chapter 3-accounting and finance

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Chapter 3

Accounting and Finance

The Balance Sheet

- the Balance Sheet presents a snapshot of the firm's assets and liabilities at one

particular moment.

the left-hand side (i.e., assets): the uses of the funds raised

the right-hand side (i.e., liabilities and owners’ equity): the sources of the

funding

the Balance Sheet Identity

Assets Liabilities + Stockholders' Equity

the definition of NWC

Net working capital = current assets – current liabilities

- liquidity:

(1) the ability to sell an asset on short notice at a price close to the market price

(2) The speed and ease with which an asset can be converted to cash

two dimensions: speed of conversion vs. loss of value

※ time and cost

- Table 3.1

the most liquid assets are put at the top of the list and the least liquid down the

list

CA

LA

CL

LL

Total Liabilities Total Assets

SE

Balance Sheet

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assets:

1. Current assets

※ Which of the following assets is typically considered most liquid? Least

liquid?

a. marketable securities

b. accounts receivable

c. inventories

※ Which of the following is a current asset?

a. properties that a firm owns

b. a firm's production equipment

c. unsold inventories

2. long-term assets:

(1) tangible assets: depreciation

(2) intangible assets: depreciation

＊ such as its patents, brand name, skilled management, and a

well-trained labor force

(3) goodwill: amortization

＊the firm has acquired other businesses in the past (M&A: Mergers

and Acquisitions), it has paid more for their assets than the value

shown in the firms' accounts

※ Which of the following represent tangible assets? Intangible assets?

a. property

b. production facilities

c. patents

d. production equipment

e. trademarks

f. copyrights

Old Assets Old Assets of Firm #1

New Assets from Firm #2:

Book value ($100)

plus

Goodwill ($20)

Firm #1 (before M&A) Firm #1 (after M&A)

Firm #2

Assets

(BV=$100)

(MV=$120)

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liabilities and owners’ equity

liabilities and owners’ equity are arranged by the priority of the claim on

the firm’s asset

(1) current liabilities

※ Which of the following is a current liability?

a. bond (i.e., debt) that matures in 3 years

b. a bank loan that is due in 24 months

c. an obligation to pay a supplier within 6 months

(2) long-term liabilities

(3) shareholders’ equity

※ shareholders are sometimes called "residual claimants" on the firm

- an example (Based on end-of-chapter Problem 15 )

QuickGrow is in an expanding market, and its sales are increasing by 25% per

year. Would you expect its net working capital to be increasing or decreasing?

- common-size balance sheets

analysts often calculate a common-size balance sheet, which reexpresses all

items as a percentage of total assets

Table 3.2

B/S

Cash

Accounts receivable

Inventories

…….

Accounts payable

…..

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Book Values (BV) and Market Values (MV)

- historical cost (adjusted for depreciation) Book values (usually, MVBV )

(1) MV(CA)BV(CA)CA) MV(noncashCA) BV(noncash

MV(Cash)BV(Cash)

(2) MV(LA)BV(LA)

(3) MV(CL)BV(CL)

(4)

MV(LL) BV(LL): timesSome

MV(LL) BV(LL): time theofMost

(5) MV(SE)BV(SE)

(6)

MV(SE)BV(SE)

lyequivalentor

MV(LA)BV(LA)

toprimarily due MV(B/S)BV(B/S)

Cash

noncash CA

LA

CL

LL

Total Liabilities

BV MV

LA

CL

LL

Total Liabilities

SE Total Assets

Total Assets SE

Cash

noncash CA

CA

LA

CL

LL

Total Liabilities

BV MV

CA

LA

CL

LL

Total Liabilities

SE Total Assets Total Assets SE

CA

LA

CL

LL

Total Liabilities

BV MV

CA

LA

CL

LL

Total Liabilities

SE

Total Assets Total Assets

SE

not equal

not equal

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- an illustration

Jupiter has invested $10 billion in producing its new plant. To finance the

investment, Jupiter borrowed $4 billion and raised the remaining funds by selling

new shares of stock in the firm. There are currently 100 million shares of stock

outstanding. Its current stock price is $75. Assume that the debt outstanding is

worth $4 billion.

Market value of equity:

$75 per share × 100 million shares = $7.5 billion

Market value of assets:

$7.5 + $4 = $11.5 billion

The thesis: the market-value balance sheet is forward-looking.

What would be Jupiter’s price per share if the auto plant had a market value of

$14 billion?

shareper 100$shares million 100

billion $10 shareper Price

What would you reassess the value of the auto plant if the value of outstanding

stock were $8 billion?

Market value of assets:

$8 + $4 = $12 billion

- an example: Market versus Book Values (Based on end-of-chapter Problem 10)

State whether each of the following events would increase or decrease the ratio of

market value to book value.

a. Big Oil announces the discovery of a major new oil field in Costaguana.

b. Big Autos increases its depreciation provision.

Debt = $4 Assets = $??

SE = $8

Balance Sheet (MV)

Debt = $4 Assets = $14

SE = $??

Balance Sheet (MV)

Debt = $4 Assets = $??

SE = $??

Balance Sheet (MV)

Debt = $4 Assets = $10

SE = $6

Balance Sheet (BV)

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The Income Statement

- the income statement lists the firm's revenues and expenses over a period of time

- Table 3.3 : an income statement & a common-size income statement

Earnings before interest and taxes:

EBIT = total revenues - costs – depreciation

= Net sales - cogs - general expense – depreciation

= 100,904 - 66,548 - 17,864 - 1,811

= $14,681 million

the format to remember:

Revenues

- Costs

- Depreciation and Amortization

Operating Income (EBIT)

- Interests

- Taxes

Net Income

Dividends

Retained Earnings

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Profits versus Cash Flow

- two reasons why profits and cash flows are not the same:

1. Depreciation

it is a noncash expense

two kinds of expenditures classified by the accounting rule:

(1) current expenditures (such as wages)

＊ current expenditures are deducted from current profits

(2) capital expenditures (such as the purchase of new machinery)

＊ capital expenditures are recognized as an annual charge for

depreciation

Revenues

- Costs

- Depreciation and Amortization (a noncash expense)


- Interests

- Taxes

Net Income

Dividends

Retained Earnings

Noncapital expenditures incurred

1. cash is paid concurrently

2. recognized in the current period

Capital expenditures incurred

1. cash is paid concurrently

2. recognized in the later periods

t t+1 t+2 t+3

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an illustration:

2. Cash versus accrual accounting

revenues and expenses are recognized when sales are made, rather than

when the cash is received or paid out

the idea:

what do we mean by saying "Increase in NWC"?

)()(

NWC in Change NWC in Increase

2016201620172017 CLCACLCA

Note:

1. CA and CL refer only to items related to operation (i.e., related

to those items in Income Statements).

CA2016 CL2016

LL2016

B/S (2016) B/S (2017)

CA2017 CL2017

LL2017

SE2017

LA2017

LA2016

SE2016

Revenues

receivable accounts become some

period thiscolected are some

- Costs

payable accounts become some

period thispaid are some



- Interests

- Taxes

Net Income

Dividends

Retained Earnings

Advertisement expense: $500

1. $500 is paid concurrently

2. $500 is recognized in the current period

Capital expenditures (buy machines; a 3-year life): $600

1. $600 is paid concurrently

2. (Straight line depreciation) $200 is recognized at

time t+1; $200 is recognized at time t+2; $200 is

recognized at time t+3

t t+1 t+2 t+3

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※ the cash flow measure:

Note that:

EBIT - Interest - Tax = NI

EBIT - Tax = NI + Interest

It follows that

Cash flow of the firm

= EBIT – Tax + Depreciation – Increase in NWC - CAPEX

= NI + Interest + Depreciation – Increase in NWC - CAPEX

an illustration

Consider a manufacturer that spends $60 to produce goods in period 0 but

does not pay the money until the end of period 1. In period 2 it sells the goods

for $ 100, but its customers do not pay their bills until period 3.

Revenues

- Costs

- Depreciation and Amortization (a noncash expense)


- Interests

- Taxes

Net Income

Dividends

Retained Earnings

Purchase goods for $60 sell goods at $100

Pay the bill of the goods: -$60

Payment collected: +$100

0 1 2 3

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The income statement at the end of each period (based on accrual accounting:

matching revenues and expenses):

Cash flows of the firm:



Period 0: 0 - 0 + 0 - 0 - 0 = $0

Period 1: 0 - 0 + 0 - 60 - 0 = -$60

Period 2: 40 - 0 + 0 - 40 - 0 = $0

Period 3: 0 - 0 + 0 - (-100) - 0 = $100

Period 0 Period 1 Period 2

Revenues $0 $0 $100

less Cost of goods sold $0 $0 $60

Net income $0 $0 $40

Period 0 Period 1 Period 2 Period 3

Sales $0 $0 $100 $0

Cost of goods sold (I/S) $0 $0 $60 $0

Accounts receivable (B/S) $0 $0 $100 $0

Inventory (B/S) $60 $60 $0 $0

Accounts payable (B/S) $60 $0 $0 $0

NWC $0 $60 $100 $0

ΔNWC (NWCt+1 - NWCt) $0 $60 $40 -$100

Cash flow $0 -$60 $0 $100

Note:



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- Example 3.2: Profits versus Cash Flows

Suppose our manufacturer spends a further $80 to produce goods in period 2

(purchased the good at time 1 and paid at time 2). It sells these goods in period 3

for $120, but customers do not pay their bills until period 4.

The income statement at the end of each period (based on accrual accounting:

matching revenues and expenses):

Cash flows of the firm:

Purchase goods for $60

sell goods at $100



0 1 2 3

Purchase goods for $80


sell goods at $120

4


Period 0 Period 1 Period 2 Period 3 Period 4

Sales $0 $0 $100 $120 $0

Cost of goods sold (I/S) $0 $0 $60 $80 $0

Accounts receivable (B/S) $0 $0 $100 $120 $0

Inventory (B/S) $60 $60+80 $0+80 $0 $0

Accounts payable (B/S) $60 $80 $0 $0 $0

NWC $0 $60 $100+80 $0+120 $0

ΔNWC (NWCt+1 - NWCt) $0 $60 $40+80 $120-$100-80 -$120

Cash flow $0 -$60 -$80 $100 $120

Note:

Cash flow = EBIT – Tax + Depreciation – Increase in NWC - CAPEX

Period 0 Period 1 Period 2 Period 3 Period 4

Revenues $0 $0 $100 $120 $0

less Cost of goods sold $0 $0 $60 $80 $0

Net income $0 $0 $40 $40 $0

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Cash flow = EBIT – Tax + Depreciation – Increase in NWC - CAPEX

Period 0: 0 - 0 + 0 - 0 - 0 = $0

Period 1: 0 - 0 + 0 - 60 - 0 = -$60

Period 2: 40 - 0 + 0 - 40 - 80 - 0 = -$80

Period 3: 40 - 0 + 0 - (120 -100 - 80) - 0 = $100

Period 4: 0 - 0 + 0 - (-120) - 0 = $120

- an illustration (based on end-of-chapter Problem 17: Income versus Cash Flow)

Start-up firms typically have negative net cash flows for several years.

a. Does this mean that they are failing?

b. Accounting profits for these firms are also commonly negative. How would

you interpret this pattern? Is there a shortcoming in our accounting rules?

a. The fact that start-up firms typically have negative net cash flows for

several years does not mean they are failing. Start-up firms invest

in inventories and other assets designed to produce income in later

periods.

b. Revenues are too low and costs are too high (relatively).

Free Cash Flow of the firm (i.e., Cash flow of the firm we just mentioned)

- it is the cash the company has available for distribution to investors after it has

paid for any new capital investment or additions to working capital

investors: debtholders and shareholders

Free cash flow of the firm


= Net income + Interest + Depreciation – Increase in NWC - CAPEX

free cash flow of the firm has two parts:

1. the cash that the firm generates from its operations

Cash flow from operation

= EBIT - taxes + depreciation - increase in NWC

= Net income + Interests + Depreciation - increase in NWC

Note:

increase in NWC = net investment in NWC

2. net investments in fixed assets: CAPEX

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- an illustration (based on end-of-chapter Problem 24:Free Cash Flow)

The following table shows an abbreviated income statement and balance sheet for

McDonald's Corporation for 2012.

In 2012 McDonald's had capital expenditures of $3,049.

a. Calculate McDonald's free cash flow in 2012.

b. If McDonald's was financed entirely by equity, how much more tax would

the company have paid? (Assume a tax rate of 35%.)

c. What would the company's free cash flow have been if it was all-equity

financed?

Suggested answer:

a.

Cash flow from operations

= net income + interest + depreciation – additions to net working capital

Free cash flow = cash flow from operations – capital expenditures

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257261473540

3,143)-(3,404616)-1,089(117)-(1221,335)-(1,375

)//(-

)()()//(

)]/()/[(-

)]/()/[(

)()(

NWC in Change NWC in Increase

20112012

20120122011201220112012

2011201120112011

2012201220122012

2011201120122012

PAPA

OthersOthersInventoryInventoryRARA

PAOthersInventoryRA

PAOthersInventoryRA

CLNCACLNCA

Cash flow from operations = 5,465 + 517 + 1,402 − 257 = 7,127

Capital expenditures = 3,049

Free cash flow = 7,127 − 3,049 = 4,078

b &c:

Addiional tax paid: 3,008.6 - 2,614 = 394.6

Free cash flow

= net income + interest + depreciation – additions to net working

capital – capital expenditures

= 5,587.4 + 0 + 1,402 - 257 - 3,049 = $3,683.4

With debt No debt

Revenues 27,567 27,567

- Costs 17,569 17,569

- Depreciation 1,402 1,402

Operating Income (EBIT) 8,596 8,596

- Interests 517 0

pretax income 8,079 8,596

- Taxes (32.35%; 35%) 2,614 3,008.6

Net Income 5,465 5587.4

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The Statement of Cash Flows

- it shows the firm's cash inflows and outflows from

(1) operations

(2) investments

(3) financing activities

- the cash-flow statement for Home Depot

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Cash flow from operation (i.e., Cash provided by operations)

= NI + Depreciation - increase in NWC

= 6,345 + 1,786 - 4 = $8,127

Compared with:

Cash flow of the firm from operation

= NI + Interest + Depreciation – Increase in NWC

= EBIT – Tax + Depreciation – Increase in NWC

Note: compare the two cash flows from operation

1. Cash flow of the firm

Net income versus Net income + Interest

the difference between the two: interests

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2. Cash flow from operation in the Statement of Cash Flows (from

shareholders' perspective)

Accounting Practice and Malpractice

- financial reporting abuses by managers window dressing of the financial

statements investors might be fooled

- the artificial figures cannot sustain accounting scandals

- recall the format of income statement

- Examples of accounting scandals

1. Enron (e.g., off-Balance-Sheet items)

2. WorldCom (e.g., operating expenses as capital expenditures)

- a demonstration:

WorldCom spent $30 billion for the current year. It can classify the cash

outflow as either operating expenses or capital expenditures (depreciated by

straight line for 10 years). What is the impact of the choice on tax payment

and shareholders’ wealth?

Revenues

- Costs



- Interests

- Taxes

Net Income

Dividends

Retained Earnings

Revenues

- Costs



- Interests

- Taxes

Net Income

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(i) classifying as operating expenses:

＊ tax shield of the year: 30 billion × 30%

(ii) classifying as capital expenditures:

＊ tax shield for each of the coming 10 years: 3 billion × 30%

Revenues

- Costs ( do not include 30 billion)

- Depreciation and Amortization (3 billion)

Operating Income (EBIT) Higher

- Interests

- Taxes (30%) tax shield: 3 billion × 30%

Net Income

Revenues

- Costs (including 30 billion)


Operating Income (EBIT) Lower

- Interests

- Taxes (30%) tax shield: 30 billion × 30%

Net Income

0 1 2 …

10

Decrease in tax payment

for operating expenses 30×0.3 0 0

3×0.3 3×0.3 3×0.3

…

… Decrease in tax payment

for capital expenditure

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Taxes

1. Corporate Tax

The U.S. tax Cuts and Jobs Act, passed in December 2017, reduced the

corporate tax rate from 35% to 21%.

- tax deductibility of depreciation and amortization

the Internal Revenue Service (IRS) allows different depreciation schedules for

a firm

(1) to calculate taxes

(2) to report its profits to shareholders

Table 3.6 (Interest tax shield)

Firms A and B both have EBIT of $100 million. Firm A pays interest of $40

million, while Firm B uses no debt.

Firm A Firm B

EBIT 100 100

Interest 40 0

Pretax income 60 100

Tax (21%) 12.6 21

Net income $47.4 $79

CF of Firm A: $47.4 + $40 = $87.4

$12.6 goes to Government as tax

CF of Firm B: $79 + $0 = $79

$21 goes to Government as tax

Revenues

- Costs



- Interests

- Taxes

Net Income

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- an example for tax deductibility of interest

Suppose that a firm with a 21% tax rate borrows $100,000 at 10% interest per

year.

Interest payment = $100,000 × 0.1 = $10,000

Tax savings = $10,000 × 0.21 = $2,100

Net interest payment = $10,000 - $2,100 = $7,900

The effective cost of the debt = %90.7000,100$

900,7$

Interest payment = $P × r

Tax savings = $P × r × TC

Net interest payment = $P × r - $P × r × TC = $P × r ×(1- TC)

The effective cost of the debt = )1($

)1($C

C rP

rP

2. Personal Tax

- Table 3.7: personal tax rates for 2018

(1) as income increases, the tax rate also increases a progressive schedule

(2) the top personal tax rate is higher than the top corporate rate

they are marginal tax rates

the marginal tax rate is the tax that the individual pays on each extra dollar

of income

- an illustration

If your total income is $50,000, your tax bill is 10% of the first $9,525 of income,

12% of the next $29,175 (i.e., 38,700 - 9,525), and 22% of the remaining $11,300:

Tax = (.10 × $9,525) + (.12 × $29,175) + (.22 × $11,300) = $6,939.5

Average tax rate = %879.1350000

5.939,6

income taxableTotal

bill tax Total

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- double taxation

Revenues

- Costs



- Interests personal tax paid by debtholders

- Taxes

Net Income

ersequityholdby

paid tax dividend :dividends cash

ersequityholdby

paid tax gain capital :earnings retained

chapter 3-accounting and finance

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