Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Chapter Accounting and Finance 3- Topics Covered  The Balance Sheet  The Income Statement  The Statement of Cash Flows  Accounting Practice & Malpractice  Taxes McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- The Balance Sheet Definition Financial statements that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- The Balance Sheet }{ The Main Balance Sheet Items Current Assets Cash & Securities Receivables Inventories + = Fixed Assets Tangible Assets Intangible Assets McGraw-Hill/Irwin Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 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” McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 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 firm’s 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 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) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = McGraw-Hill/Irwin - total Revenues - costs - deprecation Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 10 The Income Statement Pepsico Income Statement (year end 2004) Net Sales COGS Selling, G&A expenses Depreciation expense EBIT Net interest expense Taxable Income Income Taxes Net Income McGraw-Hill/Irwin 29,261 12,142 10,142 1,264 5,713 167 5,546 1,334 4,212 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 11 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” not consider changes in working capital McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 12 The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 13 The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt - year end 2004) Net Income 4,212 Non-cash expenses Depreciation 1,264 Other (109) Changes in working capital A/R=(130) A/P=(50) Inv=(100) other=(33) (313) Cash Flow from operations 5,054 Cash Flow from investments (2,330) Cash provided by financing (2,264) Net Change in Cash Position 460 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 14 Accounting Practice  Stock options  Cookie Jar Reserves  Off balance sheet assets and liabilities  Revenue recognition McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 15 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 16 Taxes Example Taxes Example Taxesand andCash CashFlows Flowscan canbebechanged changedby by the the useuse of debt of debt Firm Firm A pays A pays partpart of itsofprofits its profits as as debt debt interest interest Firm Firm B does B does not.not EBIT EBIT Interest Interest Pretax Income Pretax Income Taxes (35%) Net Income McGraw-Hill/Irwin Firm A A 100 40 60 21 21 39 Firm B 100 100 35 65 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 17 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 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65 ? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 18 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 Net Cash Flow 79 65 ? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 19 Corporate Tax Rates (2005) Taxable Income ($) 0-50,000 50,001-75,000 75,001-100,000 100,001-18,333,333 over 18,333,333 McGraw-Hill/Irwin Tax Rate (%) 15 25 34 34-39 35 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 20 Personal Tax Rates (2005) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 3- 21 IRS Web Site McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights [...]... individual pays on each extra dollar of income Average Tax Rate is the total tax bill divided by total income McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 16 Taxes Example Taxes Example Taxesand andCash CashFlows Flowscan canbebechanged changedby by the the useuse of debt of debt Firm Firm A pays A pays partpart of itsofprofits its profits as as debt debt interest...3- 11 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 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 12 The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 13 The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt - year end 2004) Net Income 4,212 Non-cash expenses... 50,001-75,000 75,001-100,000 100,001-18,333,333 over 18,333,333 McGraw- Hill/Irwin Tax Rate (%) 15 25 34 34-39 35 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 20 Personal Tax Rates (2005) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 21 IRS Web Site McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights ... Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 18 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 ? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 19 Corporate Tax Rates (2005)... (2,330) Cash provided by financing (2,264) Net Change in Cash Position 460 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 14 Accounting Practice  Stock options  Cookie Jar Reserves  Off balance sheet assets and liabilities  Revenue recognition McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 15 Taxes  Taxes have a major impact... Income McGraw- Hill/Irwin Firm A A 100 40 60 21 21 39 Firm B 100 0 100 35 65 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 3- 17 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 ? McGraw- Hill/Irwin