Introduction to Financial Management

Introduction to Financial Management

2-1 McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills Know: The difference between book value and market value The difference between accounting income and cash flow The difference between average and marginal tax rates How to determine a firms cash flow from its financial statements 2-2 Chapter Outline 2.1 2.2 2.3 2.4 The Balance Sheet The Income Statement Taxes Cash Flow 2-3

The Balance Sheet A snapshot of the firms assets and liabilities at a given point in time (as of ) Assets Left-hand side (or upper portion) In order of decreasing liquidity Liabilities and Owners Equity Right-hand side (or lower portion) In ascending order of when due to be paid Balance Sheet Identity Assets = Liabilities + Stockholders Equity 2-4 The Balance Sheet Figure 2.1 Total Value of Assets Current Assets Total Value of Liabilities and Shareholders' Equity Net Working Capital Current Liabilities

Long Term Debt Fixed Assets 1. Tangible 2. Intangible Shareholder Equity 2-5 The Balance Sheet Net working capital Current Assets minus Current Liabilities Usually positive for a healthy firm Liquidity Speed and ease of conversion to cash without significant loss of value Valuable in avoiding financial distress Debt versus Equity Shareholders equity = Assets - Liabilities 2-6 U.S. Corporation Balance Sheet Table 2.1 2-7

Market vs. Book Value Book value = the balance sheet value of the assets, liabilities, and equity. Market value = true value; 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 decisionmaking process? Return to Quick Quiz 2-8 Klingon Corporation Example 2.2 KLINGON CORPORATION Balance Sheets Market Value versus Book Value Book Market Assets CA NFA $ 400 700

$1,100 Book Market Liabilities and Shareholders Equity $ 600 LTD 1,000 Equity $1,600 $ 500 $ 500 600 1,100 $1,100 $1,600 2-9 Income Statement The income statement measures performance over a specified period of time (period, quarter, year).

Report revenues first and then deduct any expenses for the period End result = Net Income = Bottom Line Dividends paid to shareholders Addition to retained earnings Income Statement Equation: Net Income = Revenue - Expenses 2-10 U.S. Corporation Income Statement Table 2.2 2-11 Financial Statements GAAP Matching Principle: Recognize revenue when it is fully earned Match expenses required to generate revenue to the period of recognition Noncash Items Expenses charged against revenue that do not affect cash flow Depreciation = most important Return to Quick Quiz

2-12 Financial Statements Time and Costs Fixed or variable costs Not obvious on income statement Earnings Management Smoothing earnings GAAP leaves wiggle room 2-13 Example: Work the Web Publicly traded companies must file regular reports with the Securities and Exchange Commission These reports are usually filed electronically and can be searched at the SEC public site called EDGAR Click on the web surfer, pick a company, and see what you can find! 2-14 Taxes Marginal vs. Average tax rates Marginal % tax paid on the next dollar earned Average total tax bill / taxable income

If considering a project that will increase taxable income by $1 million, which tax rate should you use in your analysis? Return to Quick Quiz 2-15 Example: Marginal vs. Average Rates Suppose your firm earns $4 million in taxable income. What is the firms tax liability? What is the average tax rate? What is the marginal tax rate? 2-16 Tax on $4 million Tax Liability on $4,000,000 Corporate Tax Rates Taxable Income Levels Tax Rate Taxable Tax Income

Liability $ - $ 50,000 15% $ 50,000 $ 7,500 $ 50,001 $ 75,000

25% $ 25,000 $ 6,250 $ 75,001 $ 100,000 34% $ 25,000 $ 8,500 $

100,001 $ 335,000 39% $ 235,000 $ 91,650 $ 335,001 $ 10,000,000 34% $ 3,665,000

$ 1,246,100 $ 10,000,001 $ 15,000,000 35% $ $ 15,000,001 18,333,334 $ 18,333,333 - 38% 35% $ 4,000,000 $ 1,360,000

Average Rate = 34% Marginal Rate = 34% 2-17 The Concept of Cash Flow Cash flow = one of the most important pieces of information that can be derived from financial statements The accounting Statement of Cash Flows does not provide the same information that we are interested in here Our focus: how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase. 2-18 Cash Flow From Assets Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) Net Capital Spending (NCS) Changes in NWC (NWC) Cash Flow From Assets (CFFA) = Cash Flow to Creditors (CF/CR) + Cash Flow to Stockholders (CF/SH)

Return to Quick Quiz 2-19 Example: U.S. Corporation Balance Sheet Assets Current Assets Cash Accounts Receivable Inventory Total Fixed Assets Net Fixed assets Total assets 2009 2010 $104 455 553 $1,112 $160 688

555 $1,403 $1,644 $1,709 $2,756 $3,112 Liabiities & Owners' Equity 2009 Current Liabilities Accounts Payable $232 Notes Payable 196 Total $428 Long-term debt Owners' equity Common stock and paid-in surplus Retained earnings Total Total Liabilties & Owners Equity

2010 $266 123 $389 $408 $454 600 1,320 $1,920 640 1,629 $2,269 $2,756 $3,112 U.S. Corporation Income Statement Net sales Cost of goods sold Depreciation Earnings before interest and taxes Interest Paid

Taxable income Taxes Net Income Dividends Addition to retained earnings CFFA = OCF NCS - NWC OCF = EBIT + depreciation taxes = $694 + 65 212 = $547 NCS = ending net FA beginning net FA + depreciation = $1709 1644 + 65 = $130 NWC = ending NWC beginning NWC = ($1403 389) ($1112 428) = $330 CFFA = 547 130 330 = $87 $1,509 750 65 $694 70 $624 212 $412 $103

$309 2-20 Example: U.S. Corporation U.S. Corporation Income Statement U.S. Corporation Balance Sheet Assets Liabiities & Owners' Equity 2009 Current Assets Cash Accounts Receivable Inventory Total Fixed Assets Net Fixed assets Total assets 2010 $104 455

553 $1,112 $160 688 555 $1,403 $1,644 $1,709 $2,756 $3,112 Current Liabilities Accounts Payable Notes Payable Total Long-term debt Owners' equity Common stock and paid-in surplus Retained earnings Total Total Liabilties & Owners Equity

2009 2010 $232 196 $428 $266 123 $389 $408 $454 600 1,320 $1,920 640 1,629 $2,269 $2,756 $3,112

Net sales Cost of goods sold Depreciation Earnings before interest and taxes Interest Paid Taxable income Taxes Net Income Dividends Addition to retained earnings $1,509 750 65 $694 70 $624 212 $412 $103 $309 CFFA = CF/CR + CF/SH CF/CR = interest paid net new borrowing = $70 ($454 408) = $24 CF/SH = dividends paid net new equity

= $103 ($640 600) = $63 CFFA = $24 + $63 = $87 2-21 Table 2.5 2-22 Quick Quiz What is the difference between book value and market value? (Slide 2.8) 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? (Slide 2.12) 2-23 Quick Quiz What is the difference between average and marginal tax rates? Which should we use when making financial decisions? (Slide 2.15) How do we determine a firms cash flows?

What are the equations and where do we find the information? (Slide 2.19) 2-24 Dole Cola Example DOLE COLA 2010 Income Statement Net sales Cost of goods sold Depreciation EBIT Interest paid Taxable income Taxes Net income Dividends Addtion to retained earnings $ $ $ $ $ $ $ $ $ $

600 300 150 150 30 120 41 79 30 49 2-25 Dole Cola Operating Cash Flow DOLE COLA 2010 Income Statement Net sales Cost of goods sold Depreciation EBIT Interest paid Taxable income Taxes Net income Dividends Addtion to retained earnings $

$ $ $ $ $ $ $ $ $ 600 300 150 150 30 120 41 79 $ $ $ $ 150 150 41 259

30 49 DOLE COLA 2010 Operating Cash Flow EBIT + Depreciation - Taxes 2-26 Dole Cola Net Capital Spending & Change in Net Working Capital DOLE COLA 2010 Net Capital Spending Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation $ $ $ $ 750 500 150

400 DOLE COLA 2010 Change in Net Working Capital 2010 Current Assets $2,260.0 2010 Current Liabilities $1,710.0 2010 Net Working Capital $ 2009 Current Assets $2,130.0 2009 Current Liabilities $1,620.0 2009 Net Working Capital $ Change in Net Working Capital $ 550 510 40 2-27 Dole Cola Cash Flow from Assets DOLE COLA

2010 Cash Flow from Assets Operating Cash Flow - Net Capital Spending - Change in Net Working Capital $ $ $ $ 259 400 40 (181) 2-28 Dole Cola CFFA Option 2 DOLE COLA 2010 Income Statement Net sales Cost of goods sold Depreciation EBIT Interest paid Taxable income Taxes Net income

Dividends Addtion to retained earnings $ $ DOLE COLA 2010 Cash Flow from Assets Operating Cash Flow - Net Capital Spending - Change in Net Working Capital $ $ $ $ $ $ $ $ 600 300 150 150 30 120 41 79

$ $ $ $ 259 400 40 (181) 30 49 2-29 Dole Cola Cash Flow to Stockholders & Creditors DOLE COLA 2010 Cash Flow to Creditors Cash Flow from Assets $ (181) = CF to stockholders $ 30 + CF to creditors ??? DOLE COLA 2010 Cash Flow to Creditors

Interest Paid - Net New Borrowing ??? 2-30 Dole Cola Cash Flow to Creditors DOLE COLA 2010 Cash Flow to Creditors Interest Paid - Net New Borrowing ??? $ $ $ 30 (241) (211) 2-31 Chapter 2 END

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