Financial Statements, Cash Flow, and Taxes Chapter 2 Financial Statements, Cash Flow, and Taxes

Topics in Chapter Read the following sections: 2-1: Financial Statements and Reports 2-2: The Balance Sheet 2-3: The Income Statement

Determinants of Intrinsic Value: Calculating FCF Sales revenues − Operating costs and taxes − Required investments in operating capital Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

2-1 Financial Statements and Reports A company’s annual report consists of: Management discussion; Four basic financial statements: the balance sheet the income statement the statement of stockholders’ equity the statement of cash flows The quantitative and qualitative written materials are equally important: The financial statements report what have actually happened whereas the written materials attempt to explain why things turned out the way they did.

2-2 The Balance Sheet The balance sheet is a “snapshot” of the firm’s financial position on a particular date. Please see Figure 2-1 on P59 in the textbook for an example. The balance sheet identity: Assets = Liabilities + Stockholders’ Equity

2-2a The Balance Sheet: Assets Assets (millions) 2016 2015 Cash & equivalents $ 50 $ 60 S-T investments - 40 Accounts receivable 500 380 Inventories 1,000 820 Total current assets $ 1,550 $ 1,300 Net fixed assets 2,000 1,700 Total assets $3,550 $3,000

2-2a Assets Current assets have a life of less than one year, such as cash, short-term investments, accounts receivable, and inventories. Fixed assets have a relatively long life, including tangible and intangible assets. Assets are listed in order of decreasing “liquidity”, i.e. the length of time it typically takes to convert them to cash at fair market values.

2-2b The Balance Sheet: Liabilities & Equity Liabilities and Equity (millions) 2016 2015 Accounts payable $ 200 $ 190 Notes payable 280 130 Accruals 300 Total current liabilities 780 600 Long-term debt 1,200 1,000 Total liabilities $1,980 $1,600 Preferred Stock 100 Common Stock 500 Retained earnings 970 800 Total common equity $1,470 $1,300 Total liabilities & equity $3,550 $3,000

2-2b Liabilities & Equity Current liabilities have a life of less than one year, such as accounts payable, notes payable, and accrued expenses. Long-term liabilities are liabilities that are not due in the coming year. Liabilities represent claims that various groups have against the company’s value and are listed in the order in which they must be paid. Stockholders’ equity is residual claim which is the difference between the total value of the assets and the total value of liabilities: it represents ownership and need never be “paid off”.

2-3 The Income Statement The income statement summarizes a firm’s performance over a period of time: it’s like a video recording covering the period between before and after pictures. Please see Figure 2-2 on P63 in the textbook for an example. The Income Statement Equation: Revenues – Expenses = Net Income/Earnings/Profit

MicroDrive’s Income Statements Income Statement (millions) 2016 2015 Net sales revenue $5,000 $4,760 COGS except Depreciation 3,800 3,560 Depreciation & amortization 200 170 Other operating expenses 500 480 EBIT $500 $550 Interest expense 120 100 Pre-tax earnings (EBT) $380 $450 Taxes (40%) 152 180 Net income before preferred div. $ 228 $ 270 Preferred dividends 8 NI available to common shareholders $ 220 $ 262

Some Jargons and Acronyms: Top Line: sales (revenue) Bottom Line: net income/earnings/profit EPS: earnings per share DPS: dividend per share BVPS: book value per share PPS: market price per share