1. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Financial Statements, Taxes, and Cash Flow Chapter 2

2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.1 Prepare for Capital Budgeting Part 2: Understand financial statement and cash flow Chapter 2-Identify cash flow from financial statement Chapter 3-Financial statement and comparison Part 3: Valuation of future cash flow Chapter 4-Basic concepts Chapter 5-More exercise Part 4: Valuing stocks and bonds Chapter 6-Bond Chapter 7-Stock Part 5: Capital budgeting

3. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.2 Chapter Outline 1. The Concept of Cash Flow 2. Balance Sheet 3. Income Statement 4. Taxes 5. Cash Flow from Assets

4. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.3 1.The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements The statement of cash flows in accounting statements (in which interest payment is deducted) does not provide us with the same information that we are looking at here We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

5. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.4 Cash Flow From Assets: Identity Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

6. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.5 2.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

7. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.6 Balance Sheet Illustration Net Working Capital=Current Assets – Current Liabilities

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.7 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. 1. Historical cost less accumulated depreciation bear little resemblance to the value could be sold for today. 2. Balance sheet does not include the value of human capital, customer loyalty, etc. Which is more important to the decision-making process?

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.8 Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LT Debt$ 500 NF Assets 700 1,000SE6001,100 1,6001,1001,600

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.9 3.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 Revenues – Expenses = Income Matching principle – GAAP says to show revenue when it accrues and match the expenses required to generate the revenue, so net income is NOT a measure of the cash flow during the period.

11. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.10 4.Taxes The one thing we can rely on with taxes is that they are always changing Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income

12. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.11 Example: Marginal Vs. Average Rates Suppose your firm earns $200,000 in taxable income. What is the firm’s tax liability? What is the average tax rate? What is the marginal tax rate? If you are considering a project that will increase the firm’s taxable income by $100,000, what tax rate should you use in your analysis?

13. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.12 Example Solution Corporate tax rate table (textbook) Tax liability.15(50,000) +.25(75,000 – 50,000) +.34(100,000 – 75,000) +.39(200,000 – 100,000) = $ 61,250 Average tax rate 61,250/ 200,000 = 30.625% = $ 7,500 = 6,250 = 8,500 = 39,000 $ 61,250

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.13 Illustration of Tax Rates $0 $50,000 $75,000 $100,000 $200,000 $50,000$25,000 $100,000 15%25%34%39%

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.14 5.Cash Flow From Assets: Calculation The Cash Flow Identity Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders Cash Flow From Assets Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.15 Cash Flow Illustration Total amount of cash generated=EBIT+Depr.

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.16 Table 2.5

18. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.17 US Corporation Balance Sheet – Table 2.1

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.18 Table 2.2

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.19 Example 1: US Corporation OCF (I/S) = EBIT + depreciation – taxes = $547I/S [Accounting definition of OCF = EBIT – interest – taxes + depreciation] NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 B/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 borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63 CFFA = 24 + 63 = $87 The CF identity holds.

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.20 Review Questions 1. What is the difference between operating cash flow in FINANCE analysis and the operating cash flow in ACCOUTING cash flow statement? 2. What is the difference between book value and market value? Which should we use for financial management decision making purposes? Why? What is the order of liquidity for the following assets? Cash, account receivable, inventory, tangible fixed assets, intangible fixed assets. What is net working capital? How to calculate it?

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2.21 Review Questions (cont..) 3. What is the difference between net income and cash flow? Which do we need to use when making financial management decisions? 4. What is the difference between average and marginal tax rates? How to calculate them? Which one should we use when making capital budgeting decisions? 5. How do we determine a firm’s cash flows? What are the equations and where do we find the information? Which of the income statement account(s) is(are) non- cash item(s)?