978-1259709685 Chapter 2 Lecture Note Part 2

subject Type Homework Help
subject Pages 9
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subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

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Slide 2.17 Non-Cash Items
The matching principle also creates the recognition of non-cash items. For
example, when we purchase a machine, the cash flow occurs
immediately, but we recognize the expense of the machine over
time as it is used in the production process (i.e., depreciation).
The largest non-cash deduction for most firms is depreciation; however, other
non-cash items include amortization and deferred taxes. Non-cash
expenses reduce taxes and net income, but do not actually
represent a cash outflow. Non-cash deductions are part of the
reason that net income is not equivalent to cash flow.
Lecture Tip: In March 2004, Global Crossing reported record quarterly
earnings of $24.88 billion on revenues of $719 million. These
earnings came about because GAAP regarding non-cash items
related to the firm’s emergence from bankruptcy. According to The
Wall Street Journal Online (Global Crossing Scores A Bankruptcy
Bonanza, March 11, 2004), $8 billion of the profit was from the
ability to eliminate the liabilities associated with contracts with
equipment vendors that were renegotiated during bankruptcy.
Another $16 billion came from eliminating the common and
preferred shares that previously existed. Most of the remainder of
the “profit” came from the liabilities associated with contracts
between Global Crossing and other phone companies that were
eliminated during the bankruptcy proceedings. If these non-cash
“revenues” were eliminated from the calculations, then the firm
would have had a net loss of approximately $3 million. Clearly,
GAAP don’t always provide a clear view of earnings.
Ethics Note: Publicly traded firms have to file audited annual reports, but
that does not mean that “accounting irregularities” never slip by
the auditors. Companies that deliberately manipulate financial
statements may benefit in the short run, but it eventually comes
back to haunt them. Cendant Corporation is a good example.
Cendant was created when CUC International and HFS, Inc.
merged in late 1997. The combined company owns businesses in
the real estate and travel industries. In April 1998, the combined
company announced that accounting irregularities had been found
in the CUC financial statements and earnings would need to be
restated for 1997 and possibly 1995 and 1996 as well. Cendant’s
stock price dropped 47 percent the day after the announcement
was made (it was announced after the market closed). The
problems haunted Cendant throughout 1998. In July, it was
announced that the problem was much worse than originally
expected, and the stock price plummeted again. By the end of July,
the stock price had dropped more than 60 percent below the price
before the original announcement. The company also had to take a
$76.4 million charge in the third quarter of 1998 for the costs of
investigating the accounting irregularities. Criminal charges have
been filed against several former executives of CUC International,
and several class action lawsuits have been filed against Cendant.
The stock was trading around $41 per share prior to the
announcement and dropped to as low as $7.50 per share in
October 1998. The price started to rebound, but as of June 2005
($21.85) was still only about half of what it had been prior.
Further, the company was split into four segments in October
2005, possibly a result of the prior actions discussed above.
Other companies, such as Enron, WorldCom, etc. have fared much worse.
There were a string of accounting problems at the start of this
century, and these, along with the terrorist attacks, led to much of
the market decline during the early 2000s.
Lecture Tip: Students sometimes fail to grasp the distinction
between the economic life of an asset, the useful life of an asset for
accounting purposes, and the useful life of an asset for tax
purposes. “Economic life” refers to the period of time that the
asset is expected to generate cash flows and must be considered
when capital budgeting decisions are made. “Useful life” for
accounting purposes is largely determined by the firm’s
accountants, with guidance from GAAP, and it affects the
depreciation expense on the balance sheets and income statements
that are used for business purposes. “Useful life” for tax purposes
is determined by the Internal Revenue Service and is based on
different asset categories. This is also important for capital
budgeting because it determines the tax consequences of
depreciation, which affects cash flow.
.A Time and Costs
Slide 2.18 Time and Costs
We need to plan for both short-run cash flows and long-run cash flows. In the
short run, some costs are fixed regardless of output, and other costs
are variable. For example, fixed assets are generally fixed in the
short run, while inputs such as labor and raw materials are
variable. In the long run, all costs are variable. It is important to
identify these costs when doing a capital budgeting analysis.
Additionally, accountants typically classify costs as product costs
and period costs, rather than fixed and variable.
Lecture Tip: Distinguishing between fixed and variable costs can have
important implications for estimating cash flows. It is sometimes
helpful to remind students that variable costs are cash outflows
that vary with the level of output, while fixed costs do not. Another
important thing to point out is that the definition of short run and
long run varies for different types of businesses.
2.2. Taxes
Slide 2.19 Taxes Click on the web surfer icon to go to the IRS web site.
You can show the students how to search for the most up-to-date tax
information.
The tax code is constantly changing with the decisions of Congress. Since
corporations pay taxes, we need to be aware of these changes.
Lecture Tip: The text notes the ever-changing nature of the tax code. This
can be illustrated by the changes in the Investment Tax Credit (ITC)
between 1962 and 1986.
1962 – Seven percent ITC created to stimulate capital investment
1966 – ITC suspended
1967 – Seven percent ITC reinstated
1969 – ITC eliminated
1971 – Seven percent ITC reinstated
1975 – Credit increased to 10 percent
1986 – ITC eliminated
Tax rates affect the firm’s cash flow and, therefore, the firm’s value. Since
we want to maximize firm value, we need to include taxes in our
decisions.
Marginal tax rate – rate paid on next dollar of income
Average tax rate = tax bill / taxable income
Since decisions create incremental income, we want to use the marginal
rate in our decisions.
.A Corporate Tax Rates
It’s important to point out to students that corporations (and individuals) do
not pay a flat rate on their income, but corporate rates are not
strictly increasing either. Rates are progressive to a point, then
decline to a point, such that the largest firms end up paying a rate
(marginal = average) of 35 percent.
The average rate rises to the marginal rate at $50 million of taxable
income. The “surcharges” at 39% and 38% offset the initial lower
marginal rates.
.B Average versus Marginal Tax Rates
Slide 2.20 Marginal versus Average Rates
This slide provides an in-class example for calculating taxes and
rates, with the answers given in the notes to the slide.
Note that the tax code presented is generally simplified. To see a
more accurate reflection of the average rate by industry, check out
Table 2.5.
Lecture Tip: It is useful to stress the situations in which marginal
tax rates are relevant and those in which average tax rates are
relevant. For purposes of computing a company’s total tax
liability, the average tax rate is the correct rate to apply to before
tax profits. However, in evaluating the cash flows that would be
generated from a new investment, the marginal tax rate is the
appropriate rate to use. This is because the new investment will
generate cash flows that will be taxed above the company’s
existing profit.
Lecture Tip: The op-ed page of the March 11, 1998, issue of The
Wall Street Journal contains an article guaranteed to generate
class discussion. Entitled “Abolish the Corporate Income Tax,”
the author provides a quick overview of the situation that brought
the current income tax into being in the early 1900s, and contends
that the corporate and personal income tax systems began life as
“two separate and completely uncoordinated tax systems.” With
the passage of time, the tax code has, of course, become extremely
complex, and the author illustrates this by noting that, “Chrysler
Corporation’s tax returns comprise stacks of paper six feet high,
prepared by more than 50 accountants who do nothing else.” And,
he points out, “the Internal Revenue Service, meanwhile, has a
team of auditors who do nothing but monitor Chryslers returns.”
Given the complexity and wasted effort, the author suggests that
the rational thing to do is to abolish the corporate income tax. Do
you agree?
2.3. Net Working Capital
Slide 2.21 Net Working Capital
The difference between a firm’s current assets and its current liabilities.
Slide 2.22 U.S.C.C. Balance Sheet
Since a firm needs current assets (e.g., inventory) to generate sales, as the firm
grows, so generally does its net working capital.
2.4. Cash Flow of the Firm
Slide 2.23 Financial Cash Flow
Cash is the lifeblood of a business and is, therefore, the most important
item that can be extracted from financial statements.
We generate cash flow from assets, then use this cash flow to reward
creditors and stockholders. In conjunction with the balance sheet identity,
we know that the cash flow from assets must, therefore, equal the cash
flows to creditors and stockholders:
CF(A) CF(B) + CF(S)
Stated explicitly, the cash flow identity is
Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to
Stockholders
Slide 2.24 –
Slide 2.30 U.S.C.C. Financial Cash Flow
These slides provide a walkthrough of the calculation of the components
of cash flow.
CF of the Firm = operating cash flow – net capital spending – changes in
net working capital
Operating cash flow (OCF) = EBIT + depreciation – taxes
Net capital spending (NCS) = purchases of fixed assets – sales of fixed assets
or
NCS = ending net fixed assets – beginning net fixed assets +
depreciation
Changes in NWC = ending NWC – beginning NWC
Cash Flow to Creditors and Stockholders
Cash flow to creditors = interest paid + retirement of debt – proceeds from
new debt
or
Cash flow to creditors = interest paid – net new borrowing
= interest paid – (ending long-term debt – beginning long-term debt)
Cash flow to stockholders = dividends paid + stock repurchases – proceeds
from new stock issues
or
Cash flow to stockholders = dividends paid – net new equity raised =
dividends paid – (ending common stock, APIC & Treasury stock –
beginning common stock, APIC & Treasury stock)
It is important to point out that changes in retained earnings are not
included in “net new equity raised.”
Lecture Tip: Textbooks make financial statement analysis seem reasonably
straightforward. However, it is not always as easy to classify the
numbers that appear on the consolidated financial statements of
an actual corporation.
The cash flow identity may not appear to hold when applied in a
reasonable fashion based on the information provided in many
financial statements. It is important to point out, however, that
financial managers have a lot more information available to them
than what is provided in the consolidated statements of an annual
report. The manager will have the information available to
compute cash flow from assets, and if it is done carefully, the cash
flow identity will hold.
2.5. The Accounting Statement of Cash Flows
Slide 2.31 The Statement of Cash Flows
There is an official accounting statement called the Statement of Cash
Flows, which explains the change in the cash account on the firm’s
balance sheets between two periods. The statement typically has three
components: cash flows from operating activities, cash flows from
investing activities, and cash flows from financing activities.
It is helpful to think of cash inflows and outflows:
Sources and Uses of cash
Activities that bring in cash are sources. Firms raise cash by selling
assets, borrowing money, or selling securities.
Activities that involve cash outflows are uses. Firms use cash to buy assets,
pay off debt, repurchase stock, or pay dividends.
There are some mechanical Rules for determining Sources and Uses:
Sources:
Decrease in asset account
Increase in liabilities or equity account
Uses:
Increase in asset account
Decrease in liabilities or equity account
A. Cash Flow from Operating Activities
Slide 2.32 U.S.C.C. Cash Flow from Operations
Operating Activities
+ Net Income
+ Depreciation
Deferred Taxes
+ Decrease in current asset accounts (except cash)
+ Increase in current liability accounts (except notes payable)
- Increase in current asset accounts (except cash)
- Decrease in current liability accounts (except notes payable)
It may be good to note that cash flow from operations effectively accounts
for interest expense since it is subtracted prior to net income; however, this
flow is more generally related to financing activities.
B. Cash Flow from Investing Activities
Slide 2.33 U.S.C.C. Cash Flow from Investing
Investment Activities
+ Ending net fixed assets
- Beginning net fixed assets
+ Depreciation
C. Cash Flow from Financing Activities
Slide 2.34 U.S.C.C. Cash Flow from Financing
Financing Activities
Change in notes payable
Change in long-term debt
Change in common stock
- Dividends
Slide 2.35 U.S.C.C. Statement of Cash Flows
Putting it all together:
Net cash flow from operating activities
Net cash flow from investing activities
Net cash flow from financing activities
= Net increase (decrease) in cash over the period
2.6. Cash Flow Management
Slide 2.36 Cash Flow Management
The common assumption is that cash flow is a better metric to evaluate, as
opposed to earnings, which can be more easily manipulated by subjective
decisions allowed by GAAP (generally accepted accounting principles).
While this may be true, firms can still “manage” cash flows, particularly by,
for example, classifying items as operating rather than investing cash flows.
This will not change the total cash flow, but it may make the firm’s operations
seem stronger than they actually are. Nonetheless, since total cash flow is
unchanged by this “management,” it is thus a better measure than earnings.
Slide 2.37 Quick Quiz

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