chapter 2 of fundamentals of corporate finance
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Chapter 2
Financial Statements
Taxes and Cash Flow
McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills
Know the difference between bookvalue and market value
Know the difference betweenaccounting income and cash flow
Know the difference betweenaverage and marginal tax rates
Know how to determine a firms cash
flow from its financial statements
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Chapter Outline
The Balance Sheet
The Income Statement
Taxes Cash Flow
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Balance Sheet
The balance sheet is a snapshot of thefirms assets and liabilities at a givenpoint in time
Assets are listed in order of decreasingliquidity Ease of conversion to cash
Without significant loss of value
Balance Sheet Identity Assets = Liabilities + Stockholders Equity
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The Balance SheetFigure 2.1
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Net Working Capitaland Liquidity
Net Working Capital = Current AssetsCurrent Liabilities
Positive when the cash that will be received over the next 12months exceeds the cash that will be paid out
Usually positive in a healthy firm Liquidity
Ability to convert to cash quickly withouta significant loss in value
Liquid firms are less likely to experience financial distress
But liquid assets typically earn a lower return Trade-off to find balance between liquid and illiquid assets
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US Corporation Balance SheetTable 2.1
Place Table 2.1 (US Corp Balance Sheet)
here
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Market Value vs. BookValue
The balance sheet provides the bookvalue of the assets, liabilities, and equity.
Market value is the price at which the
assets, liabilities, or equity can actually bebought or sold.
Market value and book value are oftenvery different. Why?
Which is more important to the decision-making process?
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Example 2.2Klingon Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and ShareholdersEquity
NWC $ 400 $ 600 LTD $ 500 $ 500
NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600
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Income Statement
The income statement is more like avideo of the firms operations for a
specified period of time.
You generally report revenues first andthen deduct any expenses for the period
Matching principleGAAP says to showrevenue when it accrues and match theexpenses required to generate therevenue
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US Corporation IncomeStatementTable 2.2
Insert new Table 2.2 here (US Corp IncomeStatement)
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Work the Web Example
Publicly traded companies must fileregular reports with the Securities andExchange Commission
These reports are usually filedelectronically and can be searched at theSEC public site called EDGAR
Click on the web surfer, pick a company,and see what you can find!
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Taxes
The one thing we can rely on with taxes isthat they are always changing
Marginal vs. average tax rates
Marginal tax ratethe percentagepaid on the next dollar earned
Average tax ratethe tax bill / taxableincome
Average tax rates vary widely across differentcompanies and industries
Other taxes
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http://www.irs.gov/ -
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Example: Marginal vs.Average Rates
Suppose your firm earns $4 million intaxable income. What is the firms tax liability?
What is the average tax rate? What is the marginal tax rate?
If you are considering a project thatwill increase the firms taxable income
by $1 million, what tax rate should youuse in your analysis?
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The Concept of Cash Flow
Cash flow is one of the most importantpieces of information that a financialmanager can derive from financialstatements
The statement of cash flows does notprovide us with the same informationthat we are looking at here
We will look at how cash is generatedfrom utilizing assets and how it is paid tothose that finance the purchase of theassets
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Cash Flow From Assets
Cash Flow From Assets (CFFA) =Cash Flow to Creditors + Cash Flowto Stockholders
Cash Flow From Assets = OperatingCash FlowCapital SpendingChanges in NWC
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Example: US CorporationPart I
OCF (I/S) = EBIT + depreciationtaxes = $547
CS (B/S and I/S) = ending net fixed
assetsbeginning net fixed assets +depreciation = $130
Changes in NWC (B/S) = ending
NWCbeginning NWC = $330
CFFA = 547130330 = $87
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Example: US CorporationPart II
CF to Creditors (B/Sand I/S) = interestpaidnet new borrowing = $24
CF to Stockholders (B/Sand I/S) =
dividends paidnet new equity raised= $63
CFFA = 24 + 63 = $87
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Cash Flow Summary -Table 2.6
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Example: Balance Sheet andIncome Statement Info
Current Accounts 2012: CA = 3625; CL = 1787 2011: CA = 3596; CL = 2140
Fixed Assets and Depreciation 2012: NFA = 2194; 2011: NFA = 2261 Depreciation Expense = 500
Long-term Debt and Equity 2012: LTD = 538; Common stock & APIC = 462 2011: LTD = 581; Common stock & APIC = 372
Income Statement EBIT = 1014; Taxes = 368 Interest Expense = 93; Dividends = 285
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Example: Cash Flows
OCF = 1,014 + 500368 = 1,146
NCS = 2,1942,261 + 500 = 433
Changes in NWC = (3,6251,787)
(3,5962,140) = 382 CFFA = 1,146433382 = 331
CF to Creditors = 93(538581) = 136
CF to Stockholders = 285(462372) = 195
CFFA = 136 + 195 = 331 The CF identity holds.
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Quick Quiz
What is the difference between book valueand market value? Which should we use fordecision-making purposes?
What is the difference between accounting
income and cash flow? Which do we need touse when making decisions?
What is the difference between average andmarginal tax rates? Which should we usewhen making financial decisions?
How do we determine a firms cash flows?What are the equations, and where do wefind the information?
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Ethics Issues
Why is manipulation of financialstatements not only unethical and illegal,but also bad for stockholders?
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Comprehensive Problem
Current Accounts 2012: CA = 4,400; CL = 1,500
2011: CA = 3,500; CL = 1,200
Fixed Assets and Depreciation 2012: NFA = 3,400; 2011: NFA = 3,100
Depreciation Expense = 400 Long-term Debt and Equity (R.E. not given)
2012: LTD = 4,000; Common stock & APIC = 400
2011: LTD = 3,950; Common stock & APIC = 400
Income Statement EBIT = 2,000; Taxes = 300
Interest Expense = 350; Dividends = 500
Compute the CFFA and CF to creditors andstockholders
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End of Chapter
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