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FI3300 Corporation Finance Spring Semester 2010 Dr. Isabel Tkatch Assistant Professor of Finance 1

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FI3300 Corporation Finance. Spring Semester 2010 Dr. Isabel Tkatch Assistant Professor of Finance. Consider the Income Statement. Illustration Company, Income Statement For the Year ending December 31, 2006 (in $ millions). Questions. Was the company profitable? - PowerPoint PPT Presentation

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Page 1: FI3300 Corporation Finance

FI3300Corporation Finance

Spring Semester 2010

Dr. Isabel TkatchAssistant Professor of Finance

1

Page 2: FI3300 Corporation Finance

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Consider the Income Statement

Illustration Company, Income StatementFor the Year ending December 31, 2006 (in $ millions)

Net Sales 400

COGS 280

Gross Profit 120

Operating Expenses 40

Depreciation 20

Operating Income 60

Interest Paid 10

Earnings Before Taxes

50

Taxes 20

Net Income 30

Page 3: FI3300 Corporation Finance

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Questions

☺Was the company profitable?

☺Did the company generate a positive cash flow?

☺How did the company generate its cash flow?

Page 4: FI3300 Corporation Finance

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Learning Objectives

☺Understand the basic difference between net profit and net cash flow

☺Construct the statement of cash flows

☺Use the statement of cash flows to analyze major strengths and weaknesses of a company

Page 5: FI3300 Corporation Finance

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Net Profit vs. Net Cash Flow

☺ Firm’s preferred choice under accrual method of accounting

☺ Easily manipulated

☺ Helps evaluate the firm’s ability to generate cash

☺ Hard to manipulate

Net Profit ≠ Net Cash Flow

Page 6: FI3300 Corporation Finance

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Statement of Cash Flows

☺ Provides information about cash inflows and outflows during an accounting period

☺ Focuses on CASH

☺ Three sections to the statement of cash Flows:

☺ Cash flow from Operating Activities

☺ Cash flow from Investing Activities

☺ Cash flow from Financing Activities

Page 7: FI3300 Corporation Finance

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Useful Tip

For any item on the statement of cash flows

☺ IF the item represents a cash INFLOW you ADD that item

☺ IF an item represents a cash OUTFLOW you SUBTRACT that

item

Page 8: FI3300 Corporation Finance

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What’s Next?

We have to associate the two:

Balance Sheet Accounts:

- Accounts Receivable- Inventories

- Retained Earnings

Sections of theStatement of Cash Flows:

1.CF from Operating Activities

2.CF from Investing Activities

3.CF from Financing Activities

Page 9: FI3300 Corporation Finance

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Cash Flow from Operating Activities 1

☺ We use the indirect method: ☺ Start with the net profit (income) and “modify” until

you get the net cash flow

☺ Starting point: Net Income

☺ Step 1: add Depreciation

☺ To find CF from Operating Activities consider only cash flows that are directly related to the production and sales of goods and services

Example: page 69 in the book

Page 10: FI3300 Corporation Finance

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Cash Flow from Operating Activities 2

☺ Step 2: subtract changes in Current Assets (excluding cash):

☺ Accounts receivable

☺ Inventories

☺ Step 3: add changes in Current Liabilities (excluding notes payable and current portion of LTD):

☺ Accounts Payable

☺ Accruals

☺ Result: CF from Operating Activities

Page 11: FI3300 Corporation Finance

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Classification Balance Sheet Item 2005 2006 Difference (Change)

Cash 10 14 14 – 10 = 4

Operating Accounts Receivable 30 25 25 – 30 = -5

Operating Inventories 50 57 57 - 50 = 7

Investing Gross Fixed Assets 160 190 190 – 160 = 30

Less Acc. Depreciation (50) (70) 70 – 50 = 20

Net Fixed Assets 110 120

Total Assets 200 216

Financing Notes Payable 40 29 29 – 40 = -11

Operating Account Payable 20 35 35 – 20 = 15

Operating Accruals 28 32 32 – 28 = 4

Financing Current portion of LTD 0 0 0 – 0 = 0

Financing Long Term Debt (LTD) 52 56 56 – 52 = 4

Financing Common Stock 40 34 34 – 40 = -6

Financing Retained Earnings 20 30 30 – 20 = 10

Total Liabilities and Equity

200 216

Page 12: FI3300 Corporation Finance

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Cash Flow from Investing Activities 1

Investing activities:Buying or selling productive long-lived

assets such as plants and equipment

Gross Fixed Assets are cash investments

(Depreciation is not cash investment)

Buying or selling financial securities (e.g., stocks or bonds of other companies)

Page 13: FI3300 Corporation Finance

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Cash Flow from Investing Activities 2

☺ Starting point: zero

☺ Step 1: ☺ subtract change in Gross Fixed Assets☺ subtract change in Financial Assets

(securities of other companies)

☺ Result: CF from Investing Activities

Page 14: FI3300 Corporation Finance

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Classification Balance Sheet Item 2005 2006 Difference (Change)

Cash 10 14 14 – 10 = 4

Operating Accounts Receivable 30 25 25 – 30 = -5

Operating Inventories 50 57 57 - 50 = 7

Investing Gross Fixed Assets 160 190 190 – 160 = 30

Less Acc. Depreciation (50) (70) 70 – 50 = 20

Net Fixed Assets 110 120

Total Assets 200 216

Financing Notes Payable 40 29 29 – 40 = -11

Operating Account Payable 20 35 35 – 20 = 15

Operating Accruals 28 32 32 – 28 = 4

Financing Current portion of LTD 0 0 0 – 0 = 0

Financing Long Term Debt (LTD) 52 56 56 – 52 = 4

Financing Common Stock 40 34 34 – 40 = -6

Financing Retained Earnings 20 30 30 – 20 = 10

Total Liabilities and Equity

200 216

Page 15: FI3300 Corporation Finance

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Cash Flow from Investing Activities 3

☺ Investing activities refer to changes on the lower left-hand side of balance sheet

☺ Warning: we are looking for changes in Gross Fixed Assets, not Net Fixed Assets!

☺ What if Gross Fixed Assets are not reported in balance sheet?

Page 16: FI3300 Corporation Finance

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Assets Liabilities and Owners Equity

CashMarketable securities Net A/RInventories

Total Current Assets

Gross Fixed Assets(less Accum. Depreciation)

Net Fixed AssetsTotal Assets

Notes PayableAccounts PayableAccrued ExpensesCurrent Portion of LTD

Total Current LiabilitiesLong term (L.T.) Debt

Total LiabilitiesPreferred StockCommon StockRetained Earnings

Total Liabilities and equity

Liquidity

Assets Claims on Assets

Balance Sheet

S.T. Funds

L.T. Capital

Page 17: FI3300 Corporation Finance

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Useful Relations

Change in Gross Fixed Assets = + Change in Net Fixed Assets

+ Depreciation (on the income statement)

Depreciation (on the income statement) = Change in Accumulated

Depreciation (on the balance sheet)

Calculate using book example on page 69.

Page 18: FI3300 Corporation Finance

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Cash Flow from Financing Activities 1

Financing activities:

☺New loans (long-term, short-term debt)

☺Repayment of principal

☺Sale or repurchase of stock (common or

preferred)

☺Payment of dividends

Page 19: FI3300 Corporation Finance

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Cash Flow from Financing Activities 2

Financing activities refer to:☺ Items on lower right-hand side of the

balance sheet☺ Changes in long-term Debt☺ Changes in Equity

☺ Short-term loans☺ Changes in Notes Payable ☺ Changes in the Current Portion of long-term

Debt

☺ Dividends paid to shareholders

Page 20: FI3300 Corporation Finance

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Assets Liabilities and Owners Equity

CashMarketable securities Net A/RInventories

Total Current Assets

Gross Fixed Assets(less Accum. Depreciation)

Net Fixed AssetsTotal Assets

Notes PayableAccounts PayableAccrued ExpensesCurrent Portion of LTD

Total Current LiabilitiesLong term (L.T.) Debt

Total LiabilitiesPreferred StockCommon StockRetained Earnings

Total Liabilities and equity

Liquidity

Assets Claims on Assets

Balance Sheet

S.T. Funds

L.T. Capital

Page 21: FI3300 Corporation Finance

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Cash Flow from Financing Activities 3

☺ Starting point: zero

☺ Step 1: ☺ add change in Notes Payable☺ add change in Current Portion of LT Debt☺ add change in Long Term Debt☺ add change in Common Stock

☺ Step 2: ☺ subtract Dividend Payout

Dividends Paid = Net Income – change in Retained Earnings

☺ Result: Net CF from Financing Activities

Page 22: FI3300 Corporation Finance

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Classification Balance Sheet Item 2005 2006 Difference (Change)

Cash 10 14 14 – 10 = 4

Operating Accounts Receivable 30 25 25 – 30 = -5

Operating Inventories 50 57 57 - 50 = 7

Investing Gross Fixed Assets 160 190 190 – 160 = 30

Less Acc. Depreciation (50) (70) 70 – 50 = 20

Net Fixed Assets 110 120

Total Assets 200 216

Financing Notes Payable 40 29 29 – 40 = -11

Operating Account Payable 20 35 35 – 20 = 15

Operating Accruals 28 32 32 – 28 = 4

Financing Current portion of LTD 0 0 0 – 0 = 0

Financing Long Term Debt (LTD) 52 56 56 – 52 = 4

Financing Common Stock 40 34 34 – 40 = -6

Financing*** Retained Earnings 20 30 30 – 20 = 10

Total Liabilities and Equity

200 216

Page 23: FI3300 Corporation Finance

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Useful Relation:

Net cash flow from Operating Activities+Net cash flow from Investing Activities+Net cash flow from Financing Activities________________________________= CHANGE in the cash account (balance

sheet)

Calculate using book example on page 69.

Page 24: FI3300 Corporation Finance

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Analyzing the Statement of Cash Flows 1

Compare the Net Income and the Net Cash Flow from Operations. If

Net Income>0 but CF from Operations<0

☺ The company could be experiencing rapid growth (book example: golf ball company, Ch. 2)

☺ This could be an indicator of financial miss-management (book example: Bennie’s Auto Parts and Services Center, Ch. 1)

Page 25: FI3300 Corporation Finance

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Analyzing the Statement of Cash Flows 2

Net Cash Flow from Investing activities:

If negative, the company is investing in☺ Plant & equipment (improve efficiency)

☺ Stock of other companies (strategic reasons, e.g., joint venture)

If positive, the company is liquidating assets - Why? Could be an indicator of financial distress!

Page 26: FI3300 Corporation Finance

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Analyzing the Statement of Cash Flows 3

Where did the company get cash to pay dividends? It is a good sign if

CF from operations > Dividend payout

If not, did the company☺Liquidated assets☺Issue new equity or borrow money

To pay dividends?

Page 27: FI3300 Corporation Finance

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Analyzing the Statement of Cash Flows 4

Examine the CF from Financing activities:

☺ Big increases in debt (either short-term or long-term) are not a good sign

☺ Using internal financing rather than debt to finance growth is usually a good sign

☺ Substitution of short-term debt for long-term debt might indicate a worsening of financial conditions

Page 28: FI3300 Corporation Finance

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Summary

☺Net income vs. net cash flows

☺Statement of Cash flows☺Operating activities☺Investing activities☺Financing activities

☺Add CFs that represent inflows

☺Subtract CFs that represent outflows

☺Use the Statement of Cash Flows to analyze the company