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Financial managers need to worry about personal tax rates because the dividends and
interest payments that companies make to individuals are both subject to tax at the rates
shown in Table A.6. If these payments are heavily taxed, individuals will be more re-
luctant to buy the company™s shares or bonds. Remember that each dollar of income that
the company earns is taxed at the corporate tax rate. If the company then pays a divi-
dend out of this after-tax income, the shareholder also pays personal income tax on the
dividend. Thus income that is paid out as dividends is taxed twice, once in the hands of
the firm and once in the hands of the shareholder. Suppose instead that the company
earns a dollar which is then paid out as interest. This dollar escapes corporate tax, but
an individual who receives the interest must pay personal tax.

Taxable Income Dollars
Personal tax rates, 1999
Single Taxpayers Married Taxpayers Filing Joint Returns Tax Rate, %
0“25,750 0“43,050 15
25,750“62,450 43,050“104,050 28
62,450“130,250 104,050“158,550 31
130,250“283,150 158,550“283,150 36
Over 283,150 Over 283,150 39.6

Capital gains are also taxed, but only when the capital gains are realized. For exam-
ple, suppose that you bought Bio-technics stock when it was selling for 10 cents a share.
Its market price is now $1 a share. As long as you hold onto your stock, there is no tax
to pay on your gain. But if you sell, the 90 cents of capital gain is taxed. The marginal
tax rate on capital gains for most shareholders is 20 percent.
The tax rates in Table A.6 apply to individuals. But financial institutions are major
investors in shares and bonds. These institutions often have special rates of tax. For ex-
ample, pension funds, which hold huge numbers of shares, are not taxed on either div-
idend income or capital gains.

What information is contained in the balance sheet, income statement, and state-
ment of cash flows?
Investors and other stakeholders in the firm need regular financial information to help them
monitor the firm™s progress. Accountants summarize this information in a balance sheet,
income statement, and statement of cash flows.
The balance sheet provides a snapshot of the firm™s assets and liabilities. The assets
consist of current assets that can be rapidly turned into cash and fixed assets such as plant
and machinery. The liabilities consist of current liabilities that are due for payment shortly
and long-term debts. The difference between the assets and the liabilities represents the
amount of the shareholders™ equity.
The income statement measures the profitability of the company during the year. It
shows the difference between revenues and expenses.
The statement of cash flows measures the sources and uses of cash during the year. The
change in the company™s cash balance is the difference between sources and uses.

What is the difference between market and book value?
It is important to distinguish between the book values that are shown in the company
accounts and the market values of the assets and liabilities. Book values are historical
measures based on the original cost of an asset. For example, the assets in the balance sheet
are shown at their historical cost less an allowance for depreciation. Similarly, the figure for
shareholders™ equity measures the cash that shareholders have contributed in the past or that
the company has contributed on their behalf.

Why does accounting income differ from cash flow?
Income is not the same as cash flow. There are two reasons for this: (1) investment in fixed
assets is not deducted immediately from income but is instead spread over the expected life
of the equipment, and (2) the accountant records revenues when the sale is made rather than
when the customer actually pays the bill, and at the same time deducts the production costs
even though those costs may have been incurred earlier.

What are the essential features of the taxation of corporate and personal income?
For large companies the marginal rate of tax on income is 35 percent. In calculating
taxable income the company deducts an allowance for depreciation and interest payments. It
cannot deduct dividend payments to the shareholders.
Accounting and Finance 127

Individuals are also taxed on their income, which includes dividends and interest on their
investments. Capital gains are taxed, but only when the investment is sold and the gain

www.ibm.com/investor/FinancialGuide Guide to understanding financial data in an annual re-
Related Web port from IBM
Links www.fool.com/Features/1996/sp0708a.htm#4 A look at the balance sheet and how its compo-
nents are related

balance sheet book value marginal tax rate
Key Terms generally accepted income statement average tax rate
accounting principles (GAAP) statement of cash flows

1. Balance Sheet. Construct a balance sheet for Sophie™s Sofas given the following data. What
Quiz is shareholders™ equity?

Cash balances = $10,000
Inventory of sofas = $200,000
Store and property = $100,000
Accounts receivable = $22,000
Accounts payable = $17,000
Long-term debt = $170,000

2. Financial Statements. Earlier, we characterized the balance sheet as providing a snapshot
of the firm at one point in time and the income statement as providing a video. What did we
mean by this? Is the statement of cash flow more like a snapshot or a video?
3. Income versus Cash Flow. Explain why accounting revenue generally will differ from a
firm™s cash inflows.
4. Working Capital. QuickGrow is in an expanding market, and its sales are increasing by 25
percent per year. Would you expect its net working capital to be increasing or decreasing?
5. Tax Rates. Using Table 2.6, calculate the marginal and average tax rates for a single tax-
payer with the following incomes:

a. $20,000
b. $50,000
c. $300,000
d. $3,000,000

6. Tax Rates. What would be the marginal and average tax rates for a corporation with an in-
come level of $100,000?
7. Taxes. A married couple earned $95,000 in 1999. How much did they pay in taxes? What
were their marginal and average tax brackets?
8. Cash Flows. What impact will the following actions have on the firm™s cash balance?

a. The firm sells some goods from inventory.
b. The firm sells some machinery to a bank and leases it back for a period of 20 years.
c. The firm buys back 1 million shares of stock from existing shareholders.

9. Balance Sheet/Income Statement. The year-end 1999 balance sheet of Brandex Inc. lists
common stock and other paid-in capital at $1,100,000 and retained earnings at $3,400,000.
Problems The next year, retained earnings were listed at $3,700,000. The firm™s net income in 2000
was $900,000. There were no stock repurchases during the year. What were dividends paid
by the firm in 2000?
10. Taxes. You have set up your tax preparation firm as an incorporated business. You took
$70,000 from the firm as your salary. The firm™s taxable income for the year (net of your
salary) was $30,000. How much taxes must be paid to the federal government, including
both your personal taxes and the firm™s taxes? Assume you pay personal taxes as an unmar-
ried taxpayer. By how much will you reduce the total tax bill by reducing your salary to
$50,000, thereby leaving the firm with taxable income of $50,000? Use the tax rates pre-
sented in Tables 2.4 and 2.6.
11. Market versus Book Values. The founder of Alchemy Products, Inc., discovered a way to
turn lead into gold and patented this new technology. He then formed a corporation and in-
vested $200,000 in setting up a production plant. He believes that he could sell his patent for
$50 million.
a. What are the book value and market value of the firm?
b. If there are 2 million shares of stock in the new corporation, what would be the price per
share and the book value per share?

12. Income Statement. Sheryl™s Shingles had sales of $10,000 in 2000. The cost of goods sold
was $6,500, general and administrative expenses were $1,000, interest expenses were $500,
and depreciation was $1,000. The firm™s tax rate is 35 percent.

a. What is earnings before interest and taxes?
b. What is net income?
c. What is cash flow from operations?

13. Cash Flow. Can cash flow from operations be positive if net income is negative? Can oper-
ating cash flow be negative if net income is positive? Give examples.
14. Cash Flows. Ponzi Products produced 100 chain letter kits this quarter, resulting in a total
cash outlay of $10 per unit. It will sell 50 of the kits next quarter at a price of $11, and the
other 50 kits in two quarters at a price of $12. It takes a full quarter for it to collect its bills
from its customers. (Ignore possible sales in earlier or later quarters.)

a. Prepare an income statement for Ponzi for today and for each of the next three quarters.
Ignore taxes.
b. What are the cash flows for the company today and in each of the next three quarters?
c. What is Ponzi™s net working capital in each quarter?

15. Profits versus Cash Flow. During the last year of operations, accounts receivable increased
by $10,000, accounts payable increased by $5,000, and inventories decreased by $2,000.
What is the total impact of these changes on the difference between profits and cash
16. Income Statement. A firm™s income statement included the following data. The firm™s av-
erage tax rate was 20 percent.

Cost of goods sold $8,000
Income taxes paid 2,000
Administrative expenses 3,000
Interest expense 1,000
Depreciation 1,000
Accounting and Finance 129

a. What was the firm™s net income?
b. What must have been the firm™s revenues?
c. What was EBIT?
17. Profits versus Cash Flow. Butterfly Tractors had $14 million in sales last year. Cost of
goods sold was $8 million, depreciation expense was $2 million, interest payment on out-
standing debt was $1 million, and the firm™s tax rate was 35 percent.
a. What was the firm™s net income and net cash flow?
b. What would happen to net income and cash flow if depreciation were increased by $1
million? How do you explain the differing impact of depreciation on income versus cash
c. Would you expect the change in income and cash flow to have a positive or negative im-
pact on the firm™s stock price?
d. Now consider the impact on net income and cash flow if the firm™s interest expense were
$1 million higher. Why is this case different from part (b)?
18. Cash Flow. Candy Canes, Inc., spends $100,000 to buy sugar and peppermint in April. It
produces its candy and sells it to distributors in May for $150,000, but it does not receive
payment until June. For each month, find the firm™s sales, net income, and net cash flow.
19. Financial Statements. Here are the 1999 and 2000 (incomplete) balance sheets for Nobel
Oil Corp.
Liabilities and
Assets 1999 2000 Owners™ Equity 1999 2000
Current assets $ 310 $ 420 Current liabilities $210 $240
Net fixed assets 1,200 1,420 Long-term debt 830 920

a. What was owners™ equity at the end of 1999 and 2000?
b. If Nobel paid dividends of $100 in 2000, what must have been net income during the
c. If Nobel purchased $300 in fixed assets during the year, what must have been the depre-
ciation charge on the income statement?
d. What was the change in net working capital between 1999 and 2000?
e. If Nobel issued $200 of new long-term debt, how much debt must have been paid off dur-
ing the year?
20. Financial Statements. South Sea Baubles has the following (incomplete) balance sheet and
income statement.
(Figures in millions of dollars)
Liabilities and
Assets 1999 2000 Shareholders™ Equity 1999 2000
Current assets $ 90 $140 Current liabilities $ 50 $ 60
Net fixed assets 800 900 Long-term debt 600 750

(Figures in millions of dollars)
Revenue $1,950
Cost of goods sold 1,030
Depreciation 350
Interest expense 240

a. What is shareholders™ equity in 1999 and 2000?
b. What is net working capital in 1999 and 2000?
c. What is taxable income and taxes paid in 2000? Assume the firm pays taxes equal to 35
percent of taxable income.
d. What is cash provided by operations during 2000? Pay attention to changes in net work-
ing capital, using Table 2.3 as a guide.
e. Net fixed assets increased from $800 million to $900 million during 2000. What must
have been South Sea™s gross investment in fixed assets during 2000?
f. If South Sea reduced its outstanding accounts payable by $35 million during the year,
what must have happened to its other current liabilities?

Here are some data on Fincorp, Inc., that you should use for problems 21“28. The balance
sheet items correspond to values at year-end of 1999 and 2000, while the income statement
items correspond to revenues or expenses during the year ending in either 1999 or 2000. All
values are in thousands of dollars.
1999 2000
Revenue $4,000 $4,100
Cost of goods sold 1,600 1,700
Depreciation 500 520
Inventories 300 350
Administrative expenses 500 550
Interest expense 150 150
Federal and state taxesa 400 420
Accounts payable 300 350
Accounts receivable 400 450
Net fixed assetsb 5,000 5,800
Long-term debt 2,000 2,400
Notes payable 1,000 600


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