Brigham & Ehrhardt

Financial Management:
Theory and Practice 14e

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Chapter 2

Financial Statements, Cash Flow,

and Taxes

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Topics in Chapter
◼ Income statement
◼ Balance sheet
◼ Statement of cash flows
◼ Free cash flow
◼ Performance measures
◼ Corporate taxes
◼ Personal taxes
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 Determinants of Intrinsic Value: Calculating FCF
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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 Income Statement
2012 2013
Sales $3,432,000 $5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
Pre-tax earnings 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income $ 87,960 ($ 95,136)
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What happened to sales and
net income?
◼ Sales increased by over $2.4 million.
◼ Costs shot up by more than sales.
◼ Net income was negative.
◼ However, the firm received a tax refund
since it paid taxes of more than
$63,424 during the past two years.

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Balance Sheet: Assets
2012 2013
Cash $ 9,000 $ 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets $1,468,800 $2,886,592
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Effect of Expansion on Assets
◼ Net fixed assets almost tripled in size.
◼ AR and inventory almost doubled.
◼ Cash and short-term investments fell.

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 Balance Sheet: Liabilities &
Equity
2012 2013
Accts. payable $ 145,600 $ 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E $1,468,800 $2,886,592
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What effect did the expansion
have on liabilities & equity?
◼ CL increased as creditors and suppliers
“financed” part of the expansion.
◼ Long-term debt increased to help
finance the expansion.
◼ The company didn’t issue any stock.
◼ Retained earnings fell, due to the year’s
negative net income and dividend
payment.
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Statement of Cash Flows:
2013
Operating Activities
Net Income ($ 95,136)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 178,400
Change in accruals 148,960
Net cash provided (used) by ops. ($503,936)
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 Statement of Cash Flows:
2013
Investing Activities
Cash used to acquire FA ($711,950)
Change in S-T invest. 28,600
Net cash prov. (used) by inv. act. ($683,350)

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 Statement of Cash Flows:
2013
Financing Activities
Change in notes payable $ 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash provided (used) by fin. act. $1,185,568

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 Summary of Statement of CF
Net cash provided (used) by ops. ($ 503,936)
Net cash to acquire FA (683,350)
Net cash prov. (used) by fin. act. 1,185,568
Net change in cash (1,718)
Cash at beginning of year 9,000
Cash at end of year $ 7,282

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What can you conclude from
the statement of cash flows?
◼ Net CF from operations = -$503,936, because
of negative net income and increases in
working capital.
◼ The firm spent $711,950 on FA.
◼ The firm borrowed heavily and sold some
short-term investments to meet its cash
requirements.
◼ Even after borrowing, the cash account fell by
$1,718.

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What is free cash flow (FCF)?
Why is it important?
◼ FCF is the amount of cash available
from operations for distribution to all
investors (including stockholders and
debtholders) after making the
necessary investments to support
operations.
◼ A company’s value depends on the
amount of FCF it can generate.
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What are the five uses of FCF?
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g.,
marketable securities, investments in
other companies, etc.)
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 Calculating Free Cash Flow in 5 Easy Steps
Step 1 Step 2

Earning before interest and taxes Operating current assets

X (1 − Tax rate) − Operating current liabilities

Net operating profit after taxes Net operating working capital

Step 3

Net operating working capital

+ Operating long-term assets

Total net operating capital

Step 5
Step 4
Net operating profit after taxes
Total net operating capital this year
− Net investment in operating capital − Total net operating capital last year

Net investment in operating capital

Free cash flow
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Net Operating Profit after
Taxes (NOPAT)
NOPAT = EBIT(1 - Tax rate)

NOPAT13 = $17,440(1 - 0.4)

= $10,464.

NOPAT12 = $125,460.

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What are operating current
assets?
◼ Operating current assets are the CA
needed to support operations.
◼ Op CA include: cash, inventory,
receivables.
◼ Op CA exclude: short-term investments,
because these are not a part of operations.

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What are operating current
liabilities?
◼ Operating current liabilities are the CL
resulting as a normal part of operations.
◼ Op CL include: accounts payable and
accruals.
◼ Op CL exclude: notes payable, because this
is a source of financing, not a part of
operations.

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