ChapterTool KitChapter 2112018Financial Statements, Cash Flow, a.docx

ChapterTool KitChapter 211/20/18Financial Statements, Cash
Flow, and Taxes2-1 Financial Statements and ReportsThe
annual report contains a verbal section plus four key statements:
the balance sheet, income statement, statement of stockholders'
equity, and statement of cash flows.Our spreadsheets use
formulas rather than fixed numbers. For example, the cell for
Total assets for the most recent year contains the Sum formula
rather than just a fixed number. That way, if the data for any
inputs (cash, for instance) change, the spreadsheet will
automatically recalculate and provide the correct new value for
Total assets.In financial modeling, it is helpful to users when
input data is grouped together, so you should follow this
practice in your own models, too.2-2 The Balance SheetINPUT
DATA SECTION: Historical Data Used in the
Analysis20192018Tax rate25%25%Weighted average cost of
captal (WACC)11.50%11.50%Figure 2-1MicroDrive Inc.
December 31 Balance SheetsOlder version in manuscript
4/20(Millions of Dollars)Assets20192018Assets20192018Cash
and equivalents$100$110Cash and equivalents$100$102Short-
term investments10182Short-term investments1040Accounts
receivable500410Accounts
receivable500384Inventories1,000830Inventories1,000774Total
current assets$1,610$1,532Total current assets$1,610$1,300Net
plant and equipment2,0001,780Net property, plant, and
equipment (PP&E)2,0001,780Note: Net plant and equipment is
equal to cumulative purchases of fixed assets less cumulative
depreciation and cumulative disposed assets. Total
assets$3,610$3,312Total assets$3,610$3,080Liabilities and
EquityLiabilities and EquityAccounts
payable$200$190Accounts payable$200$180Notes
payable150100Notes
payable15028Accruals400370Accruals400370Total current
liabilities$750$660Total current liabilities$750$578Long-term
bonds520500Long-term bonds520350Total

liabilities$1,270$1,160Total liabilities$1,270$928Preferred
stock (1,000,000 shares)100100Preferred stock (1,000,000
shares)100100Common stock (50,000,000
shares)500500Common stock (50,000,000
shares)500500Retained earnings1,7401,552Retained
earnings1,7401,552Total common equity$2,240$2,052Total
common equity$2,240$2,052Total liabilities and
equity$3,610$3,312Total liabilities and equity$3,610$3,0802-2
The Income StatementFigure 2-2MicroDrive Income Statements
(and Selected Additional Information) for Years Ending
December 31(Millions, Except for Per Share
Data)20192018Older version in manuscript 4/20Net
sales$5,000$4,800Net sales50004680Costs of goods sold except
depreciation3,9003,710Costs of goods sold except
depreciation$3,900$3,618Depreciation and
amortizationa200180Depreciation and
amortizationa200180Other operating expenses500470Other
operating expenses500470Earnings before interest and taxes
(EBIT)$400$440Earnings before interest and taxes
(EBIT)400412Less interest 6040Less interest $60$56Pre-tax
earnings$340$400Pre-tax
earnings340356Taxes85100Taxes$85$89Net Income before
preferred dividends$255$300Net Income before preferred
dividends255267Preferred dividends77Preferred
dividends$7$7Net Income available to common
stockholders$248$293Net Income available to common
stockholders248260Additional InformationAdditional
InformationCommon dividends$60.0$59.4Common
dividends$60$57Addition to retained
earnings$188.0$233.6Addition to retained
earnings$188$203Number of common shares6060Number of
common shares$60$60Stock price per share$31.00$45.00Stock
price per share3138Per Share DataPer Share DataEarnings per
share, EPSb$4.13$4.88Earnings per share,
EPSb$4.13$4.33Dividends per share, DPSc$1.00$0.99Dividends
per share, DPSc$1.00$0.95Book value per share,

BVPSd$37.33$34.20Book value per share,
BVPSd$37.33$34.20Notes:a MicroDrive has no amortization
charges.b EPS = Net income available to common stockholders
Common shares outstandingc DPS = Dividends
paid to common stockholders
Common shares outstandingd BVPS = Total
common equity
Common shares outstanding2-4 Statement of
Stockholders’ EquityThe statement of stockholders' equity takes
the previous year's balance of common stock, retained earnings,
and stockholders' equity and then adds the current year's net
income and subtracts dividends paid to common stockholders.
The end result is the new balance of common stock, retained
earnings, and stockholders' equity. Figure 2-3MicroDrive Inc.
Statement of Stockholders' Equity(Millions of Dollars, Millions
of Shares)Preferred
Stock Common
SharesCommon
Stock Retained
EarningsTotal
EquityBalances, Dec. 31,
2018$10060$500$1,552$2,152Changes during year:Net
income$248$248Cash dividends(60)(60)Issuance/repurchase of
stock000Balances, Dec. 31, 2019$10060$500$1,740$2,340Note:
In financial statements, parentheses and red colors denote a
negative number.2-5 Statement of Cash FlowsInformation from
the balance sheet and income statement can be used to construct
the Statement of Cash Flows, which is shown below for
MicroDrive, in millions of dollars.Figure 2-4MicroDrive
Statement of Cash Flows for Year Ending Dec. 31(Millions of
Dollars)Operating Activities2019Net Income before preferred
dividends$255Noncash adjustmentsDepreciationa200Working
capital adjustmentsIncrease in accounts
receivableb(116)Increase in inventories(226)Increase in
accounts payable20Increase in accruals30Net cash provided
(used) by operating activities$163Investing ActivitiesCash used

to acquire fixed assetsc($420)Sale of short-term
investments30Net cash provided (used) by investing
activities($390)Financing ActivitiesIncrease in notes
payable$122Increase in bonds170Payment of common and
preferred dividends(67)Net cash provided (used) by financing
activities$225SummaryNet change in cash and
equivalents($2)Cash and securities at beginning of the
year102Cash and securities at end of the
year$100Notes:aDepreciation is a noncash expense that was
deducted when calculating net income. It must be added back to
show the correct cash flow from operations.bAn increase in a
current asset decreases cash. An increase in a current liability
increases cash. An increase in a current liability increases cash.
See the text in this section for examples and explanations.cThe
net increase in fixed assets is $220 million; however, this net
amount is after a deduction for the year’s depreciation expense.
Depreciation expense must be added back to find the increase in
gross fixed assets. From the company’s income statement, we
see that the year's depreciation expense is $200 million; thus,
expenditures on fixed assets were actually $420 million.2-6 Net
Cash Flow20192018Net
income$248.0$293.0Depreciation$200.0$180.0Net cash
flow$448.0$473.02-7 Free Cash Flow: The Cash Flow Available
for Distribution to InvestorsNet Operating Profit After
TaxesNOPAT is the amount of profit MicroDrive would
generate if it had no debt and held no financial assets.NOPAT =
EBIT x (1-T)20192018Tax rate25%25%Earnings before interest
and taxes (EBIT)$400$440x (1-T)75%75%NOPAT$300$330Net
Operating Working CapitalThe current assets (CA) used in
operations are called operating current assets. Operating CA
include the cash needed for operations, accounts receivable and
inventories.
The current liabilities (CL) that are due to operations are
called operating current liabilities. Operating CL include
accounts payable and accruals.
Net operating working capital (NOWC) is equal to operating

CA minus operating CL. NOWC is the net amount that a
company's operations tie up in current assets and current
liabilities. Calculating Operating Current Assets20192018Cash
and equivalents$100$102+ Accounts
receivable$500$384+Inventories$1,000$774Operating current
assets$1,600$1,260Calculating Operating Current
Liabilities20192018Accounts payable$200$180+
Accruals$400$370Operating current
liabilities$600$550Calculating Net Operating Working
Capital20192018Operating current assets$1,600$1,260−
Operating current liabilities$600$550Net operating working
capital$1,000$710Total Net Operating Capital (also just called
Operating Capital or just Capital)The Total Net Operating
Capital is Net Operating Working Capital plus any long-term
fixed assets or net plant, property, and equipment used in
operations.Calculating Total Net Operating Capital20192018Net
operating working capital$1,000$710+ Net plant and
equipment$2,000$1,780Total net operating
capital$3,000$2,490Alternative Calculation of Total Net
Operating Capital (also just called Operating Capital)Total
Funds Provided by Investors20192018Notes
payable$150$28Long-term bonds$520$350Preferred
stock$100$100Total common equity$2,240$2,052Total investor
supplied funds$3,010$2,530Total Funds Provided by Investors
for Operations20192018Total investor supplied
capital$3,010$2,530Less short-term investments$10$40Total
investor-supplied operating capital$3,000$2,490Free Cash
FlowMicroDrive's Free Cash Flow calculation is the cash flow
actually availabe for distribution to investors after the company
has made all necessary investments in fixed assets and working
capital to sustain ongoing operations.
Free cash flow is equal to NOPAT minus the investment made
in total net operating capital.
The investment in total net operating capital is equal to the
current year's total net operating capital minus the previous
year's total net operating capital.Calculating the Investment in

Total Net Operating Capital20192018Total net operating
capital$3,000$2,490Investment in total net operating
capital$510Calculating Free Cash Flow2019NOPAT$300−
Investment in total net operating capital$510Free cash
flow−$210Here is an alternative calculation of FCF that is
sometimes used in the financial press.2019FCF =NOPAT +
Depreciation−Gross investment in fixed assets−Investment in
NOWC =$500−$420−$290 =−$210Uses of Free Cash
Flow1. After-tax interest payments2019After-tax interest
expense = (Pre-tax interest expense) x (1-
T)=$60.0x75%=$45.02. Net repayment (issuance) of debtThe
amount of debt that is repaid is equal to the amount at the
beginning of the year minus the amount at the end of the year.
This includes notes payable and long-term debt. If the amount
of ending debt is less than the beginning debt, the company paid
of some of its debt. But if the ending debt is greater than the
beginning debt, the company actually borrowed additional funds
from creditors. In that case, it would be a negative use of
FCF.2019Repayment (issuance) to debtholders =All debt at
beginning of year - all debt at end of year=$378.0-
$670.0=−$2923. Total dividend paymentsThis includes all
dividends to preferred stockholders and dividends to common
stockholders.2019Dividends =Prefered dividends + common
dividends=$7.0+$60.0=$67.04. Net repurchase (sale) of
stockThe amount of stock that is repurchased is equal to the
amount at the beginning of the year minus the amount at the end
of the year. This includes preferred stock and common stock. If
the amount of ending stock is less than the beginning stock, the
company made net repurchases. But if the ending stock is
greater than the beginning stock, the company actually made net
issuances. In that case, it would be a negative use of
FCF.2019Repurchase stock =Preferred stock and common stock
at beginning of year
- Preferred stock and common stock at end of year=$600.0-
$600.0=$0.05. Net purchase (sale) of short-term investmentsThe
amount of net purchases of ST investments is equal to the

amount at the end of the year minus the amount at the beginning
of the year. If the amount of ending investments is greater than
the beginning investments, the company made net purchases.
But if the ending investments are less than the beginning
investments, the company actually sold investments. In that
case, it would be a negative use of FCF.2019Purchase ST
investments =ST investents at end of year - ST investments at
beginning of year=$10.0−$40.0=-$30.0Summary of uses of
FCF20191. After-tax interest payments$45.02. Net repayment
(issuance) of debt-$292.03. Total dividend payments$67.04. Net
repurchase (sale) of stock$0.05. Net purchase (sale) of short-
term investments-$30.0Total uses of FCF =−$210Notice that the
total uses of FCF equals the previously calculated value of
FCF.2-8 Performance EvaluationThe Return on Invested Capital
(ROIC)The Return on Invested Capital tells us the amount of
NOPAT per dollar of operating capital.2019ROIC
=NOPAT÷Total net operating capital =$300.00÷$3,000
=10.00%2018ROIC =NOPAT÷Total net operating capital
=$330.00÷$2,490 =13.25%The Operating Profitability Ratio
(OP)The operating profitability ratio show the amount of
NOPAT per dollar of sales.2019OP =NOPAT÷Sales
=$300.00÷$5,000 =6.00%2018OP =NOPAT÷Sales
=$330.00÷$4,800 =6.88%The Capital Requirement Ratio
(CR)The capital requirement ratio show the amount of operating
capital that is needed to generate a dollar of sales.2019CR
=Total net operating capital÷Sales =$3,000÷$5,000
=60.00%2018CR =Total net operating capital÷Sales
=$2,490÷$4,800 =51.88%Market Value AddedMarket Value
Added is the difference between the market value of
MicroDrive's stock and the amount of equity capital supplied by
shareholders.2019MVA =Stock pricex# of shares−Total
common equity =$31.00x60−$2,240.0 =$1,860−$2,240.0
=−$3802018MVA =Stock pricex# of shares−Total common
equity =$45.00x59.4−$2,052.0 =$2,673−$2,052.0
=$621Economic Value AddedEconomic Value Added represents
MicroDrive's residual income that remains after the cost of all

capital, including equity capital, has been deducted.2019EVA
=NOPAT−Operating Capital xWeighted average cost of
capital =$300−$3,000x11.5% =$300−$345
=−$452018EVA =NOPAT−Operating Capital xWeighted
average cost of capital =$330−$2,490x11.5%
=$330−$286 =$44Figure 2-6Calculating Performance
Measures for MicroDrive(Millions of Dollars)20192018Ind.
Avg.Calculating NOPATEBIT$400$440x (1 − Tax
rate)75%75%NOPAT = EBIT(1 − T)$300$330Calculating Net
Operating Working Capital (NOWC)Operating current
assets$1,600$1,260− Operating current
liabilities600550NOWC$1,000$710Calculating Total Net
Operating CapitalNOWC$1,000$710+ Net plant and
equipment2,0001,780Total net operating
capital$3,000$2,490Calculating Return on Invested Capital
(ROIC)NOPAT$300$330÷ Total net operating
capital3,0002,490ROIC = NOPAT/Total net operating
capital10.00%13.25%13.19%Weighted average cost of capital
(WACC)11.50%11.50%11.20%Calculating the Operating
Profitability Ratio (OP)NOPAT$300$330÷ Sales5,0004,800OP
= NOPAT/Sales6.00%6.88%6.75%Calculating Capital
Requirement Ratio (CR)Total net operating
capital$3,000$2,490÷ Sales5,0004,800CR = Total net operating
capital/Sales60.00%51.88%51.19%Calculating Market Value
Added (MVA)Price per share$31.00$45.00x Number of shares
(millions)60.059.4Market value of equity = P x (# of
shares)$1,860$2,673− Book value of equity2,2402,052MVA =
Market value − Book value−$380$621Calculating Economic
Value Added (EVA)Total net operating
capital$3,000.0$2,490.0x Weighted average cost of capital
(WACC)11.5%11.5%Dollar cost of
capital$345.0$286.4NOPAT$300.0$330.0− Dollar cost of
capital345.0286.4EVA = NOPAT – Dollar cost of
capital−$45.0$43.72-9 Corporate TaxesIn 2017, Congress
passed "An Act to Provide for the Reconciliation Pursuant to
Titles II and V of the Concurrent Resolution on the Budget for

Fiscal Year 2018." The Act is still widely known by the title in
one of its preliminary versions, the Tax Cut and Jobs Act
(TCJA). We will refer to it as the 2017 Tax Act or just the Act.
The 2017 Tax Act made major changes to the corporate and
personal tax regulations. Following are descriptions and
examples of several important items in the Act.Tax RatesThe
biggest change was to the actual tax rates. Prior to the the Act's
passage, corporate taxes were progressive (i.e., the rate was
higher for higher taxable income) up to $18,333,333. Beyond
this amount, the tax rate was 35%. The new tax code is not
progressive but instead applies a flat 21% rate to taxable
income.For example, consider a company with taxable income
of $200 million. Previous tax rate = 35%Taxable income =
$200millionNew tax rate = 21%Tax on income =
$42million2017 tax on same income = $70millionTax saving
due to 2018 Act = $28Percentage reduction in taxes =
40%Interest Expense Deduction LimitationBefore the Act,
corporations could deduct the entire amount of their interest
expenses when calculating taxable income. However, the Act
put a limit on the amount of interest that could be deducted. For
2018, 2019, 2020, and 2021, the Act reduced the allowable
interest expense deduction to 30% of earnings before interest,
taxes, and depreciation & amortization (EBITDA). For 2022 and
subsequent years, the Act reduced the allowable interest
expense deduction to 30% of earnings before interest and taxes
(EBIT).For example, consider a company with EBITDA of $160
million in 2019 and interest expenses of $80.EBITDA =
$160millionInterest expense = $80millionPercentage of
allowable deduction = 30%Allowable interest rate deduction =
$48millionRemaining interest expense to carry forward =
$32millionLoss CarryforwardFor example, consider a company
in the following situation.Cumulative prior unused net operating
lossess = $120million2019 taxable income prior to carryforward
adjustment = $100million2020 taxable income prior to
carryforward adjustment = $100millionCarryforward: Limitation
on offset of taxable income = 80%Federal corporate tax rate =

21%Table 2-1Apex Corporation: Tax Loss Carryforward
(Millions of Dollars)Calculation of tax if ignore carryforward
losses201820192020Taxable operating profit if no carryforward
provision$100.0$100.0Tax (21%) if no carryforward
provision$21.0$21.0Calculation of maximum allowed
carryforward lossUnadjusted taxable operating profit prior to
carryforward$100.0$100.0Maximum allowed carryforward lossa
$80.0$80.0Cumulative prior unused net operating
lossesb$120$40.0$0.0Calculation of maximum allowed
carryforward lossUnadjusted taxable profit prior to
carryforward$100.0$100.0Allowed prior unused net operating
losses carried forwardc$80.0$40.0Adjusted taxable
profit$20.0$60.0Tax on adjusted profit (21%)$4.2$12.6Tax
savings due to carryforward provisionTax if carryforward losses
are ignored$21.0$21.0Tax on adjusted profit (21%) after
carryforward$4.2$12.6Tax savings due to
carryforward$16.8$8.4Notes:aThe maximum allowed carry
forward loss is limited to 80% of the unadjusted taxable
operating profit.bThe cumulative prior unused net operating
loss for Yeart is equal to its value in Yeart-1 minus the amount
that is used in Yeart.cThe operating loss that is carried forward
is equal to the minimum of the prior unused operating losses
and 80% of the current unadjusted operating loss.Dividend
Income Received by a CorporationIf a corporation receives
dividends from another, it may exclude a portion of the
dividends from taxation.Amount of investible funds =
$136.8millionCoupon rate on preferred stock = 7.310%Dividend
exclusion rate = 50%Tax rate = 21%Pre-tax dividends received
by a company = (Preferred coupon rate)(Amount invested)=
$10.000millionTax on dividends = (Dividends)(1 − Dividend
exclusion rate)(Tax rate)= ($10)(1 − 50%)(21%)=
$1.05millionAfter-tax dividends = $8.950millionEffective tax
rate on dividends received = (After-tax dividends)/(Pre-tax
dividends)= 10.50%Suppose the company in the previous
example invests in debt rather than preferred stock because debt
usually has a higher pre-tax rate of return than preferred stock.

For example, suppose the company above invests the same
amount in debt with an interest rate higher than the coupon rate
on the preferred stock.Amount of investible funds =
$136.8millionInterest rate on debt = 8.18%Pre-tax interest
income received by a company = $11.19millionTax rate =
21%Tax on interest = (Interest income)(Tax rate)=
$2.35millionAfter-tax interest = $8.84millionEffective tax rate
on interest received = (After-tax interest)/(Pre-tax interest)=
21.0%The net result is that corporations are taxed less on
dividend income.Effective tax rate on interest received =
21.0%Effective tax rate on dividends received = 10.5%Tax
advantage of dividend versus interest income = 10.5%Dividends
and Interest Paid by a CorporationThe interest paid by a
corporation is deducted from its operating income to obtain its
taxable income. Therefore, a firm needs $1 of pre-tax income to
pay $1 of interest.In contrast, dividends paid are not deductible.
If the combined federal + state tax rate is 24.8%, how much pre-
tax income is needed to pay $1 of dividends?Combined federal
+ state tax rate = 24.8%Pre-tax income needed =$1/(1 - T)=
$1.33Working backwards, suppose a company has $1.33 in pre-
tax earnings and has a 24.8% combined federal + state tax rate.
How much can it pay in dividends?Pre-tax income = $1.33After-
tax income =(Pre-tax income)(1 - T)= $1.002-10 Personal
TaxesMost of the changes to the personal tax code are actually
suspensions of elements in the prior code and will revert to
their former values for the 2026 tax year unless Congress
intervenes. In other words, the most of the TCJA’s changes to
the personal tax code are in effect only for tax years 2018-
2025.Tax brackets and ratesHow much will a person owe on
taxable income of $9,525? On $38,700?For the 2018 tax year,
individuals with less than $9,525 of taxable income are subject
to a federal income tax rate of 10%.Top of first bracket =
$9,525Tax rate for income less than the first bracket =
10%Taxable income = $8,000Tax = $800.00How much will a
taxpayer owe on taxable income of $29,525?Top of first bracket
= $9,525Tax rate for income less than the first bracket =

10%Top of second bracket = $38,700Tax rate for income over
the first bracket but under the second bracket = 12%Taxable
income = $29,525Amount taxed at first bracket's rate
=$9,525Tax on amount in first bracket = $952.50Amount taxed
at second bracket's rate =$20,000Tax on amount in first bracket
= $2,400.00Total tax = $3,352.50Interest on municipal bonds
versus interest on corporate bondsInterest rate on municipal
bond = 5.50%Marginal tax rate on individual = 37.00%How
much must a corporate bond pay until it is a better deal than the
municipal bond?Pre-tax interest rate on corporate bond needed
to provide same after-tax return as a municipal bond = (Rate on
muni)/(1 − Marginal tax rate)= 8.73%
2-2SECTION 2-2SOLUTIONS TO SELF-TESTA firm has $8
million in total assets. It has $3 million in current liabilities,
$2 million in long-term debt, and $1 million in preferred stock.
What is the reported net worth (i.e., the reported common
equity)?Total assets$8,000,000Current
liabilities$3,000,000Long-term debt$2,000,000Preferred
stock$1,000,000The net worth of shareholders, also called
common equity, is equal to the total assets less all liabilities
and preferred stock.Net worth = common equity =$2,000,000
2-3SECTION 2-3SOLUTIONS TO SELF-TESTA firm has
$2,000,000 million in earnings before taxes. The firm has an
interest expense of $300,000 and depreciation of $200,000; it
has no amortization. What is its EBITDA? Earnings before
taxes$2,000,000Interest$300,000Depreciation$200,000Amortiza
tion$0EBITDA stands for earnings before interest, taxes, and
depreciation. To calculate EBITDA using the given information,
start with earnings before taxes and add back interest,
depreciation, and amortization.EBITDA$2,500,000Now suppose
a firm has the following information: $7 million in sales, $4
million of costs of goods sold excluding depreciation &
amortization, $500,000 of other operating expenses. What is its
EBITDA? Sales$7,000,000Costs of goods sold excluding
depreciation and amortization $4,000,000Other operating
expenses$500,000EBITDA stands for earnings before interest,

taxes, and depreciation. To calculate EBITDA using the given
information, start with sales and subtract costs of goods sold
(excluding depreciation) and other operating
costs:EBITDA$2,500,000
2-4SECTION 2-4SOLUTIONS TO SELF-TESTA firm had a
retained earnings balance of $3 million in the previous year. In
the current year, its net income is $2.5 million. If it pays $1
million in common dividends in the current year, what it its
resulting retained earnings balance?Previous retained earnings
balance$3,000,000Current net income$2,500,000Common
dividends$1,000,000This year's addition to retained earnings is
the amount of net income not paid out in dividends:Addition to
retained earnings$1,500,000The new balance of retained
earnings is the previous year's balance plus this year's addition
to retained earnings:Current retained earnings
balance$4,500,000
2-5SECTION 2-5SOLUTIONS TO SELF-TESTA firm has
inventories of $2 million for the previous year and $1.5 million
for the current year. What impact does this have on net cash
provided by operations? Previous year's
inventories$2,000,000Current year's
inventories$1,500,000Inventories are assets that a company
owns. When inventories increase (perhaps because the company
bought more goods than it sold), cash goes down due to the
increase in assets owned by the company.
When inventories decrease (perhaps because the company sold
more goods than it purchased), cash goes up due to the decrease
in assets owned by the company.
Therefore the cash flow due to a change in inventories is equal
to the previous year's inventories minus the current year's
inventories:Cash flow due to inventories = Previous year's
inventories −Current year's inventoriesChange in net cash
provided by operations$500,000
2-6SECTION 2-6SOLUTIONS TO SELF-TESTA firm has net
income of $5 million. Assuming that depreciation of $1 million
is its only noncash expense, what is the firm’s net cash

flow?Net income$5,000,000Depreciation$1,000,000Net cash
flow = Net income + Noncash expensesNet cash flow$6,000,000
2-7SECTION 2-7SOLUTIONS TO SELF-TESTSuppose a firm
has the following information: Sales = $10 million; costs of
goods sold (excluding depreciation) = $5 million; depreciation
= $1.4 million; other operating expenses = $2 million; interest
expense = $1 million. If the tax rate is 25%, what is NOPAT,
the net operating profit after taxes? Sales$10,000,000Costs of
goods sold (excluding
depreciation)$5,000,000Depreciation$1,400,000Other operating
expenses$2,000,000Interest expense$1,000,000Tax rate25%The
first step is to calculate the earnings before interest and taxes,
EBIT. This is the amount of pre-tax operating earnings.EBIT
=Sales − Costs of goods sold excluding depreciation −
Depreciation − Other operating expensesNotice that interest
expense is not subtracted because interest is not an operating
expense.EBIT = pre-tax operating earnings =$1,600,000The
second step is to calculate NOPAT, which is equal to after-tax
operating earnings.NOPAT =EBIT (1−T)NOPAT
=$1,200,000Suppose a firm has the following information: Cash
= $500,000; short-term investments = $2.5 million; accounts
receivable = $1.2 million, inventories = $1 million, and net
plant and equipment = $7.8 million. How much is tied up in
operating current assets? Cash$500,000Short-term
investments$2,500,000Accounts
receivable$1,200,000Inventories$1,000,000Net plant and
equipment$4,000,000Operating current assets are the short-term
assets used in operations. They do not include an short-term
investments or marketable securities that are not a part of
normal operations. They do not include any long-term assets.
Operating CA =Cash + Accounts receivable +
inventoriesOperating current assets =$2,700,000Suppose a firm
has the following information: Accounts payable = $1 million;
notes payable = $1.1 million; short-term debt = $1.4 million;
accruals = $500,000; and long-term bonds = $3 million. What is
the amount arising from operating current liabilities?Accounts

payable$1,000,000Notes payable$1,100,000Short-term
debt$1,400,000Accruals$500,000Long-term
bonds$3,000,000Operating current liabilities are the short-term
liabilities arising from operating acivities. They do not include
any form of debt, including notes payable, short-term debt, or
long-term bonds.Operating CL =Accounts payable +
accrualsOperating current liabilities =$1,500,000Suppose a firm
has the following information: Operating current assets = $2.7
million; operating current liabilities = $1.5 million, long-term
bonds = $3 million, net plant and equipment = $7.8 million; and
other long-term operating assets = $1 million. How much is tied
up in net operating working capital? How much is tied up in
total net operating capital? Operating current
assets$2,700,000Operating current liabilities$1,500,000Long-
term bonds$3,000,000Net plant and equipment$7,800,000Other
long-term operating assets$1,000,000Net operating working
capital (NOWC) is the net amount tied up in short-term
operating assets after adjusting for the amount arising from
short-term operating liabilities. It does not include any cash ties
up in long-term assets and it is not adjusted for any cash
provided by investors.Net operating working capital = NOWC
=Operating current assets − Operating current liabilitiesNet
operating working capital = NOWC =$1,200,000Total net
operating capital includes the net amount tied up in net
operating working capital (NOWC) and the amount tied up in all
long-term operating assets. It is not adjusted for any cash
provided by investors.Total net operating capital =Net operating
working capital + Net plant and equipment + Other long-term
operating assetsTotal net operating capital =$10,000,000A
firm’s total net operating capital for the previous year was $2
million. For the current year, its total net operating capital is
$2.5 million and its NOPAT is $1.2 million. What is its free
cash flow for the current year? Previous year's total net
operating capital$9,300,000Current year's total net operating
capital$10,000,000Current year's NOPAT$1,200,000First,
calculate the investment in total net operating

capital.Investment in total net operating capital =Current year's
total net operating capital − previous year's total net operating
capitalInvestment in total net operating capital
=$700,000Second, calculate free cash flow.Free cash flow
=NOPAT − Investment in total net operating capitalFree cash
flow =$500,000
2-8SECTION 2-8SOLUTIONS TO SELF-TESTA company has
sales of $200 million, NOPAT of $12 million, net income of $8
million, new operating working capital (NOWC) of $10 million,
total net operating capital of $100 million, and total assets of
$110 million. What is it operating profitability (OP) ratio? Its
capital requirment (CF) ratio? Its return on invested capital
(ROIC)? Sales$200millionNOPAT$12millionNet
income$8millionNet operating working capital$10millionTotal
net operating capital$100millionTotal assets$110millionThe
operating profitability (OP) ratio measures the dollars of
operating profit per dollar of sales.OP =NOPAT / SalesOP
=6%The capital requirement (CR) ratio measures the dollars of
total net operating capital tied up per dollar of sales.CR =(Total
net operating capital) / SalesCR =50%The return on invested
capital (ROIC) measures the dollars of operating profit per
dollar of total net operating capital.ROIC =NOPAT / (Total net
operating capital) = OP / CRROIC = NOPAT / (Total net
operating capital) =12%ROIC = OP / CR =12.00%A firm has
$100 million in total net operating capital. Its return on
invested capital is 14 percent, and its weighted average cost of
capital is 10 percent. What is its EVA?Total net operating
working capital$100,000,000ROIC14%WACC10%Free cash
flow =$4,000,000
2-9SECTION 2-9SOLUTIONS TO SELF-TEST If a corporation
has $85,000 in taxable income, what is its tax liability?Taxable
income$85,000Tax rate 21%Tax liability$17,850
Mini Case Data11/20/18Chapter 2 Mini CaseSituationJenny
Cochran, a graduate of The University of Tennessee with 4
years of experience as an equities analyst, was recently brought
in as assistant to the chairman of the board of Computron

Industries, a manufacturer of computer components.
During the previous year, Computron had doubled its plant
capacity, opened new sales offices outside its home territory,
and launched an expensive advertising campaign. Cochran was
assigned to evaluate the impact of the changes. She began by
gathering financial statements and other data.Computron's
Balance Sheets (Millions of Dollars)20192020AssetsCash and
equivalents$ 60$ 50Short-term investments10010Accounts
receivable400520Inventories620820Total current assets$
1,180$ 1,400Gross fixed assets$ 3,900$ 4,820Less:
Accumulated depreciation1,0001,320Net fixed assets$ 2,900$
3,500Total assets$ 4,080$ 4,900Liabilities and
equityAccounts payable$ 300$ 400Notes
payable50250Accruals200240Total current liabilities$ 550$
890Long-term bonds8001,100Total liabilities$ 1,350$
1,990Common stock1,0001,000Retained
earnings1,7301,910Total equity$ 2,730$ 2,910Total
liabilities and equity$ 4,080$ 4,900Computron's Income
Statement (Millions of Dollars)20192020Net sales$ 5,500$
6,000Cost of goods sold (Excluding depr. &
amort.)4,3004,800Depreciation and amortizationa290320Other
operating expenses350420Total operating costs$ 4,940$
5,540Earnings before interest and taxes (EBIT)$ 560$
460Less interest 68108Pre-tax earnings$ 492$ 352Taxes
(25%)12388Net Income $ 369$ 264Notes:a Computron has no
amortization charges.Other Data20202019Stock
price$57.00$40.00Shares outstanding (millions)100100Common
dividends (millions)$90$84Tax rate25%25%Weighted average
cost of capital (WACC)10.00%10.00%Computron's Statement of
Cash Flows (Millions of Dollars)
Bart Kreps: The statement of cash flows provides information
about cash inflows and outflows during an accounting period.
2020Operating Activities Net Income before preferred
dividends$ 264Noncash adjustments Depreciation and
amortization320Due to changes in working capital Change in

accounts receivable(120) Change in inventories(200) Change
in accounts payable100 Change in accruals40Net cash
provided by operating activities$ 404Investing activities
Cash used to acquire fixed assets$ (920)
Bart Kreps: Make sure to add back annual Depreciation to Net
PP&E.
Change in short-term investments90Net cash provided by
investing activities$ (830)Financing Activities Change in
notes payable$ 200 Change in long-term debt300 Payment
of cash dividends(84)Net cash provided by financing activities$
416Net change in cash and equivalents$ (10)Cash and
securities at beginning of the year60Cash and securities at end
of the year$ 50
Web 2ARead this comment
Michael Ehrhardt: The rates shown are those available in spring
2018. They may change as inflation is incorporated into the
dollar break points.11/20/18Web Extension 2A: Tool Kit for
Individual TaxesSome of the examples here are simplified for
the sake of clarity and do not necessarily reflect all the possible
exceptions and minor adjustments in the actual tax code. Do not
use these examples as a substitute for the actual IRS instruction
or the advice of a profession tax preparer.The rates shown are
those available in spring 2018. They may change as inflation is
incorporated into the dollar break points.Table 2A-1 Individual
Tax TableIf an individual'sHe/she pays this Plus this
percentageAverage tax taxable incomeamount on theon the
excessrate at is between:base of the bracketover the basetop of
bracket(1)(2)(3)(4)(5)$0$9,525$0.0010.0%10.0%$9,525$38,700
$952.5012.0%11.5%$38,700$82,500$4,453.5022.0%17.1%$82,5
00$157,500$14,089.5024.0%20.4%$157,500$200,000$32,089.5
032.0%22.8%$200,000$500,000$45,689.5035.0%30.1%$500,00
0and up$150,689.5037.0%37.0%Married (Joint Return) Tax
TableIf a couple'sIt pays this Plus this percentageAverage tax
taxable incomeamount on theon the excessrate at is

between:base of the bracketover the basetop of
bracket(1)(2)(3)(4)(5)$0$19,050$0.0010.0%10.0%$19,050$77,4
00$1,905.0012.0%11.5%$77,400$165,000$8,907.0022.0%17.1%
$165,000$315,000$28,179.0024.0%20.4%$315,000$400,000$64
,179.0032.0%22.8%$400,000$600,000$91,379.0035.0%26.9%$6
00,000and up$161,379.0037.0%37.0%Application of tax table
to single filers and married (joint return) filers.Suppose an
individual filer has taxable income (Form 1040 Line 44) of
$60,000. All the earning are from wages (i.e., none are from
dividend income or net long-term capital gains).Individual
filer:Taxable incomeTaxAverage Tax
Rate$60,000.00$9,139.5015.23%Suppose a married couple
filing jointly has taxable income (Form 1040 Line 44) of
$120,000. All the earning are from wages (i.e., none are from
dividend income or net long-term capital gains).Married (joint)
filer:Taxable incomeTaxAverage Tax
Rate$120,000.00$18,279.0015.23%As shown below, the married
joint filers have twice as much taxable income as the individual
filer and they have twice as much tax as the indidvidual filer.
Prior to the TCJA, this was not the case--married joint filers
paid more in taxes than twice the individual filers with the same
taxable income. This was called the marriage penalty, which
was common if both spouses had similar incomes. The TCJA
eliminated the marriage penalty.Married taxable income /
Individual taxable income = 2.00Married tax / Individual tax =
2.00Example: Using Tax Rates and Brackets to Calculate
Personal Taxes Exemption per person =$0Read comment.
Michael Ehrhardt: When filing a tax return in 2018 for the 2017
tax year, each taxpayer received an exemption of $4,500 for
each dependent, including the taxpayer, which reduced taxable
income. However, the TCJA eliminated personal exemptions for
2018-2025.Standard deduction (individual) =$12,000Standard
deduction (married filing joint) =$24,000Social Security (SS)
tax rate =6.20%Wage base level for capping SS tax
=$128,700Medicare tax rate =1.45%Additional Medicare Tax

rate =0.90%Additional Medicare Tax for single filers begins at
=$200,000Additional Medicare Tax for married joint filers
begins at =$250,000Income tax on wage, salaries, tips, etc.Find
the marginal income tax rate, the U.S. income tax, and the
average tax rate for a single person in the following situation.
Gross income
(all as wages reported on Form 1040 Line 7)
=$70,700.00Standard deduction =$12,000.00Taxable Income
=$58,700.00Base taxable income =$38,700.00Base tax
=$4,453.50Marginal tax rate =22.0%Tax =$8,853.50Average tax
rate =15.08%Payroll taxes: Social Security taxes and Medicare
taxesUsing the example above, how much would remain after
income taxes, Social Security taxes, and Medicare taxes? Gross
income (all as wages) =$70,700.00Amount subject to Social
Security rate =$70,700.00Social Security tax rate =6.2%Social
Security tax =$4,383.40Medicare tax rate =1.45%Additional
Medicare tax rate for high incomes =0.90%Total Medicare tax
rate =1.45%Medicare tax =$1,025.15Total payroll taxes (Social
Security and Medicare) =$5,408.55Remaining after income
taxes,
Social Security, and Medicare =$56,437.95Suppose the person
in the previous example receives a $1,000 raise. What are the
additional income taxes and combined Social Security and
Medicare taxes (assume the person is not self-employed).Pay
raise:$1,000.00Gross income (all as wages)
=$71,700.00Standard deduction =$12,000.00Taxable Income
=$59,700.00Base taxable income =$38,700.00Base tax
=$4,453.50Marginal tax rate =22.0%Tax =$9,073.50Average tax
rate =15.20%Social Security payment rate =6.2%Amount
subject to Social Security rate =$71,700.00Social Security
payment =$4,445.40Medicare payment rate =1.45%Social
Security payment =$1,039.65Remaining income after income
taxes,
Social Security, and Medicare =$57,141.45Additional income
due to raise =$703.50If the increase in income does not put the
gross income into a new tax bracket and does not exceed the

limit for Social Security taxes, then the additional after-tax
raise is equal to the pre-tax raise multiplied by the marginal tax
rate.Marginal tax rate =22%Additional income tax
=$220Additional Social Security and Medicare tax
=$76.50Total after-tax raise =$703.50Net Investment Income
TaxIn addition to tax on various types of investment income,
there is 3.8% Net Investment Income Tax levied on investment
income that exceeds a limit, as shown below.Net investment
income tax rate = 3.80%Net investment income tax threshold for
single filers = $200,000Net investment income tax threshold for
joint filers = $250,000Single filer's investment income =
$80,000Single filer's modified adjusted gross income
=$300,000Modified adjusted gross income minus the threshold
= $100,000Minimum of net investment income and excess of
modified adjusted gross income over the threshold =
$80,000Net investment income tax =$3,040Municipal bond
after-tax interestSuppose an individual is at the top tax bracket.
This person is considering purchasing either a tax-exempt
municipal bond or a a corporate bond. Total investment income
is below the threshold that triggers the additional Net Income
Investment Tax. Using the information below, which bond
should the person buy?Interest rate on corporate bond =
8.00%Interest rate on municipal bond = 5.50%Marginal tax rate
on individual = 37.00%After-tax return on corporate bond =
(Interest rate)(1 − Marginal tax rate)= 5.04%How much must a
corporate bond pay until it is a better deal than the municipal
bond?Pre-tax interest rate on corporate bond needed to
provide same after-tax return as a municipal bond = (Rate on
muni)/(1 − Marginal tax rate)= 8.73%If we know the pre-tax
yield on the corporate bond, how much must a muni pay for it
to be a better deal than the corporate bond?Pre-tax interest rate
on corporate bond = 8.73%Marginal tax rate on individual =
37.00%Required interest rate on muni = (Pre-tax rate on
corporate bond)(1 − Marginal tax rate)= 5.50%Dividend and
Capital Gains TaxationFirst, there is no separate line of Form
1040 to record the tax on qualified dividends and net long-term

gains. (The dividends we discuss will be qualied. Loosely
speaking, a qualified dividend one that is actually paid by a
domestic C corporation.) Instead, it is embedded in the
caculations of 1040 line 44, Tax. So you have to use the
"Qualified Dividends and Capital Gain Worksheet" in Form
1040. The following examples isolate the tax treatment of
dividends and gains from the embedded calculations in the
"Qualified Dividends and Capital Gain Worksheet" in Form
1040.Dividends and net long-term capital gains are taxed
exactly the same way, so we will usually refer to "combined
dividends and gains" when discussing taxes. Combined
dividends and gains are taxed differently from ordinary income.
Combined dividends and gains have progressive brackets that
differ from those for ordinary income. The following examples
are based on the combined amount of dividends and capital
gains. Note: At high incomes, there may be an additional Net
Investment Income Tax, as we illustrated previously. We omit
this from the following examples to better focus on the separate
tax on combined dividend and gains. Table 2A-2Tax Brackets
and Rates for Calculating Tax on Combined Dividends and
Long-Term Capital Gains for the 2018 Tax Year (as available in
March, 2018)Single
FilersBracketsRatesRates$0$38,6000.00%0.00%$38,600$425,80
015.00%15.00%$425,800and up20.00%20.00%Married Joint
FilersBracketsRatesRates$0$77,2000.00%0.00%$77,200$479,00
015.00%15.00%$479,000and up20.00%20.00%Summary of
BracketsSingle filers1st bracket =$38,6002nd bracket
=$425,800Amount between 1st and 2nd bracket =
$387,200Married joint filers1st bracket =$77,2002nd bracket
=$479,000Amount between 1st and 2nd bracket =
$401,800Suppose a married couple has ordinary income of
$379,000 and dividends & gains of $200,000. How much tax do
they owe on the dividends & gains?Married joint filersOrdinary
income = $379,000Dividends and gains = $150,000Line 43
taxable income = $529,000Total tax tax on dividends & gains
using calcuations shown below =$25,000Will there be taxable

income only at the 20% rate? If so, how much? Is ordinary
income > 2nd bracket = FALSETax on dividends & gain =
FALSEIs ordinary income between 1st and 2nd bracket?
TRUEAmount of bracket filled by ordinary income
=$301,800Remaining amount of bracket NOT filled by ordinary
income =$100,000Amount of bracket filled by dividends &
gains =$100,000Tax on dividends & gains between 1st and 2nd
bracket =$15,000Amount of remaining untaxed dividends &
gains = $50,000Tax on dividends & gains > over 2nd bracket
=$10,000Total Tax on div and gain if ordinary income is
between 1st and 2nd brackets = $25,000Is ordinary income in
1st bracket? FALSEAmount of bracket filled by ordinary
income =FALSERemaining amount of bracket NOT filled by
ordinary income =FALSEAmount of bracket filled by dividends
& gains =FALSETax on dividends & gains below 1st bracket
=$0Amount of remaining untaxed dividends & gains =
FALSEAmount of remaining dividends & gains below 2nd
bracket = FALSETax on dividends & gains between the brackets
= $0Amount of dividends and gains > 2nd bracket = FALSETax
on dividends & gains > over 2nd bracket =$0Total tax on
dividends & gains if ordinary < 1st bracket = $0Single
filersOrdinary income = $20,000Dividends and gains =
$500,000Line 43 taxable income = $520,000Total tax tax on
dividends & gains using calcuations shown below =$76,920Will
there be taxable income only at the 20% rate? If so, how much?
Is ordinary income > 2nd bracket = FALSETax on dividends &
gain = FALSEIs ordinary income between 1st and 2nd bracket?
FALSEAmount of bracket filled by ordinary income
=FALSERemaining amount of bracket NOT filled by ordinary
income =FALSEAmount of bracket filled by dividends & gains
=FALSETax on dividends & gains between 1st and 2nd bracket
FALSETax on dividends & gains > over 2nd bracket =$0Total
Tax on div and gain if ordinary income is between 1st and 2nd
brackets = $0Is ordinary income in 1st bracket? TRUEAmount
of bracket filled by ordinary income =$20,000Remaining

amount of bracket NOT filled by ordinary income
=$18,600Amount of bracket filled by dividends & gains
=$18,600Tax on dividends & gains below 1st bracket
$481,400Amount of remaining dividends & gains below 2nd
bracket = $387,200Tax on dividends & gains between the
brackets = $58,080Amount of dividends and gains > 2nd bracket
= $94,200Tax on dividends & gains > over 2nd bracket
=$18,840Total tax on dividends & gains if ordinary < 1st
bracket = $76,920

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