The Firm and The Financial Manager

1
Chapter 3
Accounting and Finance

Mila Getmansky Sherman
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Topics Covered

• The Balance Sheet
• The Income Statement
• The Statement of Cash Flows
• Accounting Practice Malpractice
• Taxes

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The Balance Sheet

• Definition
• Financial statements that show the value of
  the firms assets and liabilities at a particular
  point in time (from an accounting perspective).

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The Balance Sheet
The Main Balance Sheet Items
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Market Value vs. Book Value

• Book Values are determined by GAAP
• Market Values are determined by current values
• Equity and Asset Market Values are usually
  higher than their Book Values

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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 firms 100
  million shares at 75 per share and the debt at
  4 billion.
• Q What is the market value of your assets?
• A Since (AssetsLiabilities Equity), your
  assets must have a market value of 11.5 billion.

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Market Value vs. Book Value

• Example (continued)
• Book Value Balance Sheet
• Assets 10 bil Debt 4 bil Equity 6
  bil

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The Income Statement

• Definition
• Financial statement that shows the revenues,
  expenses, and net income of a firm over a period
  of time (from an accounting perspective).

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The Income Statement

• Earnings Before Income Taxes (EBIT)
• EBIT total Revenues
• - costs
• - deprecation

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The Income Statement

• Pepsico Income Statement (year end 2001)
• Net Sales 26,935
• COGS 10,754
• Other Expenses 392
• Selling, GA expenses 10,526
• Depreciation expense 1,082
• EBIT 4,181
• Net interest expense 152
• Taxable Income 4,029
• Income Taxes 1,367
• Net Income 2,662

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Profits vs. Cash Flows

• Differences
• Profits record income and expenses at the time
  of sales, not when the cash exchanges actually
  occur cash vs. accrual accounting
• Profits subtract depreciation (a non-cash
  expense)
• Profits ignore cash expenditures on new capital
  (the expense is capitalized)
• Profits do not consider changes in working
  capital

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The Statement of Cash Flows

• Definition
• Financial statement that shows the firms cash
  receipts and cash payments over a period of time.

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The Statement of Cash Flows

• Pepsico Statement of Cash Flows (excerpt - year
  end 2001)
• Net Income 2,662
• Non-cash expenses
• Depreciation 1,082
• Changes in working capital 457
• Cash Flow from operations 4,201
• Cash Flow from investments (2,637)
• Cash provided by financing (1,919)
• Net Change in Cash Position (355)

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Accounting Practice

• Stock options
• Allowance for bad debts
• Revenue recognition

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Taxes

• Taxes have a major impact on financial decisions
• Marginal Tax Rate is the tax that the individual
  pays on each extra dollar of income.
• Average Tax Rate is the total tax bill divided by
  total income.

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Taxes

• Example - Taxes and Cash Flows can be changed by
  the use of debt. Firm A pays part of its profits
  as debt interest. Firm B does not.
• Firm A Firm B
• EBIT 100 100
• Interest 40 0
• Pretax Income 60 100

Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits
as debt interest. Firm B does not. Firm
A EBIT 100 Interest 40 Pretax Income
60 Tax (35) 21 35 Net
Income 39 65
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Taxes

• FOOD FOR THOUGHT - If you were both the debt and
  equity holders of the firm, which would generate
  more cash flow to you? (assume Net Income Cash
  Flow)
• Firm A Firm B
• EBIT 100 100
• Interest 40 0
• Pretax Income 60 100
• Tax (35) 21 35
• Net Income 39 65

?
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Taxes

• FOOD FOR THOUGHT - If you were both the debt and
  equity holders of the firm, which would generate
  more cash flow to you? (assume Net Income Cash
  Flow)
• Firm A Firm B
• Net Income 39 65

?

• Interest 40 0
• Net Cash Flow 79 65

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Corporate Tax Rates (2002)
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Personal Tax Rates (2002)