Chapter 3

Fundamentals of Corporate Finance

Fourth Edition

Accounting and Finance

Slides by Matthew Will

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Topics Covered
The Balance Sheet The Income Statement The Statement of Cash Flows Accounting Practice & Malpractice Taxes

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The Balance Sheet

Definition Financial statements that show the value of the firms assets and liabilities at a particular point in time (from an accounting perspective).

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The Balance Sheet

The Main Balance Sheet Items
Current Assets Cash & Securities Receivables Inventories

Fixed Assets Tangible Assets Intangible Assets

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Current Liabilities Payables Short-term Debt

Long-term Liabilities

Shareholders Equity

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Market Value vs. Book Value

Book Values are determined by GAAP
Market Values are determined by current values Equity and Asset Market Values are usually higher than their Book Values
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Market Value vs. Book Value

Example According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firms 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.
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Market Value vs. Book Value

Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil

Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil
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The Income Statement

Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective).

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The Income Statement

Earnings Before Income & Taxes (EBIT)

EBIT =

- total Revenues - costs - deprecation

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The Income Statement

Pepsico Income Statement (year end 2001) Net Sales COGS Other Expenses Selling, G&A expenses Depreciation expense EBIT Net interest expense Taxable Income Income Taxes Net Income
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26,935 10,754 392 10,526 1,082 4,181 152 4,029 1,367 2,662

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Profits vs. Cash Flows

Differences Profits subtract depreciation (a non-cash expense) Profits ignore cash expenditures on new capital (the expense is capitalized) Profits record income and expenses at the time of sales, not when the cash exchanges actually occur Profits do not consider changes in working capital

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The Statement of Cash Flows

Definition Financial statement that shows the firms cash receipts and cash payments over a period of time.

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The Statement of Cash Flows

Pepsico Statement of Cash Flows (excerpt - year end 2001) Net Income Non-cash expenses Depreciation Other Changes in working capital
A/R=7 A/P=(236) Inv=(75) other=388

2,662 1,082 373

Cash Flow from operations Cash Flow from investments Cash provided by financing Net Change in Cash Position

1,539 4,201 (2,637) (1,919) (355)

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Accounting Practice
Stock options Allowance for bad debts Revenue recognition

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Taxes
Taxes have a major impact on financial decisions Marginal Tax Rate is the tax that the individual pays on each extra dollar of income. Average Tax Rate is the total tax bill divided by total income.
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Taxes
Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not. Firm A 100 40 60 21 39 Firm B 100 0 100 35 65

EBIT Interest Pretax Income Taxes (35%) Net Income

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Taxes
FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65

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Taxes
FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B Net Income 39 65 + Interest 40 0 Net Cash Flow 79 65

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Corporate Tax Rates (2002)

Taxable Income ($) 0-50,000 50,001-75,000 75,001-100,000 100,001-18,333,333 over 18,333,333

Tax Rate (%) 15 25 34 34-39 35

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Personal Tax Rates (2002)

Single Taxable Income ($) 0-6,000 6,000-27,950 27,950-67,700 67,700-141,250 141,250-307,050 over 307,050 Married Taxable Income ($) 0-12,000 12,000-46,700 46,700-112,850 112,850-171,950 171,950-307,050 over 307,050

Tax Rate (%) 10 15 27 30 35 38.6

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Web Resources
Click to access web sites Internet connection required

www.ibm.com/investor/financialguide www.reportgallery.com www.sec.gov/edgar.shtml http://moneycentral.msn.com/tax/workshop/welcome.asp www.aicpa.org/index.htm www.businessweek.com/2001/01_04/b3716160.htm www.irs.gov

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