Accounting and Finance

P.V. Viswanath

For use with

Fundamentals of Corporate Finance
Brealey, Myers and Marcus, 4th ed.
 Key Concepts and Skills

 Know the difference between book value and market

value
 Know the difference between accounting income
and cash flow
 Know the difference between average and marginal
tax rates
 Know how to determine a firm’s cash flow from its
financial statements

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 Chapter Outline

The Balance Sheet

The Income Statement
Taxes
Cash Flow

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 The Balance Sheet

The balance sheet is a snapshot of the firm’s

assets and liabilities at a given point in time
Assets are listed in order of liquidity
 Ease of conversion to cash

 Without significant loss of value

Balance Sheet Identity

 Assets = Liabilities + Stockholders’ Equity

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 
The Balance Sheet

Current Liabilities
Current Assets
Payables
Cash & Securities
Short-term Debt
Receivables
Inventories
+
+ = Long-term Liabilities
Fixed Assets
Tangible Assets +
Intangible Assets
Shareholders’ Equity
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 Pepsico Inc. Balance Sheet (in mil. $)

Assets 28-Dec-02 29-Dec-01 Liabilities 28-Dec-02 29-Dec-01

Current Assets Cash And Current Liabilities 6,052 4,998
Cash
Short Term 1,638 683 Accounts Payable 5,490 3,484
Investments
Net 207 966 Short/Current Long Term Debt 562 354
Receivables 2,531 2,142 Other Current Liabilities - 1,160
Inventory 1,342 1,310 Total Current Liabilities 6,052 4,998
Other Current Assets 695 752 Long Term Debt 2,187 2,651
Total Current Assets 6,413 5,853 Other long-term liabilities 5,937 5,398
Long Term Investments 2,611 2,871 Total Liabilities 14,176 13,021
Property Plant and Equipment 7,390 6,876 Common Stock & Other Paid-up Capital 30 43
Goodwill 3,631 3,374 Retained Earnings 9,268 8,605
Intangible Assets 1,588 1,467 Total Stockholder Equity 9,298 8,674
Other Assets 1,841 1,254
Total Assets 23,474 21,695 Tot Liabs & Shareholders' Equity 23,474 21,695

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 Market vs. Book Value

 The balance sheet provides the book value of the

assets, liabilities and equity.
 Market value is the price at which the assets,
liabilities or equity can actually be bought or sold.
 Market value and book value are often very
different. Why?
 Which is more important to the decision-making
process?

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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 firm’s 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
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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 Income Statement

The income statement is more like a video of

the firm’s operations for a specified period of
time.
You generally report revenues first and then
deduct any expenses for the period
Matching principle – GAAP say to show
revenue when it accrues and match the
expenses required to generate the revenue

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 Income Statement
Pepsico Inc. (in mil. $)

Income Statement Dec 02 Dec 01

Revenue 25,112.00 26,935.00
Cost of Goods Sold 10,523.00 9,837.00
Gross Profit 14,589.00 17,098.00
SG&A Expense 8,523.00 11,608.00
Depreciation & Amortization 1,112.00 1,082.00
Operating Income 4,954.00 4,408.00
Nonoperating Income 316 227
Nonoperating Expenses 178 219
Income Before Taxes 4,868.00 4,029.00
Income Taxes 1,555.00 1,367.00
Net Income After Taxes 3,313.00 2,662.00

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 Taxes

Marginal vs. average tax rates

 Marginal – the percentage paid on the next dollar earned
 Average – the tax bill / taxable income

Income before taxes was $4868 and $4029 and taxes were
$1555 and $1367 for 2002 and 2001 resp. (in mil. $)
The average tax rates were 31.94% and 33.93%.
However, the tax paid on an additional dollar of income in
either year would have been 35%, considering that in 2002,
any income over $18 mil. was taxed at a rate of 35%.

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 Statement of Cashflows

 A firm’s cashflows can be quite different from its

net income. For example:
 The income statement does not recognize capital
expenditures as expenses in the year that the capital
goods are paid for. Those expenses are spread over time
as a deduction for depreciation.
 The income statement recognizes revenues and expenses
when sales are made, even though the money may not
have been collected (revenues) or paid out (expenses).

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 The Statement of Cashflows

 The statement of cashflows shows the firm’s cash

inflows and outflows from
 Operations
 Investments and
 Financing
 The form of this statement is determined by
accounting standards.

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 Statement of Cash Flows:
Operating Activities
 Operating activities are earnings-related
activities. Generally these relate to Income Statement
activities, and items included in working
capital. Included are:
 Sales and expenses necessary to obtain sales
 Related operating activities, such as extending credit to
customers
 investing in inventories
 obtaining credit from suppliers
 payment of taxes
 insurance payments
 Other activities that don't easily fit into the other two
categories, such as settlements in lawsuits.

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 Statement of Cash Flows:
Investing and Financing Activities
 Investing activities relate to the acquisition
and disposal of noncash assets: assets which
are expected to generate income for the
company over a period of time. These include
lending funds and collecting on these loans.
 Financing activities relate to the contribution,
withdrawing and servicing of funds to support
business activities.

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 Pepsico Inc. (in mil. $)
Statement of Cash Flows 2002
Net Income 3,313
Operating Activities, Cash Flows Provided By or Used In
Depreciation 1,112
Adjustments To Net Income -390
Changes In Accounts Receivables -260
Changes In Liabilities 704
Changes In Inventories -53
Changes In Other Operating Activities 201
Total Cash Flow From Operating Activities 4,627
Investing Activities, Cash Flows Provided By or Used In
Capital Expenditures -1,437
Investments 757
Other Cashflows from Investing Activities 153
Total Cash Flows From Investing Activities -527
Financing Activities, Cash Flows Provided By or Used In
Dividends Paid -1,041
Sale Purchase of Stock -1,734
Net Borrowings -404
Total Cash Flows From Financing Activities -3,179
Effect Of Exchange Rate Changes 34
Change In Cash and Cash Equivalents $955

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 An alternate way of defining cashflows

 Sometimes we are interested in defining cashflows for other

purposes, such as project evaluation. Or we may interested in how
cash is generated from the use of assets and how it is paid to those
that finance the purchase of the assets
 For this purpose, we separate cashflows into flows from assets
and flows to shareholders and creditors.
 We are interested in whether cashflows refer to investments, in
the sense that they expand the asset base and are ultimately
reflected in the balance sheet; or to operating returns from the use
of assets, which are reflected in the income statement.
 This differs from the GAAP oriented categorization of cashflows
in the Statement of Cashflows.

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 Cashflows from Assets
 Since increases in working capital are increases in investments, they are
not relevant for the determination of cashflows pertaining to recurring
returns from the use of assets. A definition of Operating Cashflow for
project evaluation purposes becomes:
Operating Cashflow = EBIT + Depreciation – Taxes.
 The other items that appear in the Cashflows from Operations category
in the Statement of Cashflows, e.g. change in accounts receivable are,
really, short-term investments. We define these separately as Change in
Working Capital.
 Finally, we have Net Capital Spending or long-term investments.
 Together, we have
Cashflows from Assets = Operating Cashflow – Change in Working
Capital – Net Capital Spending.

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 An alternative definition of cashflows

Assets Liabilities

Change in WC CF to
Current Assets – Debt Debtholders
Current Liabilities
Interest

Fixed Assets CF to
Equity Stockholders
Net Capital Paid-in capital
Spending
Retained Earnings Dividends

Operating
Cashflow Income Statement

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 Cash Flow From Assets

 Definition:
Cash Flow From Assets = Operating Cash Flow – Net
Capital Spending – Changes in NWC
 Identity:
Since cashflows from assets have to equal cashflows from
liabilities, we have:
Cash Flow From Assets (CFFA) = Cash Flow to Creditors
+ Cash Flow to Stockholders

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 An alternative definition of cashflows

 Operating Cashflows– recurring cashflows generated by the

use of assets
 Δ (Net Working Capital) and Net Capital Spending are
investment outlays to build up the assets that generate
cashflows.
 Cashflows to Stockholders and Cashflow to Bondholders are
how the investments are funded.
 The division of cashflows into operating cashflows and new
investments in assets is important in forecasting future
cashflows. Investments in assets are the drivers and
operating cashflows are the result of this investment.
 New investment and forecasted growth in operating
cashflows need to be consistent with each other.
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 An alternate way of defining cashflows:
Summary
I. The Cashflow identity:
Cashflow from assets = Cashflow to creditors + cashflow to stockholders
II. Cashflow from assets = Operating Cashflow
- Net Capital Spending
- Change in Net Working Capital (NWC)
where
Operating Cashflow = EBIT + Depreciation – Taxes
Net Capital Spending = Δ (Net Fixed Assets) + Depreciation (approximately)
III. Cashflow to creditors = Interest paid – Net new borrowing
IV. Cashflow to stockholders = Dividends paid – Net new equity raised
Because data in the firm’s public financial statements are aggregated, it is often
difficult to recover the quantities above without access to more detailed firm
accounts.

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Example: US Corporation
Balance Sheet Information

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 US Corporation
Income Statement Information

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 Cashflow to Assets: Computation

 Operating Cash Flow (I/S) = EBIT + depreciation –

taxes = $547
 Net Capital Spending ( B/S and I/S) = ending net fixed
assets – beginning net fixed assets + depreciation =
$130
 Changes in Net Working Capital (B/S) = ending NWC –
beginning NWC = $330
 Cash Flow From Assets (CFFA) = 547 – 130 – 330 =
$87

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 Cashflow to Stockholders/Creditors

 CF to Creditors (B/S and I/S) = interest paid – net new

borrowing = $24
 CF to Stockholders (B/S and I/S) = dividends paid – net new
equity raised = $63
 CFFA = 24 + 63 = $87

 As we saw before, this is the same amount that we computed

for Cashflow from Assets

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 Quick Quiz

 What is the difference between book value and market

value? Which should we use for decision making purposes?
 What is the difference between accounting income and cash
flow? Which do we need to use when making decisions?
 What is the difference between average and marginal tax
rates? Which should we use when making financial
decisions?
 How do we determine a firm’s cash flows? What are the
equations and where do we find the information?

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