2-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Two Financial Statements, Taxes and Cash Flow

2-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Cash Flow Summary and Conclusions Chapter Organisation

2-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Understand the difference between book value (from the Balance Sheet) and market value. Understand the difference between net profit (from the Income Statement) and cash flow. Explain the differences between the average tax rate, the marginal tax rate and the flat rate. Explain the calculation of cash flow from assets, and cash flow to debtholders and shareholders.

2-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Balance Sheet Shows a firm’s accounting value on a particular date. Equation: Assets = Liabilities + Shareholders’ Equity. Assets are listed in order of liquidity. Net working capital = Current Assets – Current Liabilities.

2-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Balance Sheet Current Assets Fixed Assets 1.Tangible fixed assets 2.Intangible fixed assets Net Working Capital Current Liabilities Non-current Liabilities Shareholders’ Equity Total Value of Assets Total Value of Liabilities and Shareholders’ Equity

2-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Liquidity The speed and ease with which an asset can be converted to cash without significant loss of value. Current assets are liquid (e.g. debtors, inventory). Non-current assets are relatively non-liquid (e.g. building, equipment, goodwill). The more liquid a business is, the less likely it is to experience financial distress, but liquid assets are less profitable to hold.

2-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Debt versus Equity Creditors have first claim on a firm’s cash flow; equity holders have a residual claim. This residual claim is represented in the equation: Shareholder’s equity = Assets – Liabilities. Financial leverage or ‘gearing’ is the use of debt in a firm’s capital structure. Financial leverage increases the potential reward to shareholders, but also increases the potential for financial distress and business failure.

2-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Market Value versus Book Value Generally Accepted Accounting Principles (GAAP) require audited financial statements to show assets at historical cost or book value. Revaluations of assets to fair value are permitted. The value of a firm relates to market value, or the price that could be obtained in the current market place.

2-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Market Value versus Book Value ABC Company has non-current assets with a book value of $1,900 but they have an appraised market value of $2,400. Net working capital has a book value of $1,500, but if all current accounts were liquidated, the company would collect $1,800. ABC Company has $2,000 in long-term debt—both book value and market value.

2-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Market Value versus Book Value ABC Company BookMarketBookMarket AssetsLiabilities Net working capital $1 500$1 800 Long-term debt $2 000 Non-current assets $1 900$2 400Equity$1 400$2 200 Total$3 400$4 200Total$3 400$4 200

2-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Income Statement Measures a firm’s earnings over a period of time. Equation: Revenues – Expenses = Profit. Profit is often expressed on a per-share basis and called earnings per share (EPS). The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet.

2-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Income Statement Revenue $4 000 Cost of Goods Sold Depreciation 200 EBIT Interest 200 Taxable Income 800 Tax 240 Net Profit $560 Dividends 260 Addition to R/E $300

2-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Balance Sheet BegEnd Beg End Cash$100$190A/P $100 $150 A/R N/P Inv C/L $300 $350 C/A$600$780NCL $400 $420 NCA$400$600Cap R/E $300 $610 Total $1000 $1380Total$1000 $1380

2-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Approved Accounting Standards and the Income Statement The realisation principle is to recognise revenue at the time of sale. Costs are recorded according to the matching principle; that is, revenues are identified and costs associated with these revenues are matched and recorded. As a result of the way revenues and costs are realised, the figures shown on the Income Statement may not be representative of the cash inflows and outflows that occurred during a period.

2-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Non-cash Items Expenses charged against revenues that do not directly affect cash flow, such as depreciation, are called ‘non-cash items’. The depreciation deduction is another application of the matching principle. To effectively estimate market value, cash flows must be separated from non-cash accounting entries.

2-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Time and Costs In the long run, all business costs are variable. In the short run, some costs are effectively fixed (e.g. rates) and other costs (e.g. payments to suppliers) are variable. The distinction between fixed and variable costs is sometimes important to the financial manager but the Income Statement does not provide a good guide. This is because accountants tend to classify costs as either product costs (e.g. raw materials and manufacturing overhead) or period costs (reported as selling, general and administrative expenses).

2-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes Can be one of the largest cash outflows that a firm experiences. The size of the tax bill is determined by the Income Tax Assessment Act 1997 (Tax Act). The Tax Act is the result of political, not economic, forces.

2-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Tax Rates The average tax rate is the total tax bill divided by taxable income; that is, the percentage of income that goes in taxes. The marginal tax rate is the extra tax paid if one more dollar is earned. A flat rate is where there is only one tax rate that is the same for all income levels. It is the marginal rate that is relevant for most financial decisions.

2-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Personal and Corporate Tax Rates for the Year 2006–2007

2-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Tax Rates An individual has a taxable income of $35,000. Total tax liability is $5,850 (based on the 2006–2007 tax scales). The average tax rate is 16.7 per cent. The marginal tax rate is 30 per cent.

2-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow from Assets Equation: Cash flow from assets = cash flow to debtholders + cash flow to shareholders. The cash flow identity or equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm.

2-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow from Assets The total cash flow from assets consists of: –Operating cash flow—the cash flow that results from day-to-day activities of producing and selling; less –Capital spending—the net spending on non-current assets; less –Additions to net working capital (NWC)—the amount spent on net working capital.

2-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow from Assets Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes. Net capital spending = Ending non-current assets – Beginning non-current assets + Depreciation. Additions to NWC = Ending NWC – Beginning NWC.

2-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow to Debtholders and Shareholders The cash flow to debtholders includes any interest paid less the net new borrowing. The cash flow to shareholders includes dividends paid out by a firm less net new equity raised.

2-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Balance Sheet ($000s) Assets (‘000s) Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ $ $3 220 $ $ $3 690

2-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Balance Sheet ($000s) Liabilities and equity (‘000s) Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ $ 640 $ $2 170 $3 220 $ $ 870 $ $2 370 $3 690

2-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Income Statement ($000s) Sales $ Cost of goods sold Depreciation EBIT $ Interest Taxable income Tax Net profit$ Dividends Addition to retained earnings $200.00

2-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Cash Flow From Assets Operating cash flow: EBIT $ Depreciation – Taxes– $ Change in net working capital: Ending net working capital $ – Beginning net working capital $ Net capital spending: Ending non-current assets $ – Beginning non-current assets – Depreciation $ Cash flow from assets: $ 52.00

2-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Cash Flow to Debtholders and Shareholders Cash flow to debtholders: Interest paid $ – Net new borrowing– 40.00$ 0.00 Cash flow to shareholders: Dividends paid$ – Net new equity raised 0.00$52.00 Cash flow to debtholders and shareholders$52.00

2-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions The book values on an accounting Balance Sheet can be very different from market values. Net profit as it is computed on the Income Statement is not a cash flow, a primary reason being the deduction of depreciation (a non-cash expense). Marginal and average tax rates can be different. However it is the marginal tax rate that is relevant for most financial decisions. Cash flow from assets equals cash flow to debtholders and shareholders. It is important not to confuse book values with market values, and accounting income with cash flow.