Practical financial manaegment lasher 7th ed chapter 02

Chapter - Financial background: A Review of Accounting, Financial Statements and Taxes The Nature of Financial Statements Numerical representations of a firm’s activities for an accounting period – A picture of activities within the firm and between the firm and the outside – But can be counterintuitive Accounts Receivable Most sales are on credit Seller receives a promise of later payment, rather than immediate cash The seller records an account receivable as an asset Net income may not = cash flow Depreciation Proration of an asset’s cost over its service life Can be straight lined or accelerated Cost recorded on the income statement does not = cash spent The Nature of Financial Statements Three Financial Statements – Income statement – Balance sheet – Statement of cash flows Generated from the income statement and balance sheet The Accounting System A firm’s financial books are a collection of records in which money transactions are recorded – Double entry system – Accounting periods and closing the books – Implications – Stocks and flows Table 2-1 A Typical Income Statement The Income Statement Sales Cost and Expenses – Costs of Goods Sold – Expense – Depreciation Gross margin Earnings before interest and taxes (EBIT) The Income Statement Earnings Before Tax, and Tax Net Income Terminology: – Income = profit = earnings – Profit before tax (PBT) – Profit after tax (PAT) – Earnings before tax (EBT) – Earnings after tax (Net Income) Earnings Earnings – Also called net income – Paid out as dividends or retained in business Retained Earnings (RE) – Each year earnings not paid as dividends become an addition to equity – Retained earnings account is cumulative earnings not paid out as dividends Concept Connection Example 2-4 Calculating Personal Taxes The Harris family had the following income in 2012: Salaries: Joe $55,000 Sue 52,000 Interest on savings acct Interest on IBM bonds Interest on Boston Bonds Dividends - Gen Motors 2,000 800 1,200 600 40 Concept Connection Example 2-4 Calculating Personal Taxes In 2012 the Harris family: Sold property for $50,000, paid $53,000 years earlier Sold stock for $14,000, paid $12,000 years earlier Paid $12,000 interest on home mortgage Paid $1,800 in real estate taxes Had $3,500 withheld from pay for state income tax Contributed $1,200 to charity Have two children Exemption rate is $3,800 per person Calculate taxable income and tax liability What are marginal and average tax rates? 41 Concept Connection Example 2-4 Calculating Personal Taxes Ordinary income: Deductions: Salaries $107,000 Interest 2,800 Mortgage interest $12,000 Taxes $109,800 5,300 Charity 1,200 $18,500 Net capital gain or loss: Loss on property ($3,000) Exemptions: Gain on stock $3,800 x = 2,000 Net capital loss $15,200 ($1,000) Total Income $108,800 Taxable Income $75,100 (excludes dividends) 42 Concept Connection Example 2-4 Calculating Personal Taxes Use the married filing jointly schedule as follows: 10% of the entire first bracket $17,400 x 10 = $1,740 15% of the amount in the second bracket ($70,700- $17,400) x 15 = 7,995 ($75,100 - $70,700) x 25 = 1,000 25% of the amount in the third bracket Tax Liability $10,835 Tax on dividends $600 x 15 = 90 Total tax liability $10,925 Average tax rate: $10,925/$75,700 = 14.4% Marginal tax rate = bracket rate = 25% (15% if dividends or capital gains) 43 Personal Taxes Tax Rates and Investment Decisions – Comparing municipal (muni) and corporate bonds Interest on muni’s not subject to federal taxes At same rate muni’s return is higher after taxes If the rates differ, restate corporate to an after tax yield Multiply by one minus investor’s marginal tax rate (1 – marginal tax rate) 44 Concept Connection Example 2-5 Comparing Taxable and Tax Exempt Returns The Harris family (25% bracket) has a choice between an IBM bond paying 11% and a Boston bond paying 9% Solution: IBM after tax = 11% x (1 - 25) = 8.25% < Boston = 9% Therefore prefer the Boston bond if risks are similar If marginal tax rate is 15% 11% x (1 - 15) = 9.35% then prefer IBM High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes 45 Corporate Taxes Similar in principle to personal taxes: total income is revenue Earnings Before Tax (EBT) is taxable income Corporate tax rates not consistently rise as taxable income rises 46 Table 2-5 Corporate Income Tax Schedule The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income So a corporation earning more than $18,333,333 pays 35% on all of its income from the first dollar 47 Concept Connection Example 2-6 Corporate Income Taxes Calculate the tax liability for corporations with the following EBTs: a $280,000 b $500,000 c $16,000,000 d $23,000,000 SOLUTION: a Applying the corporate tax table to $280,000 yields the following: $ 50,000 × 15 = $ 7,500 $ 25,000 × 25 = 6,250 $ 25,000 × 34 = 8,500 $180,000 × 39 = $ 70,200 $ 92,450 b Between $335,000 and $10 million the overall tax rate is 34% so the tax on $500,000 is $500,000 × 34 = $170; 000 48 Concept Connection Example 2-6 Corporate Income Taxes c We don’t have to go through the calculations in the bottom brackets because we know that the system recovers those benefits to an overall 34% up to $10 million $10,000,000 × 34 = $3,400,000 $ 5,000,000 × 35 = $1,750,000 $ 1,000,000 × 38 = $ 380,000 $5,530,000 d Over $18,333,333, the tax is a flat 35% of all income starting from nothing, so the tax on $23,000,000 is $23,000,000 × 35 = $8,050,000 49 Corporate Taxes Taxes and Financing – The tax system favors debt financing – Result: A debt-financed firm pays less tax than an identical equity financed company – But the availability of debt is limited because it makes the borrowing company risky 50 Corporate Taxes Corporate Taxes Dividends Paid to Corporations – Dividends paid to another corporation are partially tax exempt 52 Figure 2-2 Multiple Taxation 53 Figure 2-3 Tax Loss Carry Back and Forward 54