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.