Welcome to Excel in finance video number 12.
If you want to download this workbook and follow along,
click on the link directly below the video.
And you can download this workbook business 233 chapter
2.
Hey, two more topics, we're going
to talk about in this chapter 2--
why debt is good also why it's bad.
And then we've got to just briefly look at taxes.
Now why is debt good?
Well, debt is good because it saves cash.
What?
Wait a second.
If I'm borrowing money and paying interest,
how does it save cash?
Well, on the income statement debt expense
is a reduction from your income, which
means any reduction from income means you pay fewer taxes.
So there's a tax advantage.
It actually saves you some cash.
And why is debt bad?
Well, do I even have to answer this in the year 2010?
All the humans on the planet saw what
happened between 2007 and '10.
Too much debt can get you in big trouble.
Too much debt, you may go bankrupt.
Now let's see an example here.
If you use new debt to buy an asset, $500, we could--
so we're talking about debt.
So we use debt.
We go out and borrow the money, $500, and we buy an asset.
But what's the other possibility?
We could have used equity.
So ultimately, we're going to see one little income
statement.
And we're going to see what net income was when we used debt
to buy that $500 asset.
And then we're going to see-- oh, that should say without--
so income statement without debt.
Or said a different way, you used equity.
So here it is.
We buy 500.
The annual interest rate on the contract says 8%.
And our tax rate is 30% Let's first calculate interest
on debt.
It's simply-- and I'm going to use our round function, just
like we did last video.
Round, round?
Well, we need to take our debt we owe times our interest rate.
And this is just a flat rate for the whole year of 8%.
Now we may have to pay some pennies to a banker.
So when I type a comma, the number of digits,
last video we saw zero to the dollar
like for income taxes, which we will again
have to do down here.
But right now, we're talking pennies.
So you have to put a two to here to say, hey,
round to that second digit to the right of the decimal.
$40, actually didn't-- $40, we got no pennies there.
So it didn't matter.
But in general, that's smart to use the round function.
So cash-- this is cash going back to the bank.
We pay our interest, $40.
But wait a second, we're going to indirectly
have cash coming in from our savings on our tax bill.
Now think about this. $40, we subtract it on our tax bill.
So any subtraction means $40 is subtracted.
That means we avoided paying 30% on 40 bucks.
So to figure out the tax advantage for $40
at a rate of 30, we simply go, hey, equals this times our 30%.
And that says to us our cash savings.
Now I'm going to put a round here
even though I'm always careful about this because you never
know when the input will change.
I have rounded it to the penny.
If all of a sudden this was 8.75,
then we would have had to--
well, we're happy that we rounded.
I'm going to control Z. So if $40 went up,
the avoidance of $12 is what this really is.
But get this, if we didn't use debt
and instead we used equity, when we paid out the dividends,
there would be no tax benefit.
We avoided paying $12 out as cash, which
is the same as getting cash in.
So if you go to the store and they say, you have a $10 bill
and you're about to buy the thing for $10, and they go,
oh, we're going to give you a $2 discount, what do they do?
They give you back $2.
You expected to pay 10.
But they gave you a discount.
That's like cash coming in.
And anytime you can avoid having your cash go out,
it's like you saved cash.
So the difference equals that minus this.
That's one way to analyze it and think about it.
And that's good.
You should be able to do that.
But here's an even more maybe straightforward way.
Income, net sales 1,000, expenses total
are 400-- so our net earnings before interest and tax is 600.
And we have an interest expense of 40.
Notice over here-- same income statement,
but no interest expense.
So what do we do?
We say equals EBIT minus our interest.
And that will give us our taxable earnings equals round.
And I'm going to say taxable earnings times our tax rate
comma.
And we're going to the dollar or the integer.
So we put a zero.
$68-- no problem.
We do our calculation just like we
did the last couple of videos.
Taxable earnings minus our tax, there's our net income.
But come over here and let's do it.
Tax-- you can already see the difference.
We subtracted it to get to our tax point.
No subtraction here.
That's a fat 600.
So I say equals round.
Oh, no, that's 600 times our 30% comma zero, close parentheses
and $180.
So the tax is higher.
Notice there's the difference of 12.
Notice cash going out of 180, if we didn't use debt, cash of 168
because we used debt.
So that savings shows up, equals this minus this.
No, wait a second, 420, 390--
you mean net income is greater when
we don't use the debt and the interest expense?
Yeah, of course.
That interest is allowed on the income statement
as an operating expense.
The parallel, if we used equity, dividends are not.
They show up somewhere else.
So for us, the financial manager,
we're not interested in that net income.
We're interested in the cash flow.
And there's a huge advantage when we use debt.
So you could see the difference there.
But the relevant calculation is understanding
that, when you can take a interest rate,
calculate your interest, put it on the income statement,
subtract it, and avoid paying taxes.
So that's why debt is considered good.
Now let's go on one other topic concerned with taxes.
There's something called average tax rate and marginal tax
rate for the next dollar.
Now tax tables are different for whether you're
individual or a corporation.
This is a table I got.
Maybe it's a year or a couple years old,
but nevertheless, you get the idea.
No way.
15% for the first 50,000?
Then between [? 50,001 ?] and 75,000
in essence 25,000, the next 25,000, you have to pay 25%.
The next 25,000, because 100k minus 75,000 is 25,000.
The next, 25,000, 34%.
And then between [? 335 ?] and 100,000,
[? 339. ?] And then you can see how it goes down here.
So when you have 300,000, like we have here,
you have to calculate it in a bunch of steps.
So the first one--
I'm just going to go equals the three--
no, I can't do the 300,000.
It's the first bit there.
So that times this.
Now the next bit.
We still haven't exceeded this amount here.
So I'm going to have to take the difference in the tax table.
So in parentheses, this minus this times
whatever this rate is.
Still, we're not anywhere near the hurdle.
We've only gone from 50,000 up to 75,000.
So the next one we have to do the same thing here
in parentheses.
100,000, the next 25,000 in essence, times this tax rate.
And finally, now we're approaching the ceiling here.
This 335 is greater than our amount.
So the next amount is going to be this amount here
minus all of the taxes.
So we've had taxes on 100,000 so far.
So we have to say, equals our amount minus all of the taxes,
that 100,000 that we've already so far been taxed
on, times this one right here because we're
[INAUDIBLE] this bracket right here all the way
down to there-- so 39% percent.
That's how you calculate taxes.
Now in this chapter, they're just
alerting you to this fact of how to calculate taxes.
We're pretty much not going to have
to calculate taxes like this.
But we do need to know the difference
between average and marginal.
So let's figure out our total tax bill.
Alt equals, it's got the right rate.
So I hit Enter.
Wow, 100,250-- so average tax rate.
This is the amount that went out cashwise.
And this is our taxable income.
So you just compare the two.
This is the part.
This is part of the whole, part of the total.
So to calculate a percentage, you
say the part divided by the total.
So our average tax rate 0.33417.
But in financial analysis, you may have a whole range
of income numbers.
But if you're thinking about buying a new machine,
you have to analyze, not all of these.
But if you add a new machine and it brings-- so
you're at 300,000.
And if a machine is going to bring in an extra 100,000,
that's on top of this.
Well, this is all the taxes for that.
So the marginal rate is, what if you brought in 100,000--
right, I'm sorry.
If you brought in a 100,000 of income,
where would it fall within this bracket?
Well, it would fall right here.
It's 39.
It's actually probably not 39.
It's 100,000.
35,000 of it would be 39.
And the remaining 65,000 would be at 34.
So you would actually have to calculate.
But in essence, you always ask the question,
what's the marginal rate from the next dollar.
And for us, it's going to be 39.
So that's the marginal rate.
Why is this important?
Because if you're analyzing the cash flows
from a particular asset, you always got to think of--
if we add some more dollars, where are we going to be taxed?
Now later and in later chapters, I think, 10 or 11 or something
like that, they'll just give us the marginal tax rate.
They'll say, here's your project you're analyzing
and here's the marginal tax rate.
But that's how you do it.
You'd have to actually do your calculations,
figure out where you were, and find the marginal tax rate.
That's it for this chapter 2.
Chapter 3 is going to be an extension of chapter 2.
Remember, we were analyzing, looking
at financial statements, learning
a little bit about them, learning how to look
at cash flows.
And next chapter, chapter 3, we'll
analyze financial statements with ratio analysis
and a few other analysis tricks.
All right, we'll see you next chapter and next video.