CORPORATE FINANCE

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CORPORATE FINANCE
LAN Yu Ping (Ricky), Associate Professor Internati
onal Finance College Email rickylan_at_sina.com
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• Chapter 2
• Financial Statements,
• Taxes,
• and Cash Flow

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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

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Outline

• 2.1 The Balance Sheet(???)
• 2.2 The Income Statement(???)
• 2.3 Taxes(??)
• 2.4 Cash Flow(???)

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2.1 The Balance Sheet

• The balance sheet is a snapshot(??) of the firms
  assets and liabilities at a given point in time.
• Financial calendar (year,????)

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Figure 2.1 The Balance Sheet
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2.1.1 Left hand side-Assets(??)

• Assets are listed in order of liquidity (???),
  refer to the speed and ease with which an asset
  can be converted to cash
• Current and fixed assets.

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2.1.1.1 Current assets(????)

• An asset that has a life of less than one year,
  e.g. cash, short term investment, inventory,
  account receivable.

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2.1.1.2 Fixed assets(????)

• An asset that has life of longer than one year,
  can be tangible or intangible, e.g. machine,
  truck, buildings, trademark, patent, etc.,

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2.1.2Right Hand Side - Liabilities and owners
equity(????????)

• Right hand side includes
• Liabilities
• Owners equity

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2.1.2.1 Liabilities

• Liabilities are classified as current or long
  term liabilities
• Current liabilities - payment term shorter than
  one year
• Long term liabilities payment term longer than
  one year.

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2.1.2.2 Shareholders Equity(????)

• The difference between total assets and total
  liabilities is the shareholders equity, or
  common equity, or owners equity

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2.1.3 Balance Sheet Identity (????????)

• Assets Liabilities owners Equity or
• Owners equity assets liabilities.
• The balance sheet is intended to reflect the
  fact that, if the firm were to sell all of its
  assets and use the money to pay off its debts,
  then whatever residual value remained would
  belong to the shareholders. So the left hand side
  is always equal to the right hand side.

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2.1.4Financial leverage (????)

• Financial leverage debt is like a lever in the
  sense that using it can greatly magnify both
  gains and loses
• Financial leverage is measured by
• liabilities/assets, or liabilities/equity
• The more debt a firm has, the greater is its
  degree of financial leverage

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US Corporation Balance Sheet Table 2.1
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2.1.5 Net working capital (NWC,?????)

• NWC Current assets - Current liabilities.
• As on Table 2.1,
• On 31/12/03, NWC 1403 - 369 1034
• On 31/12/02, NWC 1112 - 428 684
• In a healthy firm, NWC is usually positive, which
  means that the cash that will be available over
  the next 12 months exceed the cash that must be
  paid over the same period.

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2.1.6 Market Value 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.

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Example 2.2 Klingon Corporation
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2.1.7 Questions

• Market value and book value are often very
  different. Why?
• Which is more important to the decision-making
  process?

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2.2 Income Statement(???????)

• The income statement measures performance over
  some period of time
• The income statement is more like a video of the
  firms operations for a specified period of time.

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2.2.1 The income statement equation
(?????)

• Revenue Expenses Income
• You generally report revenues first and then
  deduct any expenses for the period.

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Table 2.2
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2.2.2 GAAP (??????)

• GAAP generally accepted accounting principle

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2.2.2.1 The revenue recognition principle
(??????)

• This principle requires companies to record when
  revenue is (1) realized or realizable and (2)
  earned, not when cash is received. This way of
  accounting is called accrual basis accounting
  (???????).
• Reference Income and expenditure realization
  system, or accounting on cash basis (???????)?

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2.2.2.2 The matching principle (??????, ???? ).

• Expenses have to be matched with revenues as long
  as it is reasonable to do so. Expenses are
  recognized not when the work is performed, or
  when a product is produced, but when the work or
  the product actually makes its contribution to
  revenue.

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2.2.3 Non-cash items (?????)

• Non-cash items makes the main difference between
  accounting statement and cash flow

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2.2.3.1 Depreciation (??)

• Depreciation is one of the main non-cash items-a
  fixed asset which had caused cash outflow when it
  was purchased, will depreciate over many years.
• Depreciation is an application of the matching
  principle in GAAP (matching the expense of
  purchasing the asset with the benefits produced
  from owning it)

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2.2.3.2 Acquisition Cost (????)

• Deducting of acquisition cost may also cause big
  non-cash outflow.
• Example of Clear Channel Communications P29
• Example of PCCW-HKT
• Example of AOL TIME WARNER

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Work the Web Example

• Publicly traded companies must file regular
  reports with the Securities and Exchange
  Commission
• For US listed companies (www.sec.gov) - Filings
  Forms (EDGAR), http//www.sec.gov/edgar/searched
  gar/companysearch.html
• For HK listed companies
• http//www.hkex.com.hk/invest/index.asp?idhttp//
  www.hkex.com.hk/invest/welcome_e.asp
• For Chinese listed companies
• http//www.sse.org.cn/main/Default.aspx
• http//www.my0578.com/default.htm

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2.3 Taxes

• Taxes is one of the largest cash outflows that a
  firm experience
• Taxes code is always changing, because it is the
  result of political, not economic, forces.

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2.3.1 Corporate tax

• Corporate tax rates are different on different
  income levels, as shown on p31
• ?????????
• ??????????????????33??????????????????
  ????????????,??18?27???????????3????(?3??)???18
  ??????????????3???10????(?10??)?,??27??????

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2.3.2 Marginal vs. average tax rates (?????????)

• Marginal the percentage paid on the next dollar
  earned
• Average the tax bill / taxable income
• Example as on p32 Table 2.4

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2.3.3 Other taxes in China

• ??????(????????)?????????????17????13????
• ??????(??????????????????)3-5 (?????5-20)
• ??????(???????????????????????????????????????????
  ????????????? )3-45

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2.4 Cash Flow (???)

• By cash flow, we simply mean the difference
  between the number of dollars that came in and
  the number that went out.
• Cash flow is one of the most important pieces of
  information that a financial manager can derive
  from financial statements
• Cash flow identity
• Cash Flow From Assets (CFFA) Cash Flow to
  Creditors Cash Flow to Stockholders.

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2.4.1 Cash flow from assets (CFFA)

• We will firstly look at how cash is generated
  from utilizing assets and how it is paid to those
  that finance the purchase of the assets
• Cash Flow From Assets involves three components
  
• Operating cash flow (cash flow that results from
  the firms day to day activities of producing and
  selling)
• Capital spending (net spending on fixed assets)
• The change in net working capital (the amount
  spent on net working capital).
• Capital Spending Changes in NWC.

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Look at Table 2.2 on p27
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2.4.1.1 Operating cash flow (OCF,?????)

• Calculating OCF by I/S (Income Statement)
• OCF Revenue Cost of goods sold Taxes 1509
  750 - 212 547
• depreciation is an non-cash expense, not an cash
  outflow
• interest is a financing expense
• (P33 last paragraph)

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2.4.1.1.1 Difference from the statement of cash
flow(?????)

• In accounting, there is a standard statement
  called the statement of cash flow (SCF), which is
  a little bit different with our discussion here
• In SCF, cash flow includes Net cash inflow from
  operating activities, Net cash inflow from
  investment activities, Net cash flow from
  financing activities The balance of the above
  three is Net increase in cash or cash equivalent.
• In SCF, operating cash flow is defined as net
  income plus depreciation, since it considers that
  interest paid is an operating expenses. It is the
  main difference from our analysis on cash flow.

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2.4.1.1.2 The optional expression of OCF

• EBDIT (Earning before depreciation, interest and
  taxes) Revenue Cost of goods sold
• EBIT (Earning before interest and taxes)
• EBDIT Depreciation
• OCF Revenue Cost of goods sold Taxes
• EBIT depreciation - taxes

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Look at Table 2.1 on P24
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2.4.1.2 Net Capital Spending (NCS, ??????)

• NCS is money spent on fixed assets less money
  received from the sale of fixed assets
• NCS Ending net fixed assets Beginning net
  fixed assets Depreciation 1709 1644 65
  130 (B/S I/S)
• Depreciation is added, because it was written off
  from the fixed assets though it was non-cash
  items
• NCS can be negative if the firm sold off more
  assets than it purchased.

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2.4.1.3 Change in Net Working Capital (NWC,
??????)

• Change in NWC is the additional investment in
  current assets
• Ending NWC Beginning NWC
• As on Table 2.1,
• Ending NWC 1403 - 389 1014
• Beginning NWC 1112 - 428 684
• Change in NWC 1014 684 330
• US Corporation had a net investment of 330 in
  NWC for the year.

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2.4.1.4 Conclusion cash flow from assets (CFFA,
?????????)

• US Corporation
• 2003 cash flow from assets
• operation cash flow 547
• -net capital spending 130
• -change in NWC 330
• CFFA 87

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2.4.1.5 How to explain the result?

• A positive cash flow from assets sometimes is
  called by a different name, FREE CASH
  FLOW(?????), because it is free to distribute to
  creditors or shareholders, and need not to put in
  fixed asset or working capital investment
• A negative cash flow from assets means that the
  firm raised more money by borrowing, and issuing
  more stocks than it paid out to creditors and
  stockholders that year.

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2.4.2 Cash flows to creditors and stockholders
(????????????)

• It represent the net payment to creditors and
  stockholders during that year.

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2.4.2.1 Cash flow to creditors

• CF to creditors (bondholders)
• interest paid new borrowing
• As on Table 2.2 (I/S, P27),
• interest paid 70
• As on Table 2.1 (B/S, P24),
• new borrowing Ending LTD-Beginning LTD
• 454 408 46
• CF to creditors 70 46 24

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2.4.3 Cash flow to stockholders

• Cash flow to stockholders
• dividend paid net new equity raised
• As on Table 2.2 (I/S, P27),
• Dividend paid to shareholder is 103
• As on Table 2.1 (B/S,P24),
• Common stock paid-in surplus(????????) is
  40
• Cash flow to stockholders
• 103 40 63

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2.4.4 Summary on cash flow of US Corporation

• OCF (I/S) EBIT depreciation taxes 547
• NCS ( B/S and I/S) ending net fixed assets
  beginning net fixed assets depreciation 130
• Changes in NWC (B/S) ending NWC beginning NWC
  330
• CFFA 547 130 330 87
• 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
• CF to Creditors stockholders 24 63 87
• CFFA CF to creditors stockholders

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Table 2.5
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2.5 Example Balance Sheet and Income Statement
Information

• Current Accounts
• 2001 CA 4500 CL 1300
• 2002 CA 2000 CL 1700
• Fixed Assets and Depreciation
• 2001 NFA 3000 2002 NFA 4000
• Depreciation expense 300
• LT Liabilities and Equity
• 2001 LTD 2200 Common Equity 500 RE 500
• 2002 LTD 2800 Common Equity 750 RE 750
• Income Statement Information
• EBIT 2700 Interest Expense 200 Taxes
  1000 Dividends 1250

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2.5.1 Calculation on cash flows

• OCF EBIT Depreciation Taxes
• 2700 300 1000 2000
• NCS NFA(02) NFA(01) Depreciation
• 4000 3000 300 1300
• Changes in NWC (CA CL)(02) (CA CL)(01)
• (2000 1700) (1500 1300) 100
• CFFA OCF NCS CHANGE IN NWC
• 2000 1300 100 600

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2.5.2 Calculation on cash flows

• CF to Creditors Interest Expense LTD(02)
  
• LTD(01)
• 200 (2800
  2200) -400
• CF to Stockholders Dividend paid - Common
• 
  (Equity(02)-Common Equity(01))
• 1250 (750
  500) 1000
• CFFA CF to Creditors CF to Stockholders
• -400 1000 600
• The CF identity holds.

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Quick Quiz

• What is the difference between book value and
  market value?
• Book value is the value of the assets,
  liabilities or equity shown on the balance sheet.
  Market value is the price at which the assets,
  liabilities or equity can actually be bought or
  sold at the market.
• What is the revenue recognition principle?
• This principle requires companies to record when
  revenue is (1) realized or realizable and (2)
  earned, not when cash is received. This way of
  accounting is called accrual basis accounting.
• What is the matching principle?
• Expenses have to be matched with revenues as long
  as it is reasonable to do so.

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Exercises

• An example Cash Flows for Dole Cola P38-40
• Chapter review and self-test problem P41-43
• Questions and problems (6,10,19)
• ch2templates(Q1Q2).xls