Earnings Vs Cash Flows

PAGE 1

CHAPTER 3

EARNINGS VS CASH FLOWS

THE FOCUS OF FINANCIAL STATEMENTS IN ACCOUNTING IS NET INCOME OR EARNINGS (PROFIT) AFTER TAXES

SINCE NET INCOME MAY BE DERIVED BY DIFFERENT FIRMS USING DIFFERENT GAAP, COMPARISON OF FIRMS MAY BECOME DIFFICULT

EVEN IF THE FIRMS UNDER COMPARISON USE THE SAME GAAP, NET INCOME MAY NOT GIVE A TRUE PICTURE OF A FIRM’S PERFORMANCE, BECAUSE OF NONCASH CHARGES SUCH AS DEPRECIATION AS TAX DEDUCTIBLE EXPENSES

THEREFORE IN FINANCE WE USE CASH FLOWS TO GET A BETTER PICTURE OF A FIRM’S PERFORMANCE IN A PERIOD

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DIFFERENT INCOMES AND CASH FLOWS

· REVENUE (SALES) = UNITS SOLD * UNIT PRICE

· EBITDA = REVENUE –CASH OPERATING COSTS (CHARGES)

(I.E. COGS + MARKETING &ADMINISTRATIVE EXPENSES)

· STRAIGHT LINE DEPRECIATION

= (INITIAL COST-EXPECTED SALVAGE)

EXPECTED USEFUL LIFE

· EBIT = REVENUE-CASH OPERATING COSTS-DEPRECIATION

· EBT = EBIT-INTEREST

· TAXES = EBT * TAXRATE

· NI = EBT - TAXES

· NI = (EBIT – INTEREST) (1-TAXRATE)

· A-T OPERATING INCOME OR NOPAT (NET OPERATING PROFIT AFTER

TAX )= EBIT* (1-TAXRATE)

· NET OPERATING CASH FLOW = A-T OPERATING INCOME OR NOPAT+

DEPRECIATION

· NET CASH FLOW = NET INCOME + DEPRECIATION

· NET CASH FLOW = NET OPERATING CASH FLOW -

INTEREST (1-TAX RATE)

· FREE CASH FLOW= NET OPERATING CASH FLOW-INVESTMENT

(CHANGE) IN GROSS OPERATING CAPITAL

= NET OPERATING CASH FLOW-(CAPITAL EXPENDITURES+

CHANGE IN NET OPERATING WORKING CAPITAL)

= NOPAT - INVESTMENT (CHANGE) IN NET OPERATING

CAPITAL

· GROSS OPERATING CAPITAL = NET OPERATING WORKING CAPITAL+

GROSS FIXED ASSETS

· NET OPERATING CAPITAL = NET OPERATING WORKING CAPITAL +

NET FIXED ASSETS

· NET OPERATING CAPITAL = GROSS OPERATING CAPITAL –

ACCUMULATED DEPRECIATION

· NET OPERATING WORKING CAPITAL= CURRENT ASSETS -(A/P + ACCRUALS)

· INVESTMENT IN GROSS OPERATING CAPITAL (t)= GROSS OPERATING CAPITAL(t)- GROSS OPERATING CAPITAL (t-1)

· INVESTMENT IN NET OPERATING CAPITAL(t)=

NET OPERATING CAPITAL(t)- NET OPERATING CAPITAL (t-1)

· INVESTMENT IN NET OPERATING CAPITAL(t) = INVESTMENT IN GROSS

OPERATING CAPITAL(t)-

DEPRECIATION (t)

PAGE 3

CASH FLOW PROBLEM

MILLENNIUM CORP’S PARTIAL BALANCE SHEETS FOR 2007 & 2008 ARE SHOWN BELOW. MILLENNIUM WENT INTO BUSINESS IN 2007 WITH A FIXED ASSET WITH AN INITIAL COST OF $800,000, AN EXPECTED SALVAGE VALUE OF $50,000 AND A USEFUL LIFE OF 5 YEARS. IN 2008 MILLENNIUM ACQUIRED ANOTHER FIXED ASSET . THE COST OF THAT ASSET WAS $810,000. ITS EXPECTED SALVAGE VALUE AND USEFUL LIFE WERE $10,000 AND 4 YEARS. BOTH ASSETS ARE DEPRECIATED USING STRAIGHT LINE DEPRECIATION. MILLENNIUM GENERATED REVENUES OF $750,000 AND $1,000,000 IN 2007 AND 2008 RESPECTIVELY. OPERATING EXPENSES EXCLUDING DEPRECIATION WERE 50% OF REVENUES IN EACH OF 2007 AND 2008. INTEREST EXPENSES IN 2007 AND 2008 WERE $25,00 0 AND 30,000 RESPECTIVELY. MILLENNIUM’S TAX RATE WAS 25% IN 2007 AND 2008.

31/12/2007 31/12/2008

CURRENT ASSETS $ 100,000 $ 120,000

A/P + ACCRUALS 20,000 30,000

GROSS FIXED ASSETS 800,000 1,610,000

COMPUTE THE FOLLOWING FOR 2007 AND 2008:

1. TOTAL DEPRECIATION EXPENSE

2. ACCUMULATED DEPRECIATION

3. NET OPERATING WORKING CAPITAL

4. NET FIXED ASSETS

5. GROSS OPERATING CAPITAL

6. NET OPERARTING CAPITAL

7. EBIT DA

8. EBIT

9. A-T OPERATING INCOME OR NET OPERATING PROFIT AFTER TAX (NOPAT)

10. A-T OPERATING OR NET OPERATING CASH FLOW

11. NET INCOME

12. NET CASH FLOW

13. INVESTMENT IN GROSS OPERATING CAPITAL

14. INVESTMENT IN NET OPERATING CAPITAL

15. FREE CASH FLOW

PAGE 4

SOLUTION TO CASH FLOW PROBLEM

ALL AMOUNTS ARE IN DOLLARS

2007 2008

REVENUE 750,000 1,000,000

LESS

OPERATING EXPENSES

(EXCLUDING DEPRECIATION) 375,000 500,000

EBITDA 375,000 500,000

LESS

DEPRECIATION 1 150,000 350,000

EBIT 2 225,000 150,000

LESS

INTEREST 25,000 30,000

EBT (TAXABLE INCOME) 200,000 120,000

LESS

TAXES @ 25% 50,000 30,000

NET INCOME3 150,000 90,000

1. ANNUAL DEPRECIATION ON ASSET ACQUIRED IN 2007

= 800,000-50,000

5

= 150,000

ANNUAL DEPRECIATION ON ASSET ACQUIRED ON 2008

= 810,000-10,000

4

= 200,000

TOTAL DEPRECIATION FOR 2007 = 150,000

TOTAL DEPRECIATION FOR 2008 = 150,000 + 200,000 = 350,000

2. ACCUMULATED DEPRECIATION FOR 2007 = 150,000

ACCUMULATED DEPRECIATION FOR 2008 = 150,000+350,000=500,000

PAGE 5

3. NET OPERATING WORKING CAPITAL= CURRENT ASSETS- (A/P+ACCRUALS)

FOR 2007: 100,000-20,000=80,000

FOR 2008: 120,000-30,000=90,000

4. NET FIXED ASSETS = GROSS FIXED ASSETS-ACCUMULATED DEPRECIATION

FOR 2007: 800,000-150,000=650,000

FOR 2008: 1,610,000-500,000=1,110,000

5. GROSS OPEREATING CAPITAL = NET OPERATING WORKING CAPITAL+

GROSS FXED ASSETS

FOR 2007: 80,000+800,000 = 880,000

FOR 2008: 90,000+1,610,000 =1,700,000

6. NET OPERATING CAPITAL = NET OPERATING WORKING CAPITAL+

NET FXED ASSETS

FOR 2007: 80,000+650,000 = 730,000

FOR 2008: 90,000+1,110,000= 1,200,000

6. EBITDA = REVENUE – CASH OPERATING EXPENSES

REVENUE :

FOR 2007: 750,000

FOR 2008: 1,000,000

CASH OPERATING EXPENSES = 50% OF REVENUE

FOR 2007: = .5* 750,000 = 375,000

FOR 2008: =.5 *1,000,000 = 500,000

EBITDA :

FOR 2007: 375,000

FOR 2008: 500,000

PAGE 6

7. EBIT = REVENUE - OPERATING EXPENSES EXCLUDING DEPRECATION-

DEPRECIATION

= EBITDA-DEPRECIATION

DEPRECIATION

FOR 2007: =150,000

FOR 2008: =350,000

EBIT:

FOR 2007: = 750,000-375,000-150,000 = 225,000

FOR 2008: = 1,000,000-500,000-350,000 = 150,000

8. NOPAT = EBIT (1-TAXRATE)

FOR 2007: = 225,000 * (1-.25) = 168,750

FOR 2008: = 150,000 * (1-.25) = 112,500

9. A-T OR NET OPERATING CASH FLOW = NOPAT + DEPRECIATION

FOR 2007: = 168,750 + 150,000 = 318,750

FOR 2008: = 112,500 + 350,000 = 462,500

10. NET INCOME = (EBIT - INTEREST) * (1-TAXRATE)

FOR 2007: = (225,000-25,000) * (1-.25) = 150,000

FOR 2008: = (150,000-30,000) * (1-.25) = 90,000

11. NET CASH FLOW = NET INCOME + DEPRECIATION

FOR 2007: =150,000 +150,000 = 300,000

FOR 2008: = 90,000 +350,000 = 440,000

12. INVESTMENT IN GROSS OPERATING CAPITAL DURING YEAR (t) =

GROSS OPERATING CAPITAL AT END OF YEAR (t) -

GROSS OPERATING CAPITAL AT END OF YEAR (t-1)

INVESTMENT IN GROSS OPERATING CAPITAL:

FOR 2007: 880,000 -0 = 880,000

FOR 2008: 1,700,000 -880,000 = 820,000

PAGE 7

13. INVESTMENT IN NET OPERATING CAPITAL DURING YEAR (t) =

NET OPERATING CAPITAL AT END OF YEAR (t) -

NET OPERATING CAPITAL AT END OF YEAR (t-1)

FOR 2007: 730,000-0 = 730,000

FOR 2008: 1,200,000- 730,000 = 470,000

10. FREE CASH FLOW = NET OPERATING CASH FLOW - INVESTMENT IN GROSS

OPERATING CAPITAL

= NOPAT - INVESTMENT IN NET OPERATING CAPITAL

FOR 2007: 318,750-880,000 = (561,250)

OR

168,750-730,000 = (561,250)

FOR 2008: 462,500-820,000 = (357,500

OR

112,500-470,000 = (357,500)

PAGE 8

SOME IMPORTANT TAX CONSIDERATIONS

INDIVIDUAL CORPORATE

INVESTORS INVESTORS

INTEREST INCOME FROM CORPORATE BONDS FULLY TAXED FULLY TAXED

INTEREST INCOME FROM MUNICIPAL BONDS TAX EXEMPT TAX EXEMPT

DIVIDEND INCOME FROM PREFERRED OR

COMMON STOCK FULLY TAXED 70% TAX EXEMPT

TAX PROBLEM

ANSWER THE FOLLOWING PROBLEM, FIRST AS AN INDIVIDUAL INVESTOR AND THEN AS A CORPORATE INVESTOTR

YOU HAVE THE OPPORTUNITY TO INVEST IN ONE OF THE FOLLOWING THREE INVESTMENTS. INVESTMENT #1 IS A CORPORATE BOND THAT IS EXPECTED TO PAY $200,000 IN ANNUAL INTEREST. INVESTMENT #2 IS A MUNICIPAL BOND THAT IS EXPECTED TO PAY $140,000 IN ANNUAL INTEREST INCOME. INVESTMENT #3 IS A PREFERRED STOCK THAT IS EXPECTED TO PAY $170,000 IN ANNUAL DIVIDEND INCCOME. THE APPLICABLE TAX RATE IS 40% FOR EACH INVESTMENT:

1. WHAT IS THE BEFORE-TAX INCOME?

2. WHAT IS THE TAXABLE INCOME?

3. WHAT IS THE INCOME TAX TO BE PAID?

4. WHAT IS THE AFTER-TAX INCOME?

5. IF ALL THE THREE INVESTMENTS ARE OF EQUAL RISK, WHICH

WOULD YOU CHOOSE? WHY?

PAGE 9

SOLUTION TO TAX PROBLEM

INDIVIDUAL INVESTOR

#1 #2 #3

Corporate Bond Municipal Bond Pfd. Stock

Before-Tax Income $200,000 $140,000 $170,000

Taxable Income $200,000 $ 0 $170,000

Tax Liability @ 40% $ 80,000 $ 0 $ 68,000

After-Tax Income $120,000 $140,000 $102,000

Investment Choice # 2 (municipal Bond) Provides The Most After-Tax Income

CORPORATE INVESTOR

#1 #2 #3

Corporate Bond Municipal Bond Pfd. Stock

Before-Tax Income $200,000 $140,000 $170,000

Taxable Income $200,000 $ 0 $ 51,000

Tax Liability @ 40% $ 80,000 $ 0 $ 20,400

After-Tax Income $120,000 $140,000 $149,600

Investment Choice #3 (Pfd. Stock) Provides The Most After-Tax Income

PAGE 10

BEFORE-TAX AND AFTER-TAX RETURNS (YIELDS)

AFTER-TAX RETURN (IN DOLLARS OR %)

=

BEFORE-TAX RETURN (IN DOLLARS OR %) * (1-EFFECTIVE TAX RATE),

WHERE

EFFECTIVE TAX RATE = (TAXABLE PORTION * TAX RATE)]

EXAMPLE:

SUPPOSE YOU HAVE $ 1 MILLION TO INVEST EITHER IN A CORPORATE

BOND WITH AN INTEREST RATE OF 10% OR A MUNICIPAL BOND WITH AN

INTEREST RATE OF 6%. THE INTEREST INCOME FROM THE CORPORATE

BOND IS FULLY TAXABLE, WHEREAS THE INTEREST INCOME FROM THE

MUNICI[PAL BOND IS FULLY TAX EXEMPT. WHAT IS THE AFTER-TAX

RETURN FROM EACH INVESTMENT, IF THE TAX RATE IS 40%?

CORPORATE BOND MUNICIPAL BOND

INVESTMENT $ 1 MILLION $ 1 MILLION

BEFORE-TAX RETURN 10% ($100,000) 6% ($60,000)

TAXABLE PORTION 100% (FULLY TAXED) 0% (TAX EXEMPT)

TAX RATE 40% 40%

EFFECTIVE TAX RATE (1*.4)=.4 I.E. 40% (0*.4)=0

AFTER-TAX RETURN 10* (1-.4) = 10*.6 = 6% 6*(1-0) = 6%

OR OR

$ 100,000 * (1-.4) =$ 60,000 $60,000 *(1-0) =$60,000

PAGE 11

BEFORE-TAX YIELD (RETURN) = AFTER-TAX YIELD (RETURN)

(1-EFFECTIVE TAX RATE)

IN THE ABOVE EXAMPLE:

CORPORATE BOND MUNICIPAL BOND

AFTER-TAX RETURN 6% 6%

EFFECTIVE TAX RATE 40% (.4) 0

BEFORE-TAX RETURN 6/(1-.4) = 10% 6/(1-0) = 6%

A MUNICIPAL BOND HAS AN INTEREST RATE OF 5.25%, THE INTEREST INCOME BEING FULLY TAX EXEMPT. WHAT INTEREST RATE SHOULD A CORPORATE BOND OFFER, IF THE INTEREST INCOME IS FULLY TAXABLE, TO BE COMPETITIVE WITH THE MUNICIPAL BOND UNDER THE FOLLOWING ASSUMPTIONS?

1. INVESTOR IS IN THE 30% TAX BRACKET

2. INVESTOR IS IN THE 40% TAX BRACKET

SOLUTION:

SINCE THE MUNICIPAL BOND INTEREST INCOME IS FULLY TAX EXEMPT, ITS AFTER-TAX RETURN TO AN INVESTOR IS THE SAME AS THE BEFORE-TAX RETURN, NAMELY, 5.25% TO BE COMPETITIVE WITH THE MUNICIPAL BOND, THE CORPORATE BOND SHOULD SET AN INTEREST RATE (BEFORE-TAX RETURN TO THE INVESTOR) SUCH THAT INVESOR WILL GET 5.25% AFTER-TAX.

BEFORE-TAX RETURN = AFTER-TAX RETURN / (1-EFFECTIVE TAX RATE)

CASE 1: TAX RATE IS 30%

EFFECTIVE TAX RATE FOR THE CORPORATE BOND (FULLY TAXABLE) = 30%

BEFORE-TAX RETURN = 5.25/(1-.3) = 5.25/.7 = 7.5%

CASE 2: TAX RATE IS 40%

EFFECTIVE TAX RATE FOR THE CORPORATE BOND (FULLY TAXABLE) = 40%

BEFORE-TAX RETURN = 5.25/(1-.4) = 5.25/.6 = 8.75%

PAGE 12

Progressive Tax Rates, Marginal Tax Rate and Average Tax Rate

Many countries, including the USA, have an income tax system (individual and corporate), called Progressive Tax System (I would rather call it Graduated Tax System),in which different amounts of taxable income are taxed at different rates, the rates generally increasing as the taxable amount increases. In such a system, the tax rate at which the next $ of taxable income will be taxed is called the Marginal Tax Rate. Since different portions of the taxable income are taxed at different (increasing rates), the overall tax liability is computed using the different taxable income portions and their applicable tax rates. This results in an Average Tax Rate which, many times, is lower than the Marginal Tax Rate.

The following example illustrates the application of Progressive Tax Rates, Marginal Tax rate and Average Tax Rate. The income brackets and applicable tax rates are created just for this example.

Portion of Taxable Marginal

Income Tax Rate

<=$50,000 10%

>50,000, but <=100,000 15%

>$100,000 but <=200,000 20%

>$200,000 30%

For an entity with a taxable income of $125,000, compute tax liability and average tax rate.

Tax Liability=(50,000*0.1)+(50,000*0.15)

+(25,000*0.20)= $17,500

Average Tax Rate = Tax Liability/Taxable Income

=17,500/125,000=0.14 or 14%

Marginal Tax Rate = 20% until taxable income > 200,000

Thus, the Average Tax Rate < Marginal Tax Rate

In the USA, the tax rates are structured such that once taxable income exceeds a certain level, average rate and marginal rate will be the same

PAGE 13

Loss Carry Backward and Forward

Another feature of the tax system in many countries is that no tax is paid in the year in which there is a loss and the loss can be carried back to offset taxable incomes on which taxes were paid and refunds claimed. Also, unused losses can be carried forward to reduce taxable incomes and taxes. Currently in the USA, losses should be carried back 2 years and then forward 20 years. Here is an example to illustrate this tax feature.

Let us assume that a business in 2010 had a loss of $1 million (EBT=-$1 million). Obviously tax paid for 2010 (filed in 2011)is zero. Suppose the business had taxable incomes of $200,000 in 2008 and $400,000 in 2009. The business, however, expects to have a taxable income of $900,000 in 2011, before application of unused losses. Also assume the average tax rate for the business in 2008 and 2009 was 30% and is expected to remain so in 2011. Compute the refunds the business can claim applying 2010 losses to prior periods and its expected tax liability for 2011?

Apply (in 2011)loss of 200,000 to 2008 and claim a refund of 60,000 (200,000*0.3). Also, Apply (in 2011) 400,000 to 2009 and claim a refund of 120,000 (400,000*0.3). The total refund claimed in 2011 will be $180,000. The business would have used up loss of 600,000, leaving 400,000 to be used in future periods. Applying this amount to 2011, taxable income is expected to become 500,000 (900000-400000). Expected tax liability for 2011 (claimed in 2012)will be $150,000 (500000*0.3).