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Finance and Accounting Lecture 2

Corporate Finance Ronald F. Singer FINA 4330. Finance and Accounting Lecture 2. Fall, 2009. Financial Statements. Generally Finance Professionals get their information from Financial Statements prepared by accountants.

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Finance and Accounting Lecture 2

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  1. CorporateFinanceRonald F. SingerFINA 4330 Finance and Accounting Lecture 2 Fall, 2009 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 Cash 1,000 Short-term debt 900 Inventory 500 Accounts payable 600 Accounts Rec. 1,000 Long-term debt 3,000 Plant & equip. 4,000 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, 2008 (Book value $ thousands) AssetsLiabilities and Stockholders Equity Cash 1,000 Short-term debt 900 Inventory 500 Accounts payable 600 Accounts Rec. 1,000 Long-term debt 3,000 Plant & equip. 4,000 Other assets 1,000 Stockholders’ Equity 3,000 Total Assets $7,500 Total Liabilities and Stockholders’ Equity $7,500 Number of Shares = 1,000,000 => Book Value /Share = $3 FINA4330 Corporate Finance

  8. Macintosh Enterprises Pro-Forma Income Statement (Year ending December 31, 2008) ($ thousand) Sales $5,000 Less: Operating Expenses (COGS) 2,000 Depreciation & Amortization 500 Allocated G & A Costs 300 Operating Income (EBIT)$2,200 Less: Interest Expense 770 Earnings Before Tax(taxable income) 1,430 Less Tax (@ 40%) 572 Net Income (Earnings after Tax) $858 Earnings per Share (EPS) = Net Income/Shares = $0.858 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 • Cash Revenue is not the same as Sales. An increase in “Receivables” must be subtracted from Sales to get Cash Revenues. A decrease in “Receivables” must be added to Sales to get Cash Revenues. FINA4330 Corporate Finance

  11. Transform income statement into Cash Flow • 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

  12. 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 (+300) a/c receivable +200 a/c payable +150 Inventory +100 S.term liabil -50 Other S.T.A +100 Total change 400 100 FINA4330 Corporate Finance

  13. 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 Less: increase (decrease) in Working Capital (WC change) increase (decrease) in accounts receivable 200 increase (decrease) in Inventory 100 increase (decrease) in other Short Term Assets 100 increase (decrease) in accounts payable 150 increase (decrease) in Short Term Liabilities (50) 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

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