publicly traded firms mustprovide to investors. Here “investors” include both institutions (banks, insurancecompanies, pension funds, and the like) and individuals. Thus, this chapter beginswith a discussion of what the basic financial statements are, how they are used,and what kinds of financial information users need.The value of any business asset—whether it is a financial assetsuch as a stockor a bond, or a real (physical) assetsuch as land, buildings, and equipment—depends on the usable, after-tax cash flows the asset is expected to produce.Therefore, the chapter also explains the difference between accounting incomeand cash flow. Finally, since it is after-taxcash flow that is important, the chap-ter provides an overview of the federal income tax system.Much of the material in this chapter reviews concepts covered in basic ac-counting courses. However, the information is important enough to go over again.Accounting is used to “keep score,” and if a firm’s managers do not know thescore, they won’t know if their actions are appropriate. If you took midterm examsbut were not told how you were doing, you would have a difficult time improvingyour grades. The same thing holds in business. If a firm’s managers—whetherthey are in marketing, personnel, production, or finance—do not understand fi-nancial statements, they will not be able to judge the effects of their actions, andthe firm will not be successful. Although only accountants need to know how tomakefinancial statements, everyone involved with business needs to know how tointerpretthem. 36CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES A BRIEF HISTORY OF ACCOUNTING AND FINANCIAL STATEMENTSAre you interested inFinancial statements are pieces of paper with numbers written on them, but itlearning more about theis important to also think about the real assets that underlie the numbers. If youhistory of accounting? Ifunderstand how and why accounting began, and how financial statements areso, take a tour through theused, you can better visualize what is going on, and why accounting informa-“Virtual History oftion is so important.Accounting” organized by theAssociation of Chartered Accountants inThousands of years ago, individuals (or families) were self-contained in thethe United States and located atsense that they gathered their own food, made their own clothes, and built their//.acaus.org/history/own shelters. Then specialization began—some people became good at mak-index.html.ing pots, others at making arrowheads, others at making clothing, and so on.As specialization began, so did trading, initially in the form of barter. At first,each artisan worked alone, and trade was strictly local. Eventually, though, mas-ter craftsmen set up small factories and employed workers, money (in the formof clamshells) began to be used, and trade expanded beyond the local area. Asthese developments occurred, a primitive form of banking began, with wealthymerchants lending profits from past dealings to enterprising factory ownerswho needed capital to expand or to young traders who needed money to buywagons, ships, and merchandise.When the first loans were made, lenders could physically inspect borrowers’assets and judge the likelihood of the loan’s being repaid. Eventually, though,lending became more complex—borrowers were developing larger factories,traders were acquiring fleets of ships and wagons, and loans were being madeto develop distant mines and trading posts. At that point, lenders could nolonger personally inspect the assets that backed their loans, and they neededsome way of summarizing borrowers’ assets. Also, some investments were madeon a share-of-the-profits basis, and this meant that profits (or income) had tobe determined. At the same time, factory owners and large merchants neededreports to see how effectively their own enterprises were being run, and gov-ernments needed information for use in assessing taxes. For all these reasons, aneed arose for financial statements, for accountants to prepare those state-ments, and for auditors to verify the accuracy of the accountants’ work.The economic system has grown enormously since its beginning, and ac-counting has become more complex. However, the original reasons for finan-cial statements still apply: Bankers and other investors need accounting infor-mation to make intelligent decisions, managers need it to operate theirbusinesses efficiently, and taxing authorities need it to assess taxes in a reason-able way.It should be clear that it is not easy to translate physical assets intuitively intonumbers, which is what accountants do when they construct financial state-ments. The numbers shown on balance sheets generally represent the histori-cal costs of assets. However, inventories may be spoiled, or even miss-ing; fixed assets such as machinery and buildings obsolete, may have higher or lowervalues than their historical costs; and accounts receivable may be uncollectable.Also, some liabilities such as obligations to pay retirees’ medical costs may noteven show up on the balance sheet. Similarly, some costs reported on the in-come statement may be understated, as would be true if a plant with a usefullife of 10 years were being depreciated over 40 years. When you examine a setA BRIEF HISTORY OF ACCOUNTING AND FINANCIAL STATEMENTS37 of financial statements, you should keep in mind that a physical reality lies be-hind the numbers, and you should also realize that the translation from physi-cal assets to “correct” numbers is far from precise.As mentioned previously, it is important for accountants to be able to gen-erate financial statements, while others involved in the business need to knowhow to interpret them. Particularly, financial managers must have a workingknowledge of financial statements and what they reveal to be effective. Spread-sheets provide financial managers a powerful and reliable tool to conductfinancial analysis, and with several different types of spreadsheet models are pro-vided with the text. These models demonstrate how financial principles taughtin this book are applied in practice. Readers are encouraged to use these mod-els to gain insights into various concepts and procedures.FINANCIAL further STATEMENTS AND REPORTSOf the various reports corporations issue to their stockholders, the annual re-Annual ReportA report issued annually by aport is probably the most important. Two types of information are given in thiscorporation to its stockholders. Itreport. First, there is a verbal section, often presented as a letter from the chair-contains basic financialman, that describes the firm’s operating results during the past year and dis-statements, as well ascusses new developments that will affect future operations. Second, the annualmanagement’s analysis of the pastreport presents four basic financial statements—the balance sheet,the incomeyear’s operations and opinionsstatement,the statement of retained earnings,and the statement of cash flows.Takenabout the firm’s future prospects.together, these statements give an accounting picture of the firm’s operationsand financial position. Detailed data are provided for the two or three most re-cent years, along with historical summaries of key operating statistics for the1past 5 or 10 years.The quantitative and verbal materials are equally important. The financialFor an excellent exampleof a corporate annualstatements report what has actually happenedto assets, earnings, and dividendsreport, take a look at 3M’sover the past few years, whereas the verbal statements attempt to explain whyannual report found atthings turned out the way they did.//.mmm4>>/For illustrative purposes, we shall use data taken from Allied Food Products,about3M/index.jhtml. Then, click ona processor and distributor of a wide variety of staple foods, to discuss the basicinvestor relations and annual reports onthe left-hand side of your screen. Herefinancial statements. Formed in 1978 when several regional firms merged, Al-you can find several recent annuallied has grown steadily, and it has earned a reputation for being one of the bestreports in Adobe Acrobat format.firms in its industry. Allied’s earnings dropped a bit in 2001, to $113.5 millionversus $117.8 million in 2000. Management reported that the drop resultedfrom losses associated with a drought and from increased costs due to a three-month strike. However, management then went on to paint a more optimisticpicture for the future, stating that full operations had been resumed, that sev-eral unprofitable businesses had been eliminated, and that 2002 profits were ex-pected to rise sharply. Of course, an increase in profitability may not occur, and1Firms also provide quarterly reports, but these are much less comprehensive. In addition, largerfirms file even more detailed statements, giving breakdowns for each major division or subsidiary,with the Securities and Exchange Commission (SEC). These reports, called 10-K reports,are madeavailable to stockholders upon request to a company’s corporate secretary. Finally, many largerfirms also publish statistical supplements,which give financial statement data and key ratios goingback 10 to 20 years, and their reports are available on the World Wide Web.38CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES analysts should compare management’s past statements with subsequent results.In any event, the information contained in an annual report is used by investors tohelp form expectations about future earnings and dividends. Therefore, the annualreport is obviously of great interest to investors.SELF-TEST QUESTIONSWhat is the annual report, and what two types of information are given init?What four types of financial statements are typically included in the annualreport?Why is the annual report of great interest to investors?THE BALANCE SHEETBalance SheetThe left-hand side of Allied’s year-end 2001 and 2000 balance sheets,whichA statement of the firm’s financialare given in Table 2-1, shows the firm’s assets, while the right-hand side showsposition at a specific point in time.the liabilities and equity, or the claims against these assets. The assets are listedin order of their “liquidity,” or the length of time it typically takes to convertthem to cash. The claims are listed in the order in which they must be paid: Ac-counts payable must generally be paid within 30 days, notes payable within 90Allied Food Products: December 31 Balance Sheets TABLE 2-1(Millions of Dollars)ASSETS20012000LIABILITIES AND EQUITY20012000Cash and marketable securities$10$80Accounts payable$60$ 30Accounts receivable375315Notes payable11060Inventories615415Accruals140130Total current assets$1,000$ 810Total current liabilities$ 310$ 220Net plant and equipment1,000870Long-term bonds754580Total debt$1,064$ 800Preferred stock (400,000 shares)4040Common stock (50,000,000 shares)130130Retained earnings766710Total common equity$ 896$ 840Total assets$2,000$1,680Total liabilities and equity$2,000$1,680NOTE:The bonds have a sinking fund requirement of $20 million a year. Sinking funds are discussed in Chapter 8, but in brief, a sinking fundsimply involves the repayment of long-term debt. Thus, Allied was required to pay off $20 million of its mortgage bonds during 2001. The currentportion of the long-term debt is included in notes payable here, although in a more detailed balance sheet it would be shown as a separate itemunder current liabilities.THE BALANCE SHEET39 days, and so on, down to the stockholders’ equity accounts, which representownership and need never be “paid off.”Some additional points about the balance sheet are worth noting:1.Cash versus other assets. Although the assets are all stated in terms ofdollars, only cash represents actual money. (Marketable securities can beconverted to cash within a day or two, so they are almost like cash and arereported with cash on the balance sheet.) Receivables are bills others oweAllied. Inventories show the dollars the company has invested in raw ma-terials, work-in-process, and finished goods available for sale. And netplant and equipment reflect the amount of money Allied paid for its fixedassets when it acquired those assets in the past, less accumulated depreci-ation. Allied can write checks for a total of $10 million (versus current li-abilities of $310 million due within a year). The noncash assets shouldproduce cash over time, but they do not represent cash in hand, and theamount of cash they would bring if they were sold today could be higheror lower than the values at which they are carried on the books.2.Liabilities versus stockholders’ equity.The claims against assets are oftwo types—liabilities (or money the company owes) and the stockhold-2Common Stockholders’ Equityers’ ownership position.The common stockholders’ equity,or net(Net Worth)worth,is a residual. For example, at the end of 2001,The capital supplied by commonstockholders—common stock,CommonAssets Liabilities Preferred stock paid-in capital, retained earnings,stockholder’s equityand, occasionally, certain reserves.$2,000,000,000 $1,064,000,000 $40,000,000 $896,000,000Total equityis common equity pluspreferred stock.Suppose assets decline in value; for example, suppose some of the ac-counts receivable are written off as bad debts. Liabilities and preferredstock remain constant, so the value of the common stockholders’ equitymust decline. Therefore, the risk of asset value fluctuations is borne bythe common stockholders. Note, however, that if asset values rise (per-haps because of inflation), these benefits will accrue exclusively to thecommon stockholders.3.Preferred versus common stock.Preferred stock is a hybrid, or a crossbetween common stock and debt. In the event of bankruptcy, preferredstock ranks below debt but above common stock. Also, the preferred div-idend is fixed, so preferred stockholders do not benefit if the company’searnings grow. Finally, many firms do not use any preferred stock, andthose that do generally do not use much of it. Therefore, when the term“equity” is used in finance, we generally mean “common equity” unlessthe word “total” is included.4.Breakdown of the common equity accounts.The common equity sec-tion is divided into two accounts—“common stock” and “retained earn-2One could divide liabilities into (1) debts owed to someone and (2) other items, such as deferredtaxes, reserves, and so on. Because we do not make this distinction, the terms debtand liabilitiesareused synonymously. It should be noted that firms occasionally set up reserves for certain contin-gencies, such as the potential costs involved in a lawsuit currently in the courts. These reserves rep-resent an accounting transfer from retained earnings to the reserve account. If the company winsthe suit, retained earnings will be credited, and the reserve will be eliminated. If it loses, a loss willbe recorded, cash will be reduced, and the reserve will be eliminated.40CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES Retained Earningsings.” The retained earningsaccount is built up over time as the firmThat portion of the firm’s earnings“saves” a part of its earnings rather than paying all earnings out as divi-that has been saved rather thandends. The common stock account arises from the issuance of stock topaid out as dividends.raise capital, as discussed in Chapter 9.The breakdown of the common equity accounts is important for somepurposes but not for others. For example, a potential stockholder wouldwant to know whether the company actually earned the funds reported inits equity accounts or whether the funds came mainly from selling stock.A potential creditor, on the other hand, would be more interested in thetotal equity the owners have in the firm and would be less concerned withthe source of the equity. In the remainder of this chapter, we generallyaggregate the two common equity accounts and call this sum common eq-uityor net worth.5.Inventory accounting.Allied uses the FIFO (first-in, first-out) methodto determine the inventory value shown on its balance sheet ($615 mil-lion). It could have used the LIFO (last-in, first-out) method. During aperiod of rising prices, by taking out old, low-cost inventory and leavingin new, high-cost items, FIFO will produce a higher balance sheet inven-tory value but a lower cost of goods sold the income statement. (Thisis strictly accounting; companies actually on use older items first.) Since Al-lied uses FIFO, and since inflation has been occurring, (a) its balancesheet inventories are higher than they would have been had it used LIFO,(b) its cost of goods sold is lower than it would have been under LIFO,and (c) its reported profits are therefore higher. In Allied’s case, if thecompany had elected to switch to LIFO in 2001, its balance sheet figurefor inventories would have been $585,000,000 rather than $615,000,000,and its earnings (which will be discussed in the next section) would havebeen reduced by $18,000,000. Thus, the inventory valuation method canhave a significant effect on financial statements. This is important whenan analyst is comparing different companies.6.Depreciation methods.Most companies prepare two sets of financialstatements—one for tax purposes and one for reporting to stockholders.Generally, they use the most accelerated method permitted under the lawto calculate depreciation for tax purposes, but they use straight line,which results in a lower depreciation charge, for stockholder reporting.However, Allied has elected to use rapid depreciation for both stock-holder reporting and tax purposes. Had Allied elected to use straight linedepreciation for stockholder reporting, its 2001 depreciation expensewould have been $25,000,000 less, so the $1 billion shown for “net plant”on its balance sheet would have been $25,000,000 higher. Its net incomeand its retained earnings would also have been higher.7.The time dimension.The balance sheet may be thought of as a snap-shot of the firm’s financial position at a point in time—for example, onDecember 31, 2000. Thus, on December 31, 2000, Allied had $80 mil-lion of cash and marketable securities, but this account had been reducedto $10 million by the end of 2001. The balance sheet changes every dayas inventories are increased or decreased, as fixed assets are added or re-tired, as bank loans are increased or decreased, and so on. Companieswhose businesses are seasonal have especially large changes in their bal-ance sheets. Allied’s inventories are low just before the harvest season, butTHE BALANCE SHEET41 they are high just after the fall crops have been brought in and processed.Similarly, most retailers have large inventories just before Christmas butlow inventories and high accounts receivable just after Christmas. There-fore, firms’ balance sheets change over the year, depending on when thestatement is constructed.SELF-TEST QUESTIONSWhat is the balance sheet, and what information does it provide?How is the order of the information shown on the balance sheet determined?Why might a company’s December 31 balance sheet differ from its June 30balance sheet?THE INCOME STATEMENTIncome StatementA statement summarizing theTable 2-2 gives the 2001 and 2000 income statementsfor Allied Food Prod-firm’s revenues and expenses overucts. Net sales are shown at the top of each statement, after which various costsan accounting period, generally aquarter or a yearare subtracted to obtain the net income available to common shareholders,.which is generally referred to as net income. These costs include operatingDepreciationcosts, interest costs, and taxes. A report on earnings and dividends per share isThe charge to reflect the cost ofgiven at the bottom of the income statement. Earnings per share (EPS) is calledassets used up in the production“the bottom line,” denoting that of all the items on the income statement, EPSprocess. Depreciation is not a cashis the most important. Allied earned $2.27 per share in 2001, down from $2.363outlay.in 2000, but it still raised the dividend from $1.06 to $1.15.Taking a closer look at the income statement, we see that depreciation andTangible Assetsamortization are important components of total operating costs. DepreciationPhysical assets such as plant andand amortization are similar in that both represent allocations of the costs ofequipment.assets over their useful lives; however, there are some important distinctions.Recall from accounting that depreciationis an annual charge against incomeAmortizationthat reflects the estimated dollar cost of the capital equipment used up in theA noncash charge similar toproduction process. Depreciation applies to tangible assets,such as plant anddepreciation except that it is usedequipment, whereas amortizationapplies to intangible assetssuch as patents,to write off the costs of intangiblecopyrights, trademarks, and goodwill. Some companies use amortization toassets.write off research and development costs, or the accounting goodwill that isrecorded when one firm purchases another for more than its book value. SinceIntangible Assetsthey are similar, depreciation and amortization are often lumped together onAssets such as patents, copyrights,the income statement.trademarks, and goodwill.Managers, security analysts, and bank loan officers often calculate EBITDA,EBITDAwhichisdefinedasearningsbeforeinterest,taxes,depreciation,andamorti-Earnings before interest, taxes,depreciation, and amortization.3Effective after December 15, 1997, companies must report “comprehensive income” as well as netincome. Comprehensive income is equal to net income plus several comprehensive income items.One example of comprehensive income is the unrealized gain or loss that occurs when a marketablesecurity, classified as available for sale, is marked-to-market. For our purposes, in this introductoryfinance text, we will assume that there are no comprehensive income items, so we will present onlybasic income statements throughout the text.42CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES Allied Food Products: Income Statements for Years Ending TABLE 2-2December 31 (Millions of Dollars, Except for Per-Share Data)20012000Net sales$3,000.0$2,850.0Operating costs excluding depreciation and amortization2,616.22,497.0Earnings before interest, taxes, depreciation, and amortization (EBITDA)$383.8$353.0Depreciation100.090.0Amortization0.00.0Depreciati on and amortization$100.0$90.0Earnings before interest and taxes (EBIT, or operating income)$283.8$ 263.0Less interest88.060.0Earnings before taxes (EBT)$195.8$ 203.0Taxes (40%)78.381.2bNet income before preferred dividends$ 117.5$ 121.8Preferred dividends4.04.0Net income$ 113.5$ 117.8Common dividends$57.5$53.0Addition to retained earnings$56.0$64.8Per-share data:Common stock price$23.00$26.00aEarnings per share (EPS)$2.27$2.36aDividends per share (DPS)$1.15$1.06aBook value per share (BVPS)$17.92$16.80aCash flow per share (CFPS)$4.27$4.16a There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings after preferred dividends—that is, on net incomeavailable to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS for 2001 are as follows:Net income$113,500,000Earnings per share EPS $2.27.Common shares outstanding50,000,000Dividends paid to common stockholders$57,500,000Dividends per share DPS $1.15.Common shares outstanding50,000,000Total common equity$896,000,000Book value per share BVPS $17.92.Common shares outstanding50,000,000Net income Depreciation Amortization$213,500,000Cash flow per share CFPS $4.27.Common shares outstanding50,000,000b On a typical firm’s income statement, this line would be labeled “net income” rather than “net income before preferred dividends.” However, whenwe use the term net income in this text, we mean net income available to common shareholders. To simplify the terminology, we refer to netincome available to common shareholders as simply net income. Students should understand that when they review annual reports, firms use theterm net income to mean income after taxes but before preferred and common dividends.zation.Alliedcurrentlyhasnoamortizationcharges,sothedepreciationandamortizationonitsincomestatementcomessolelyfromdepreciation.In2001,Allied’s EBITDA was $383.8 million. Subtracting the $100 million of de-preciation expense from its EBITDA leaves the company with $283.8 millionin operating income (EBIT). After subtracting $88 million in interest expenseTHE INCOME STATEMENT43 and $78.3 million in taxes, we obtain net income before preferred dividends of$117.5 million. Finally, we subtract out $4 million in preferred dividends,which leaves Allied with $113.5 million in net income available to commonstockholders. When analysts refer to a company’s net income, they generallymean net income available to common shareholders. Likewise, throughout thisbook unless otherwise indicated, net income means net income available tocommon stockholders.Whilethebalancesheetcanbethoughtofasasnapshotintime,thein-comestatementreportsonoperationsoveraperiodoftime,forexample,dur-ingthecalendaryear2001.During2001Alliedhadsalesof$3billion,anditsnetincomeavailabletocommonstockholderswas$113.5million.Incomestatementscancoveranyperiodoftime,buttheyareusuallypreparedmonthly,quarterly,orannually.Ofcourse,sales,costs,andprofitswillbelargerthelongerthereportingperiod,andthesumofthelast12monthly(or4quarterly)incomestatementsshouldequalthevaluesshownontheannualincomestatement.For planning and control purposes, management generally forecastsmonthly (or perhaps quarterly) income statements, and it then compares actualresults to the budgeted statements. If revenues are below and costs above theforecasted levels, then management should take corrective steps before theproblem becomes too serious.SELF-TEST QUESTIONSWhat is an income statement, and what information does it provide?Why is earnings per share called “the bottom line”?Differentiate between amortization and depreciation.What is EBITDA?Regarding the time period reported, how does the income statement differfrom the balance sheet?STATEMENT OF RETAINED EARNINGSChanges in retained earnings between balance sheet dates are reported in theStatement of Retainedstatement of retained earnings.Table 2-3 shows that Allied earned $113.5Earningsmillion during 2001, paid out $57.5 million in common dividends, and plowedA statement reporting how much$56 million back into the business. Thus, the balance sheet item “Retainedof the firm’s earnings wereearnings” increased from $710 million at the end of 2000 to $766 million at theretained in the business ratherend of 2001.than paid out in dividends. TheNotethat“Retainedearnings”representsaclaimagainstassets,notasset sfigure for retained earnings thatperse.Moreover,firmsretainearningsprimarilytoexpandthebusiness,andappears here is the sum of thethismeansinvestinginplantandequipment,ininventories,andsoon,notpil-annual retained earnings for eachyear of the firm’s history.ingupcashinabankaccount.Changesinretainedearningsoccurbecause44CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES FINANCIAL ANALYSIS ON THE INTERNETwiderangeofvaluablefinancialinformationisavailableon Other sources for up-to-date market information areAtheInternet.Withjustacoupleofclicks,aninvestorcancnnfn.comand cbs.marketwatch>.Each also has aneasilyfindthekeyfinancialstatementsformostpubliclytradedarea where you can obtain stock quotes along with com-companies.pany financials, links to Wall Street research, and links toSay, for example, you are thinking about buying DisneySEC filings.stock, and you are looking for financial information regarding Another good source is .quicken>.Enter thethe company’s recent performance. Here’s a partial (but by noticker symbol in the area labeled quotes and research. Themeans a complete) list of places you can go to get started:site will take you to an area where you can find a link tothe company’s financial statements, along with analysts’earnings estimates and SEC filings. This site also has a One source is Yahoo’s finance web site, finance.yahoo.asection where you can estimate the stock’s intrinsiccom.Here you will find updated market informationvalue. (In Chapter 9 we will discuss various methods foralong with links to a variety of interesting research sites.calculating intrinsic value.)Enter a stock’s ticker symbol, click on Get Quotes, and If you are looking for charts of key accounting variablesyou will see the stock’s current price, along with recent(for example, sales, inventory, depreciation and amortiza-news about the company. Click on Profile (under Moretion, and reported earnings), along with the financialInfo) and you will find a report on the company’s key fi-statements, take a look at .smartmoney>.nancial ratios. Links to the company’s income statement, Another good place to look is .marketguide>.balance sheet, and statement of cash flows can also beHere you find links to analysts’ research reports alongfound. The Yahoo site also has a list of insider transac-with the key financial statements.tions, so you can tell if a company’s CEO and other key Two other places to consider: .hoovers.comandinsiders are buying or selling their company’s stock. Inmy.zacks>.Eachhasfreeresearchavailablealongwithaddition, there is a message board where investors sharemoredetailedinformationprovidedtosubscribers.opinions about the company, and there is a link to thecompany’s filings with the Securities and Exchange Com-Once you have accumulated all of this information, you maymission (SEC). Note that, in most cases, a more completebe looking for sites that provide opinions regarding the direc-list of the SEC filings can be found at .sec.govor attion of the overall market and views regarding individual stocks..edgar-online>.Two popular sites in this category are The Motley Fool’s website, .fool>, and the web site for The Street>,.thestreet>.Keep in mind that this list is just a small subset of the in-aTo avoid redundancy, we have intentionally left off //in all web addressesformation available online. You should also realize that a lot ofgiven here. A quick way to change an address is to highlight the portion of thethese sites change their content over time, and new and inter-address that is different and type in the appropriate letters of the new address.Once you’re finished just press Enter.esting sites are always being added to the Internet.Allied Food Products: Statement of Retained Earnings for Year EndingTABLE 2-3December 31, 2001 (Millions of Dollars)Balance of retained earnings, December 31, 2000$710.0Add: Net income, 2001113.5aLess: Dividends to common stockholders(57.5)Balance of retained earnings, December 31, 2001$766.0aHere, and throughout the book, parentheses are used to denote negative numbers.STATEMENT OF RETAINED EARNINGS45 ANALYSTS ARE INCREASINGLY RELYING ON CASH FLOW TO VALUE STOCKSokyo-basedSoftbankrecentlyacquiredseveralInternet-penses, primarily the amortization of approximately $120Trelated businesses, including Ziff-Davis Inc., which publishesmillion in goodwill per year. Even with continuing invest-more than 80 magazines including PC Weekand PC Magazine.ments in our key businesses, Ziff-Davis has the financialZiff-Davis also provides training courses in computer technol-flexibility to continue to repay indebtedness with free cashogy, and it distributes information through the Internet andflow.computer trade shows.In an article on Softbank, Barron’sindicated that Ziff-DavisTimothy C. O’Brien,has been “losing money,” and a quick look at the company’s re-Chief Financial Officer, Ziff-Daviscent income statements confirms that it had losses in 1998 andCash-flow measures such as EBITDA have long been popularthe first quarter of 1999. Despite the company’s negative re-with bankers and other short-term lenders, who focus more onported earnings, the company’s chief financial officer, Timothyborrowers’ ability to generate cash to pay off loans than on ac-O’Brien, took exception with the notion that Ziff-Davis wascounting earnings. In the past, these measures were less popu-“losing money.” So, he sent Barron’sthe following response:lar with stock analysts, who focused on reported earnings andTo the Editor:price earnings ratios. However, today more and more Wall Streetanalysts are siding with Tim O’Brien, arguing that cash flowIn his discussion of Softbank, Neil Martin (Internationalmeasures such as EBITDA often provide a better indication ofTrader,June 14) referred to Ziff-Davis as “losing money.” Intrue value than do earnings per share.fact, Ziff-Davis continues to generate significant positiveThese analysts note that the DA part of EBITDA reduces re-cash flow.ported profits but not cash, so EBITDA reflects the cash -We are a diversified media company. Analysts measureable to a firm avail better than accounting profits. It is logical thatour strength and stability relative to our ability to generatecredit analysts interested in a company’s ability to repay itsEBITDA (earnings before interest, taxes, depreciation, andloans focus heavily on EBITDA, but what about equity analysts,amortization).Analystsprojectthatwewillgeneratewho are seeking to find a firm’s value to its stockholders? First,EBITDAof approximately $220 million in 1999, and thatmost analysts agree that a firm’s value depends on its ability totakes into account our substantial investment in ZDTV, thegenerate cash flows over the long run. If depreciation andcompany’s 24-hour cable network devoted to computing andamortization (DA) charges truly reflect a decline in the assetsthe Internet.used to produce cash flows, then the DA will have to be rein-Ziff-Davis did report a net loss for 1998 and for the firstvested in the business if cash flows are to continue. The DAquarter of 1999. However, this loss was due to noncash ex-may reflect “available cash” in the short run, but it is not trulycommonstockholdersallowthefirmtoreinvestfundsthatotherwisecouldbedistributedasdividends.Thus,retainedearningsasreportedonthebalancesheetdonotrepresentcashandarenot“available”forthepaymentofdividendsorany-4thingelse.4The amount reported in the retained earnings account is notan indication of the amount of cashthe firm has. Cash (as of the balance sheet date) is found in the cash account, an asset account. Apositive number in the retained earnings account indicates only that in the past the firm has earnedsome income, but its dividends have been less than its earnings. Even though a company reportsrecord earnings and shows an increase in the retained earnings account, it still may be short of cash.The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes,and an expensive stereo, hence have a high net worth, but if you had only 23 cents in your pocketplus $5 in your checking account, you would still be short of cash.46CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES available to investors because it will have to be reinvested ifated. The mouse will help Microsoft for three years, after whichthe business is to continue to operate.it will be obsolete. Here it would be appropriate for MicrosoftSo, analysts must consider the nature of the D and Ato amortize the goodwill at the rate of $1 million per year; thischarges. If depreciation is related to essential assets, as it usu-$1 million would need to be reinvested to maintain Microsoft’sally is, then it is a cost that should be deducted to get an ideacash flow, and this $1 million of its EBITDA would not representof the firm’s long-run cash generating potential. Amortization islong-run earning potential.analyzed similarly, but here there is more ambiguity, becauseNow consider the case of Softbank’s acquisition of Ziff-amortization is related to two primary types of write-offs: (1)Davis. Softbank paid far more for Ziff-Davis than -Davis’ ac-Ziffamortization of research and development costs associated withcounting value as reflected on its balance sheet, and that dif-products such as airplanes, computers, software, and pharma-ference was recorded as goodwill. Softbank paid the high priceceutical drugs, and (2) amortization of merger-related goodwill,because Ziff-Davis was earning an abnormally high rate of re-which reflects the difference between the price a company paysturn on its book assets, and it was expected to earn high re-when it acquires another company and the book turns on into the future because it had created a niche in value of the theacquired company. Both types of amortization can be huge, sopublishing industry that would be hard for a new competitor tothere can be huge differences between EBIT and EBITDA.overcome. Here, because the above-normal earning power isThe key question then becomes, “Will the company be re-likely to be sustained over time, EBITDA is more reflective ofquired to reinvest the cash flow reflected in the DA part oflong-run cash flow potential than is accounting profit.EBITDA if it is to continue to generate cash flow on into the fu-Amortization will be high in an industry if patents are im-ture?” If the answer is yes, then the DA component is not “freeportant, as is the case in the pharmaceutical industry, or ifcash flow” that is available to investors, and it should be de-mergers are producing a lot of goodwill, as has been the caseducted when determining the firm’s long-run earning power. Ifwith high-tech and financial services firms. This was spelled outthe answer is no, then DA does represent free cash flow and isin a recent “Heard on the Street” column in The Wall Streetavailable to investors.Journal,which noted that cash flow valuations are now inThe situation where all this is most important is when merg-vogue in the cable, high-tech, Internet, pharmaceutical, and fi-ers occur and large amounts of goodwill are created. Considernancial services sectors.two examples. First, suppose Microsoft acquires a small softwarecompany whose owner developed and patented a new type ofSOURCES: Barron’s,July 19, 1999, 54; and “Analysts Increasingly Favor Using Cashmouse. Microsoft paid $3.1 million for the company, whoseFlow Over Reported Earnings in Stock Valuations,” Heard on The Street, The Wallbook value was $100,000, so $3 million of goodwill was cre-Street Journal,April 1, 1999, C2.SELF-TEST QUESTIONSWhat is the statement of retained earnings, and what information does itprovide?Why do changes in retained earnings occur?Explain why the following statement is true: “Retained earnings as reportedon the balance sheet do not represent cash and are not ‘available’ for thepayment of dividends or anything else.”STATEMENT OF RETAINED EARNINGS47 NET CASH FLOWWhen you studied income statements in accounting, the emphasis was proba-Net Cash Flowbly on the firm’s net income. In finance, however, we focus on net cash flow.The actual net cash, as opposed toThe value of an asset (or a whole firm) is determined by the cash flow it gen-accounting net income, that a firmerates. The firm’s net income is important, but cash flow is even more impor-generates during some specifiedtant because dividends must be paid in cash and because cash is necessary toperiod.purchase the assets required to continue operations.As we discussed in Chapter 1, the firm’s goal should be to maximize its stockprice. Since the value of any asset, including a share of stock, depends on thecash flow produced by the asset, managers should strive to maximize the cashflow available to investors over the long run. A business’s net cash flowgenerallyAccounting Profitdiffers from its accounting profitbecause some of the revenues and expensesA firm’s net income as reported onlisted on the income statement were not paid in cash during the year. The re-its income statement.lationship between net cash flow and net income can be expressed as follows:Net cash flow Net income Noncash revenues Noncash charges.(2-1)The primary examples of noncash charges are depreciation and amortization.These items reduce net income but are not paid out in cash, so we add themback to net income when calculating net cash flow. Another example of a non-cash charge is deferred taxes. In some instances, companies are allowed to defertax payments to a later date even though the tax payment is reported as an ex-pense on the income statement. Therefore, deferred tax payments would be5added to net income when calculating net cash flow.At the same time, somerevenues may not be collected in cash during the year, and these items must besubtracted from net income when calculating net cash flow.Typically, depreciation and amortization are by far the largest noncash items,and in many cases the other noncash items roughly net out to zero. For thisreason, many analysts assume that net cash flow equals net income plus depre-ciation and amortization:Net cash flow Net income Depreciation and amortization.(2-2)To keep things simple, we will generally assume Equation 2-2 holds. However,you should remember that Equation 2-2 will not accurately reflect net cashflow in those instances where there are significant noncash items beyond de-preciation and amortization.WecanillustrateEquation2-2with2001dataforAlliedtakenfromTable2-2:Net cash flow $113.5 $100.0 $213.5 million.To illustrate depreciation itself, suppose a machine with a life of five yearsand a zero expected salvage value was purchased in 2000 for $100,000 andplaced into service in 2001. This $100,000 cost is not expensed in the purchaseyear; rather, it is charged against production over the machine’s five-year de-preciable life. If the depreciation expense were not taken, profits beoverstated, and taxes would be too high. So, the annual would depreciation charge isdeducted from sales revenues, along with such other costs as labor and raw ma-5Deferred taxes may arise, for example, if a company uses accelerated depreciation for tax purposesbut straight-line depreciation for reporting its financial statements to investors.48CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES IN VALUING STOCKS, IS IT EARNINGS OR CASH FLOW THAT MATTERS?hen it comes to valuing a company’s stock, what’s morecome the dominant providers of Internet service, which if trueWimportant: cash flow or earnings? Analysts often disagree,will lead to much higher growth in the future. Second, in recentand the measure used often depends on the industry. For ex-years cable companies have become acquisition targets. For ex-ample, analysts have traditionally emphasized cash flow ratherample, AT&T recently acquired cable giant Tele-Communicationsthan earnings when valuing cable stocks. This distinction hasInc. and Media One. This takeover activity has helped bid upbeen important because, traditionally, cable companies havethe prices of all cable stocks.had to make large capital expenditures. These expendituresTo be sure, many analysts take a more sanguine 6><#00aa00'>view of thegenerate large depreciation expenses, which depress reportedcable industry’s future prospects. Cable companies continue toearnings. However, since depreciation is a noncash expense,face increased competition from digital satellite companies,cable companies often continue to show strong cash flows,and other technologies are emerging to compete with cable foreven when earnings are declining or even negative.providing high-speed Internet access. Finally, despite theirFor example, in recent years leading cable companies suchgrowth potential, it is clear that to compete in the years aheadas Tele-Communications Inc., Cox Communications, and Comcastthe cable companies will have to continue making large capitalCorporation have all reported low or negative earnings. Never-expenditures. As a result, much of the cash flow will not betheless, over the past five years cable stocks have outperformedavailable to pay dividends to shareholders—rather, it will bethe overall market, generating an average annual return in ex-required for investments that are necessary to maintain existingcess of 30 percent. One reason for this strong performance isrevenues. So, while cash flow will probably continue to be anthat each of these companies has generated a strong cash flow.important determinant of cable stock values, more and moreBesides their growth in cash flow, there are at least twoanalysts are insisting that these companies must also begin toother reasons cable stocks have performed so well despite weakgenerate positive earnings.earnings. First, many believe that the cable companies will be-terials,todetermineincome.However,becausethe$100,000wasactuallyex-pendedbackin2000,thedepreciationchargedagainstincomein2001andsubsequent years is not a cash outlay, as are labor or raw materials charges. De-preciation is a noncash charge, so it must be added back to net income to obtain the netcash flow.If we assume that all other noncash items (including amortization)sum to zero, then net cash flow is simply equal to net income plus depreciation.SELF-TEST QUESTIONSDifferentiate between net cash flow and accounting profit.In accounting, the emphasis is on net income. What is emphasized in fi-nance, and why is that item emphasized?Assuming that depreciation is its only noncash cost, how can someone cal-culate a business’s cash flow?STATEMENT OF CASH FLOWSNet cash flow represents the amount of cash a business generates for its share-holders in a given year. However, the fact that a company generates high cashSTATEMENT OF CASH FLOWS49 flow does not necessarily mean that the amount of cashreported on its balancesheet will also be high. The cash flow may be used in a variety of ways. For ex-ample, the firm may use its cash flow to pay dividends, to increase inventories,to finance accounts receivable, to invest in fixed assets, to reduce debt, or to buyback common stock. Indeed, the company’s cash position as reported on thebalance sheet is affected by a great many factors, including the following:1.Cash flow.Other things held constant, a positive net cash flow will leadto more cash in the bank. However, as we discuss below, other things aregenerally not held constant.2.Changes in working capital.Net working capital, which is discussed indetail in Chapter 15, is defined as current assets minus current liabilities.Increases in current assets other than cash, such as inventories and ac-counts receivable, decrease cash, whereas decreases in these accounts in-crease cash. For example, if inventories are to increase, the firm must usesome of its cash to buy the additional inventory, whereas if inventoriesdecrease, this generally means the firm is selling off inventories and notreplacing them, hence generating cash. On the other hand, increases incurrent liabilities such as accounts payable increase cash, whereas de-creases in these accounts decrease it. For example, if payables increase,the firm has received additional credit from its suppliers, which savescash, but if payables decrease, this means the firm has used cash to pay offits suppliers.3.Fixed assets.If a company invests in fixed assets, this will reduce its cashposition. On the other hand, the sale of fixed assets will increase cash.4.Security transactions.If a company issues stock or bonds during theyear, the funds raised will enhance its cash position. On the other hand,if it uses cash to buy back outstanding debt or equity, or pays dividends toits shareholders, this will reduce cash.Statement of Cash FlowsEach of the above factors is reflected in the statement of cash flows,whichA statement reporting the impactsummarizes the changes in a company’s cash position. The statement separatesof a firm’s operating, investing,activities into three categories:and financing activities on cashflows over an accounting period.1.Operating activities,which includes net income, depreciation, and changesin current assets and current liabilities other than cash and short-termdebt.2.Investing activities,which includes investments in or sales of fixed assets.3.Financing activities,which includes cash raised during the year by issuingshort-term debt, long-term debt, or stock. Also, dividends paid orcash used to buy back outstanding stock or bonds since reduces the company’scash, such transactions are included here.Accountingtextsexplainhowtopreparethestatementofcashflows,butthestatementisusedtohelpanswerquestionssuchasthese:Isthefirmgen-eratingenoughcashtopurchasetheadditionalassetsrequiredforgrowth?Isthefirmgeneratinganyextracashthatcanbeusedtorepaydebtortoinvestinnewproducts?Will inadequate cash flows force the company to issue morestock? Suchinformationisusefulbothformanagersandinvestors,sothestatementofcashflowsisanimportantpartoftheannualreport.Financial50CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES managersgenerallyusethisstatement,alongwiththecashbudget,whenfore-casting their companies’ cash positions. This issue is considered in more detailin Chapter 15.Table 2-4 is Allied’s statement of cash flows as it would appear in the com-pany’s annual report. The top part of the table shows cash flows generated byand used in operations—for Allied, operations provided net cash flows ofminus$2.5 million. The operating cash flows are generated in the normalcourse of business, and this amount is determined by adjusting the net incomefigure to account for depreciation and amortization plus other cash flows re-lated to operations. Allied’s day-to-day operations in 2001 provided $257.5 lion; however, the increase in receivables and inventories more than mil- offset thisamount, resulting in a negative$2.5 million cash flow from operations.The second section shows long-term fixed-assets investing activities. Alliedpurchased fixed assets totaling $230 million; this was the only long-term in-vestment it made during 2001.Allied Food Products: Statement of Cash Flows for 2001 TABLE 2-4(Millions of Dollars)OPERATINGACTIVITIESNet income before preferred dividends$117.5Additions (Sources of Cash)aDepreciation and amortization100.0Increase in accounts payable30.0Increase in accruals10.0Subtractions (Uses of Cash)Increase in accounts receivable(60.0)Increase in inventories(200.0)Net cash provided by operating activities($2.5)LONG-TERMINVESTINGACTIVITIESbCash used to acquire fixed assets($230.0)FINANCINGACTIVITIESIncrease in notes payable$50.0Increase in bonds174.0Payment of common and preferred dividends(61.5)Net cash provided by financing activities$162.5Net decrease in cash and marketable securities($70.0)Cash and securities at beginning of year80.0Cash and securities at end of year$10.0aDepreciation and amortization are noncash expenses that were deducted when calculating net income.They must be added back to show the actual cash flow from operations.bThe net increase in fixed assets is $130 million; however, this net amount is after deducting the year’sdepreciation expense. Depreciation expense must be added back to find the actual expenditures onfixed assets. From the company’s income statement, we see that the 2001 depreciation expense is $100million; thus, expenditures on fixed assets were actually $230 million.STATEMENT OF CASH FLOWS51 Allied’s financing activities, shown in the third section, include borrowingfrom banks (notes payable), selling new bonds, and paying dividends on itscommon and preferred stock. Allied raised $224 million by borrowing, but itpaid $61.5 million in preferred and common dividends, so its net inflow offunds from financing activities was $162.5 million.When all of the sources and uses of cash are totaled, we see that Allied’s cashoutflows exceeded its cash inflows by $70 million during 2001. It met thatshortfall by drawing down its cash and marketable securities holdings by $70million, as confirmed by Table 2-1, the firm’s balance sheet.Allied’s statement of cash flows should be worrisome to its managers and tooutside analysts. The company had a $2.5 million cash shortfall from opera-tions, it spent $230 million on new fixed assets, and it paid out another $61.5million in dividends. It covered these cash outlays by borrowing heavily and byselling off most of its marketable securities. Obviously, this situation cannotcontinue year after year, so something will have to be done. In Chapter 3, wewill consider some of the actions Allied’s financial staff might recommend toease the cash flow problem.SELF-TEST QUESTIONSWhatisthestatementofcashflows,andwhattypesofquestionsdoesita nswer?Identify and briefly explain the three different categories of activities shownin the statement of cash flows.MODIFYING ACCOUNTING DATA FOR MANAGERIAL DECISIONSThus far in the chapter we have focused on financial statements as they are pre-pared by accountants and presented in the annual report. However, these state-ments are designed more for by creditors and tax collectors than for man-agers and equity (stock) use analysts. Therefore, certain modifications are used forcorporate decision making and stock valuation purposes. In the following sec-tions we discuss how financial analysts combine stock prices and accountingdata to evaluate and reward managerial performance.OPERATINGASSETSANDOPERATINGCAPITALDifferent firms have different financial structures, different tax situations, anddifferent amounts of nonoperating assets. These differences affect traditionalaccounting measures such as the rate of return on equity. They can cause twofirms, or two divisions within a single firm, that actually have similar operationsto appear to be operated with different efficiency. This is important, because ifmanagerial compensation systems are to function properly, operating managersmust be judged and compensated for those things that are under their control, FINANCIAL STATEMENTS, CASH FLOW, AND TAXES52CHAPTER 2 not on the basis of things outside their control. Therefore, to judge managerialperformance, we need to compare managers’ ability to generate operating income(or EBIT) with the operating assetsunder their control.Thefirststepinmodifyingthetraditionalaccountingframeworkistod ivideOperating Assetstotalassetsintotwocategories,operatingassets,whichconsistofthecash andThe cash and marketablemarketable securities,accountsreceivable,inventories,andfixedassetsnecessarysecurities, accounts receivable,tooperatethebusiness,andnonoperatingassets,whichwouldincludecashinventories, and fixed assetsand marketablesecurities above the level required for normal operations,in-necessary to operate the business.vestmentsinsubsidiaries,landheldforfutureuse,andthelike.Moreover,oper-atingassetsarefurtherdividedintoworkingcapitalandfixed assets such as plantNonoperating Assetsandequipment.Obviously,ifamanagercangenerateagivenamountofprofitsCash and marketable securitiesandcashflowswitharelativelysmallinvestmentinoperatingassets,thatreducesabove the level required fortheamountofcapitalinvestorsmustputupandthusincreasestherateofreturnnormal operations, investments inonthatcapital.subsidiaries, land held for futureThe primary source of capital for business is investors—stockholders, bond-use, and other nonessential assets.holders, and lenders such as banks. Investors must be paid for the use of theirmoney, with payment coming as interest in the case of debt and as dividendsplus capital gains in the case of stock. So, if a company acquires more assetsthan it actually needs, and thus raises too much capital, then its capital costswill be unnecessarily high.Must all of the capital used to acquire assets be obtained from investors?The answer is no, because some of the funds will come from suppliers and bereported as accounts payable, while other funds will come as accrued wages and ac-crued taxes, which amount to short-term loans from workers and tax authorities.Generally, both accounts payable and accruals are “free” in the sense that noexplicit fee is charged for their use. Therefore, if a firm needs $100 million ofcurrent assets, but it has $10 million of accounts payable and another $10 mil-lion of accrued wages and taxes, then its investor-supplied capital would be only$80 million.Operating Working CapitalThose current assets used in operations are called operating working cap-Current assets used in operations.ital, and operating working capital less accounts payable and accruals is callednetoperating working capital. Therefore, net operating working capital is6Net Operating Working Capitalthe working capital acquired with investor-supplied funds.Here is a workableOperating working capital lessdefinition in equation form:accounts payable and accruals. It isAll currentthe working capital acquired withNet operating working capital All current assets liabilities that do.(2-3)investor-supplied funds.not charge interest6Note that the term “capital” can be given two meanings. First, when accountants use the term“capital,” they typically mean the sum of long-term debt, preferred stock, and common equity, orperhaps those items plus interest-bearing short-term debt. However, when economists use theterm, they generally mean assets used in production, as in “labor plus capital.” If all funds wereraised from long-term sources, and if all assets were operating assets, then money capital wouldequal operating assets, and the accountants’ capital would always equal the economists’ capital.When you encounter the term “capital” in the business and financial literature, it can mean eitherasset capital or money capital. For example, in Coca-Cola’s operating manuals, which explain to itsemployees how Coke wants the company to be operated, capital means “assets financed by investor-supplied capital.” However, in most accounting and finance textbooks, and in the traditional financeliterature, “capital” means investor-supplied capital, not assets. It might be easier if we picked onemeaning and then used it consistently in this book. However, that would be misleading, becauseboth meanings are encountered in practice. Therefore, we shall use the term “capital” in both ways.However, you should be able to figure out which definition is implied from the context in whichthe term is used.MODIFYING ACCOUNTING DATA FOR MANAGERIAL DECISIONS53 Nowthinkabouthowtheseconceptscanbeusedinpractice.First,allcompaniesmustcarrysomecashto“greasethewheels”oftheiroperations.Companies continuously cash checks from customers and write checks to sup-pliers, employees, and so on. Because inflows and outflows do not coincide per-fectly, a company must keep some cash and marketable securities in its bank ac-count. In other words, some cash and marketable securities is required toconduct operations. The same is true for most other current assets, such as in-ventory and accounts receivable, which are required for normal operations. Ourmeasure of operating working capital assumes that cash and marketable securi-ties on the balance sheet represent the amount that is required under normaloperations. However, in some instances companies have large holdings of cashand marketable securities that they are holding as a reserve for some contin-gency, or as a “parking place” for funds prior to an acquisition, a major captialinvestment program, or the like. In such instances, the excess cash and mar-ketable securities should not be viewed as part of operating working capital.Looking at the other side of the balance sheet, some current liabilities—es-pecially accounts payable and accruals—arise in the normal course of opera-tions. Moreover, each dollar of these current liabilities is a dollar that the com-pany does not have to raise from investors to acquire current assets. Therefore,when finding the net operating working capital, we deduct these current liabil-ities from the operating current assets. Other current liabilities that charge in-terest, such as notes payable to banks, are treated as investor-supplied thus are not deducted when calculating net operating working capitaland capital.We can apply these definitions to Allied, using the balance sheet data givenback in Table 2-1. Here is the net operating working capital for 2001:Net operatingCash andAccountsAccountsworking ?marketable Inventories?? ? Accruals??receivablepayablecapitalsecurities ($10 $375 $615) ($60 $140) $800 million.Allied’s total operating capital for 2001 was Total operating capital Net operating working capital Net fixed assets(2-4) $800 $1,000 $1,800 million.Now note that Allied’s net operating working capital a year earlier, at year-end 2000, was Net operating working capital ($80 $315 $415) ($30 $130) $650 million,and, since it had $870 million of fixed assets, its total operating capital was Total operating capital $650 $870 $1,520 million.Therefore, Allied increased its operating capital from $1,520 to $1,800 million,or by $280 million, during 2001. Furthermore, most of this increase went intoworking capital, which rose by $150 million. This 23 percent increase in netoperating working capital, when sales only rose 5 percent (from $2,850 to54CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES $3,000 million), should set off warning bells in your head: What caused Alliedto tie up so much additional cash in working capital? Are inventories not mov-ing? Are receivables not being collected and thus building up? We will addressthese questions in detail later in the chapter.NETOPERATINGPROFITAFTERTAXES(NOPAT)If two companies have different amounts of debt, hence different interestcharges, they could have identical operating performances but different net in-comes—the one with more debt would have a lower net income. Net incomeis certainly important, but as the example below shows, net income does not al-ways reflect the true performance of a company’s operations or the effectivenessof its operating managers and employees. A better measurement for comparingmanagers’ performance is net operating profit after taxes, or NOPAT, whichNet Operating Profit Afteris the amount of profit a company would generate if it had no debt and held noTaxes (NOPAT)7nonoperating assets. NOPAT is defined as follows:The profit a company wouldgenerate if it had no debt and heldNOPAT EBIT(1 Tax rate).(2-5)no nonoperating assets.Using data from the income statement in Table 2-2, Allied’s 2001 NOPAT wasNOPAT $283.8(1 0.4) $283.8(0.6) $170.3 million.Thus, Allied generated an after-tax profit of $170.3 million from its operations.This was a little better than the 2000 NOPAT of $263(0.6) $157.8 million.However, the income statements in Table 2-2 show that Allied’s earnings pershare declined from 2000 to 2001. This decrease in EPS was caused by an in-crease in interest expense, not by a decrease in operating profit. See Table 2-2.Moreover, the balance sheets in Table 2-1 show that debt increased from 2000to 2001. But why did Allied increase its debt? The reason was that Allied’s in-vestment in operating capital increased dramatically from 2000 to 2001, andthat increase was financed primarily with debt.FREECASHFLOWEarlier in the chapter we defined net cash flow as being equal to net incomeplus noncash adjustments, typically net income plus depreciation and amortiza-Free Cash Flowtion. Note, though, that cash flows cannot be maintained over time unless de-The cash flow actually availablepreciating fixed assets are replaced and new products are developed, so man-for distribution to all investorsagement is not completely free to use cash flows however it chooses. Therefore,(stockholders and debtholders)we now define another term, free cash flow, which is the cash flow actuallyafter the company has made allavailable for distribution to all investors (stockholders and debtholders) after thethe investments in fixed assets,company has made all the investments in fixed assets, new products, and working cap-new products, and working capitalnecessary to sustain ongoingital necessary to sustain ongoing operations.operations.7For firms with a more complicated tax situation, it is better to define NOPAT as follows: NOPAT (Net income before preferred dividends) (Net interest expense)(1 Tax rate). Also, if firmsare able to defer paying some of their taxes, perhaps by the use of accelerated depreciation, thenNOPAT should be adjusted to reflect the taxes that the company actually paid on its operating in-come. For additional information see Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Mea-suring and Managing the Value of Companies,3rd edition (New York: John Wiley & Sons, Inc., 2000);and G. Bennett Stewart III, The Quest for Value(New York: HarperCollins Publishers, Inc., 1991).MODIFYING ACCOUNTING DATA FOR MANAGERIAL DECISIONS55 When you studied income statements in accounting, the emphasis probablywas on the firm’s net income, which is its accounting profit. However, we beganthis chapter by telling you that the value of a company’s operations is deter-mined by the stream of cash flows that the operations will generate now and inthe future. As the statement of cash flows shows, accounting profit and cashflow can be quite different.To be more specific, the value of a company’s operations depends on all thefuture expected free cash flows (FCF), defined as after-tax operating profitminus the amount of investment in working capital and fixed assets necessary tosustain the business. Thus, free cash flow represents the cash that is actuallyavailable for distribution to investors. Therefore, the way for managers to maketheir companies more valuable is to increase their free cash flow.CALCULATINGFREECASHFLOWAs shown earlier in the chapter, Allied had a 2001 NOPAT of $170.3 million.Operating Cash FlowIts operating cash flow is NOPAT plus any noncash adjustments as shown onEqual to NOPAT plus anythe statement of cash flows. For Allied, where depreciation is the only noncash8noncash adjustments, calculatedcharge, the 2001 operating cash flow ison an after-tax basis.Operating cash flow NOPAT Depreciation(2-6) $170.3 $100 $270.3 million.Pleasenotethatthisdefinitionofoperatingcashflowiscalculatedonanafter-taxbasis.Asshownearlierinthechapter,Alliedhad$1,520millionofoperatingassets,oroperatingcapital,attheendof2000,but$1,800millionattheendof2001.Therefore,during2001itmadeanetinvestmentinoperatingcapitalofNet investment in operating capital $1,800 $1,520 $280 million.Fixed assets rose from $870 to $1,000 million, or by $130 million. However,Allied took $100 million of depreciation, so its gross investment in fixed assetswas $130 $100 $230 million for the year. With this background, we findthe gross investment in operating capital as follows:Gross investment Net investment Depreciation $280 $100 $380 million.Allied’s free cash flow in 2001 wasFCF Operating cash flow Gross investment in operating capital(2-7) $270.3 $380 $109.7 million.8In those instances in which operating costs include an amortization expense, operating cash flowwould also need to include an adjustment for the amortization charge. However, in practice, onlya small percentage of firms report amortization expenses on their income statements. Moreover,the accounting and tax treatments of amortization charges are often quite complex. For these rea-sons, we have chosen to disregard amortization expenses when calculating operating cash flow andfree cash flow. See Copeland, Koller, and Murrin, Valuation:Measuring and Managing the Value ofCompanies,for a more detailed discussion of how to incorporate amortization expenses into thecalculation of free cash flow.56CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES If we subtract depreciation from both operating cash flow and gross investmentin operating capital in Equation 2-7, we obtain the following algebraicallyequivalent expression for free cash flow:FCF NOPAT Net investment in operating capital(2-7a) $170.3 $280 $109.7 million.Even Allied had a positive NOPAT, its very high investment in op-erating though capital resulted in a negative free cash flow. Since free cash flow is whatis available for distribution to investors, not only was there nothing for in-vestors, but investors actually had to provide moremoney to Allied to keep thebusiness going. Investors provided most of the required new money as debt.Is a negative free cash flow always bad? The answer is, “Not necessarily. Itdepends on whythe free cash flow was negative.” If FCF was negative becauseNOPAT was negative, this is bad, because the company is probably experienc-ing operating problems. Exceptions to this might be startup companies, orcompanies that are incurring significant current expenses to launch a newproduct line. Also, many high-growth companies have positive NOPAT butnegative free cash flow due to investments in operating assets needed to sup-port growth. There is nothing wrong with profitable growth, even if it causesnegative cash flows in the short term.SELF-TEST QUESTIONSWhat is net operating working capital?What is total operating capital?What is NOPAT? Why might it be a better performance measure than net in-come?What is free cash flow? Why is free cash flow the most important determi-nant of a firm’s value?MVA AND EVANeither traditional accounting data nor the modified data discussed in the pre-ceding section bring in stock prices. Since the primary goal of management isto maximize the firm’s stock price, we need to bring stock prices into the pic-ture. Financial analysts have therefore developed two new performance mea-sures, MVA, or Market Value Added, and EVA, or Economic Value Added.9These concepts are discussed in this section.9The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-foundersof the consulting firm Stern Stewart & Company. Stern Stewart copyrighted the terms “EVA” and“MVA,” so other consulting firms have given other names to these values. Still, EVA and MVA arethe terms most commonly used in practice.MVA AND EVA57 MARKETVALUEADDED(MVA)Theprimarygoalofmostfirmsistomaximizeshareholders’wealth.Thisgoalobviouslybenefitsshareholders,butitalsohelps to ensurethatscarceresourcesareallocatedefficiently,whichbenefitstheecon ximized by maximizing the difference between omy.Shareholderwealthisma the market value ofthe firm’s stock and the amount of equity capital that was supplied by share-Market Value Added (MVA)holders. This difference is called the Market Value Added (MVA):The difference between theMVA Market value of stock Equity capital supplied by shareholdersmarket value of the firm’s stock (Shares outstanding)(Stock price) Total common equity.(2-8)and the amount of equity capitalinvestors have supplied.To illustrate, consider our illustrative company, Allied Food Products. In2001, its total market equity value was $1,150 million, while its balance sheetshowed that stockholders had put up only $896 million. Thus, Allied’s MVAwas $1,150 $896 $254 million. This $254 million represents the differencebetween the money that Allied’s stockholders have invested in the corporationsince its founding—including retained earnings—versus the cash they couldget if they sold the business. The higher its MVA, the better the job manage-ment is doing for the firm’s shareholders.ECONOMICVALUEADDED(EVA)Whereas MVA measures the effects of managerial actions since the very incep-tion of a company, Economic Value (EVA) focuses on managerial ef-Economic Value Added (EVA)Value Added added to shareholders byfectiveness in a given year. The basic formula for EVA is as follows:management during a given year.EVA Net operating profit after taxes, or NOPAT After-tax dollar cost of capital used to operations EBIT(1 Corporate tax rate)If you want to read more support (Total investor-supplied operating capital)(After-tax percentageabout EVA and MVA, surfcost of capital).(2-9)over to //Total investor-supplied operatingcapitalisthesum of theinterest-bearingdebt,.sternstewart.comand hear about it from thepreferredstock,andcommonequityusedtoacquirethecompany’snetoperat- people that invented it, Stern Stewart &ingassets,thatis,its netoperatingworkingcapitalplusnetplantandequipment.Co. While you are there, you may like toEVAisanestimateofabusiness’strueeconomicprofitfortheyear,anditdif- take a look at a video of executives10ferssharplyfromaccountingprofit.EVArepresentstheresidualincomethatre-describing how EVA has helped them,mainsafterthecostofallcapital,includingequitycapital,hasbeendeducted,which can be found at //.sternstewart>/evaabout/whereasaccountingprofitisdeterminedwithouti mposingachargeforequitycomments.shtml.To see the video, youcapital.AswewilldiscussmorecompletelyinChapter10,equitycapitalhasacost,will need Real Player, which can bebecausefundsprovidedbyshareholderscouldhavebeeninvestedelsewheredownloaded for free from //wheretheywouldhaveearnedareturn.Shareholdersgiveuptheopportunityto.realplayer>.investfundselsewherewhentheyprovidecapitaltothefirm.Thereturntheycouldearnelsewhereininvestmentsofequalriskrepresentsthecostofequitycap-ital.Thiscostisanopportunitycostratherthananaccountingcost,butitisquiterealnevertheless.Note that when calculating EVA we do not add back depreciation. Althoughit is not a cash expense, depreciation is a cost, and it is therefore deducted when10The most important reason EVA differs from accounting profit is that the cost of equity capitalis deducted when EVA is calculated. Other factors that could lead to differences include adjust-ments that might be made to depreciation, to research and development costs, to inventory valua-tions, and so on. See Stewart, The Quest for Value.58CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES determining both net income and EVA. Our calculation of EVA assumes thatthe true economic depreciation of the company’s fixed assets exactly equals thedepreciation used for accounting and tax purposes. If this were not the case, ad-justments would have to be made to obtain a more accurate measure of EVA.EVAprovidesagoodmeasureoftheextenttowhichthefirmhasaddedtoshareho ldervalue.Therefore,ifmanagersfocusonEVA,thiswillhelptoensurethattheyoperateinamannerthatisconsistentwithmaximizingshareholderwealth.NotetoothatEVAcanbedeterminedfordivisionsaswellasforthecom-panyasawhole,soitprovidesausefulbasisfordeterminingmanagerialcompen-sationatalllevels.Asaresultofallthis,EVAisbeingusedbyanincreasingnum-beroffirmsastheprimarybasisfordeterminingmanagerialcompensation.Table2-5showshowAllied’sMVAandEVAarecalculated.Thestockpricewas$23pershareatyear-end2001, downfrom$26pershareattheendof2000;itspercentageafter-taxcostofcapitalwas10.3percentin2000and10.0percentin2001,anditstaxratewas40percent.OtherdatainTable2-5weregiveninthebasicfinancialstatementsprovidedearlierinthechapter.Note first that the lower stock price and the higher book value of equity (dueto retaining earnings during 2001) combined to reduce the MVA. The 2001MVA is still positive, but $460 $254 $206 million of stockholders’ valuewas lost during 2001.EVA for 2000 was just barely positive, and in 2001 it was negative. Operat-ing income (NOPAT) rose, but EVA still declined, primarily because theamount of capital rose more sharply than NOPAT—by about 18 percent ver-sus 8 percent—and the cost of this increased capital pulled EVA down.Recall also that net income fell somewhat from 2000 to 2001, but not nearlyso dramatically as the decline in EVA. Net income does not reflect the amountMVA and EVA for Allied (Millions of Dollars)TABLE 2-520012000MVA CALCULATIONPrice per share$23.0$26.0Number of shares (millions)5050Market value of equity$1,150.0$1,300.0Book value of equity896.0840.0MVA Market value Book value$254.0$460.0EVA CALCULATIONEBIT$283.8$263.0Tax rate40%40%NOPAT EBIT (1 T)$170.3$157.8aTotal investor-supplied operating capital$1,800.0$1,520.0After-tax cost of capital (%)10.0%10.3%Dollar cost of capital$180.0$156.6EVA NOPAT Capital cost($9.7)$1.2aInvestor-supplied operating capital equals the sum of notes payable, long-term debt, preferred stock,and common equity. It could also be calculated as total liabilities and equity minus accounts payableand accruals.MVA AND EVA59 MANY FIRMS ADOPT EVA IN AN ATTEMPT TO ENHANCE SHAREHOLDER WEALTHccording to Fortunemagazine, “Economic Value Addedof debt capital is easy to determine because it shows up in fi-A(EVA)” is today’s hottest financial idea. Developed and pop-nancial statements as interest expense; however, the cost of eq-ularized by the consulting firm Stern Stewart & Co., EVA helpsuity capital, which is actually much larger than the cost of debtmanagers ensure that a given business unit is adding to stock-capital, does not appear in financial statements. As a result,holder value, while investors can use it to spot stocks that aremanagers often regard equity as free capital, even though it ac-likely to increase in value. Right now, relatively few managerstually has a high cost. So, until a management team determinesand investors are using EVA, so those who do use it have aits cost of capital, it cannot know whether it is covering allcompetitive advantage. However, Fortunethinks this situationcosts and thereby adding value to the firm.won’t last long, as more managers and investors are catchingAlthough EVA is perhaps the most widely discussed conceptthe EVA fever every day.in finance today, it is not completely new; the need to earnWhat exactly is EVA? EVA is a way to measure an operation’smore than the cost of capital is actually one of the oldest ideastrue profitability. The cost of debt capital (interest expense) isin business. However, the idea is often lost because of a mis-deducted when calculating net income, but no cost is deductedguided focus on conventional accounting.to account for the cost of common equity. Therefore, in an eco-One of EVA’s greatest virtues is its direct link to stock prices.nomic sense, net income overstates “true” income. EVA over-AT&T found an almost perfect correlation between its EVA andcomes this flaw in conventional accounting.its stock price. Moreover, security analysts have found thatEVA is found by taking the after-tax operating profit andstock prices track EVA far more closely than other factors suchsubtracting the annual cost of allthe capital a firm uses. Suchas earnings per share, operating margin, or return on equity.highly successful giants as Coca-Cola, AT&T, Quaker Oats, BriggsThis correlation occurs because EVA is what investors really care& Stratton, and CSX have jumped on the EVA bandwagon andabout, namely, the net cash return on their capital. Therefore,attribute much of their success to its use. According to AT&T fi-more and more security analysts are calculating companies’nancial executive William H. Kurtz, EVA played a major role inEVAs and using them to help identify good buys in the stockAT&T’s decision to acquire McCaw Cellular. In addition, AT&Tmarket.made EVA the primary measure of its business unit managers’performance.Surprisingly, many corporate executives have no idea howSOURCES:“The Real Key to Creating Wealth,” Fortune,September 20, 1993, 38–44;much capital they are using or what that capital costs. The costand “America’s Wealth Creators,”Fortune, November 22, 1999, 275.of equity capital employed, but EVA does. Because of this omission, net incomeis not as useful as EVA for setting corporate goals and measuring managerialperformance.WewillhavemoretosayaboutbothMVAandEVAlaterinthebook,butwecanclosethissectionwithtwoobservations.First,thereisarelationshipbetweenMVAandEVA,butitisnotadirectone.Ifacompanyhasahistoryofnegative EVAs, then its MVA will probably be negative, and vice versa if ithas a history of positive EVAs. However, the stock price, which is the key in-gredient in the MVA calculation, depends more on expected future perfor-mance thanonhistoricalperformance.Therefore,acompanywithahistoryofnegative EVAs could have a positive MVA, provided investors expect a turn-around in the future.The second observation is that when EVAs or MVAs are used to evaluatemanagerial performance as part of an incentive compensation program, EVA isthe measure that is typically used. The reasons are (1) EVA shows the valueadded during a given year, whereas MVA reflects performance over the com-pany’s entire life, perhaps even including times before the current managerswere born, and (2) EVA can be applied to individual divisions or other units ofa large corporation, whereas MVA must be applied to the entire corporation.60CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES For these reasons, MVA is used primarily to evaluate top corporate officersover periods of five to 10 years, or longer.SELF-TEST QUESTIONSDefine the terms “Market Value Added (MVA)” and “Economic Value Added(EVA).”How does EVA differ from accounting profit?THE FEDERAL INCOME TAX SYSTEM A web site of interestThe value of any financial asset (including stocks, bonds, and mortgages), asconcerning federal tax lawwell as most real assets such as plants or even entire firms, depends on theis //stream of cash flows produced by the asset. Cash flows from an asset consist of.taxsites>/usableincome plus depreciation, and usable income means income after taxes.federal.html. From thisOur tax laws can be changed by Congress, and in recent years changes havehome page one can visit other sites that provide summaries of recent taxoccurred frequently. Indeed, a major change has occurred, on average, everylegislation or current information onthree to four years since 1913, when our federal income tax system began. Fur-corporate and individual tax rates.ther, certain parts of our tax system are tied to the inflation rate, so changesoccur automatically each year, depending on the rate of inflation during theprevious year. Therefore, although this section will give you a good back-ground on the basic nature of our tax system, you should consult current rateschedules and other data published by the Internal Revenue Service (availablein U.S. post offices) before you file your personal or business tax returns.Currently (2001), federal income tax rates for individuals go up to 39.6 per-cent, and, when Social Security, Medicare, and state and city income taxes areincluded, the marginal tax rate on an individual’s income can easily exceed 50percent. Business income is also taxed heavily. The income from partnershipsand proprietorships is reported by the individual owners as personal incomeand, consequently, is taxed at federal-plus-state rates going up to 50 percent ormore. Corporate profits are subject to federal income tax rates of up to 39 per-cent, plus state income taxes. Furthermore, corporations pay taxes and then dis-tribute after-tax income to their stockholders as dividends, which are also taxed.So, corporate income is really subject to double taxation. Because of the magni-tude of the tax taxes play a critical role in many financial decisions.As this text bite, is being written, a Republican Congress and administration con-tinue to debate the merits of different changes in the tax laws. Even in the un-likely event that no explicit changes are made in the tax laws, changes stilloccur because certain aspects of the tax calculation are tied will to the inflation rate.Thus, by the time you read this chapter, tax rates and other factors will almostcertainly be different from those we provide. Still, if you understand this sec-tion, you will understand the basics of our tax system, and you will know howto operate under the revised tax code.Taxes are so complicated that university law schools offer master’s degrees intaxation to lawyers, many of whom are also CPAs. In a field complicatedenough to warrant such detailed study, only the highlights can be covered in abook such as this. This is really enough, though, because business managersand investors should and do rely on tax specialists rather than trusting theirTHE FEDERAL INCOME TAX SYSTEM61 own limited knowledge. Still, it is important to know the basic elements of thetax system as a starting point for discussions with tax experts.INDIVIDUALINCOMETAXESIndividuals pay taxes on wages and salaries, on investment income (dividends,interest, and profits from the sale of securities), and on the profits of propri-Individual Tax Rates in April 2001TABLE 2-6Single IndividualsYOU PAY THIS PLUS THIS PERCENTAGE AVERAGE TAX AMOUNT ON THE BASE ON THE EXCESS RATE AT TOP IF YOUR TAXABLE INCOME ISOF THE BRACKETOVER THE BASEOF BRACKETUp to $26,250$ 015.0%15.0%$26,250–$63,5503,937.5028.022.6$63,550–$132,600 14,381.5031.027.0$132,600–$288,35035,787.0036.031.9Over $288,35091,857.0039.639.6Married Couples Filing Joint ReturnsYOU PAY THIS PLUS THIS PERCENTAGE AVERAGE TAX AMOUNT ON THE BASE ON THE EXCESS RATE AT TOP IF YOUR TAXABLE INCOME ISOF THE BRACKETOVER THE BASEOF BRACKETUp to $43,850$ 015.0%15.0%$43,850–$105,9506,577.5028.022.6$105,950–$161,4 5023,965.5031.025.5$161,450–$288,35041,170.5036.030.1Over $288,35086,854.5039.639.6NOTES:a.These are the tax rates in April 2001. The income ranges at which each tax rate takes effect, as wellas the ranges for the additional taxes discussed below, are indexed with inflation each year, so theywill change from those shown in the table.b.Theaveragetaxrateapproaches39.6percentastaxableincomeriseswithoutlimit.At$1millionoftaxableincome,theaveragetaxratesforsingleindividualsandmarriedcouplesfilingjointreturnsare37.4percentand36.9percent,respectively,whileat$10milliontheyare39.4and39.3percent,respectively.c.In 2000, a personal exemptionof $2,800 per person or dependent could be deducted from grossincome to determine taxable income. Thus, a husband and wife with two children would have a 2000exemption of 4 $2,800 $11,200. The amount of the exemption is scheduled to increase withinflation. However, if gross income exceeds certain limits ($193,400 for joint returns and $128,950 forsingle individuals in 2000), the exemption is phased out, and this has the effect of raising theeffective tax rate on incomes over the specified limit by about 0.5 percent per family member, or 2.0percent for a family of four. In addition, taxpayers can claim itemized deductionsfor charitablecontributions and certain other items, but these deductions are reduced if the gross income exceeds$128,950 (for both single individuals and joint returns), and this raises the effective tax rate for high-income taxpayers by another 1 percent or so. The combined effect of the loss of exemptions and thereduction of itemized deductions is about 3 percent, so the marginal federal tax rate for high-incomeindividuals goes up to about 42.6 percent.In addition, there is the Social Security tax, which amounts to 6.2 percent (12.4 percent for a self-employed person) on up to $76,200 of earned income, plus a 1.45 percent Medicare payroll tax (2.9percent for self-employed individuals) on allearned income. Finally, older high-income taxpayers whoreceive Social Security payments must pay taxes on 85 percent of their Social Security receipts, upfrom 50 percent in 1994. All of this pushes the effective tax rate up even further.62CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES Progressive Taxetorships and partnerships. Our tax rates are progressive—that is, the higherA tax system where the tax rate isone’s income, the larger the percentage paid in taxes. Table 2-6 gives the taxhigher on higher incomes. Therates for single individuals and married couples filing joint returns under thepersonal income tax in the Unitedrate schedules that were in effect in April 2001.States, which goes from 0 percenton the lowest increments of1.Taxable incomeis defined as gross income less a set of exemptions andincome to 39.6 percent, isdeductions that are spelled out in the instructions to the tax forms indi-progressive.viduals must file. When filing a tax return in 2001 for the tax year 2000,each taxpayer received an exemption of $2,800 for each dependent, in-Taxable Incomecluding the taxpayer, which reduces taxable income. However, this ex-Gross income minus exemptionsemption is indexed to rise with inflation, and the exemption is phased outand allowable deductions as set(taken away) for high-income taxpayers. Also, certain expenses includingforth in the Tax Code.mortgage interest paid, state and local income taxes paid, and charitablecontributions, can be deducted and thus be used to reduce taxable in-come, but again, high-income taxpayers lose most of these deductions.Marginal Tax Rate2.The marginal tax rateis defined as the tax rate on the last unit of in-The tax rate applicable to the lastcome. Marginal rates begin at 15 percent and rise to 39.6 percent. Note,unit of a person’s income.though, that when consideration is given to the phase-out of exemptionsand deductions, to Social Security and Medicare taxes, and to state taxes,the marginal tax rate can actually exceed 50 percent.Average Tax Rate3.One can calculate average tax ratesfrom the data in Table 2-6. For ex-Taxes paid divided by taxableample, if Jill Smith, a single individual, had taxable income of $35,000,income.hertaxbillwouldbe$3,937.50 ($35,000 $26,250)(0.28) $3,937.50 $2,450 $6,387.50. Her average tax ratewould be $6,387.50/$35,000 18.25% versus a marginal rateof 28 percent. If Jill received a raise of$1,000, bringing her income to $36,000, she would have to pay $280 of itas taxes, so her after-tax raise would be $720. In addition, her Social Se-curity and Medicare taxes would increase by $76.50, which would cut hernet raise to $643.50.4.As indicated in the notes to the table, the tax code indexes tax brackets toBracket Creepinflation to avoid the bracket creepthat occurred several years ago and11A situation that occurs whenthat in reality raised tax rates substantially.progressive tax rates combine withinflation to cause a greater portionTaxes on Dividend and Interest Incomeof each taxpayer’s real income tobe paid as taxes.Dividend and interest income received by individuals from corporate securitiesis added to other income and thus is taxed at rates going up to about 50 per-12cent.Since corporations pay dividends out of earnings that have already been11Forexample,ifyouweresingleandhadataxableincomeof$26,250,yourtax billwouldbe$3,937.50.Nowsupposeinflationcausedpricestodoubleandyourincome,beingtiedtoacost-of-livingindex,roseto$52,500.Becauseourtaxratesareprogressive,iftaxbracketswerenotindexed,yourtaxeswouldjumpto$11,287.50.Yourafter-taxincomewouldthusincreasefrom$22,312.50to$41,212.50,but,becausepriceshavedoubled,yourrealincomewoulddeclinefrom$22,312.50to$20,606.25(calculatedasone-halfof$41,212.50).Youwouldbeinahighertaxbracket,soyouwouldbepayingahigherpercentageofyourrealincomeintaxes.Ifthishappenedtoeveryone,andifCon-gressfailedtochangetaxratessufficiently,realdisposableincomeswoulddeclinebecausethefederalgovernmentwouldbetakingalargershareofthenationalproduct.Thisiscalledthefederalgov-ernment’s“inflationdividend.”However,sincetaxbracketsarenowindexed,ify ourincomedoubledduetoinflation,yourtaxbillwoulddouble,butyourafter-taxrealincomewouldremainconstantat$22,312.50.Bracketcreepwasarealproblemuntilthe1980s,whenindexingputanendtoit.12You do not pay Social Security and Medicare taxes on interest, dividends, and capital gains, onlyon earned income, but state taxes are generally imposed on dividends, interest, and capital gains.THE FEDERAL INCOME TAX SYSTEM63 taxed, there is double taxationof corporate income—income is first taxed at thecorporate rate, and when what is left is paid out as dividends, it is taxed againat the personal rate.ItshouldbenotedthatunderU.S.taxlaws,interestonmoststateandlocalgovernmentbonds,calledmunicipalsor“munis,”isnotsubjecttofederalincometaxes.Thus,investorsgettokeepalloftheinterestreceivedfrommostmunici-palbondsbutonlyafractionoftheinterestreceivedfrombondsissuedbycor-porationsorbytheU.S.government.Thismeansthatalower-yieldingmunicanprovidethesameafter-taxreturnasahigher-yieldingcorporatebond.Forex-ample,ataxpayerinthe39.6percentmarginaltaxbracketwhocouldbuyamunithatyielded5.5percentwouldhavetoreceiveabefore-taxyieldof9.11percentonacorporateorU.S.Treasurybondtohavethesameafter-taxincome:Yield on muniEquivalent pre-tax yield on taxable bond1 Marginal tax rate5.5% 9.11%.1 0.396If we know the yield on the taxable bond, we can use the following equation tofind the equivalent yield on a muni:Pre-tax yield Equivalent yield on muni ?on taxable??(1 Marginal tax rate)bond 9.11% (1 0.396) 9.11%(0.604) 5.5%.The exemption from federal taxes stems from the separation of federal andstate powers, and its primary effect is to help state and local governments bor-row at lower rates than they otherwise could.Munis always yield less than corporate bonds with similar risk, maturity, andliquidity. Because of this, it would make no sense for someone in a zero or verylow tax bracket to buy munis. Therefore, most munis are owned by high-bracket investors.Capital Gains versus Ordinary IncomeAssets such as stocks, bonds, and real estate are defined as capital assets.If youbuy a capital asset and later sell it for more than your purchase price, the profitCapital Gain or Lossis called a capital gain;if you suffer a loss, it is called a capital loss.An assetThe profit (loss) from the sale of asold within one year of the time it was purchased produces a short-term gain orcapital asset for more (less) thanlossand one held for more than a year produces a long-term gain or loss.Thus, ifits purchase price.you buy 100 shares of Disney stock for $42 per share and sell it for $52 pershare, you make a capital gain of 100 $10, or $1,000. However, if you sell thestock for $32 per share, you will have a $1,000 capital loss. Depending on how13long you held the stock, you will have a short-term or long-term gain or loss.If you sell the stock for exactly $42 per share, you make neither a gain nor aloss; you simply get your $4,200 back, and no tax is due.13If you have a net capital loss (capital losses exceed capital gains) for the year, you can currentlydeduct only up to $3,000 of this loss against your other income (for example, salary, interest, anddividends). This $3,000 loss limitation is not applicable to losses on the sale of business assets,which by definition are not capital assets.64CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES Short-term capital gains are added to such ordinary income as wages, divi-dends, and interest and then are taxed at the same rate as ordinary income.However, long-term capital gains are taxed differently. The top rate on long-term gains is 20 percent. Thus, if in 2000 you were in the 39.6 percent taxbracket, any short-term gains you earned would be taxed like ordinary in-come, but your long-just term gains would be taxed at 20 percent. Thus, capitalgains on assets held for more than 12 months are better than ordinary income14for many people because the tax bite is smaller.Capital gains tax rates have varied over time, but they have generally beenlower than rates on ordinary income. The reason is simple—Congress wantsthe economy to grow, for growth we need investment in productive assets, andlow capital gains tax rates encourage investment. To see why, suppose youowned a company that earned $1 million after corporate taxes. Because it isyour company, you could have it pay out the entire $1 million profit as divi-dends, or you could have it retain and reinvest all or part of the income to ex-pand the business. If it paid dividends, they would be taxable to you at a rate of39.6 percent. However, if the company reinvests its income, that reinvestmentshould cause the company’s earnings and stock price to increase. Then, if youwait for one year and then sell some of your stock at a now-higher price, youwill have earned capital gains, but they will be taxed at only 20 percent. Fur-ther, you can postpone the capital gains tax indefinitely by simply not sellingthe stock.It should be clear that a lower tax rate on capital gains will encourage in-vestment. The owners of small businesses will want to reinvest income to getcapital gains, as will stockholders in large corporations. Individuals with moneyto invest will understand the tax advantages associated with investing in newlyformed companies versus buying bonds, so new ventures will have an easiertime attracting equity capital. All in all, lower capital gains tax rates stimulate15capital formation and investment.CORPORATEINCOMETAXESThe corporate tax structure, shown in Table 2-7, is relatively simple. To illus-trate, if a firm had $65,000 of taxable income, its tax bill would beTaxes $7,500 0.25($15,000) $7,500 $3,750 $11,250,14The Tax Code governing capital gains is very complex, and we have illustrated only the mostcommon provision.15Fifty percent of any capital gains on the newly issued stock of certain small companies is excludedfrom taxation, provided the small-company stock is held for five years or longer. The remaining 50percent of the gain is taxed at a rate of 20 percent for most taxpayers. Thus, if one bought newlyissued stock from a qualifying small company and held it for at least five years, any capital gainswould be taxed at a maximum rate of 10 percent for most taxpayers. This provision was designedto help small businesses attract equity capital.THE FEDERAL INCOME TAX SYSTEM65 Corporate Tax Rates as of January 2001TABLE 2-7IT PAYS THIS PLUS THIS PERCENTAGE IF A CORPORATION’SAMOUNT ON THE BASE ON THE EXCESS AVERAGE TAX RATE TAXABLE INCOME ISOF THE BRACKETOVER THE BASE AT TOP OF BRACKETUp to $50,000$015%15.0%$50,000–$75,0007,5002518.3$75,000–$100,00013,75034 22.3$100,000–$335,00022,2503934.0$335,000–$10,000,000113,9003434.0$ 10,000,000–$15,000,0003,400,0003534.3$15,000,000–$18,333,3335,150,0 003835.0Over $18,333,3336,416,6673535.0anditsaveragetaxratewouldbe$11,250/$65,000 17.3%.Notethatcor-porateincomeabove$18,333,333hasanaverageandmarginaltaxrateof3516percent.Interest and Dividend Income Received by a CorporationInterest income received by a corporation is taxed as ordinary income at regu-lar corporate tax rates. However, 70 percent of the dividends received by one corpora-tion from another is excluded from taxable income, while the remaining 30 percent is16Priorto1987,manylarge,profitablecorporationssuchasGeneralElectricandBoeingpaidnoincometaxes.Thereasonsforthiswereasfollows:(1)expenses,especiallydepreciation,werede-fineddifferentlyforcalculatingtaxableincomethanforreportingearningstostockholders,sosomecompaniesreportedpositiveprofitstostockholdersbutlosses—hencenotaxes—totheInternalReve nueService;and(2)somecompaniesthatdidhavetaxliabilitiesusedvarioustaxcreditstooffsettaxesthatwouldotherwisehavebeenpayable.Thissituationwaseffectivelyelim-inatedin1987.The principal method used to eliminate this situation is the Alternative Minimum Tax (AMT).Under the AMT, both corporate and individual taxpayers must figure their taxes in two ways, the“regular” way and the AMT way, and then pay the higher of the two. The AMT is calculated asfollows: (1) Figure your regular taxes. (2) Take your taxable income under the regular method andthen add back certain items, especially income on certain municipal bonds, depreciation in excessof straight-line depreciation, certain research and drilling costs, itemized or standard deductions(for individuals), and a number of other items. (3) The income determined in (2) is defined as AMTincome, and it must then be multiplied by the AMT tax rate to determine the tax due under theAMT system. An individual or corporation must then pay the higher of the regular tax or the AMTtax. In 2000, there were two AMT tax rates for individuals (26 percent and 28 percent, dependingon the level of AMT income and filing status). Most corporations have an AMT of 20 percent.However, there is no AMT for very small companies, defined as those that have had average salesof less than $5 million for the last three years and whose average sales continue to be less than $7.5million.66CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES 17taxed at the ordinary tax rate.Thus, a corporation earning more than$18,333,333 and paying a 35 percent marginal tax rate would pay only(0.30)(0.35) 0.105 10.5% of its dividend income as taxes, so its effective taxrate on dividends received would be 10.5 percent. If this firm had $10,000 inpre-tax dividend income, its after-tax dividend income would be $8,950:After-tax Before-tax income Taxesincome Before-tax income (Before-tax income)(Effective tax rate) Before-tax income(1 Effective tax rate) $10,000 [1 (0.30)(0.35)] $10,000(1 0.105) $10,000(0.895) $8,950.If the corporation pays its own after-tax income out to its stockholders asdividends, the income is ultimately subjected to triple taxation: (1) the originalcorporation is first taxed, (2) the second corporation is then taxed on the divi-dends it received, and (3) the individuals who receive the final dividends aretaxed again. This is the reason for the 70 percent exclusion on intercorporatedividends.Ifacorporationhassurplusfundsthatcanbeinvestedinmarketablesecu-rities,thetaxfactorfavorsinvestmentinstocks,whichpaydividends,ratherthaninbonds,whichpayinterest.Forexample,supposeGEhad$100,000toinvest,anditcouldbuyeitherbondsthatpaidinterestof$8,000peryearorpreferredstockthatpaiddividendsof$7,000.GEisinthe35percenttaxbracket;therefore,itstaxontheinterest,ifitboughtbonds,wouldbe0.35($8,000) $2,800,anditsafter-taxincomewouldbe$5,200.Ifitboughtpreferred(orcommon)stock,itstaxwouldbe0.35[(0.30)($7,000)] $735,anditsafter-taxincomewouldbe$6,265.OtherfactorsmightleadGEtoin-vestinbonds,butthetaxfactorcertainlyfavorsstockinvestmentswhenthe18investorisacorporation.Interest and Dividends Paid by a CorporationA firm’s operations can be financed with either debt or equity capital. If it usesdebt, it must pay interest on this debt, whereas if it uses equity, it is expected to17The size of the dividend exclusion actually depends on the degree of ownership. Corporationsthat own less than 20 percent of the stock of the dividend-paying company can exclude 70 percentof the dividends received; firms that own more than 20 percent but less than 80 percent can exclude80 percent of the dividends; and firms that own more than 80 percent can exclude the entire divi-dend payment. We will, in general, assume a 70 percent dividend exclusion.18This illustration demonstrates why corporations favor investing in lower-yielding preferredstocks over higher-yielding bonds. When tax consequences are considered, the yield on the pre-ferred stock, [1 0.35(0.30)](7.0%) 6.265%, is higher than the yield on the bond, (1 0.35)(8.0%) 5.200%. Also, note that corporations are restricted in their use of borrowed fundsto purchase other firms’ preferred or common stocks. Without such restrictions, firms could en-gage in tax arbitrage,whereby the interest on borrowed funds reduces taxable income on a dollar-for-dollar basis, but taxable income is increased by only $0.30 per dollar of dividend income. Thus,current tax laws reduce the 70 percent dividend exclusion in proportion to the amount of borrowedfunds used to purchase the stock.THE FEDERAL INCOME TAX SYSTEM67 pay dividends to the equity investors (stockholders). The interest paidby a cor-poration is deducted from its operating income to obtain its taxable income,but dividends paid are not deductible. Therefore, a firm needs $1 of pre-tax in-come to pay $1 of interest, but if it is in the 40 percent federal-plus-state taxbracket, it must earn $1.67 of pre-tax to pay $1 of dividends:$1$1Pre-tax income needed $1.67.to pay income $1 of dividends1 Tax rate0.60Working backward, if a company has $1.67 in pre-tax income, it must pay $0.67in taxes [(0.4)($1.67) $0.67]. This leaves it with after-tax income of $1.00.Table 2-8 shows the situation for a firm with $10 million of assets, sales of$5 million, and $1.5 million of earnings before interest and taxes (EBIT). Asshown in Column 1, if the firm were financed entirely by bonds, and if it madeinterest payments of $1.5 million, its taxable income would be zero, taxes wouldbe zero, and its investors would receive the entire $1.5 million. (The term in-vestorsincludes both stockholders and bondholders.) However, as shown inColumn 2, if the firm had no debt and was therefore financed only by stock, allof the $1.5 million of EBIT would be taxable income to the corporation, thetax would be $1,500,000(0.40) $600,000, and investors would receive only$0.9 million versus $1.5 million under debt financing. The rate of return to in-vestors on their $10 million investment is therefore much higher if debt is used.Of course, it is generally not possible to finance exclusively with debt capi-tal, and the risk of doing would offset the benefits of the higher expected in-come. Still, the so fact that interest is a deductible expense has a profound effect on theway businesses are financed—our corporate tax system favors debt financing over eq-uity financing.This point is discussed in more detail in Chapters and 13.Corporate Capital GainsBefore 1987, corporate long-term capital 10 gains were taxed at lower rates thancorporateordinaryincome,sothesituationwassimilarforcorporationsandReturns to Investors under Bond and Stock FinancingTABLE 2-8USE BONDS USE STOCK (1)(2)Sales$5,000,000$5,000,000Operating costs3,500,0003,500,000Earnings before interest and taxes (EBIT)$1,500,000$1,500,000Interest1,500,0000Taxable income$ 0$1,500,000Federal-plus-state taxes (40%)0600,000After-tax income$ 0$ 900,000Income to investors$1,500,000$ 900,000Rate of return on $10 million of assets15.0%9.0%68CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES individuals. Under current law, however, corporations’ capital gains are taxed atthe same rates as their operating income.Corporate Loss Carry-Back and Carry-ForwardTax Loss Carry-Back Ordinary corporate operating losses can be carried back (carry-back)to eachand Carry-Forwardof the preceding 2 years and forward (carry-forward)for the next 20 years andOrdinary corporate operatingused to offset taxable income in those years. For example, an operating loss inlosses can be carried backward for2002couldbecarriedbackandusedtoreducetaxableincomein2000and2001,2 years or forward for 20 years toand forward, if necessary, and used in 2003, 2004, and so on, to the year 2022.offset taxable income in a givenThelossistypicallyappliedfirsttotheearliestyear,thentothenextearliestyear.year,andsoon,untillosseshavebeenuseduporthe20-yearcarry-forwardlimit has been reached.Toillustrate,supposeApexCorporationhad$2millionofpre-taxprofits(taxableincome)in2000and2001,andthen,in2002,Apexlost$12million.Also,assumethatApex’sfederal-plus-statetaxrateis40percent.AsshowninTable2-9,thecompanywouldusethecarry-backfeaturetorecomputeitstaxesfor2000,using$2millionofthe2002operatinglossestoreducethe2000pre-taxprofittozero.Thiswouldpermitittorecoverthetaxespaidin2000.Therefore,in2002Apexwouldreceivearefundofits2000taxesbe-causeofthelossexperiencedin2002.Because$10millionoftheunrecoveredlosseswouldstillbeavailable,Apexwouldrepeatthisprocedurefor2001.Thus,in2002thecompanywouldpayzerotaxesfor2002andalsowouldre-ceivearefundfortaxespaidin2000and2001.Apexwouldstillhave$8mil-lionofunrecoveredlossestocarryforward,subjecttothe20-yearlimit.This$8millioncouldbeuseduntiltheentire$12millionlosshadbeenusedtooffsettaxableincome.Thepurposeofpermittingthislosstreatmentistoavoidpenalizingcorporationswhoseincomesfluctuatesubstantiallyfromyeartoyear.Apex Corporation: Calculation of Loss Carry-Back and Carry-ForwardTABLE 2-9for 2000–2001 Using a $12 Million 2002 Loss20002001Original taxable income$2,000,000$2,000,000Carry-back credit 2,000,000 2,000,000Adjusted profit$ 0$ 0Taxes previously paid (40%)800,000800,000Difference Tax refund$ 800,000$ 800,000Total refund check received in 2003: $800,000 $800,000 $1,600,000Amount of loss carry-forward available for use in 2003–2022:2002 loss$12,000,000Carry-back losses used4,000,000Carry-forward losses still available$8,000,000THE FEDERAL INCOME TAX SYSTEM69 TAX HAVENSany multinational corporations have found anWhile activities such as Murdoch’s are legal, some haveMinteresting but controversial way to reducequestioned their ethics. Clearly, shareholders want corporationstheir tax burdens: By shifting some of their opera-to take legal steps to reduce taxes. Indeed, many argue thattions to countries with low or nonexistent taxes, they can sig-managers have a fiduciary responsibility to take such actionsnificantly reduce their total tax bills. Over the years, severalwhenever they are cost effective. Moreover, citizens of the var-countries have passed tax laws that make the countries taxious tax havens benefit from foreign investment. Who loses?havensdesigned to attract foreign investment. Notable exam-Obviously, the United States loses tax revenue whenever a do-ples include the Bahamas, Grand Cayman, and the Netherlandsmestic corporation establishes a subsidiary in a tax haven. Ul-Antilles.timately, this loss of tax revenue either reduces services orRupert Murdoch, chairman of global media giant News Cor-raises the tax burden on other corporations and individuals.poration, has in some years paid virtually no taxes on his U.S.Nevertheless, even the U.S. government is itself somewhat am-businesses, despite the fact that these businesses representbivalent about the establishment of off-shore subsidiaries—itroughly 70 percent of his total operating profit. How has Mur-does not like to lose tax revenues, but it does like to encour-doch been able to reduce his tax burden? By shifting profits toage foreign investment.a News Corp. subsidiary that is incorporated in the NetherlandsAntilles. As Murdoch puts it, “Moving assets around like that isone of the advantages of being global.”To learn more about taxhavens, check out //.escapeartist.comforImproper Accumulation to Avoid Payment an in-depth analysis intoof Dividendstax havens, includingcountry profiles and indexes of offshoreCorporations could refrain from paying dividends and thus permit their stock-banks and foreign markets.holders to avoid personal income taxes on dividends. To prevent this, the TaxCode contains an improper accumulationprovision that states that earningsImproper Accumulationaccumulated by a corporation are subject to penalty rates if the purpose of the ac-Retention of earnings by acumulation is to enable stockholders to avoid personal income taxes.A cumulative totalbusiness for the purpose ofof $250,000 (the balance sheet item “retained earnings”) is by law exemptedenabling stockholders to avoidfrom the improper accumulation tax for most corporations. This is a benefitpersonal income taxes.primarily to small corporations.The improper accumulation penalty applies only if the retained earnings inexcess of $250,000 are shown by the IRS to be unnecessary to meet the reasonableneeds of the business.A great many companies do indeed have legitimate reasonsfor retaining more than $250,000 of earnings. For example, earnings may beretained and used to pay off debt, to finance growth, or to provide the corpo-ration with a cushion against possible cash drains caused by losses. How mucha firm should properly accumulate for uncertain contingencies is a matter ofjudgment. We shall consider this matter again in Chapter 14, which deals withcorporate dividend policy.Consolidated Corporate Tax ReturnsIf a corporation owns 80 percent or more of another corporation’s stock, it canaggregate income and file one consolidated tax return; thus, the losses of onecompany can be used to offset the profits of another. (Similarly, one division’s70CHAPTER 2 FINANCIAL STATEMENTS, CASH FLOW, AND TAXES losses can be used to offset another division’s profits.) No business ever wantsto incur losses (you can go broke losing $1 to save 35?? in taxes), but tax offsetsdo help make it more feasible for large, multidivisional corporations to under-take risky new ventures or ventures that will suffer losses during a develop-mental period.TAXATIONOFSMALLBUSINESSES: S CORPORATIONSThe Tax Code provides that small businesses that meet certain restrictions asspelled out in the code may be set up as corporations and thus receive the ben-efits of the corporate form of organization—especially limited liability—yetstill be taxed as proprietorships or partnerships rather than as corporations.S CorporationThese corporations are called S corporations.(“Regular” corporations areA small corporation that, undercalled C corporations.) If a corporation elects S corporation status for tax pur-Subchapter S of the Internalposes, all of the business’s income is reported as personal income by its stock-Revenue Code, elects to be taxedholders, on a pro rata basis, and thus is taxed at the rates that apply to individ-as a proprietorship or auals. This is an important benefit to the owners of small corporations in whichpartnership yet retains limitedall or most of the income earned each year will be distributed as dividends, be-liability and other benefits of thecause then the income is taxed only once, at the individual level.corporate form of organization.SELF-TEST tax rates are QUESTIONSExplain what is meant by this statement: “Our progressive.”Are tax rates progressive for all income ranges?Explain the difference between marginal tax rates and average tax rates.What is a “municipal bond,” and how are these bonds taxed?What are capital gains and losses, and how are they taxed relative to ordi-nary income?How does the federal income tax system treat corporate dividends receivedby a corporation versus those received by an individual? Why is this dis-tinction made?What is the difference in the tax treatment of interest and dividends paid bya corporation? Does this difference favor debt or equity financing?Briefly explain how tax loss carry-back and carry-forward procedures work.DEPRECIATIONDepreciation plays an important role in income tax calculations—the largerthe depreciation, the lower the taxable income, the lower the tax bill, hence thehigher the cash flow from operations. Congress specifies, in the Tax Code, boththe life over which assets can be depreciated for tax purposes and the methodsof depreciation that can be used. We will discuss in detail how depreciation iscalculated, and how it affects income and cash flows, when we take up capitalbudgeting in Chapters 11 and 12.DEPRECIATION71 The primary purposes of this chapter were (1) to describe the basic financialstatements, (2) to present some background information on cash flows, and (3)to provide an overview of the federal income tax system. The key concepts cov-ered are listed below. The four basic statements contained in the annual reportare the balancesheet, the income statement, the statement of retained earnings, and thestatement of cash flows. Investors use the information provided in thesestatements to form expectations about the future levels of earnings anddividends, and about the firm’s riskiness. The balance sheetshows assets on the left-hand side and liabilities andequity, or claims against assets, on the right-hand shot of the firm’s side. The balance sheetmay be thought of as a snap financial position at a par-ticular point in time. The income statementreports the results of operations over a period oftime, and it shows earnings per share as its “bottom line.” The statement of retained earningsshows the change in retained earn-ings between the balance sheet dates. Retained earnings represent a claimagainst assets, not assets per se. The statement of cash flowsreports the impact of operating, investing,and financing activities on cash flows over an accounting period. Netcashflowdiffersfromaccountingp