1. Financial Statements, Cash Flow, and Taxes
Chapter 2
Financial Statements, Cash Flow, and Taxes

2. Topics in Chapter Read the following sections:
2-1: Financial Statements and Reports
2-2: The Balance Sheet
2-3: The Income Statement

3. Determinants of Intrinsic Value: Calculating FCF
Sales revenues −
Operating costs and taxes −
Required investments in operating capital
Free cash flow
(FCF) =
FCF1
FCF2
FCF∞
...
Value =
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Firm’s debt/equity mix
Cost of debt
Cost of equity
Market risk aversion
Firm’s business risk

4. 2-1 Financial Statements and Reports
A company’s annual report consists of:
Management discussion;
Four basic financial statements:
the balance sheet
the income statement
the statement of stockholders’ equity
the statement of cash flows
The quantitative and qualitative written materials are equally important:
The financial statements report what have actually happened whereas the written materials attempt to explain why things turned out the way they did.

5. 2-2 The Balance Sheet
The balance sheet is a “snapshot” of the firm’s financial position on a particular date.
Please see Figure 2-1 on P59 in the textbook for an example.
The balance sheet identity:
Assets = Liabilities + Stockholders’ Equity

6. 2-2a The Balance Sheet: Assets
Assets (millions)
2016
2015
Cash & equivalents $ $
S-T investments - 40
Accounts receivable
500
380
Inventories
1,000
820
Total current assets
$ 1,550
$ 1,300
Net fixed assets
2,000
1,700
Total assets
$3,550
$3,000

7. 2-2a Assets
Current assets have a life of less than one year, such as cash, short-term investments, accounts receivable, and inventories.
Fixed assets have a relatively long life, including tangible and intangible assets.
Assets are listed in order of decreasing “liquidity”, i.e. the length of time it typically takes to convert them to cash at fair market values.

8. 2-2b The Balance Sheet: Liabilities & Equity
Liabilities and Equity (millions)
2016
2015
Accounts payable
$ 200
$ 190
Notes payable
280
130
Accruals
300
Total current liabilities
780
600
Long-term debt
1,200
1,000
Total liabilities
$1,980
$1,600
Preferred Stock
100
Common Stock
500
Retained earnings
970
800
Total common equity
$1,470
$1,300
Total liabilities & equity
$3,550
$3,000

9. 2-2b Liabilities & Equity
Current liabilities have a life of less than one year, such as accounts payable, notes payable, and accrued expenses.
Long-term liabilities are liabilities that are not due in the coming year.
Liabilities represent claims that various groups have against the company’s value and are listed in the order in which they must be paid.
Stockholders’ equity is residual claim which is the difference between the total value of the assets and the total value of liabilities: it represents ownership and need never be “paid off”.

10. 2-3 The Income Statement
The income statement summarizes a firm’s performance over a period of time: it’s like a video recording covering the period between before and after pictures.
Please see Figure 2-2 on P63 in the textbook for an example.
The Income Statement Equation:
Revenues – Expenses = Net Income/Earnings/Profit

11. MicroDrive’s Income Statements
Income Statement (millions)
2016
2015
Net sales revenue
$5,000
$4,760
COGS except Depreciation
3,800
3,560
Depreciation & amortization
200
170
Other operating expenses
500
480
EBIT
$500
$550
Interest expense
120
100
Pre-tax earnings (EBT)
$380
$450
Taxes (40%)
152
180
Net income before preferred div. $
$ 270
Preferred dividends 8
NI available to common shareholders
$ 220
$ 262

12. Some Jargons and Acronyms:
Top Line: sales (revenue)
Bottom Line: net income/earnings/profit
EPS: earnings per share
DPS: dividend per share
BVPS: book value per share
PPS: market price per share