Finance and Accounting Lecture 2 Fall, /28/2015FINA4330 Corporate Finance1 Corporate Finance Ronald F. Singer FINA 4330

Financial Statements Generally Finance Professionals get their information from Financial Statements prepared by accountants. In general, Financial Statements are used to determine how the firm “is doing,” in particular, how it has done over some period of time. 11/28/2015FINA4330 Corporate Finance2

Financial Statements Although we are also interested in the financial health of companies; generally, financial statements have to be modified in order to focus on our objective. In general, the “focus of our objective” is cash flow Most corporations prepare three basic financial statements: Income Statement Balance Sheet Cash Flow Statements 11/28/2015FINA4330 Corporate Finance3

Focus of Finance Cash Flow!!! What is Cash Flow? It is the amount of cash generated and available to security holders. 11/28/2015FINA4330 Corporate Finance4

Financial Statements Income Statement: – A Listing of Revenue, Expenses, and Profits over a period of time Balance sheet – A listing of Assets, Liabilities, and Net Worth at a single point in time. Generally in terms of Book Value. Cash Flow Statement – The Flow of Cash over a period of time 11/28/2015FINA4330 Corporate Finance5

Macintosh Enterprises Balance Sheet December 31, 2008 (BV $ thousands) Assets Liabilities and Stockholders Equity Cash 1,000Short-term debt 900 Inventory 500 Accounts payable 600 Accounts Rec. 1,000 Long-term debt 3,000 Plant & equip. 4,000 Other assets 1,000 Stockholders’ Equity ??? Total Assets $7,500 Total Liabilities and Stockholders’ Equity ??? 11/28/2015FINA4330 Corporate Finance6

Macintosh Enterprises Balance Sheet December 31, 2008 (Book value $ thousands) Assets Liabilities and Stockholders Equity Cash 1,000Short-term debt 900 Inventory 500 Accounts payable 600 Accounts Rec. 1,000 Long-term debt 3,000 Plant & equip. 4,000 Other assets 1,000 Stockholders’ Equity 3,000 Total Assets $7,500 Total Liabilities and Stockholders’ Equity $7,500 Number of Shares = 1,000,000 => Book Value /Share = $3 11/28/2015FINA4330 Corporate Finance7

Macintosh Enterprises Pro-Forma Income Statement (Year ending December 31, 2008) ($ thousand) Sales $5,000 Less: Operating Expenses (COGS) 2,000 Depreciation & Amortization 500 Allocated G & A Costs 300 Operating Income (EBIT) $2,200 Less: Interest Expense 770 Earnings Before Tax(taxable income) 1,430 Less Tax 40%) 572 Net Income (Earnings after Tax) $858 Earnings per Share (EPS) = Net Income/Shares = $ /28/2015FINA4330 Corporate Finance8

Transform income statement into Cash Flow Now we are ready to transform this income statement into Cash Flow Adjustments Necessary: 1. Changes in Fixed Assets: Depreciation and Amortization is not a cash expense and thus should not be subtracted from Cash Flow. But, New Investment is a cash expense (when paid for) and should be subtracted. 11/28/2015FINA4330 Corporate Finance9

Transform income statement into Cash Flow 2.Cash Revenue is not the same as Sales. An increase in “Receivables” must be subtracted from Sales to get Cash Revenues. A decrease in “Receivables” must be added to Sales to get Cash Revenues. 11/28/2015FINA4330 Corporate Finance10

Transform income statement into Cash Flow 3.Cost of Goods Sold (COGS) is the DIRECT expense associated with producing the goods that are SOLD in the period. Costs associated with goods that are produced but will be sold in future periods are not counted. If the firm pays for goods THAT ARE NOT SOLD, there is a cash flow out which must be accounted for. In order to account for this, we include changes in Inventory in the Cash Flow statement. 11/28/2015FINA4330 Corporate Finance11

Transform income statement into Cash Flow In general: Increases in Working Capital must be subtracted from Earning to get Cash Flow In this case suppose: Changes in Working Capital (+300) a/c receivable +200 a/c payable +150 Inventory +100 S.term liabil -50 Other S.T.A +100 Total change /28/2015FINA4330 Corporate Finance12

Macintosh Enterprises Pro-Forma Cash Flow Statement (Year ending December 31, 2006) ($ thousand) Earnings Before Interest and Taxes (from Income Statement) $2,200 Less: Tax on Operations 40% (Note: tax rate times EBIT not $572) 880 Operating Income after Tax (EBIT(1-t)) 1,320 Plus: Non-Cash Expenses (Depreciation & Amortization) 500 1,820 Less: increase (decrease) in Working Capital (WC change) increase (decrease) in accounts receivable 200 increase (decrease) in Inventory 100 increase (decrease) in other Short Term Assets 100 increase (decrease) in accounts payable 150 increase (decrease) in Short Term Liabilities (50) Change in Working Capital Free Cash Flow from Operations $1,520 Less: “After Tax” interest payments I(1-t) (note: = 770 (1-.40)) 462 Less: Dividends to preferred stockholders 100 Less: Investment (net of capital gains tax) 400 Free Cash Flow to Common Stockholders 558 EBITDA (2, ) $2,700 13