Chapter 2 Accounting statements and cash flows

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Chapter 2 - Accounting statements and cash flows

• Three key issues in finance
• I. Capital Budgeting decision
• Is this project worthwhile?
• Examples of projects -
• IBM considers building a new plant in Taiwan
• Compaq evaluates the proposal for a new marketing
  campaign
• UH decides to go to a new healthcare system for
  its employees
• Common features
• Involve cash flows at different points in time,
  some negative (outlays), some positive (revenues)
• Cash flows could be uncertain (risky)

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Three key issues in finance

• II. Capital structure decision
• If a project is worthwhile, what is the best way
  to finance the project - Debt/Equity?
• Equity Initial inflow of new equity and
  subsequent payment of dividends to equity holders
• Debt Initial inflow of borrowed amount and
  subsequent payment of interest and eventually
  principal
• Common features
• Involves cash flows at different points in time
• Cash flows could be uncertain (risky)

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Three key issues in finance

• III. Dividend policy decision
• (Distribution of cash flows decision)
• How should the cash flows from the project be
  distributed?
• Retained earnings - Used later to finance future
  projects
• Dividends - Paid to shareholders over a period of
  time
• Common features
• Cash flows at different points in time
• Cash flows could be uncertain (risky)

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Objective of the firm

• All three decisions should be made such that they
  lead to a maximization of firm value
• Effect on value of
• Cash flows occurring at different points in time
• Cash flows associated with different degrees of
  uncertainty
• Effect on value of
• Time
• Uncertainty

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Cash flow - unit of analysis

• Source of information on cash flows
• Financial statements
• Balance sheet
• Income statement
• Sources and uses statement
• Use information in financial statements to
  estimate cash flows
• Interpreting financial statements
• Go from net income and earnings values to
  FINANCIAL CASH FLOWS

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The Balance sheet

• Is a financial snapshot at a point in time of
• All the assets that the company owns and
• All the claims against those assets
• The basic relationship in a balance sheet is
• Assets Liabilities Shareholders equity

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Financial cash flows

• Balance sheets can be used to deduce the value of
  the firm
• Things to bear in mind
• Financial not accounting cash flows
• Align cash flows by when they occur
• e.g. in an income statement revenues is
  recognized when there is an exchange of goods not
  necessarily when payment is made
• Depreciation is accounted for tax purposes
  although it is not a cash outflow
• Valuation at cost not necessarily market value

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Current versus Non-current Assets and Liabilities

• Current assets
• Assets which will turn into cash in one year
• Inventory is a current asset
• Ought to be sold and generate cash within the
  year
• Accounts Receivables also ought to be received
  within the year
• Non-current assets
• Property and capital equipment constitute the
  non-current part of assets
• Intangible assets - patents, RD

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• Similarly liabilities are current if they are to
  be paid within the year
• Accounting liquidity Ease with which assets can
  be converted into cash
• Taxes
• Corporations in the U.S. maintain two sets of
  books
• Tax accounting
• Greater depreciation
• Lower taxes
• Financial accounting - reverse

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Market value versus book value of equity

• Market value Book value Multiple
• COMPAQ 48,702.18 9,429.27 5.17
• GE 254,454.51 33,698.12 7.55
• INTEL 146,727.93 19,946.70 7.36
• MCD 37,582.30 8,999.59 4.18
• MICROSOFT 205,264.50 11,363.81 18.06
• Financial statements provide the best information
  as long as we recognize their limitations