70 Part 2 Fundamental Concepts in Financial Management
What is free cash # ow (FCF)?
Why is FCF an important determinant of a! rm’s value?
A company has EBIT of $30 million, depreciation of $5 million, and a 40%
tax rate. It needs to spend $10 million on new! xed assets and $15 million
to increase its current assets, and it expects its payables to increase by $2
million and its accruals to increase by $3 million. What is its free cash # ow?
($3 million)SELF^ TEST (^)
3-7 INCOME TAXES
Individuals and corporations pay out a signi! cant portion of their income as taxes,
so taxes are important in both personal and corporate decisions. We summarize
the key aspects of the U.S. tax system for individuals in this section and for corpo-
rations in the next section, using 2008 data. The details of our tax laws change
fairly often—annually for things that are indexed for in" ation—but the basic
nature of the tax system is likely to remain intact.
3-7a Individual Taxes
Individuals pay taxes on wages and salaries, on investment income (dividends,
interest, and pro! ts from the sale of securities), and on the pro! ts of proprietor-
ships and partnerships. The tax rates are progressive—that is, the higher one’s
income, the larger the percentage paid in taxes. Table 3-5 gives the tax rates that
were in effect April 2008.
Taxable income is de! ned as “gross income less a set of exemptions and
deductions.” When! ling a tax return in 2008 for the tax year 2007, taxpayers
received an exemption of $3,400 for each dependent, including the taxpayer, which
reduces taxable income. However, this exemption is indexed to rise with in" ation,
and the exemption is phased out (taken away) for high-income taxpayers. Also,
certain expenses, including mortgage interest paid, state and local income taxes
paid, and charitable contributions, can be deducted and thus be used to reduce
taxable income; but again, high-income taxpayers lose most of these deductions.
The marginal tax rate is de! ned as “the tax rate on the last dollar of income.”
Marginal rates begin at 10% and rise to 35%. Note, though, that when consider-
ation is given to the phase-out of exemptions and deductions, to Social Security
and Medicare taxes, and to state taxes, the marginal tax rate may actually exceed
50%. Average tax rates can be calculated from the data in Table 3-5. For example,
if a single individual had taxable income of $35,000, his or her tax bill would
be $4,386.25 # ($35,000 " $31,850)(0.25)! $4,386.25 # $787.50! $5,173.75. Her
average tax rate would be $5,173.75/$35,000! 14.78% versus a marginal rate of
25%. If she received a raise of $1,000, bringing her income to $36,000, she would
have to pay $250 of it as taxes; so her after-tax raise would be $750.
Note too that interest income received by individuals from corporate securities
is added to other income and thus is taxed at federal rates going up to 35%, plus
state taxes.^14 Capital gains and losses, on the other hand, are treated differently.
Assets such as stocks, bonds, and real estate are de! ned as capital assets. When you
buy a capital asset and later sell it for more than you paid, you earn a pro! t that is
called a capital gain; when you suffer a loss, it is called a capital loss. If you held
Progressive Tax
A tax system where the tax
rate is higher on higher
incomes. The personal
income tax in the United
States, which ranges from
0% on the lowest incomes
to 35% on the highest
incomes, is progressive.
Progressive Tax
A tax system where the tax
rate is higher on higher
incomes. The personal
income tax in the United
States, which ranges from
0% on the lowest incomes
to 35% on the highest
incomes, is progressive.
Marginal Tax Rate
The tax rate applicable to
the last unit of a person’s
income.
Marginal Tax Rate
The tax rate applicable to
the last unit of a person’s
income.
Average Tax Rate
Taxes paid divided by
taxable income.
Average Tax Rate
Taxes paid divided by
taxable income.
Capital Gain or Loss
The profit (loss) from the
sale of a capital asset for
more (less) than its
purchase price.
Capital Gain or Loss
The profit (loss) from the
sale of a capital asset for
more (less) than its
purchase price.
(^14) Under U.S. tax laws, interest on most state and local government bonds, called municipals or “munis,” is not
subject to federal income taxes. This has a signi! cant e# ect on the values of munis and on their rates of return.
We discuss rates and returns in Chapter 8.