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Chapter 2

Chapter 2. Financial Statements, Cash Flow, and Taxes. Topics in Chapter. Balance sheet Income statement Statement of cash flows Free cash flow MVA and EVA Corporate taxes . Importance of Financial Statements. Form the basis for understanding the financial position of a business

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Chapter 2

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  1. Chapter 2 Financial Statements, Cash Flow, and Taxes

  2. Topics in Chapter • Balance sheet • Income statement • Statement of cash flows • Free cash flow • MVA and EVA • Corporate taxes

  3. Importance of Financial Statements • Form the basis for understanding the financial position of a business • Provide information regarding the financial policies and strategies and insight into future performance • 10-K and 10-Q

  4. Balance Sheet

  5. Balance Sheet: Assets

  6. Balance Sheet: Liabilities & Equity

  7. Changes on liabilities & equity • CL increased as creditors and suppliers “financed” part of the expansion. • Long-term debt increased to help finance the expansion. • The company didn’t issue any stock. • Retained earnings fell, due to the year’s negative net income and dividend payment.

  8. Dell’s Balance Sheet • http://finance.yahoo.com/q/bs?s=DELL+Balance+Sheet&ann

  9. Balance Sheet highlights • Net plant and equipment= gross plant and equipment– accumulated depreciation • Common stock at par and additional paid-in (capital surplus) • Retained earnings • Annual addition to retained earnings = net income – dividends paid • Net worth – common equity

  10. Income Statement

  11. Income Statement Example

  12. Dell’s Income Statement • http://finance.yahoo.com/q/is?s=DELL+Income+Statement&annual

  13. MicroDrive Income Statement

  14. Income Statement Highlight • Operating expenses • Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments, etc. • Earnings per common share (EPS) • Companies that issued convertible securities (such as bonds convertible into common stock) and stock options, must calculate two types of earnings per share: basic and diluted.

  15. Statement of Cash Flows • Provides information about cash inflows and outflows during an accounting period • Focuses on CASH. • Has THREE sections: • Cash flow from Operating Activities (OCF) • Cash flow from Investing Activities (ICF) • Cash flow from Financing Activities (FCF )

  16. Compute the changes in some accounts over two periods Accounts receivables Notes payable Depreciation Fixed assets Accruals etc … Which accountitem goes to Which section ? Operating Investing Financing

  17. Useful Tip 1 No matter which section you are doing (operating, investing or financing), • IF the change of an account leads to a cash INFLOW, you add that change (+); IF the change leads to a cash OUTFLOW, you subtract that change(-) • inflow: decreases in assets or increases in liabilities or equity. outflow: increases in assets or decreases in liabilities or equity.

  18. Useful Tip 2 Cash flow from Operating Activities + Cash flow from Investing Activities + Cash flow from Financing Activities = CHANGE in cash account

  19. Cash flows from operating activities 1 Net income + depreciation +/- change in A/R +/- change in Inv. +/- change in A/P +/- change in Accruals

  20. Cash flows from operating activities 2

  21. Cash flows from investing activities 1 • Investing activities: • Buying or selling productive assets (plant & equipment) • Buying or selling financial securities(e.g., stocks and bonds of other companies,)

  22. Cash flows from investing activities 2

  23. Cash flows from investing activities 3 Warning: we want changes in GROSS fixed assets. We don’t want the changes in net fixed assets! BUT, if gross fixed assets are not reported in balance sheet …

  24. Cash flows from investing activities 4 change in gross fixed assets = change in net fixed assets + depreciation

  25. Cash flows from financing activities 1 +/- changes in N/P +/- changes in current long-term debt +/- changes in long-term debt +/- changes in common and preferred stock +/- changes in capital surplus - Payment of dividends

  26. Cash flows from financing activities 2

  27. Cash Flows Workshop Solve Assignment 3.1

  28. Dell’s Statement of Cash Flow • http://finance.yahoo.com/q/cf?s=DELL+Cash+Flow&annual

  29. Analyzing Statement of Cash Flows 1 Statement of CF can help you analyze a company: 1) Relationship between net income and net cash flow from operations (OCF) • If net income positive, but OCF is negative, could mean: • Company is growing rapidly • Financial mis-management

  30. Analyzing Statement of Cash Flows 2 2) Net cash flow from investing activities (ICF) If negative, company is making investments • Buying plant & equipment (improve efficiencies) • Buying another company’s stock (strategic reasons, e.g., joint venture) If positive, company is liquidating assets. Why? Financial distress?

  31. Analyzing Statement of Cash Flows 3 3) Does company have sufficient cash to pay dividends? OCF should exceed dividends. If dividends exceed OCF, why? • Company liquidated assets to pay dividends? • Company issued equity or borrow to pay dividends? • Neither situation is good.

  32. Analyzing Statement of Cash Flows 4 4) Changes in debt • Look at cash flow from financing activities • substantial increases in debt (either short-term or long-term) • Substituting short-term debt for long-term debt may indicate worsening financial health.

  33. What is free cash flow (FCF)? Why is it important? • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends on the future FCF it can generate.

  34. What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock (repurchase). 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

  35. Calculating Free Cash Flow in 5 Easy Steps Step 1 Step 2 Earning before interest and taxes Operating current assets X (1 − Tax rate) − Operating current liabilities Net operating profit after taxes Net operating working capital Step 3 Net operating working capital + Operating long-term assets Total net operating capital Step 5 Step 4 Net operating profit after taxes Total net operating capital this year − Net investment in operating capital − Total net operating capital last year Net investment in operating capital Free cash flow

  36. NOPAT = EBIT(1 - Tax rate) =EBIT - Tax Step1: Net Operating Profit after Taxes (NOPAT)

  37. Operating CA = cash and equivalent + inventory + accounts receivables. Operating CL = accounts payable + accruals Operating CA Operating CL NOWC = - Step2: Net Operating Working Capital (NOWC)

  38. Step 3: Total net operating capital (or operating capital) Operating Capital = NOWC + Net fixed assets.

  39. Step 4: net investment in operating capital Net investment in operating capital = operating capital this year - operating capital last year

  40. FCF = NOPAT - Net investment in operating capital Equation (2-6) Step 5: Free Cash Flow (FCF)

  41. Alternative FCF equation (2-9) FCF = operating cash flow - gross investment in long-term operating asset • investment in NOWC Equation (2-9)

  42. Is a negative FCF bad? • If –NOPAT leads to a –FCF, then bad. • High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. ROIC: return on invested capital • ROIC = NOPAT / operating capital

  43. Market Value Added (MVA) • MVA = Market Value of the Firm - Book Value of the Firm • Market Value = (# shares of stock)(price per share) + Value of debt • Book Value = Total common equity + Value of debt

  44. MVA (Continued) • If the market value of debt is close to the book value of debt, then MVA = Market value of equity – book value of equity • This applies when it is hard to find the market value of debt.

  45. MVA (Assume market value of debt = book value of debt.) • Market Value of Equity 2010: • (100,000)($6.00) = $600,000. • Book Value of Equity 2010: • $557,632. • MVA = $600,000 - $557,632 = $42,368.

  46. Economic Value Added (EVA) EVA = NOPAT – Operating capital x WACC = Operating capital x ROIC – Operating capital x WACC = Operating capital (ROIC-WACC)

  47. MVA and EVA (Table 2-5)

  48. 2009 Corporate Tax Rates

  49. Features of Corporate Taxation • Progressive rate up until $18.3 million taxable income. • Below $18.3 million, the marginal rate is not equal to the average rate. • Above $18.3 million, the marginal rate and the average rate are 35%.

  50. After Chapter Homework • Problems: (2-3), (2-4), (2-5), (2-10), (2-12 abcde), mini case d,e,f,g,h. • Course website: Statement of Cash Flow assignment 3.2, 3.3.

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