Chapter 3 business finance

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Closely held corporations
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a corporation that is owned by a few individuals who are typically associated with the firms management
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balance sheet
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which shows what assets the company owns and who has claims on those assets as of a given date—for example, December 31, 2014.
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annual report
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A report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management’s analysis of the firm’s past operations and future prospects.
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annual report
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is the most important report that corporations issue to stockholders, and it contains two types of information.
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verbal section of the annual report
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describes the firm’s operating results during the past year and discusses new developments that will affect future operations the
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the annual report provides these four basic financial statements:
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balance sheet, income statement, statement of cash flows, the statement of stock holders equity
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income statement
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which shows the firm’s sales and costs (and thus profits) during some past period—for example, 2014.
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The statement of cash flows
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which shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash.
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.The statement of stockholders’ equity,
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which shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year.
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management’s verbal statements
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attempt to explain why things turned out the way they did and what might happen in the future.
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firm’s financial statements
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report what has actually happened to its assets, earnings, and dividends over the past few years,
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annual report
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can be used to help forecast future earnings and dividends
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balance sheet
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a “snapshot” of a firm’s position at a specific point in time
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left side of the balance sheet statement shows
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the assets that the company owns
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right side of the balance sheet statement shows
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the firm’s liabilities and stockholders’ equity, which are claims against the firm’s assets.
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Current assets consist of
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assets that should be converted to cash within one year; and they include cash and cash equivalents, accounts receivable, and inventory.
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Long-term assets are
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assets expected to be used for more than one year; they include plant and equipment in addition to intellectual property such as patents and copyrights
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net of accumulated depreciation
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Plant and equipment is generally reported as
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Allied’s long-term assets consist entirely of
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net plant and equipment, and we often refer to them as “net fixed assets.”
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“net fixed assets.”
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net plant and equitpment
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Book value per share
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total common equity/shares outstanding
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preferred stock
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generally like debt because it pays a fixed amount each year
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preferred stock
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it is like common stock because a failure to pay the preferred dividend does not expose the firm to bankruptcy.
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liabilities (or money the company owes to others) and stockholders’ equity
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The claims against assets are of two basic types
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Current liabilities consist of
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claims that must be paid off within one year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year.
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Long-term debt includes
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bonds that mature in more than a year.
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stockholders’ equity
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it is the amount that stockholders paid to the company when they bought shares the company sold to raise capital, in addition to all of the earnings the company has retained over the years:
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stock holders equity formula
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paid in capital plus retained earnings
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retained earnings are not just the earnings retained in the latest year—they are
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the cumulative total of all of the earnings the company has earned during its life.
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stockholders equity as residential
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total assets-total liabilities
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If Allied had invested surplus funds in bonds backed by subprime mortgages and the bonds’ value fell below their purchase price,
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the true value of the firm’s assets would have declined, liabilities would not change, common equity declines, reduction in retained earnings and equity, assets = liabilities, sheet would balance
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bonds
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common stock is more risky than
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Assets on the balance sheet are
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are listed by the length of time before they will be converted to cash (inventories and accounts receivable) or used by the firm (fixed assets).
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hey must be paid:
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claims are listed in the order in which
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within a few days
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Accounts payable must generally be paid
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promptly
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accruals must be paid
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one year
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notes payable to banks must be paid within
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ownership and need never be “paid off.”
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stockholders’ equity accounts represent
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Pay income tax to the government Hold profits within the firm Pay them to shareholders
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corporations can do these with their profits
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Assets must, of course
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equal liabilities and equity; otherwise, the balance sheet does not balance.
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only the cash and equivalents account represents
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actual spendable money
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dollar terms,
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assets are reported in
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Accounts receivable represent
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credit sales that have not yet been collected.
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raw materials, work in process, and finished goods
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Inventories show the cost of
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Net fixed assets represent
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the cost of the buildings and equipment used in operations minus the depreciation that has been taken on these assets.
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The noncash assets should
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generate cash over time, but they do not represent cash in hand.
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working capital
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Current assets are often called
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working capital
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these assets “turn over
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turn over
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they are used and then replaced throughout the year
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The total of accounts payable, accruals, and notes payable represent
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current liabilities on its balance sheet.
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net working capital
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If we subtract current liabilities from current assets, the difference is called
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net working capital formula
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current assets- (current liabilities-notes payable)
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Current liabilities include
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accounts payable, accruals, and notes payable to the bank
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free” liabilities
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(accruals and accounts payable
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interest-bearing notes payable
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which incur interest expense that is included as a financing cost on the firm’s income statement
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net operating working capital
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Current assets minus non-interest-bearing current liabilities.
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net operating working capital formula
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current assets- (current liabilities-notes payable)
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A company’s total debt includes
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its short-term and long-term interest-bearing liabilities.
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Total liabilities equal
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total debt plus the company’s “free” (non-interest bearing) liabilities.
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total debt formula
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short term debt + long term debt
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total liabilities formula
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total debt + (accounts payable + accruals)
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“hybrid” securities
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such as preferred stock, convertible bonds, and long-term leases
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Preferred stock is a
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hybrid between common stock and debt,
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convertible bonds are
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debt securities that give the bondholder an option to exchange their bonds for shares of common stock.
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Internal Revenue Service (IRS) rules
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is used to calculate taxes
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two sets of financial statements
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Internal Revenue Service (IRS) rules, the other is based on GAAP and is used for reporting to investors.
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straight-line depreciation
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for stockholder reporting
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net operating working capital (NOWC) formula
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(current assets- excess cash)-(current liabilities-notes payable)
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balance sheet.
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Every entity—including state and local governments, nonprofit agencies, and individual households—has
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The balance sheet summarizes the
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assets that the firm owns and the debt and equity capital that was used to finance those assets. The assets are divided into those expected to be used within a year and those expected to be used for more than one year. liabilities and capital are divided into those items that must be paid off within a year and those that have longer maturities
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paid-in capital, retained earnings
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Stockholders’ equity consists of
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paid-in capital
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which is the amount of money the firm has raised by issuing newly created shares to stockholders,
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retained earnings
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which is the sum of all past earnings minus all past dividends.
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500
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firm has current assets consisting of $100 cash, $300 of accounts receivable, and $400 of inventories. Its current liabilities include $200 of accounts payable, $100 of accrued wages and taxes, and $200 of notes payable to its bank. The cash balance is not considered “excess” cash. What is its NOWC?
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income statements
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A report summarizing a firm’s revenues, expenses, and profits during a reporting period, generally a quarter or a year.
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the bottom line,”
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Earnings per share (EPS)
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Earnings per share (EPS)
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net income/common shares outstanding
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dividends per share
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dividends paid to common stockholders/ common shares outstanding
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book value per share
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total common equity/common shares outstanding
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operating income
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Earnings from operations before interest and taxes (i.e., EBIT).
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operating income
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is derived from the firm’s regular core business—in Allied’s case, from producing and selling food products. Moreover, it is calculated before deducting interest expenses and taxes, which are considered to be non-operating costs
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EBIT
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earnings before interest and taxes
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operating income
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sales revenues-operating costs
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depreciation
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The charge to reflect the cost of assets depleted in the production process. is not a cash outlay.
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depreciation
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is an annual charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were depleted in the production process
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amortization
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amounts to the same thing except that it represents the decline in value of intangible assets such as patents, copyrights, trademarks, and goodwill
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costs
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depreciation and amortization are reported as
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ebitda
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Earnings before interest, taxes, depreciation, and amortization
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18,000
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Last year Firm X had sales of $100,000, labor costs of $30,000, material costs of $30,000, and depreciation of $10,000. Assume that labor and material costs were paid in cash. The tax rate on its net income was 40%. What was the firm’s net income?
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“cash is king.”
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in finance
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statement of cash flows
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A report that shows how items that affect the balance sheet and income statement affect the firm’s cash flows
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statement of cash flows
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is the accounting report that shows how much cash the firm is generating. The statement is divided into four sections
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statement of cash flows sections
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operating activities, long term investing activities, financing activities, and summary
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operating activities
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This section deals with items that occur as part of normal ongoing operations
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Depreciation and amortization
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The first adjustment relates to depreciation and amortization. Allied’s accountants subtracted depreciation (it has no amortization expense), which is a noncash charge, when they calculated net income. Therefore, depreciation must be added back to net income when cash flow is determined.
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Increase in inventories.
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To make or buy inventory items, the firm must use cash. It may receive some of this cash as loans from its suppliers and workers (payables and accruals); but ultimately, any increase in inventories requires cash
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annual report
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contains both verbal and quantitative information.
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quantitative information consists of four financial statements
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1) Balance Sheet, (2) Income Statement, (3) Statement of Cash Flows, and (4) Statement of Stockholders’ Equity.
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balance sheet
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shows the firm’s assets and claims against those assets, assets are equal to liabilities and equity
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when they must be paid
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claims are listed in the order of
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Current assets include
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cash and their equivalents, accounts receivable, inventory
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their liquidity
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Assets are shown in order of
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long-term assets
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exceed one year
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current liabilities and long term debt
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Liabilities are divided into
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total debt and total liabilities
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We differentiate between
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its short-term and long-term interest bearing liabilities
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A company’s total debt includes both
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total debt plus the companys free liabilities
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total liabilities equal
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the difference between current assets and current liabilities
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net working capital formula
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net operating working capital is equal to
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current assets less the difference between current liabilities and notes payable.
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net worth
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is capital supplied by common stockholders and represents ownership
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income statement
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reports on operations over a period of time
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earnings per share
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bottom line of income statement
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the balance sheet through the retained earnings account
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The income statement is tied to
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retained earnings for the year
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net income minus dividends paid
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retained earnings for the year
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this amount is added to the cumulative retained earnings from prior years to obtain the year-end retained earnings balance.
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the cash flow the asset is expected to produce
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The value of any asset, including a share of stock, is based on
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statement of cash flows
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shows how much cash a firm generates
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statement of stockholders’ equity
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Changes in stockholders’ equity during an accounting period are reported in the
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Changes in stockholders’ equity can come from
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new stock issues, stock repurchases, net income, and dividends paid
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depreciation
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must be added back to net income when cash flow is determined.
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repayment of long term debt
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Which of the following does NOT increase cash and cash equivalents during the year
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net operating work capital
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NOWC
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net operating work capital formula
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current assets – (current liabilities-notes payable)
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accounting data rather than cash flow
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The focus on traditional financial statements is
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investors, managers, and stock analysts.
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cash flow is important to
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The equation for free cash flow is:
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FCF = [EBIT(1 – T) + Depreciation and amortization] – [Captial expenditures + ?Net operating working captial]
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free cash flow
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is the cash flow actually available for payments to all investors (stockholders and debtholders) after the company has made investments in fixed assets, new products, and operating working capital
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bad
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Negative FCF is not always
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negative FCF means that the company does not have
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means the company doesnt have sufficient internal funds to finance its investments in fixed assets and working capital, and that it will have to raise new money in the capital markets to pay for these investments.
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bad, because the company is probably experiencing operating problems
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If FCF is negative because after-tax operating income is negative this is
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market values
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The financial statements reflect historical data, but managers’ performance must be evaluated on the basis of
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Market Value Added
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represents the difference between the money stockholders have invested in the firm versus the cash they could receive if the firm were sold.
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The equation for MVA is:
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MVA = (Shares outstanding Ă— Stock price) – Total common equity
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the difference is maximized
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Shareholder wealth is maximized when
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the higher the firms MVA,
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the better the job management is doing for its shareholders.
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economic value added
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is sometimes called “economic profit and it is closely related to MVA
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The equation for EVA is:
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= EBIT(1 – T) – (Total investor-supplied operating capital Ă— After-tax percentage cost of capital)
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Note that total invested capital is equal to the sum of
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notes payable, long-term debt, and total common equity
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a deduction for the cost of equity
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EVA differs from net income because EVA has
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EVA
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useful for establishing reasonable compensation for divisional managers as well as top company officers.
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Taxable income is defined as
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gross income less a set of exemptions and deductions.
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a long term capital gain
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is taxed at a maximum rate of 15%,
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short term capital gain
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is taxed as ordinary income
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dividend and interest income
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investment income consists of
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ordinary income
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Interest income (except interest on state and local government debt which is exempt from federal taxes) is taxed as
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long term capital gains
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dividends are taxed at the same rate as
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home mortgage
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interest payments are not tax deductible for individuals except for interest on
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Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows
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Key Financial Statements
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balance sheet
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provides a snapshot of a firm’s financial position at one point in time.
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Income statement – summarizes a firm’s revenues and expenses over a given period of time.
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summarizes a firm’s revenues and expenses over a given period of time.
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Statement of stockholders’ equity
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shows how much of the firm’s earnings were retained, rather than paid out as dividends.
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Statement of cash flows
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reports the impact of a firm’s activities on cash flows over a given period of time.
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what is D’Leon Inc.
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Snack food company that underwent major expansion in 2013. So far, expansion results have been unsatisfactory.
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D’Leon Inc. unsatisfactory because
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Company’s cash position is weak. Suppliers are being paid late. Bank has threatened to cut off credit. Board of Directors has ordered that changes must be made!
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AT operating income=
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= EBIT(1 – Tax rate)
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What effect did the expansion have on net operating working capital?
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NOWC= Current assets-(current liabilities-notes payable)
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do not reflect market values.
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Accounting statements insufficient for evaluating managers’ performance because they
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MVA =
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Difference between market value and book value of a firm’s common equity.(P0 x Number of shares) – Book value.
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EVA =
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Estimate of a business’ true economic profit for a given year.
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Shareholder wealth has been destroyed!
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2014 MVA IS -$267,592 2013 mva IS = $186,232
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.If EVA is positive
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AT operating income > cost of capital needed to produce that income.
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to ensure MVA is positive.
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Positive EVA on annual basis helps
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MVA is applicable to entire firm
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while EVA can be calculated on a divisional basis as well.
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AR would increase and Cash would decrease
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What if D’Leon’s sales manager decided to offer 60-day credit terms to customers, rather than 30-day credit terms?If competitors match terms, and sales remain constant… A/R would . Cash would .
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If competitors don’t match, and sales double… Short-run: .
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Inventory and fixed assets to meet increased sales. A/R , Cash . Company may have to seek additional financing.
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Collections increase and the company’s cash position would improve.
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If competitors don’t match, and sales double… long run:
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What happens if D’Leon depreciates fixed assets over 7 years (as opposed to the current 10 years)?
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No effect on physical assets. Fixed assets on the balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve.
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Federal Income Tax System
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Individual Taxes Corporate Taxes
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Corporate and Personal Taxes
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Both have a progressive structure (the higher the income, the higher the marginal tax rate).
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Corporations Rates begin at
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15% and rise to 35% for corporations with income over $10 million, although corporations with income between $15 million and $18.33 million pay a marginal tax rate of 38%. Also subject to state tax (around 5%).
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individuals Rates begin at
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10% and rise to 39.6% for single individuals with incomes over $400,000 and married couples filing jointly with incomes over $450,000. May be subject to state tax.
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Interest paid:
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tax deductible for corporations (paid out of pre-tax income),but usually not for individuals (interest on home loans being the exception).
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Interest earned:
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usually fully taxable (an exception being interest from a “muni”).
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Dividends paid:
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paid out of after-tax income.
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Dividends received:
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most investors pay 15% taxes. Investors in the 10% or 15% tax bracket pay 0% on qualified dividends.
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20% taxes on dividends.
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Single individuals with incomes over $400,000 and married couples filing jointly with incomes over $450,000 pay
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Dividends are paid out of
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—- are paid out of net income which has already been taxed at the corporate level, this is a form of “double taxation”.
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tax excludable, in order to avoid “triple taxation.”
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A portion of dividends received by corporations is
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carry losses back to offset profits in previous years or forward to offset profits in the future.
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Tax Loss Carry-Back and Carry-Forward – since corporate incomes can fluctuate widely, the Tax Code allows firms to
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capital gains
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– defined as the profits from the sale of assets not defined as the profits from the sale of assets not normally transacted in the normal course of business, capital gains for individuals are generally taxed as ordinary income if held for a year or less, and at the capital gains rate if held for more than a year.
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long-term capital gains..
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Most taxpayers pay 15% taxes on
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20% taxes on long-germ capital gains
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Single individuals with incomes over $400,000 and married couples filing jointly with incomes over $450,000 pay
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Which of the following actions are most likely to directly increase cash as shown on a firm’s balance sheet? Explain and state the assumptions that underlie your answer. a.It issues $8 million of new common stock. b.It buys new plant and equipment at a cost of $3 million. c.It reports a large loss for the year. d.It increases the dividends paid on its common stock.
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.Statements (b) and (d) will decrease the amount of cash on a company’s balance sheet. Statement (a) will increase cash through the sale of common stock. Selling stock provides cash through financing activities. On one hand, Statement (c) would decrease cash; however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.
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annual report
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issued once a year by a corporation, contains basic financial statements, analysis of past performances, and future prospects
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balance sheet
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provides a quantitative summary of a companys assets, liabilities, and net worth at a specific point in time
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income statement
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gives details about the firms sales costs and profits for the past accounting period
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statement of retained earnings
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explains the changes in a companies retained earnings over the accounting year
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statement of cash flows
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provides details about the flow of funds from operating, financing, and investing activities
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statement of cash flows
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how much cash is a firm generating through operating, financing and investing activities?
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balance sheet
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how much debt and equity has the firm issued to finance its assets
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personal judgment is allowed when
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as long as the information follows the GAAP
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will decrease the amount of cash on a company’s balance sheet.
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b.It buys new plant and equipment at a cost of $3 million.d.It increases the dividends paid on its common stock.
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It issues $8 million of new common stock.
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a. will increase cash through the sale of common stock. Selling stock provides cash through financing activities.
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.c.It reports a large loss for the year.
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would decrease cash; however, it is also possible that it would increase cash, if the firm receives a tax refund for taxes paid in a prior year
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inventory increased
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net collection of inventory items increased by more than the firm sold between year one and year two because
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the cash and cash equivalent had 200 to spend
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the firm had 200 of actual money to spend because the balance sheet said that
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decrease
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if everything else on a balance sheet remains the same then the cash and cash equivalents will
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the statement of cash flow helps determine
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helps determine if the company is generating enough cash and if it will need to generate more cash by selling dividends or issuing new debt
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cash flow of 1,000,000
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$1,000,000 in revenues does not mean the same thing as
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revenues
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could mean collections that still need to be made
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operating activity
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a company records a loss of money on the sale of its outdated inventory
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financing activity
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uses cash to purchase 10% of its common stock
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investing activity
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a company buys common stock in its suppliers firm with its extra cash
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operating activity
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earns revenue from its cash receipts from royalties
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operating activity
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day to day actions needed to conduct business
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operating activity
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affect a firms cash position
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investing activity
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purchase or sale of investment
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financing activity
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cash inflow or outflows to repay or obtain capital
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equity
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sum of what initial stockholders paid when they bought company shares and the earnings that the company has retained over the years
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free cash flow
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analyze the companys real cash postiosn
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free cash flow
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residual cash flow after taking into account, operating cash flows, including fixed asset acquisitions, asset sales and working capital expenditures.
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market value added and economic value added
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performance measures
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MVA
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evaluates shareholder wealth
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net operating profit after taxes
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NOPAT means
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progressive
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the US federal tax system is
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capital gain taxed at the current ordinary income tax
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you sell shares you bought for more than you bought them for, how will it be treated when taxed?
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lower taxable income, decrease tax deducted from earnings and lead to higher operating cash flow.
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an increase in depreciation expense leads to
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alternative minimum tax (amt)
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tax payers must pay the higher of the
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pretax
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if pay a 1$ IN income pay a dollar in
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NWC=currents assets-current liabilities NOWC= current assets-(AP+accruels) Triangle NOWC= current assets-(current liabilities-notes payable)
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formula differences between NWC, NOWC, and triangle NOWC
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net plant – net plant + depreciation notes payable+Long Term debt+ total common equity
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capital expenditure formula
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common stock plus retained earnings
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formula for total common equity
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EBIT(1-T)- ( total invested capital*WACC)
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formula for EVA

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