chapter i & ii tutorial introduction financial statements

Chapter I & IITutorial

Introduction

Financial statements

Role and Environment of Managerial Finance

• Finance and its major areas and opportunities

• Managerial finance function and its relationship to economics and accounting

• Primary activities of financial manager

• Goal of the firm, corporate governance, role of ethics and agency issue

• Financial institutions and markets

• Business taxes and their importance in financial decisions

Critical Thinking

• Starbucks case: foreign expansion

• Possible issues for CFO: Currency risk

• What additional concerns might a CFO face when a company expands into international markets?

Exercise 1 - 2

• You are a treasurer at AIMCO, who develops technology for video conferencing

• Manager of a division asks you to authorize a capital expenditure of $10,000

• The funds are for a project on which $2,5 million had been spent over the past years

• He admits though that the technology concept developed has been surpassed

• Use marginal cost-benefit analysis

Example 1 - 2 Solution

• Sunk costs – ignored by marginal benefit analysis = $2,5m are irrelevant

• Will the $10,000 additional investment generate a revenue exceeding $10,000?

• Compare to other possible projects

• Competitors, industry, new technology

Exercise 1 - 3

• The end of the year party

• The treasurer’s staff contends that the firm is running low on cash and might have trouble paying its bills.

• The controller’s staff disagrees as the firm continues to be very profitable.

• Can both sides be right?

Exercise 1 - 3 Solution

• Cash Flow vs. Accrued Profits

• Expenses have shorter due date than expected revenues

• Short term financing

• Cash crunch, company experience, employee morale

Exercise 1 - 4

• Some branches of Donut Shop, Inc., have dropped the practice of allowing employees to accept tips.

• You notice that the lines are longer and more mistakes are being made in your order.

• Why tips can be viewed as stock options and incorrect orders could represent a case of agency cost?

• If tips are gone, how can they reduce these agency costs?

Exercise 1 - 4 Solution

• Agency costs - incurred by stockholders to ensure against dishonest acts and to give incentives to management

• Banning tips reduced performance

• Profit sharing plan

• Unnecessary backlash

Problem 1 - 2

• Marginal cost benefit analysis

• Benefits from new robotics $560,000

• Benefits from old robotics $400,000

• Cost of new equipment $220,000

• Sale of old equipment $70,000

• Calculate marginal benefits, costs, net benefit.

• What do you recommend that the company do? Why?

• What other factors should you consider?

Problem 1 - 2 Solution

• Marginal benefits = 560,000 - 400,000 = 160,000

• Marginal cost = 220,000 - 70,000 = 150,000

• Net benefits = MB - MC = 10,000

• Net benefit positive = recommend replacement

• Consider timing, cash flow and risk

Problem 1 - 3

• Accrual income versus cash flow

• Value of books shipped $760,000

• Collected in cash $690,000

• Cost of books $300,000

• Using accrual accounting show the firm’s net profit

• Using cash accounting show the firm’s net cash flow

• Which of the statements is more useful to the financial manager and why?

Problem 1 - 3 Solution

• Net profit = Sales - Cost of goods sold = 760,000 - 300,000 = 460,000

• Net cash flow = Cash receipts - Cost of goods sold = 690,000 - 300,000 = 390,000

• Cash flow statement is more useful to financial manager

Problem 1 - 4

• Identifying agency problems, costs and resolutions

• The front desk receptionist routinely takes an extra 20 minutes of lunch to run personal errands.

• Division managers are padding cost estimates so as to show short-term efficiency gains when the costs come in lower than the estimates.

Problem 1 - 4 Solution

• Employee compensated for unproductive time

• Installing time clock

• Opportunity costs. Money budgeted to cover inflated costs is not available for other projects.

• Base reward system on how close the estimates are.

Problem 1 - 4 cont…

• The firm’s CEO has secret talks with a competitor about the possibility of a merger in which (s)he would become a CEO of the combined firm.

• A branch manager lays off experienced full-time employees and staffs customer service positions with part-time workers to lower costs and raise profit. His bonus is based on profitability.

Problem 1 - 4 Solution cont…

• The CEO may negotiate a deal favoring the buyer.

• Open the firm up for purchase bids.

• Part time workers are generally not as productive as full-time employees.

• Implementing stock incentive plan.

Problem 1 - 5

• Corporate Taxes

• EBIT = $92,500

• $75,000 to $100,000– Base tax 13,750 + 34% * amount over $75,000

• Calculate firm’s tax liability.

• How much are after tax earnings?

• What was the firm’s average tax rate?

• What was the firm’s marginal tax rate?

Problem 1 - 5 Solution

• Total taxes due– 13,750+[0.34*(92,500-75,000)]

– 13,750+5,950 = 19,700

• After tax earnings: 92,500 - 19,700 = 72,800

• Average tax rate: 19,700 / 92,500 = 21,3%

• Marginal tax rate: 34%

Financial Statements

• Balance sheet

• Income statement

• Cash flow

• Statement of retained earnings

• Statement of stockholders equity

Balance Sheet

• Assets– Cash

– Accounts receivable

– Inventories

– Land and buildings

– Machinery and equipment

– Other

– Accumulated depreciation

• Liabilities– Accounts payable

– Accruals

– Long-term debt

– Stockholder’s equity

– Retained earnings

Income Statement

• Revenue– Sales revenue

– Interest income

– Irregular income

• Expense– Cost of goods sold

– Operating expenses

– Depreciation expense

– Interest expense

Cash Flow

• Analyses the firm’s ability to generate cash and cash equivalents

• Direct and Indirect method to calculate

• Statement of CF shows:– Where did the cash come from?

– What was it used for?

– What was the change in the cash balance?

• Operating, Investing and Financing activities

• Sources vs. Usage of funds

Problem 2 - 1

• See book

Problem 2 - 2

• See book