Chapter 3 Accounting and Finance Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Chapter 3 Accounting and Finance Slides by Matthew Will McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered The Balance Sheet The Income Statement The Statement of Cash Flows Accounting Practice & Malpractice Taxes 2

The Balance Sheet Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective). 3

Balance Sheet PepsiCo Balance Sheet (December 31, 2006) $Millions

The Main Balance Sheet Items The Balance Sheet The Main Balance Sheet Items Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets Current Liabilities Payables Short-term Debt + Long-term Liabilities Shareholders’ Equity = 5

The Balance Sheet Common-Size Balance Sheet All items in the balance sheet are expressed as a percentage of total assets. 3

Common Size Balance Sheet

Market Value vs. Book Value Book Values are determined by GAAP Market Values are determined by current values Generally Accepted Accounting Principles (GAAP) Procedures for preparing financial statements. Equity and Asset “Market Values” are usually higher than their “Book Values” 6

Market Value vs. Book Value Example According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion. 8

Market Value vs. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil 10

The Income Statement Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective). 11

The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = Total Revenues - costs – deprecation = 35,753 – 27,292 – 1,406 = $ 7,055 million 12

Pepsico Income Statement (year end 2006) The Income Statement Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642 13

Profits vs. Cash Flows Differences “Profits” subtract depreciation (a non-cash expense) “Profits” ignore cash expenditures on new capital (the expense is capitalized) “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur “Profits” do not consider changes in working capital 14

The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time. 15

The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt - year end 2006) Net Income 5,642 Non-cash expenses Depreciation 1,406 Other 0 Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155 1,328 Cash Flow from operations 8,376 Cash Flow from investments (933) Cash provided by financing (7,508) Net Change in Cash Position (65) 18

Cash Flows Free Cash Flow (FCF) FCF = EBIT - taxes depreciation Cash available for distribution to investors after firm pays for new investments or additions to working capital FCF = EBIT - taxes depreciation - change in net working capital - capital expenditures

Accounting Practice Stock options Cookie Jar Reserves Off balance sheet assets and liabilities Revenue recognition 19

Taxes Taxes have a major impact on financial decisions Marginal Tax Rate is the tax that the individual pays on each extra dollar of income. Average Tax Rate is the total tax bill divided by total income. 20

Taxes Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not. Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65 23

Taxes FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65 ? 24

Taxes FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B Net Income 39 65 ? + Interest 40 0 Net Cash Flow 79 65 26

Corporate Tax Rates (2008)

Personal Tax Rates (2008)

IRS Web Site www.irs.gov

Web Resources www.prars.com www.corporateinformation.com www.sec.gov/edgar.shtml www.edgaronline.com www.ibm.com/investor/financialguide www.quicken.com finance.yahoo.com www.irs.gov www.fasb.org www.iasb.org