Fundamentals of Corporate Finance Phần 3 pot

122 APPENDIX A

countants have discretion concerning the treatment of intangible assets such as patents,

trademarks, or franchises. Some believe that including these intangibles on the balance

sheet provides the best measure of the company’s value as an ongoing concern. Others

take a more conservative approach, and they exclude intangible assets. This approach is

better suited for measuring the liquidation value of the firm.

Another source of imprecision arises from the fact that firms are not required to in￾clude all their liabilities on the balance sheet. For example, firms are not always re￾quired to include as liabilities on the balance sheet the value of their lease obligations.5

They likewise are not required to include the value of several potential obligations such

as warrants6 sold to investors or issued to employees.

Even bigger differences can arise in international comparisons. Accounting practices

can vary greatly from one country to another. For example, in the United States firms

generally maintain one set of accounts that is sent to investors and a different set of ac￾counts that is used to calculate their tax bill.7 That would not be allowed in most coun￾tries. On the other hand, United States standards are more stringent in most other re￾gards. For example, German firms have far greater leeway than United States firms to

tuck money away in hidden reserve accounts.

When Daimler-Benz AG, producer of the Mercedes-Benz automobile, decided to list

its shares on the New York Stock Exchange in 1993, it was required to revise its ac￾counting practices to conform to United States standards. While it reported a modest

profit in the first half of 1993 using German accounting rules, it reported a loss of $592

million under the much more revealing United States rules, primarily because of dif￾ferences in the treatment of reserves.

Such differences in international accounting standards pose a problem for financial

analysts who attempt to compare firms using data from their financial statements. This

is why foreign firms must restate their financial results using the generally accepted ac￾counting principles (GAAP) of the United States before their shares can be listed on a

U.S. stock exchange. Many firms have been reluctant to do this and have chosen to list

their shares elsewhere.

Other countries allow foreign firms to be listed on stock exchanges if their financial

statements are prepared according to International Accounting Standards (IAS) rules,

which impose considerable uniformity in accounting practices and are nearly as reveal￾ing as U.S. standards. The nearby box reports on current negotiations for international

accounting standards.

The lesson here is clear. While accounting values are often the starting point for the

financial analyst, it is usually necessary to probe more deeply. The financial manager

needs to know how the values on the statements were computed and whether there are

important assets or liabilities missing altogether.

The trend today is toward greater recognition of the market values of various assets

and liabilities. Firms are now required to acknowledge on the balance sheet the value of

SEE BOX

5 Some airlines at times actually have not had any aircraft on their balance sheets because their aircraft

were all leased. In contrast, General Electric owns the world’s largest private airfleet because of its leasing

business.

6 A warrant is the right to purchase a share of stock from the corporation for a specified price, called the ex￾ercise price.

7 For example, in their published financial statements most firms in the United States use straight-line depre￾ciation. In other words, they make the same deduction for depreciation in each year of the asset’s life. How￾ever, when they calculate taxable income, the same companies usually use accelerated depreciation—that is,

they make larger deductions for depreciation in the early years of the asset’s life and smaller deductions in the

later years.

Accounting and Finance 123

unfunded pension liabilities and other postemployment benefits, such as medical bene￾fits.8 In addition, a growing (although still controversial) trend toward “market-value

accounting” would have them record many assets at market value rather than at histor￾ical book value.

Taxes

Taxes often have a major effect on financial decisions. Therefore, we should explain

how corporations and investors are taxed.

CORPORATE TAX

Companies pay tax on their income. Table A.4 shows that there are special low rates of

corporate tax for small companies, but for large companies (those with income over

$18.33 million) the corporate tax rate is 35 percent. Thus for every $100 that the firm

earns it pays $35 in corporate tax.

When firms calculate taxable income they are allowed to deduct expenses. These ex￾penses include an allowance for depreciation. However, the Internal Revenue Service

(IRS) specifies the rates of depreciation that the company can use for different types of

equipment.9 The rates of depreciation that are used to calculate taxes may differ from

the rates that are used when the firm reports its profits to shareholders.

The company is also allowed to deduct interest paid to debtholders when calculating

its taxable income, but dividends paid to shareholders are not deductible. These divi￾dends are therefore paid out of after-tax income. Table A.5 provides an example of how

interest payments reduce corporate taxes.

8 When General Motors recognized the value of its postemployment obligations to GM employees, it resulted

in the largest quarterly loss in United States history.

9 We will tell you more about these allowances later.

TABLE A.4

Corporate tax rates, 1999 Taxable Income, Dollars Tax Rate, %

0–50,000 15

50,001–75,000 25

75,001–100,000 34

100,001–18,333,333 Varies between 39 and 34 percent

Over 18,333,333 35

TABLE A.5

Firms A and B both have

earnings before interest and

taxes (EBIT) of $100 million,

but A pays out part of its

profits as debt interest. This

reduces the corporate tax

paid by A.

Firm A Firm B

EBIT 100 100

Interest 40 0

Pretax income 60 100

Tax (35% of pretax income) 21 35

Net income 39 65

Note: Figures in millions of dollars.

FINANCE IN ACTION

The bad news about taxes is that each extra dollar of revenues increases taxable in￾come by $1 and results in 35 cents of extra taxes. The good news is that each extra dol￾lar of expense reduces taxable income by $1 and therefore reduces taxes by 35 cents.

For example, if the firm borrows money, every dollar of interest it pays on the loan re￾duces taxes by 35 cents. Therefore, after-tax income is reduced by only 65 cents.

Self-Test 5 Recalculate the figures in Table A.5 assuming that Firm A now has to make interest

payments of $60 million. What happens to taxes paid? Does net income fall by the ad￾ditional $20 million interest payment compared with the case considered in Table A.5,

where interest expense was only $40 million?

When firms make profits, they pay 35 percent of the profits to the Internal Revenue

Service. But the process doesn’t work in reverse; if the firm takes a loss, the IRS does

124

A Hill of Beans

The world cannot have a truly global financial system

without the help of its accountants. They are letting in￾vestors down.

The biggest impediment to a global capital market is not

volatile exchange rates, nor timid investors. It is that

firms from one country are not allowed to sell their

shares in many others, including, crucially, in the United

States. And the reason for that is the inability of different

countries to settle on an international standard for re￾porting.

In order to change this, the International Accounting

Standards Committee has been trying for years to per￾suade as many companies as possible to adopt its

standards, and to convince securities regulators such

as America’s Securities and Exchange Commission to

let such firms list on their stock exchanges. But the

IASC has so far failed to produce standards that the

SEC is willing to endorse. It should produce them now.

The purpose of accounting standards is simple: to

help investors keep track of what managers are doing

with their money. Countries such as America and

Britain, in which managers are accountable to lots of

dispersed investors, have had to develop standards

that are more transparent and rigorous than those of

other countries. And since the purpose of international

standards is to encourage such markets on a global

scale, it makes sense to use these countries’ standards

as a guide.

British and American accounting standards have

their respective flaws, debated ad nauseam by accoun￾tancy’s aficionados. But they are both superior to the

IASC’s existing standards in two main ways. First, they

promote transparency by making firms attach to their

aggregate financial tables (such as the profit-and-loss

statement) a set of detailed notes disclosing exactly

how the main items (such as inventories and pension li￾abilities) are calculated. Second, they lay down rules on

how to record certain transactions. In many cases,

there is no intellectually “ right” way to do this. The point

is simply that there is a standard method, so that man￾agers cannot mislead investors by choosing the method

for themselves.

Let the Markets Do the Talking

If the merits of Anglo-American accounting are so obvi￾ous, why has the IASC not adopted its standards? Even

in their present state, the international standards are

more rigorous than many domestic ones, and therefore

unpopular with local firms. But by introducing a rigor￾ous set of international standards, acceptable to the

SEC, the committee could unleash some interesting

competition. Companies which adopted the new stan￾dards would enjoy the huge advantage of being able to

sell their shares anywhere; those opting for less disclo￾sure would be punished by investors. It is amazing how

persuasive the financial markets can be.

Source: © 1999 The Economist Newspaper Group. Reprinted with

permission. Further reproduction prohibited. www.economist.com.

Accounting and Finance 125

not send it a check for 35 percent of the loss. However, the firm can carry the losses

back and deduct them from taxable income in earlier years, or it can carry them forward

and deduct them from taxable income in the future.10

PERSONAL TAX

Table A.6 shows the U.S. rates of personal tax. Notice that as income increases the tax

rate also increases. Notice also that the top personal tax rate is higher than the top cor￾porate rate.

The tax rates presented in Table A.6 are marginal tax rates. The marginal tax rate

is the tax that the individual pays on each extra dollar of income. For example, as a sin￾gle taxpayer, you would pay 15 cents of tax on each extra dollar you earn when your in￾come is below $25,750, but once income exceeds $25,750, you would pay 28 cents of

tax on each dollar of income up to an income of $62,450. For example, if your total in￾come is $40,000, your tax bill is 15 percent of the first $25,750 of income and 28 per￾cent of the remaining $14,250:

Tax = (.15 × $25,750) + (.28 × $14,250) = $7,852.50

The average tax rate is simply the total tax bill divided by total income. In this ex￾ample it is $7,852.50/$40,000 = .196 = 19.6 percent. Notice that the average rate is

below the marginal rate. This is because of the lower rate on the first $25,750.

Self-Test 6 What are the average and marginal tax rates for a single taxpayer with a taxable income

of $70,000? What are the average and marginal tax rates for married taxpayers filing

joint returns if their joint taxable income is also $70,000?

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.

TABLE A.6

Personal tax rates, 1999 Taxable Income Dollars

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

MARGINAL TAX RATE

Additional taxes owed per

dollar of additional income.

AVERAGE TAX RATE

Total taxes owed divided by

total income.

126 APPENDIX A

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.

Summary

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

realized.

www.ibm.com/investor/FinancialGuide Guide to understanding financial data in an annual re￾port from IBM

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

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

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.

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