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Fundamentals
of Corporate
Finance

Chapter 3
Accounting and Finance

Sixth Edition

Richard A. Brealey
Stewart C. Myers
Alan J. Marcus

Slides by
Matthew Will

McGraw
McGraw Hill/Irwin
Hill/Irwin

Copyright Copyright
2009 byThe
McGraw-Hill
Companies,
Inc. All rights
2009
by The McGraw-Hill
Companies,
Inc. All rights

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Topics Covered
The Balance Sheet
The Income Statement
The Statement of Cash Flows
Accounting Practice & Malpractice
Taxes

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The Balance Sheet

Definition
Financial statement that show
the value of the firms assets and
liabilities at a particular point in
time (from an accounting
perspective).

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Balance Sheet
PepsiCo Balance Sheet (December 31, 2006)
$Millions

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The Balance Sheet

The Main Balance Sheet Items

Current Assets
Cash & Securities
Receivables
Inventories

Fixed Assets
Tangible Assets
Intangible Assets

Current Liabilities
Payables
Short-term Debt

+
Long-term Liabilities

+
Shareholders Equity

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The Balance Sheet

Common-Size Balance Sheet

All items in the balance sheet are

expressed as a percentage of total
assets.

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Common Size Balance Sheet

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Market Value vs. Book Value

Book Values are determined by GAAP
Market Values are determined by current values
Generally Accepted Accounting Principles
(GAAP)
Procedures for preparing financial statements.

Equity and Asset Market Values are usually

higher than their Book Values

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Market Value vs. Book Value

Example
According to GAAP, your firm has equity worth $6
billion, debt worth $4 billion, assets worth $10
billion. The market values your firms 100 million
shares at $75 per share and the debt at $4 billion.
Q: What is the market value of your assets?
A: Since (Assets=Liabilities + Equity), your assets
must have a market value of $11.5 billion.

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Market Value vs. Book Value

Example (continued)
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil

Market Value Balance Sheet

Assets = $11.5 bil
Debt = $4 bil
Equity = $7.5 bil

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The Income Statement

Definition
Financial statement that shows
the revenues, expenses, and net
income of a firm over a period of
time (from an accounting
perspective).

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The Income Statement

Earnings Before Income & Taxes (EBIT)

EBIT = Total Revenues - costs deprecation

=
35,753
27,292 1,406
= $ 7,055 million

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The Income Statement

Pepsico Income Statement (year end 2006)
Net Sales
COGS
Selling, G&A expenses
Depreciation expense
EBIT
Net interest expense
Taxable Income
Income Taxes
Net Income

35,753
15,762
11,530
1,406
7,055
66
6,989
1,347
5,642

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Profits vs. Cash Flows

Differences
Profits subtract depreciation (a non-cash expense)
Profits ignore cash expenditures on new capital
(the expense is capitalized)
Profits record income and expenses at the time of
sales, not when the cash exchanges actually occur
Profits do not consider changes in working capital

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The Statement of Cash Flows

Definition
Financial statement that shows
the firms cash receipts and cash
payments over a period of time.

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The Statement of Cash Flows

Pepsico Statement of Cash Flows (excerpt - year end 2006)
Net Income 5,642
Non-cash expenses
Depreciation
1,406
Other
0
Changes in working capital
A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155

1,328

Cash Flow from operations 8,376

Cash Flow from investments
(933)
Cash provided by financing
(7,508)
Net Change in Cash Position
(65)

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Cash Flows
Free Cash Flow (FCF)

Cash available for distribution to investors after

firm pays for new investments or additions to
working capital

FCF =

EBIT
- taxes depreciation
- change in net working capital
- capital expenditures

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Accounting Practice
Stock options
Cookie Jar Reserves
Off balance sheet assets and liabilities
Revenue recognition

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Taxes
Taxes have a major impact on financial
decisions
Marginal Tax Rate is the tax that the
individual pays on each extra dollar of
income.
Average Tax Rate is the total tax bill divided
by total income.

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Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits as
debt interest. Firm B does not.
Firm A Firm B
EBIT 100 100
Interest
40
0
Pretax Income
60
Taxes (35%) 21
35
Net Income 39
65

100

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Taxes
FOOD FOR THOUGHT - If you were both the debt
and equity holders of the firm, which would generate
more cash flow to you? (assume Net Income = Cash
Flow)
Firm A
Firm B
EBIT
100
100
Interest
40
0
Pretax Income
60
100
Taxes (35%)
21
35
Net Income
39
65

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Taxes
FOOD FOR THOUGHT - If you were both the debt
and equity holders of the firm, which would generate
more cash flow to you? (assume Net Income = Cash
Flow)
Firm A
Firm B
Net Income
39
65
+ Interest
40
0
Net Cash Flow
79
65

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Corporate Tax Rates (2008)

Taxable Income ($)

0-50,000
50,001-75,000
75,001-100,000
100,001-18,333,333
over 18,333,333

Tax Rate (%)

15
25
34
34-39
35

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Personal Tax Rates (2008)

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IRS Web Site

www.irs.gov

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Web Resources