2 - 1
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Balance sheet
?Income statement
?Statement of cash flows
?Accounting income versus cash flow
?MVA and EVA
?Personal taxes
?Corporate taxes
CHAPTER 2
Financial Statements,
Cash Flow,and Taxes
2 - 2
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2001 2000
Cash 7,282 9,000
Short-term inv,0 48,600
AR 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less,Depr,263,160 146,200
Net FA 939,790 344,800
Total assets 2,866,592 1,468,800
Balance Sheets,Assets
2 - 3
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
1,733,760
Liabilities and Equity
2001 2000
Accts payable 524,160 145,600
Notes payable 720,000 200,000
Accruals 489,600 136,000
Total CL 481,600
Long-term debt 1,000,000 323,432
Common stock 460,000 460,000
Retained earnings (327,168) 203,768
Total equity 132,832 663,768
Total L&E 2,866,592 1,468,800
2 - 4
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
(519,936)
Income Statement
Sales 5,834,400 3,432,000
COGS 5,728,000 2,864,000
Other expenses 680,000 340,000
Deprec,116,960 18,900
Tot,op,costs 6,524,960 3,222,900
EBIT (690,560) 209,100
Interest exp,176,000 62,500
EBT (866,560) 146,600
Taxes (40%) (346,624) 58,640
Net income 87,960
2001 2000
2 - 5
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Other Data
No,of shares 100,000 100,000
EPS ($5.199) $0.88
DPS $0.110 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000
2001 2000
2 - 6
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Statement of Retained Earnings (2001)
Balance of retained
earnings,12/31/00 $203,768
Add,Net income,2001 (519,936)
Less,Dividends paid (11,000)
Balance of retained
earnings,12/31/01 ($327,168)
2 - 7
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Statement of Cash Flows,2001
OPERATING ACTIVITIES
Net Income (519,936)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 378,560
Change in accruals 353,600
Net cash provided by ops,(523,936)
2 - 8
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
L-T INVESTING ACTIVITIES
Investments in fixed assets
(711,950)
FINANCING ACTIVITIES
Change in s-t investments 48,600
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash from financing 1,234,168
Sum,net change in cash (1,718)
Plus,cash at beginning of year 9,000
Cash at end of year 7,282
2 - 9
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Net cash from operations = -$523,936,
mainly because of negative net income.
?The firm borrowed $1,185,568 and sold
$48,600 in short-term investments to
meet its cash requirements.
?Even after borrowing,the cash account
fell by $1,718.
What can you conclude about the
company’s financial condition from its
statement of cash flows?
2 - 10
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the expansion have on
net operating working capital (NOWC)?
NOWC01 = ($7,282 + $632,160 + $1,287,360)
- ($524,160 + $489,600)
= $913,042.
NOWC00 = $793,800.
= -Operating CA Operating CLNOWC
2 - 11
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the expansion have on
capital used in operations?
= NOWC + Net fixed assets.
= $913,042 + $939,790
= $1,852,832.
= $1,138,600.
Operating
capital01
Operating
capital00
Operating
capital
2 - 12
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Did the expansion create additional net
operating profit after taxes (NOPAT)?
NOPAT = EBIT(1 - Tax rate)
NOPAT01 = -$690,560(1 - 0.4)
= -$690,560(0.6)
= -$414,336.
NOPAT00 = $125,460.
2 - 13
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is your initial assessment of the
expansion’s effect on operations?
2001 2000
Sales $5,834,400 $3,432,000
NOPAT ($414,336) $125,460
NOWC $913,042 $793,800
Operating capital $1,852,832 $1,138,600
2 - 14
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the company’s
expansion have on its net cash flow
and operating cash flow?
NCF01 = NI + DEP = -$519,936 + $116,960
= -$402,976.
NCF00 = $87,960 + $18,900 = $106,860.
OCF01 = NOPAT + DEP
= -$414,336 + $116,960
= -$297,376.
OCF00 = $125,460 + $18,900
= $144,360.
2 - 15
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What was the free cash flow (FCF)
for 2001?
FCF = NOPAT - Net capital investment
= -$414,336 - ($1,852,832 - $1,138,600)
= -$414,336 - $714,232
= -$1,128,568.
How do you suppose investors reacted?
2 - 16
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is the company’s EVA?
Assume the firm’s after-tax cost of
capital (COC) was 11% in 2000
and 13% in 2001.
EVA01 = NOPAT- (COC)(Capital)
= -$414,336 - (0.13)($1,852,832)
= -$414,336 - $240,868
= -$655,204.
EVA00 = $125,460 - (0.11)($1,138,600)
= $125,460 - $125,246
= $214.
2 - 17
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Would you conclude
that the expansion increased or
decreased MVA?
MVA = -,
During the last year stock price has
decreased 73%,so market value of
equity has declined,Consequently,
MVA has declined.
Equity capital
supplied
Market value
of equity
2 - 18
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Probably not.
?A/P increased 260% over the past
year,while sales increased by only
70%.
?If this continues,suppliers may cut
off trade credit.
Does the company pay its suppliers
on time?
2 - 19
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?No,the negative NOPAT shows
that the company is spending
more on it’s operations than it is
taking in.
Does it appear that the sales price
exceeds the cost per unit sold?
2 - 20
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
1,The company offers 60-day credit
terms,The improved terms are
matched by its competitors,so sales
remain constant.
What effect would each of these
actions have on the cash account?
?A/R would ?
?Cash would ?
2 - 21
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2,Sales double as a result of the
change in credit terms.
?Short-run,Inventory and fixed
assets ? to meet increased
sales,A/R ?,Cash ?,
Company may have to seek
additional financing.
?Long-run,Collections increase
and the company’s cash
position would improve.
2 - 22
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?The expansion was financed
primarily with external capital.
?The company issued long-term debt
which reduced its financial strength
and flexibility.
How was the expansion financed?
2 - 23
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Would external capital have been
required if they had broken even in
2001 (Net income = 0)?
?Yes,the company would still have
to finance its increase in assets.
2 - 24
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What happens if fixed assets are
depreciated over 7 years (as opposed
to the current 10 years)?
?No effect on physical assets.
?Fixed assets on balance sheet
would decline.
?Net income would decline.
?Tax payments would decline.
?Cash position would improve.
2 - 25
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Other policies that
can affect financial statements
?Inventory valuation methods.
?Capitalization of R&D expenses.
?Policies for funding the company’s
retirement plan.
2 - 26
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Does the company’s positive stock
price ($2.25),in the face of large losses,
suggest that investors are irrational?
?No,it means that investors
expect things to get better in
the future.
2 - 27
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Why did the stock price fall
after the dividend was cut?
?Management was,signaling” that
the firm’s operations were in trouble.
?The dividend cut lowered investors’
expectations for future cash flows,
which caused the stock price to
decline.
2 - 28
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What were some other sources of
financing used in 2001?
?Selling financial assets,Short term
investments decreased by $48,600.
?Bank loans,Notes payable increased
by $520,000.
?Credit from suppliers,A/P increased
by $378,560.
?Employees,Accruals increased by
$353,600.
2 - 29
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is the effect of the $346,624
tax credit received in 2001.
?This suggests the company paid at least
$346,624 in taxes during the past 2 years.
?If the payments over the past 2 years were
less than $346,624 the firm would have
had to carry forward the amount of its loss
that was not carried back.
?If the firm did not receive a full refund its
cash position would be even worse.
2 - 30
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2000 Tax Year Single Individual
Tax Rates
Taxable Income Tax on Base Rate*
0 - 26,250 0 15%
26,250 - 63,550 3,937.50 28%
63,550 - 132,600 14,381.50 31%
132,600 - 288,350 35,787.00 36%
Over 288,350 91,857.00 39.6%
*Plus this percentage on the amount over the
bracket base.
2 - 31
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Assume your salary is $45,000,and you
received $3,000 in dividends.
You are single,so your personal
exemption is $2,800 and your itemized
deductions are $4,550.
On the basis of the information
above and the 2000 tax year tax rate
schedule,what is your tax liability?
2 - 32
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Calculation of Taxable Income
Salary $45,000
Dividends 3,000
Personal exemptions (2,800)
Deductions (4,550)
Taxable Income $40,650
2 - 33
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Tax Liability:
TL = $3,937.50 + 0.28($14,400)
= $7,969.50.
?Marginal Tax Rate = 28%.
?Average Tax Rate:
Tax rate = = 19.6%.
$40,650 - $26,250
$7,969.5
$40,650
2 - 34
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2000 Corporate Tax Rates
Taxable Income Tax on Base Rate*
0 - 50,000 0 15%
50,000 - 75,000 7,500 25%
75,000 - 100,000 13,750 34%
100,000 - 335,000 22,250 39%
Over 18.3M 6.4M 35%
*Plus this percentage on the amount over the
bracket base.
...,..,..
2 - 35
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Assume a corporation has $100,000 of
taxable income from operations,$5,000
of interest income,and $10,000 of
dividend income.
What is its tax liability?
2 - 36
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Operating income $100,000
Interest income 5,000
Taxable dividend
income 3,000*
Taxable income $108,000
Tax = $22,250 + 0.39 ($8,000)
= $25,370.
*Dividends - Exclusion
= $10,000 - 0.7($10,000) = $3,000.
2 - 37
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
State and local government bonds
(municipals,or,munis”) are
generally exempt from federal
taxes.
Taxable versus Tax Exempt Bonds
2 - 38
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Exxon bonds at 10% versus California
muni bonds at 7%.
?T = Tax rate = 28%.
?After-tax interest income:
Exxon = 0.10($5,000) - 0.10($5,000)(0.28)
= 0.10($5,000)(0.72) = $360.
CAL = 0.07($5,000) - 0 = $350.
2 - 39
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Solve for T in this equation:
Muni yield = Corp Yield(1-T)
7.00% = 10.0%(1-T)
T = 30.0%.
At what tax rate would you be
indifferent between the muni and the
corporate bonds?
2 - 40
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?If T > 30%,buy tax exempt munis.
?If T < 30%,buy corporate bonds.
?Only high income,and hence high
tax bracket,individuals should buy
munis.
Implications
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Balance sheet
?Income statement
?Statement of cash flows
?Accounting income versus cash flow
?MVA and EVA
?Personal taxes
?Corporate taxes
CHAPTER 2
Financial Statements,
Cash Flow,and Taxes
2 - 2
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2001 2000
Cash 7,282 9,000
Short-term inv,0 48,600
AR 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less,Depr,263,160 146,200
Net FA 939,790 344,800
Total assets 2,866,592 1,468,800
Balance Sheets,Assets
2 - 3
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
1,733,760
Liabilities and Equity
2001 2000
Accts payable 524,160 145,600
Notes payable 720,000 200,000
Accruals 489,600 136,000
Total CL 481,600
Long-term debt 1,000,000 323,432
Common stock 460,000 460,000
Retained earnings (327,168) 203,768
Total equity 132,832 663,768
Total L&E 2,866,592 1,468,800
2 - 4
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
(519,936)
Income Statement
Sales 5,834,400 3,432,000
COGS 5,728,000 2,864,000
Other expenses 680,000 340,000
Deprec,116,960 18,900
Tot,op,costs 6,524,960 3,222,900
EBIT (690,560) 209,100
Interest exp,176,000 62,500
EBT (866,560) 146,600
Taxes (40%) (346,624) 58,640
Net income 87,960
2001 2000
2 - 5
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Other Data
No,of shares 100,000 100,000
EPS ($5.199) $0.88
DPS $0.110 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000
2001 2000
2 - 6
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Statement of Retained Earnings (2001)
Balance of retained
earnings,12/31/00 $203,768
Add,Net income,2001 (519,936)
Less,Dividends paid (11,000)
Balance of retained
earnings,12/31/01 ($327,168)
2 - 7
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Statement of Cash Flows,2001
OPERATING ACTIVITIES
Net Income (519,936)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 378,560
Change in accruals 353,600
Net cash provided by ops,(523,936)
2 - 8
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
L-T INVESTING ACTIVITIES
Investments in fixed assets
(711,950)
FINANCING ACTIVITIES
Change in s-t investments 48,600
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash from financing 1,234,168
Sum,net change in cash (1,718)
Plus,cash at beginning of year 9,000
Cash at end of year 7,282
2 - 9
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Net cash from operations = -$523,936,
mainly because of negative net income.
?The firm borrowed $1,185,568 and sold
$48,600 in short-term investments to
meet its cash requirements.
?Even after borrowing,the cash account
fell by $1,718.
What can you conclude about the
company’s financial condition from its
statement of cash flows?
2 - 10
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the expansion have on
net operating working capital (NOWC)?
NOWC01 = ($7,282 + $632,160 + $1,287,360)
- ($524,160 + $489,600)
= $913,042.
NOWC00 = $793,800.
= -Operating CA Operating CLNOWC
2 - 11
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the expansion have on
capital used in operations?
= NOWC + Net fixed assets.
= $913,042 + $939,790
= $1,852,832.
= $1,138,600.
Operating
capital01
Operating
capital00
Operating
capital
2 - 12
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Did the expansion create additional net
operating profit after taxes (NOPAT)?
NOPAT = EBIT(1 - Tax rate)
NOPAT01 = -$690,560(1 - 0.4)
= -$690,560(0.6)
= -$414,336.
NOPAT00 = $125,460.
2 - 13
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is your initial assessment of the
expansion’s effect on operations?
2001 2000
Sales $5,834,400 $3,432,000
NOPAT ($414,336) $125,460
NOWC $913,042 $793,800
Operating capital $1,852,832 $1,138,600
2 - 14
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What effect did the company’s
expansion have on its net cash flow
and operating cash flow?
NCF01 = NI + DEP = -$519,936 + $116,960
= -$402,976.
NCF00 = $87,960 + $18,900 = $106,860.
OCF01 = NOPAT + DEP
= -$414,336 + $116,960
= -$297,376.
OCF00 = $125,460 + $18,900
= $144,360.
2 - 15
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What was the free cash flow (FCF)
for 2001?
FCF = NOPAT - Net capital investment
= -$414,336 - ($1,852,832 - $1,138,600)
= -$414,336 - $714,232
= -$1,128,568.
How do you suppose investors reacted?
2 - 16
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is the company’s EVA?
Assume the firm’s after-tax cost of
capital (COC) was 11% in 2000
and 13% in 2001.
EVA01 = NOPAT- (COC)(Capital)
= -$414,336 - (0.13)($1,852,832)
= -$414,336 - $240,868
= -$655,204.
EVA00 = $125,460 - (0.11)($1,138,600)
= $125,460 - $125,246
= $214.
2 - 17
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Would you conclude
that the expansion increased or
decreased MVA?
MVA = -,
During the last year stock price has
decreased 73%,so market value of
equity has declined,Consequently,
MVA has declined.
Equity capital
supplied
Market value
of equity
2 - 18
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Probably not.
?A/P increased 260% over the past
year,while sales increased by only
70%.
?If this continues,suppliers may cut
off trade credit.
Does the company pay its suppliers
on time?
2 - 19
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?No,the negative NOPAT shows
that the company is spending
more on it’s operations than it is
taking in.
Does it appear that the sales price
exceeds the cost per unit sold?
2 - 20
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
1,The company offers 60-day credit
terms,The improved terms are
matched by its competitors,so sales
remain constant.
What effect would each of these
actions have on the cash account?
?A/R would ?
?Cash would ?
2 - 21
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2,Sales double as a result of the
change in credit terms.
?Short-run,Inventory and fixed
assets ? to meet increased
sales,A/R ?,Cash ?,
Company may have to seek
additional financing.
?Long-run,Collections increase
and the company’s cash
position would improve.
2 - 22
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?The expansion was financed
primarily with external capital.
?The company issued long-term debt
which reduced its financial strength
and flexibility.
How was the expansion financed?
2 - 23
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Would external capital have been
required if they had broken even in
2001 (Net income = 0)?
?Yes,the company would still have
to finance its increase in assets.
2 - 24
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What happens if fixed assets are
depreciated over 7 years (as opposed
to the current 10 years)?
?No effect on physical assets.
?Fixed assets on balance sheet
would decline.
?Net income would decline.
?Tax payments would decline.
?Cash position would improve.
2 - 25
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Other policies that
can affect financial statements
?Inventory valuation methods.
?Capitalization of R&D expenses.
?Policies for funding the company’s
retirement plan.
2 - 26
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Does the company’s positive stock
price ($2.25),in the face of large losses,
suggest that investors are irrational?
?No,it means that investors
expect things to get better in
the future.
2 - 27
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Why did the stock price fall
after the dividend was cut?
?Management was,signaling” that
the firm’s operations were in trouble.
?The dividend cut lowered investors’
expectations for future cash flows,
which caused the stock price to
decline.
2 - 28
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What were some other sources of
financing used in 2001?
?Selling financial assets,Short term
investments decreased by $48,600.
?Bank loans,Notes payable increased
by $520,000.
?Credit from suppliers,A/P increased
by $378,560.
?Employees,Accruals increased by
$353,600.
2 - 29
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What is the effect of the $346,624
tax credit received in 2001.
?This suggests the company paid at least
$346,624 in taxes during the past 2 years.
?If the payments over the past 2 years were
less than $346,624 the firm would have
had to carry forward the amount of its loss
that was not carried back.
?If the firm did not receive a full refund its
cash position would be even worse.
2 - 30
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2000 Tax Year Single Individual
Tax Rates
Taxable Income Tax on Base Rate*
0 - 26,250 0 15%
26,250 - 63,550 3,937.50 28%
63,550 - 132,600 14,381.50 31%
132,600 - 288,350 35,787.00 36%
Over 288,350 91,857.00 39.6%
*Plus this percentage on the amount over the
bracket base.
2 - 31
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Assume your salary is $45,000,and you
received $3,000 in dividends.
You are single,so your personal
exemption is $2,800 and your itemized
deductions are $4,550.
On the basis of the information
above and the 2000 tax year tax rate
schedule,what is your tax liability?
2 - 32
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Calculation of Taxable Income
Salary $45,000
Dividends 3,000
Personal exemptions (2,800)
Deductions (4,550)
Taxable Income $40,650
2 - 33
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Tax Liability:
TL = $3,937.50 + 0.28($14,400)
= $7,969.50.
?Marginal Tax Rate = 28%.
?Average Tax Rate:
Tax rate = = 19.6%.
$40,650 - $26,250
$7,969.5
$40,650
2 - 34
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
2000 Corporate Tax Rates
Taxable Income Tax on Base Rate*
0 - 50,000 0 15%
50,000 - 75,000 7,500 25%
75,000 - 100,000 13,750 34%
100,000 - 335,000 22,250 39%
Over 18.3M 6.4M 35%
*Plus this percentage on the amount over the
bracket base.
...,..,..
2 - 35
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Assume a corporation has $100,000 of
taxable income from operations,$5,000
of interest income,and $10,000 of
dividend income.
What is its tax liability?
2 - 36
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Operating income $100,000
Interest income 5,000
Taxable dividend
income 3,000*
Taxable income $108,000
Tax = $22,250 + 0.39 ($8,000)
= $25,370.
*Dividends - Exclusion
= $10,000 - 0.7($10,000) = $3,000.
2 - 37
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
State and local government bonds
(municipals,or,munis”) are
generally exempt from federal
taxes.
Taxable versus Tax Exempt Bonds
2 - 38
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Exxon bonds at 10% versus California
muni bonds at 7%.
?T = Tax rate = 28%.
?After-tax interest income:
Exxon = 0.10($5,000) - 0.10($5,000)(0.28)
= 0.10($5,000)(0.72) = $360.
CAL = 0.07($5,000) - 0 = $350.
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Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Solve for T in this equation:
Muni yield = Corp Yield(1-T)
7.00% = 10.0%(1-T)
T = 30.0%.
At what tax rate would you be
indifferent between the muni and the
corporate bonds?
2 - 40
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?If T > 30%,buy tax exempt munis.
?If T < 30%,buy corporate bonds.
?Only high income,and hence high
tax bracket,individuals should buy
munis.
Implications
