FIN 422: Student Managed Investment Fund Topic 8: Financial Statements  Larry Schrenk, Instructor

Overview Balance Sheet Income Statement Statement of Cash Flows Examples

Readings Damodaran. Investment Philosophies, Chapter 3 Damodaran. Investment Valuation, Chapter 3 Koller, Goedhart, and Wessels. Valuation, Chapter 9

1. Balance Sheet

Questions

Basic Financial Statements

Accounting Balance Sheet

Principles of Accounting Balance Sheet

Measuring Asset Value

Financial Balance Sheet

2. Income Statement

Income Statement

Principles of Accounting Income Statement

Measuring Accounting Profitability

Measuring Financial Leverage

Accounting Inconsistencies

Capitalizing vs. Expensing Costs An expenditure is either i) capitalized as a cost of the asset on the balance sheet or ii) expensed on the income statement Expenses are matched with revenue in same time period Capital expenditures are depreciated

Operating vs Capital Leases Advantages of an Operating Lease Operating leases provide much-needed flexibility to companies that frequently update or replace their equipment. The lessee is protected from the risk of obsolescence. Accounting is simpler: the asset does not have to be included in the balance sheet. The corresponding debt liability does not have to be calculated or included. Lease payments are operational expenses, so they are fully tax deductible. It provides improved Return on Asset (ROA) without capital budgeting restraints. Advantages of a Capital Lease Capital leases recognize expenses sooner than equivalent operating leases. The lessee is allowed to claim depreciation each year on the asset. In addition to depreciation, the interest expense component of the lease payment can also be deducted as an operational expense.

Operating vs Capital Leases: Comparison Chart Operating Lease Lease criteria - Ownership Ownership of the asset might be transferred to the lessee at the end of the lease term. Ownership is retained by the lessor during and after the lease term. Bargain Purchase Option Bargain purchase option to buy the equipment at less than fair market value. No bargain purchase option. Term Term > 75% of the estimated economic life Term < 75 percent of the estimated economic life Present Value PV of lease payments > 90% of the original cost PV of lease payments < 90% of the original cost Risks and Benefits Transferred to lessee. Lessee pays maintenance, insurance and taxes Right to use only. Risk and benefits remain with lessor. Lessee pays maintenance costs Accounting Lease is an asset and liability; payments on balance sheet Payments are operating expenses and on Profit and Loss statement Tax Lessee claims depreciation expense and interest expense Lease payment is a rental expense

Dealing with Operating Lease Expenses

Effects of Capitalizing Operating Leases

Capitalizing Operating Leases Debt Value of Operating Leases = PV(Operating Lease Expenses) discounted at the cost of debt Amortization Adjusted Operating Income = Operating Income + Operating Lease Expense – Depreciation on Leased Asset

Capitalizing Operating Leases: Data A firm has an operating lease with the expenses below. The pre-tax cost of debt is 5.48%. Its EBIT is $10,000.00 and debt is $25,000.00. Year CF 2,500.00 1 2,000.00 2 3 4 1,800.00 5 1,600.00 6+

Capitalizing Operating Leases: Converting Operating Lease to Debt Notes: Discount rate is 5.48% The year 6+ cash flows are modelled as a ten year annuity. Year CF PV 1 2,000.00 1,896.09 2 1,797.59 3 1,704.20 4 1,800.00 1,454.09 5 1,600.00 1,225.38 6+ 5,371.39 Debt Value = 13,448.73

Capitalizing Operating Leases: Restated Financials Operating Income with operating leases reclassified as debt = $25,000.00 + 13,448.73 = $38,448.73 Operating Income Adjustment Operating Income $10,000.00 + Current Year’s Lease Expense 2,500.00 - Depreciation on Leased Expense 1,494.30 Adjusted Operating Income $11,005.70

R&D Expenses: Operating or Capital Expenses

Effects of Capitalizing R&D

Capitalizing R&D Determine amortizable life of R&D Collect past R&D expenses over amortizable life Sum up unamortized R&D over the period

Capitalizing R&D: Data A firm has past R&D with the expenses below. This year’s R&D expense is $1,594.90 and the tax rate is 35%. Year CF -1 1026.00 -2 698.00 -3 399.00 -4 211.00 -5 89.00

Capitalizing R&D: Converting R&D Year R&D Expense Unamortized Portion This Year’s Amortization 1,594.90 1.00 1,594.00 -1 1026.00 0.80 820.80 205.20 -2 698.00 0.60 418.80 139.60 -3 399.00 0.40 159.60 79.80 -4 211.00 0.20 42.20 -5 89.00 0.00 17.80 Value of R&D 3,035.40 484.60 Amortization of Asset for Current Year = $484.60 (5-year, straight line) Adjustment to Operating Income = 1,594.90 – 484.60 = $1,109.40 Tax Effect of R&D Expensing = 1,109.40 x 0.35 = $388.00

3. Statement of Cash Flows

Statement of Cash Flows

Valuation Cash Flows