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 firms cash flow from its
  financial statements

3
Chapter Outline

• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow

4
The Balance Sheet

• The balance sheet is a snapshot of the firms
  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

5
The Balance Sheet
6
Pepsico Inc. Balance Sheet (in mil. )
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?

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 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.

9
Market Value vs. Book Value

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

10
Income Statement

• The income statement is more like a video of the
  firms 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

11
Income Statement Pepsico Inc. (in mil. )
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.

13
Statement of Cashflows

• A firms 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).

14
The Statement of Cashflows

• The statement of cashflows shows the firms cash
  inflows and outflows from
• Operations
• Investments and
• Financing
• The form of this statement is determined by
  accounting standards.

15
Statement of Cash FlowsOperating 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.

16
Statement of Cash FlowsInvesting 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.

17
Pepsico Inc. (in mil. )Statement of Cash Flows
2002
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.

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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.

20
An alternative definition of cashflows
21
Cash Flow From Assets

• DefinitionCash Flow From Assets Operating
  Cash Flow Net Capital Spending Changes in NWC
• IdentitySince cashflows from assets have to
  equal cashflows from liabilities, we haveCash
  Flow From Assets (CFFA) Cash Flow to Creditors
  Cash Flow to Stockholders

22
An alternative definition of cashflows

• Operating Cashflows recurring cashflows
  generated by the use of assets
• ? (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.

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An alternate way of defining cashflows Summary
I. The Cashflow identityCashflow 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 ?
(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 firms public
financial statements are aggregated, it is often
difficult to recover the quantities above without
access to more detailed firm accounts.
24
Example US Corporation Balance Sheet Information
25
US Corporation Income Statement Information
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

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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

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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 firms cash flows? What
  are the equations and where do we find the
  information?