1. Accounting and Finance
Fundamentals of
Corporate Finance
Fourth Edition
Chapter 3
Accounting and Finance
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 1 1 1 1 1 2

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

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

4. 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

5. Market Value vs. Book Value
Book Values are determined by GAAP
Market Values are determined by current values
Equity and Asset “Market Values” are usually higher than their “Book Values” 6

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

7. 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

8. 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

9. The Income Statement Earnings Before Income & Taxes (EBIT)
EBIT = - total Revenues
- costs
- deprecation 12

10. Pepsico Income Statement (year end 2001)
The Income Statement
Pepsico Income Statement (year end 2001)
Net Sales ,935
COGS ,754
Other Expenses
Selling, G&A expenses ,526
Depreciation expense ,082
EBIT ,181
Net interest expense
Taxable Income 4,029
Income Taxes 1,367
Net Income 2,662 13

11. 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

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

13. The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year end 2001)
Net Income 2,662
Non-cash expenses
Depreciation 1,082
Other
Changes in working capital
A/R=7 A/P=(236) Inv=(75) other= ,539
Cash Flow from operations 4,201
Cash Flow from investments (2,637)
Cash provided by financing (1,919)
Net Change in Cash Position (355) 18

14. Accounting Practice Stock options Allowance for bad debts
Revenue recognition 19

15. 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

16. 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
EBIT 100
Interest 40
Pretax Income 60
Taxes (35%) 21
Net Income
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
Interest
Pretax Income
Taxes (35%)
Net Income 23

17. 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
Interest
Pretax Income
Taxes (35%)
Net Income ? 24

18. 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 ?
+ Interest
Net Cash Flow 26

19. Corporate Tax Rates (2002)

20. Personal Tax Rates (2002)

21. Web Resources Web Links www.ibm.com/investor/financialguide
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