1. Financial statements, taxes and cash flow Chapter 2

2. 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 2-2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

3. Chapter outline The balance sheet The income statement Taxes Cash flow 2-3 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

4. The balance sheet The balance sheet is a snapshot of a firm’s assets and liabilities at a given point in time. Assets: The left-hand side: − Current or fixed − In order of decreasing liquidity Liabilities and owners’ equity: The right-hand side: – Current or long term – In ascending order of when due to be paid Balance sheet identity Assets = Liabilities + Shareholders’ equity 2-4 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

5. The balance sheet (cont.) Figure 2.1 2-5 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

6. The balance sheet (cont.) Net working capital – Current assets minus current liabilities – Usually positive for a healthy firm Liquidity − Speed and ease of conversion to cash without significant loss of value − Valuable in avoiding financial distress Debt versus equity − Shareholders’ equity = Assets - Liabilities 2-6 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

7. Oz Company balance sheet Table 2.1 Visit au.finance.yahoo.com for more financial statements and balance sheets 2-7 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

8. Market value vs book value Market value is the price at which assets, liabilities or equity can actually be bought or sold. The balance sheet provides the book value of assets, liabilities and equity. Market value and book value are often very different. Why? Which is more important to the decision- making process? 2-8 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

9. Battler Company Example 2.2 Battler Company Balance sheets Book value versus market value BookMarketBookMarket AssetsLiabilities and Shareholders’ equity NWC 400 600LTD 500 NFA 700 1 000SE6001 100 $1 100$1 600$1 100$1 600 2-9 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

10. The income statement The income statement measures performance over a specified period of time (period, quarter, year). Report revenues first and then deduct any expenses for the period. End result = Net income = ‘Bottom line’ – Dividends paid to shareholders – Addition to retained earnings Income statement equation: Net income = Revenue - Expenses 2-10 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

11. OZ Company income statement Table 2.2 2-11 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

12. The income statement (cont.) AAS and the income statement – The matching principle Recognise revenue when it is fully earned. Matching expenses required to generate revenue to the period of recognition Non-cash items – Expenses charged against revenue that do not affect cash flow. – Most important of these is depreciation. 2-12 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

13. The income statement (cont.) Time and costs – Fixed or variable costs – Not obvious on income statement Earnings management – Smoothing earnings – Wriggle room 2-13 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

14. Example: Work the Web Most Australian companies post their annual reports on their websites. Look for them in the investor or shareholder areas. Go to companies’ websites and see what kinds of financial reports you can find. Example: Virgin Blue 2-14 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

15. Taxes The one thing we can rely on with taxes is that they are always changing. Tax bill depends on tax code, which can be amended by political will. Corporate tax in Australia and New Zealand – Flat rate tax (currently 30%) Marginal vs average tax rates – Marginal–the percentage paid on the next dollar earned – Average–the tax bill/taxable income Other taxes 2-15 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

16. Personal tax rates (2009/2010) Table 2.3 2-16 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

17. Example: Marginal vs average tax rates Bony Bushman has a taxable income in Australia of $96 000. – What is his tax bill? – What is his average tax rate ? – What is his marginal tax rate? 2-17 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

18. Example: Marginal vs average tax rates Total9600023930 Average tax rate 24.9270833% Marginal tax rate 38% Personal tax rate Taxable incomeRate $0-6000Nil 6001-3500015% 35001-8000030% 80001-18000038% 180001-45% Tax calculation Taxable incomeTax liability 60000 290004350 4500013500 160006080 2-18 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

19. Taxation of dividends: An imputation system Major effect is that the double taxation of company profits is negated. Company advises the shareholder of the amount of company tax already paid on the dividend. Shareholder then adds this amount of tax to the cash dividend that they have received and pays personal tax on the grossed-up amount. Shareholder receives a tax (franking) credit equivalent to the amount of tax paid by the company. 2-19 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

20. Effect of a $700 dividend fully franked at 30% tax rate—Example 2.5 2-20 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

21. Cash flow Cash flow is some of the most important information that a financial manager can derive from financial statements. The difference between the number of dollars that come in and the number that go out. The statement of cash flows does not provide us with the same information that we are looking at here. Cash flow identity Cash flow from assets = Cash flow to creditors + Cash flow to shareholders 2-21 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

22. Cash flow (cont.) Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital. Operating cash flow – Cash generated from a firm’s normal business activities Capital spending – Money spent on fixed assets less money received from the sale of fixed assets Change in net working capital – Net increase in current assets over current liabilities 2-22 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

23. Cash flow (cont.) Free cash flow – Different from cash flow from assets – Cash that the firm is free to distribute to creditors and shareholders because it is not needed for working capital or fixed asset investments Cash flow to creditors – A firm’s interest payments to creditors less net new borrowings Cash flow to shareholders – Dividends paid out by a firm less net new equity raised 2-23 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

24. OZ Company example OCF (I/S) = EBIT + Depreciation – Taxes = $547I/S NCS (B/S and I/S) = Ending net fixed assets – Beginning net fixed assets + Depreciation = $130B/S Changes in NWC (B/S) = Ending NWC – Beginning NWC = $330 CFFA = 547 – 130 – 330 = $87 CF to creditors (B/S and I/S) = Interest paid – Net new borrowings = $24 CF to stockholders (B/S and I/S) = Dividends paid – Net new equity raised = $63 CFFA = 24 + 63 = $87 2-24 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

25. Cash flow summary Table 2.5 2-25 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

26. 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? 2-26 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

27. Quick quiz (cont.) 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? 2-27 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

28. Apple Isle example 2-28 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

29. Apple Isle (cont.) Operating cash flow 2-29 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

30. Apple Isle (cont.) Cash flow from assets, cash flow to stockholders and creditors 2-30 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

31. Chapter 2 END 2-31