Finance and Accounting Lecture 2

1. CorporateFinanceRonald F. SingerFINA 4330 Finance and Accounting Lecture 2 Fall, 2010 FINA4330 Corporate Finance

2. Financial Statements • Generally Finance Professionals get their information from Financial Statements prepared by accountants. • In general, Financial Statements are used to determine how the firm “is doing,” in particular, how it has done over some period of time. FINA4330 Corporate Finance

3. Financial Statements • Although we are also interested in the financial health of companies; generally, financial statements have to be modified in order to focus on our objective. • In general, the “focus of our objective” is cash flow • Most corporations prepare three basic financial statements: Income Statement Balance Sheet Cash Flow Statements FINA4330 Corporate Finance

4. Focus of Finance • Cash Flow!!! • What is Cash Flow? • It is the amount of cash generated and available to security holders. FINA4330 Corporate Finance

5. Financial Statements • Income Statement: • A Listing of Revenue, Expenses, and Profits over a period of time • Balance sheet • A listing of Assets, Liabilities, and Net Worth at a single point in time. Generally in terms of Book Value. • Cash Flow Statement • The Flow of Cash over a period of time FINA4330 Corporate Finance

6. Macintosh Enterprises Balance Sheet December 31, 2008 (BV $ thousands) AssetsLiabilities and Stockholders Equity Current Assets Current Liabilities Cash 1,000 Accounts payable 500 Accounts Receivable 1,000 Notes payable 75 Inventory 450 Accrued expenses 75 Other 50 Total Current Liabilities 650 Total Current Assets $2,500 Long term Liabilities Fixed Assets Deferred Taxes 1,000 Property, Plant & equip. 4,600 Long term debt 2,000 Less Accumulated Dep. 600 Total long term liability 3,000 Net PP&E 4,000 Intangible & Other assets 1,000 Stockholders’ Equity ??? Total Assets $7,500 Total Liabilities and Stockholders’ Equity ??? FINA4330 Corporate Finance

7. Macintosh Enterprises Balance Sheet December 31, 2009 (BV $ thousands) AssetsLiabilities and Stockholders Equity Current Assets Current Liabilities Cash 800 Accounts payable 650 Accounts Receivable 1,200 Notes payable 25 Inventory 550 Accrued expenses 75 Other 150 Total Current Liabilities 750 Total Current Assets $2,700 Long term Liabilities Fixed Assets Deferred Taxes 1,000 Property, Plant & equip. 4,600 Long term debt 2,000 Less Accumulated Dep. 600 Total long term liability 3,000 Net PP&E 4,000 Intangible & Other assets 1,000 Stockholders’ Equity ??? Total Assets $7,500 Total Liabilities and Stockholders’ Equity ??? FINA4330 Corporate Finance

8. Macintosh Enterprises Pro-Forma Income Statement (Year ending December 31, 2009) ($ thousand) Sales $5,000 Less: Operating Expenses (COGS) 2,000 Depreciation & Amortization 600 Selling, general and administrative exp. 300 Operating Income $2,100 Other income 100 Earnings Before Interest and Taxes (EBIT) 2,200 Less: Interest Expense 770 Pretax (Taxable) Income 1,430 Less Tax (@ 40%) 572 Net Income (Earnings after Tax) $858 Addition to retained earnings 58 Dividends 800 Earnings per Share (EPS) = Net Income/Shares = $0.858 Dividends per share (DPS) = $0.80 FINA4330 Corporate Finance

9. Transform income statement into Cash Flow Now we are ready to transform this income statement into Cash Flow Adjustments Necessary: 1. Changes in Fixed Assets: Depreciation and Amortization is not a cash expense and thus should not be subtracted from Cash Flow. But, New Investment is a cash expense (when paid for) and should be subtracted. FINA4330 Corporate Finance

10. Transform income statement into Cash Flow 2. Cost of Goods Sold (COGS) is the DIRECT expense associated with producing the goods that are sold in the period. Costs associated with goods that are produced but will be sold in future periods are not counted. If the firm pays for goods THAT ARE NOT SOLD, there is a cash flow out which must be accounted for. In order to account for this, we include changes in Inventory in the Cash Flow statement. FINA4330 Corporate Finance

11. Transform income statement into Cash Flow • In general: Increases in Working Capital must be subtracted from Earning to get Cash Flow • In this case suppose: Changes in Working Capital (+100) Change in cash -200 a/c receivable +200 a/c payable +150 Inventory +100 Notes payable -50 Other S.T.A +100 Total change 200 100 FINA4330 Corporate Finance

12. Macintosh Enterprises Pro-Forma Cash Flow Statement (Year ending December 31, 2006) ($ thousand) Earnings Before Interest and Taxes (from Income Statement) $2,200 Less: Tax on Operations (@ 40% (Note: tax rate times EBIT not $572) 880 Operating Income after Tax (EBIT(1-t)) 1,320 Plus: Non-Cash Expenses (Depreciation & Amortization) 500 1,820 Increase (decrease) in cash holdings -200 increase (decrease) in accounts receivable 200 increase (decrease) in Inventory 100 increase (decrease) in other Short Term Assets 100 Change in Short Term Assets 200 Less: increase (decrease) in accounts payable 150 increase (decrease) in Short Term Liabilities (50) Changer in Short Term Liabilities 100 Less: Net Change in Working Capital 300 300 Free Cash Flow from Operations $1,520 Less: “After Tax” interest payments I(1-t) (note: = 770 (1-.40)) 462 Less: Dividends to preferred stockholders 100 Less: Investment (net of capital gains tax) 400 Free Cash Flow to Common Stockholders 558 EBITDA (2,200 + 500) $2,700