1- 1 Financial Management Princeton PMBA Program August 22, 2015 to November 24, 2015 Dr. Richard Michelfelder

1- 2 Course Outline - Topics 1. Introductions to Financial Statements 2. Time Value of Money, Discount Rates and Rate of Return 3. Risk, Returns and Cost of Capital 4. Project Investment Decision-making 5. Stock and Bond Valuation 6. Capital Structure 7. Dividend Policy 8. Mergers & Acquisitions

1- 3 Outline 1 Introduction to Financial Statements 1.1 The Balance Sheet 1.2 The Income Statement 1.3 The Statement of Cash Flows 1.4 Accounting Practice 1.5 Income Taxes 1.6 Financial Ratios 1.7 DuPont Equations 1.8 Using Financial Ratios 1.9 Measuring Company Performance 1.10 The Role of Financial Ratios

1- 4 The Balance Sheet Definition Financial statements that show the value of the firm’s assets and liabilities at a particular point in time (from an historic cost accounting, not market value perspective).

1- 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 =

1- 6 The Balance Sheet Shareholder’s Equity = Total Assets – Total Liabilities Shareholders’ Equity: consists of paid in investment capital plus retain earnings - may be greater or less than market value of equity - for comparison look at Market-to-Book ratio: - Stock Market Price (P) /Shareholder’s Equity (B) or P/B ratio Shareholders’ Equity = Total Assets – Total Liabilities

1- 7 Market Value vs. Book Value Book Values are determined by GAAP (historic cost accounting) Market Values are determined by current values Equity and Asset “Market Values” are usually higher than their “Book Values”

1- 8 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.

1- 9 Market Value vs. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bilDebt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.5 bilDebt = $4 bil Equity = $7.5 bil

1- 10 Market and Book Value Review Market to Book Value for S&P 500 Market Trends

1- 11 S&P 500 Financials M/B Trend

1- 12 The Income Statement Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

1- 13 The Income Statement Earnings Before Income & Taxes, Depreciation & Amortization (EBITDA) EBITDA = Total Revenues - Operating Expenses Measure of profit less subject to “financial engineering” as EBITDA is gross of interest, taxes, depreciation & amortization.

1- 14 The Income Statement Pepsico Income Statement Net Sales$65,492 $66,504 Cost of Goods Sold 31,291 31,593 Other Expenses (Dep. Intang.) Selling, Gen. &Adm. expenses 22,281 22,408 Depreciation expense 2,689 2,737 Operating Profit 9,112 9,633 Other Income Earnings Before Interest & Taxes 9,203 9,690 Net Interest Expense (899) (856) Taxable Income 8,304 8,834 Income Taxes 2,090 2,372 Net Income 6,214 6,462

1- 15 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  CF can be low while net income is high

1- 16 The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time. CF = Cash Inflow – Cash Outflow

1- 17 The Statement of Cash Flows Pepsico Statement of Cash Flows Net Income6,2146,462 Non-cash expenses Depreciation2,6892,737 Changes in working capital (424) (255) A/R, A/P, Inv, other __________ Cash Flow from operations8,479 8,944 Cash Flow from investments (3,005) (5,618) Cash provided by financing (3,306) (5,135) Effect of Exchange Rate Changes 62 (67) Net Change in Cash Position 2,230 (1,876)

1- 18 Accounting Practice  There are many accounting issues subject to subjective judgment. A few examples are:  Revenue recognition  Off-balance-sheet financing Operating v. capital leases  Expensing v. capitalizing an “expenditure”

1- 19 Income 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.

1- 20 Income 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 AFirm B EBIT Interest 40 0 Pretax Income Taxes (35%) Net Income 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 EBIT100 Interest 40 Pretax Income 60 Taxes (35%) 21 Net Income 39

1- 21 Income Taxes 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 AFirm B EBIT Interest 40 0 Pretax Income Taxes (35%) Net Income ?

1- 22 Income Taxes 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 AFirm B Net Income Interest 40 0 Net Cash Flow Assuming $500 mil. in investment, what is the ROE with no debt and with 50% debt. Firm A ROE = 15.6% and Firm B ROE = 13%. ?

1- 23 Corporate Tax Rates (2002)

1- 24 Personal Tax Rates (2002)

1- 25 Financial Ratios (Financial Statement Analysis)  Five General Categories:  Valuation Value of firm or specific assets  Leverage Measures use of debt and associated fixed expenses  Liquidity Measures firm’s access to cash  Profitability Measures return on investments  Efficiency Productivity of the use of firm’s assets

1- 26 Leverage Ratios

1- 27 Leverage Ratios

1- 28 Liquidity Ratios

1- 29 Liquidity Ratios

1- 30 Efficiency Ratios

1- 31 Efficiency Ratios

1- 32 Profitability Ratios

1- 33 Profitability Ratios

1- 34 Market Value Ratios

1- 35 Market Value Ratios

1- 36 The DuPont Equations  A breakdown of ROE and ROA into component ratios

1- 37 The DuPont Equations asset turnover Operating profit margin

1- 38 The DuPont Equations leverage ratio asset turnover Operating profit margin debt burden

1- 39 MVA & Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. EP = economic profit = (ROI – r) x (Invested Capital) Market Value Added = The difference between the market value of common stock and its book value

1- 40 Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital EVA = Residual Income = Income Earned - Income Required = Income Earned – [cost of capital x invested capital] © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

1- 41 Measuring Performance