1. Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.

2.  balance sheet  Stock statement  Organizing the value of assets (right-hand side) Different categories at a given time Short term Long term  Organizing the methods of financing of the assets (left-hand side) Different categories at a given time Short-term Long-term  Debt  equity 2 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

3.  Current Assets less than a year easily convertible secondary mkts  Fixed Assets more than a year Lumpy  Total Assets  Current Liabilities less than a year  Long-term Liabilities more than a year fixed obligations  Equity infinite variable  Liabilities & Equity 3 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

4.  Cash  cash & checking accounts at banks  Marketable Securities  equity & debt securities of other firms  Accounts Receivable  good sold & invoiced but not paid for  Inventories  Both inputs & outputs 4 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

5.  plant & equip  value of all physical assets of the firm  less depreciation  loss of value due to wear & tear or innovation 5 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

6.  Kinds of assets  value of patents  good guy capital  value of training to employees  management  Valuation ??  no book value  market value difficult to determine 6 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

7.  Payables  accounts payable  notes payable  Accruals  wage accruals  tax accruals  interest accruals 7 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

8.  Current Assets - Current Liabilities  19X2 $761 - 486 = 275  19X1 $707 - 455 = 252  Liquidity measure  ability to pay current liabilities  Change in NWC 8 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

9.  Cash, checking  Receivable  Due from employer  Inventories  Food  Gasoline  Home heating oil  Visa bill  Accruals  Electricity  Rent  Cable  cell 9 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

10.  Discount bonds  lump-sum payment at term (prin & int)  Coupon bonds  interest annuity paid at equal intervals  principal repaid at term  Mortgage bonds  annuity paid including (prin & int)  Deferred Tax liabilities 10 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

11.  Preferred Stock  Stockholder equity  Common Stock value of all stock issued at Par  Capital Surplus incremental value stock relative to par  Accumulated Retained Earnings historical sum of retained earnings 11 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

12.  proportion of debt to equity finance  increased leverage increases default risk debt - fixed payments, default & loss of control equity - residual payments, no default  measures of capital structure  debt ratio = total liabilities / total assets  debt to equity ratio = total liabilities / equity 12 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

13.  NWC = Current assets (CA) – current liabilities (CL) CA = Cash + marketable securities + receivables + inventories CL = Payables + Accruals  Measure of the liquidity health of the firm  Higher positive value means higher ability to pay its obligations  Higher value means firm is investing more in assets that do not earn a return 13 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

14.  Cash, checking $204.43  Receivable Work = $653.11  Inventories Food = $26 Gasoline = $11  CA = $894.54  Visa bill Min pymt = $40.00  Accruals Electricity = $53.72 Rent = $500.00 Cable = $45.98 Cell = $52.87 Tuition = $650.00  CL = $1342.57 14 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

15.  Speed of conversion  How quickly assets can be coverted to cash Cash to fixed assets  How quickly liabilities must be converted to cash Payables to equity (infinite term)  Assets and liabilities ordered by liquidity  Most liquid assets to least liquid Those most easily converted to cash on top Those hardest to covert into case on bottom  Most liquid liabilities to least liquid Those coming due first on top Those which never become due on bottom 15 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

16.  Debt holders  Payment schedule fixed by contract Priority of payment makes debt less risky Less risk (to debt holders) means lower costs Interest cost deductible before taxes Risk to firm managers Non payment leads to loss of control  Bankruptcy judge controls firm  Managers/owners no longer control assets  Equity  Stockholders get residual  Higher risk, higher expected return 16 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

17.  Balance sheet  All items book value Book values are easy to calculate Assets are valued at what was paid minus depreciation (for tax purposes) Liabilities are valued at principal remaining Equity = total assets – total liabilities  Market value  What you can get in secondary markets Receivables, inventories, fixed assets Much harder to calculate because fixed assets may have very small market 17 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

18.  CA = $894.54  Clothing = $750  Cell = $150  Lap top = $1500  Misc = $650  Capital = $50,000  TA = $53,944.54  CL = $1342.57  LT Debt = $24,000.00  Equity = $28,601.97  TL & E = $53,944.54 18 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

19.  Flow statement  Accounting of cash flows into various categories over a period of time Positive cash flows (revenues, sales) Revenues from sales Income from financial investments Royalties, rentals, licensing agreements Negative cash flows (costs, expenses) Cost of goods sold COGS - variable cost  Labor, inputs Operating costs – fixed costs  Management, marketing 19 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

20.  Total Operating Revenues (sales)  (cost of goods sold) variable over short run  (selling & administrative costs) fixed over short run  (capital cost allowance) CCA Allowance as depreciation for tax computation  Operating Income  misc income Revenue from investments, royalties, etc.  Earnings before Interest and Taxes (EBIT) 20 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

21.  Earnings before Interest and Taxes  (Interest expense on fixed liabilities)  Earnings before Taxes  (Taxes)  Capital cost allowance (CCA) non-cash item  Net Income (net cash flow)  Retained earnings  Dividends 21 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

22.  dividends  earnings distributed as a proportional cash flow back to the stock holder  retained earnings  buy assets current assets, fixed assets  pay liabilities lines of credit, bank loans, bonds 22 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

23.  Operating Cash Flow  Cash flows to providers of capital  Capital Spending (Fixed assets)  Purchase of new capital  Repair of existing capital  Change in NWC (Current assets)  NWC = CA – CL  Financing for current assets not financed through current liabilities 23 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

24.  Depreciation is not a cash flow  Deduction for reducing taxable income  Interest expense is not deducted  not an operating expense  finance expense  Operating cash flows should be positive  Support interest payments to debt holders  Support dividend payments to stockholders 24 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

25.  Change in debt can be positive or negative  New financing through debt (negative)  Paying off existing debt (positive)  Cash flow to debt holders should be positive  Bond holders do not want to see interest paid through the issue of new debt  Cash flow to debt holders may be negative  Debt used to finance new project  Principal repayment not cash flow to debt holder 25 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

26.  Change in equity can be positive or negative  financing through new equity issue (negative)  Repurchase of stock (positive)  Should be positive  Stock holders do not want to see their dividend being paid from a new issue of stock  May be negative  New issue being used to finance new project 26 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

27.  Purchases of fixed assets over the year  New projects  Overhaul or maintenance of old machines  Measure of addition of value to the firm over the year 27 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

28.  Additions to current assets not financed through additions to current liabilities  Negative value for NWC financing (more sales) Need more inventories, cash, receivables But need more long-term financing for these needs  Positive value for NWC financing (less sales) Need less inventories, cash, receivables Cash flow returned to firm for use elsewhere 28 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

29.  Cash, checking $204.43  Receivable Work = $653.11  Inventories Food = $26 Gasoline = $11  CA = $894.54  Visa bill Min pymt = $40.00  Accruals Electricity = $53.72 Rent = $500.00 Cable = $45.98 Cell = $52.87 Tuition = $650.00  CL = $1342.57 29 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

30. Marginal Tax rate Average Tax rate Income Tax 30 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

31.  Progressive tax rates  Marginal tax rate increases with income  Average tax rate increases with income  Marginal tax rate > average tax rate  Proportional  Marginal and average tax rate constant with income  Regressive  Marginal tax rate decreases with income  Average tax rate decreases with income 31 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

32.  Sources of income  Wages & salaries Progressive Taxable income Less deductions & exclusions  Rental, proprietorships, & partnerships Deduction of expenses  Capital gains Progressive Fraction of full gains  Corporate Deductions for expenses, tax breaks 32 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

33.  Government allowance for the reduction in value of assets over time  Depreciation of assets Lowers book value of assets on balance sheet Allows reduction of taxable income  Government sets the CCA rate for classes of assets Buildings 4% Motorized equipment30% Pollution control equip50% Leasehold improvementsstraight line 33 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

34.  Delivery van initial cost $60,000 34 9/4/2015 3040.03/04 notes by A.P. Palasvirta, Ph.D.

35. September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 35 end-of year balance sheets 2,0052,006 2,0052,006 cash$114$160payables$232$266 receivables$445$688S-T debt$196$123 inventory$553$555 CA$1,112$1,403CL$428$389 L-T debt$408$454 liabilities$836$843 common shares$600$640 retained earnings$1,320$1,629 fixed assets$1,644$1,709owner equity$1,920$2,269 total assets$2,756$3,112total$2,756$3,112

36. September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 36 income statement 2006 net sales$1,509 cogs($750) CCA($65) EBIT$694 interest pd($70) EBT$624 taxes($250) CCA$65 net income$439 retained$374 dividend($65)

37.  Operating CF = EBIT + CCA (depreciation) – taxes  CCA is not a real cash flow Allowance by the government for reduction in the value of assets Non-cash item Because of aging Because of new technologies  Adjustment to reduce taxable income  Interest expense not counted  Operating CF = 694 + 65 – 250 = 509 September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 37

38.  Cost of goods sold  Variable cost over the short run Variable with level of production Labor Inputs (raw materials) Energy  Operating costs  Fixed over short run Management (administrative) marketing September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 38

39.  Investment in fixed assets  Ending FX 2006 - FX 2005 + CCA = capital spending Change in fixed assets over the year Minus the depreciation of the asset during the year  capital spending = 1709-1644 + 65  Depreciation added just shows that the firm must spend at least 65 to keep the assets at the same book value September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 39

40.  Ending NWC 2006 - NWC 2005 = ΔNWC  Investment in new net working capital  When sales grow, your requirements for current assets increase New cash requirements, additional receivables, higher levels of inventories Some of these assets are financed by increases in current liabilities such as accruals and payables The difference must be financed by other forms of financing  If sales decrease the ΔNWC will be negative  ΔNWC = 1014 – 684 = 330 September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 40

41.  Interest Pd – net new borrowing = Cash flow to creditors  Ending L-T Debt 2005 - L-T Debt 2006 + Int pd = cash flow to creditors  Bondholders are interest in this being positive Bondholders do not want new debt to paying interest payments to old debt holders  Cash flow to creditors = 408 – 454 + 70 = 24 Including S-T debt 836 – 843 + 70 =63 Does it make sense to include short term debt? September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 41

42.  Dividends – New Equity = cash flow to shareholders  Ending CS 2005 - CS 2006 + Div = cash flow to shareholders  Shareholders like bondholders do not want to see the dividend paid by issuing new stock  Capital gain creates for the shareholder Increase in investment net of depreciation should increase the value of the firm Price appreciation of stock is at market value not book value, not on balance sheet  CF shareholders = 600 – 640 + 65 = 25 September 4, 2015 3040.05/06 notes by A.P. Palasvirta, Ph.D. 42