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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 by©The
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

.3 The Balance Sheet Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective).3.

3.4 Balance Sheet PepsiCo Balance Sheet (December 31. 2006) $Millions .

5 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 .3.

3. .6 The Balance Sheet  Common-Size Balance Sheet  All items in the balance sheet are expressed as a percentage of total assets.

3.7 Common Size Balance Sheet .

Equity and Asset “Market Values” are usually higher than their “Book Values” .3. 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.8 Market Value vs.

Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity). your assets must have a market value of $11. debt worth $4 billion.5 billion. your firm has equity worth $6 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion. Book Value Example According to GAAP. . assets worth $10 billion.3.9 Market Value vs.

3.10 Market Value vs.5 bil .5 bil Debt = $4 bil Equity = $7. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.

expenses. . and net income of a firm over a period of time (from an accounting perspective).3.11 The Income Statement Definition Financial statement that shows the revenues.

292 – 1.055 million .3.costs – deprecation = 35.753 – 27.12 The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = Total Revenues .406 = $ 7.

530 1.347 5.753 15.989 1.406 7. G&A expenses Depreciation expense EBIT Net interest expense Taxable Income Income Taxes Net Income 35.642 .055 66 6.3.13 The Income Statement Pepsico Income Statement (year end 2006) Net Sales COGS Selling.762 11.

3. not when the cash exchanges actually occur  “Profits” do not consider changes in working capital . 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.14 Profits vs.

3. .15 The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

16 The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt .328 Cash Flow from operations 8.376 Cash Flow from investments (933) Cash provided by financing (7.3.956 CL=155 1.642 Non-cash expenses Depreciation 1.year end 2006) Net Income 5.508) Net Change in Cash Position (65) .406 Other 0 Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1.

change in net working capital .3.17 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 .capital expenditures .taxes depreciation .

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

3. Average Tax Rate is the total tax bill divided by total income. .19 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.

Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 Taxes (35%) 21 35 Net Income 39 65 100 .3.Taxes and Cash Flows can be changed by the use of debt. Firm B does not. Firm A pays part of its profits as debt interest.20 Taxes Example .

21 Taxes FOOD FOR THOUGHT .3.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 ? .

3. 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 ? .22 Taxes FOOD FOR THOUGHT .If you were both the debt and equity holders of the firm.

000 100.000 50.001-75.23 Corporate Tax Rates (2008) Taxable Income ($) 0-50.333.333 Tax Rate (%) 15 25 34 34-39 35 .000 75.001-18.333 over 18.001-100.333.3.

3.24 Personal Tax Rates (2008) .

gov .3.25 IRS Web Site www.irs.

26 Web Resources .3.