1. FIN 422: Student Managed Investment Fund
Topic 8: Financial Statements 
Larry Schrenk, Instructor

2. Overview Balance Sheet Income Statement Statement of Cash Flows
Examples

3. Readings Damodaran. Investment Philosophies, Chapter 3
Damodaran. Investment Valuation, Chapter 3
Koller, Goedhart, and Wessels. Valuation, Chapter 9

4. 1. Balance Sheet

5. Questions

6. Basic Financial Statements

7. Accounting Balance Sheet

8. Principles of Accounting Balance Sheet

9. Measuring Asset Value

10. Financial Balance Sheet

11. 2. Income Statement

12. Income Statement

13. Principles of Accounting Income Statement

14. Measuring Accounting Profitability

15. Measuring Financial Leverage

16. Accounting Inconsistencies

17. Capitalizing vs. Expensing Costs
An expenditure is either i) capitalized as a cost of the asset on the balance sheet or ii) expensed on the income statement
Expenses are matched with revenue in same time period
Capital expenditures are depreciated

18. Operating vs Capital Leases
Advantages of an Operating Lease
Operating leases provide much-needed flexibility to companies that frequently update or replace their equipment.
The lessee is protected from the risk of obsolescence.
Accounting is simpler: the asset does not have to be included in the balance sheet. The corresponding debt liability does not have to be calculated or included.
Lease payments are operational expenses, so they are fully tax deductible.
It provides improved Return on Asset (ROA) without capital budgeting restraints.
Advantages of a Capital Lease
Capital leases recognize expenses sooner than equivalent operating leases. The lessee is allowed to claim depreciation each year on the asset.
In addition to depreciation, the interest expense component of the lease payment can also be deducted as an operational expense.

19. Operating vs Capital Leases: Comparison Chart
Operating Lease
Lease criteria -
Ownership
Ownership of the asset might be transferred to the lessee at the end of the lease term.
Ownership is retained by the lessor during and after the lease term.
Bargain
Purchase Option
Bargain purchase option to buy the equipment at less than fair market value.
No bargain purchase option.
Term
Term > 75% of the estimated economic life
Term < 75 percent of the estimated economic life
Present Value
PV of lease payments > 90% of the original cost
PV of lease payments < 90% of the original cost
Risks and
Benefits
Transferred to lessee. Lessee pays maintenance, insurance and taxes
Right to use only. Risk and benefits remain with lessor. Lessee pays maintenance costs
Accounting
Lease is an asset and liability; payments on balance sheet
Payments are operating expenses and on Profit
and Loss statement
Tax
Lessee claims depreciation expense and interest expense
Lease payment is a rental expense

20. Dealing with Operating Lease Expenses

21. Effects of Capitalizing Operating Leases

22. Capitalizing Operating Leases
Debt Value of Operating Leases = PV(Operating Lease Expenses) discounted at the cost of debt
Amortization
Adjusted Operating Income = Operating Income + Operating Lease Expense – Depreciation on Leased Asset

23. Capitalizing Operating Leases: Data
A firm has an operating lease with the expenses below. The pre-tax cost of debt is 5.48%. Its EBIT is $10, and debt is $25,
Year CF
2,500.00 1
2,000.00 2 3 4
1,800.00 5
1,600.00 6+

24. Capitalizing Operating Leases: Converting Operating Lease to Debt
Notes:
Discount rate is 5.48%
The year 6+ cash flows are modelled as a ten year annuity.
Year CF PV 1
2,000.00
1,896.09 2
1,797.59 3
1,704.20 4
1,800.00
1,454.09 5
1,600.00
1,225.38 6+
5,371.39
Debt Value =
13,448.73

25. Capitalizing Operating Leases: Restated Financials
Operating Income with operating leases reclassified as debt = $25, , = $38,448.73
Operating Income Adjustment
Operating Income $10,000.00
+ Current Year’s Lease Expense 2,500.00
- Depreciation on Leased Expense 1,494.30
Adjusted Operating Income $11,005.70

26. R&D Expenses: Operating or Capital Expenses

27. Effects of Capitalizing R&D

28. Capitalizing R&D Determine amortizable life of R&D
Collect past R&D expenses over amortizable life
Sum up unamortized R&D over the period

29. Capitalizing R&D: Data
A firm has past R&D with the expenses below. This year’s R&D expense is $1, and the tax rate is 35%.
Year CF -1 -2
698.00 -3
399.00 -4
211.00 -5
89.00

30. Capitalizing R&D: Converting R&D
Year
R&D Expense
Unamortized Portion
This Year’s Amortization
1,594.90
1.00
1,594.00 -1
0.80
820.80
205.20 -2
698.00
0.60
418.80
139.60 -3
399.00
0.40
159.60
79.80 -4
211.00
0.20
42.20 -5
89.00
0.00
17.80
Value of R&D
3,035.40
484.60
Amortization of Asset for Current Year = $ (5-year, straight line)
Adjustment to Operating Income = 1, – = $1,109.40
Tax Effect of R&D Expensing = 1, x 0.35 = $388.00

31. 3. Statement of Cash Flows

32. Statement of Cash Flows

33. Valuation Cash Flows