Accounting and Finance

1. Accounting and Finance P.V. Viswanath For use with Fundamentals of Corporate Finance Brealey, Myers and Marcus, 4th ed.

2. Key Concepts and Skills • Know the difference between book value and market value • Know the difference between accounting income and cash flow • Know the difference between average and marginal tax rates • Know how to determine a firm’s cash flow from its financial statements P.V. Viswanath

3. Chapter Outline • The Balance Sheet • The Income Statement • Taxes • Cash Flow P.V. Viswanath

4. The Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity P.V. Viswanath

5. Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets = The Balance Sheet P.V. Viswanath

6. Pepsico Inc. Balance Sheet (in mil. $) P.V. Viswanath

7. Market vs. Book Value • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process? P.V. Viswanath

8. 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. P.V. Viswanath

9. Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil Market Value vs. Book Value Example Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil P.V. Viswanath

10. Income Statement • The income statement is more like a video of the firm’s operations for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue P.V. Viswanath

11. Income Statement Pepsico Inc. (in mil. $) P.V. Viswanath

12. Taxes • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average – the tax bill / taxable income Income before taxes was $4868 and $4029 and taxes were $1555 and $1367 for 2002 and 2001 resp. (in mil. $) The average tax rates were 31.94% and 33.93%. However, the tax paid on an additional dollar of income in either year would have been 35%, considering that in 2002, any income over $18 mil. was taxed at a rate of 35%. P.V. Viswanath

13. Statement of Cashflows • A firm’s cashflows can be quite different from its net income. For example: • The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Those expenses are spread over time as a deduction for depreciation. • The income statement recognizes revenues and expenses when sales are made, even though the money may not have been collected (revenues) or paid out (expenses). P.V. Viswanath

14. The Statement of Cashflows • The statement of cashflows shows the firm’s cash inflows and outflows from • Operations • Investments and • Financing • The form of this statement is determined by accounting standards. P.V. Viswanath

15. Statement of Cash Flows:Operating Activities • Operating activities are earnings-related activities. Generally these relate to Income Statement activities, and items included in working capital. Included are: • Sales and expenses necessary to obtain sales • Related operating activities, such as extending credit to customers • investing in inventories • obtaining credit from suppliers • payment of taxes • insurance payments • Other activities that don't easily fit into the other two categories, such as settlements in lawsuits. P.V. Viswanath

16. Statement of Cash Flows:Investing and Financing Activities • Investing activities relate to the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time. These include lending funds and collecting on these loans. • Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities. P.V. Viswanath

17. Pepsico Inc. (in mil. $)Statement of Cash Flows 2002 P.V. Viswanath

18. An alternate way of defining cashflows • Sometimes we are interested in defining cashflows for other purposes, such as project evaluation. Or we may interested in how cash is generated from the use of assets and how it is paid to those that finance the purchase of the assets • For this purpose, we separate cashflows into flows from assets and flows to shareholders and creditors. • We are interested in whether cashflows refer to investments, in the sense that they expand the asset base and are ultimately reflected in the balance sheet; or to operating returns from the use of assets, which are reflected in the income statement. • This differs from the GAAP oriented categorization of cashflows in the Statement of Cashflows. P.V. Viswanath

19. Cashflows from Assets • Since increases in working capital are increases in investments, they are not relevant for the determination of cashflows pertaining to recurring returns from the use of assets. A definition of Operating Cashflow for project evaluation purposes becomes: Operating Cashflow = EBIT + Depreciation – Taxes. • The other items that appear in the Cashflows from Operations category in the Statement of Cashflows, e.g. change in accounts receivable are, really, short-term investments. We define these separately as Change in Working Capital. • Finally, we have Net Capital Spending or long-term investments. • Together, we have Cashflows from Assets = Operating Cashflow – Change in Working Capital – Net Capital Spending. P.V. Viswanath

20. An alternative definition of cashflows P.V. Viswanath

21. Cash Flow From Assets • Definition:Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC • Identity:Since cashflows from assets have to equal cashflows from liabilities, we have:Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders P.V. Viswanath

22. An alternative definition of cashflows • Operating Cashflows– recurring cashflows generated by the use of assets • Δ (Net Working Capital) and Net Capital Spending are investment outlays to build up the assets that generate cashflows. • Cashflows to Stockholders and Cashflow to Bondholders are how the investments are funded. • The division of cashflows into operating cashflows and new investments in assets is important in forecasting future cashflows. Investments in assets are the drivers and operating cashflows are the result of this investment. • New investment and forecasted growth in operating cashflows need to be consistent with each other. P.V. Viswanath

23. An alternate way of defining cashflows: Summary I. The Cashflow identity:Cashflow from assets = Cashflow to creditors + cashflow to stockholders II. Cashflow from assets = Operating Cashflow - Net Capital Spending - Change in Net Working Capital (NWC)whereOperating Cashflow = EBIT + Depreciation – TaxesNet Capital Spending = Δ (Net Fixed Assets) + Depreciation (approximately)III. Cashflow to creditors = Interest paid – Net new borrowingIV. Cashflow to stockholders = Dividends paid – Net new equity raised Because data in the firm’s public financial statements are aggregated, it is often difficult to recover the quantities above without access to more detailed firm accounts. P.V. Viswanath

24. Example: US Corporation Balance Sheet Information P.V. Viswanath

25. US Corporation Income Statement Information P.V. Viswanath

26. Cashflow to Assets: Computation • Operating Cash Flow (I/S) = EBIT + depreciation – taxes = $547 • Net Capital Spending ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 • Changes in Net Working Capital (B/S) = ending NWC – beginning NWC = $330 • Cash Flow From Assets (CFFA) = 547 – 130 – 330 = $87 P.V. Viswanath

27. Cashflow to Stockholders/Creditors • CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 • CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63 • CFFA = 24 + 63 = $87 • As we saw before, this is the same amount that we computed for Cashflow from Assets P.V. Viswanath

28. Quick Quiz • What is the difference between book value and market value? Which should we use for decision making purposes? • What is the difference between accounting income and cash flow? Which do we need to use when making decisions? • What is the difference between average and marginal tax rates? Which should we use when making financial decisions? • How do we determine a firm’s cash flows? What are the equations and where do we find the information? P.V. Viswanath