1. Copyright © 2006 McGraw Hill Ryerson Limited3-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

2. Copyright © 2006 McGraw Hill Ryerson Limited3-2 Chapter 3 Accounting and Finance The Balance Sheet The Income Statement The Statement of Cash Flows Taxes

3. Copyright © 2006 McGraw Hill Ryerson Limited3-3 The Balance Sheet Financial statement which shows the value of the firm’s assets and liabilities at a particular time.

4. Copyright © 2006 McGraw Hill Ryerson Limited3-4 The Balance Sheet Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity =

5. Copyright © 2006 McGraw Hill Ryerson Limited3-5 The Balance Sheet Structure of the Balance Sheet

6. Copyright © 2006 McGraw Hill Ryerson Limited3-6 The Balance Sheet Current Assets  These are the most liquid assets  These could be:  Cash and Marketable Securities  Accounts Receivable  Inventories  Other Current Assets

7. Copyright © 2006 McGraw Hill Ryerson Limited3-7 The Balance Sheet Non-Current Assets  Long-term assets which are unlikely to be turned into cash soon  These could be:  Net Fixed Assets  Intangible Assets  Other Assets

8. Copyright © 2006 McGraw Hill Ryerson Limited3-8 The Balance Sheet Net Fixed Assets  Long lived assets such as buildings, plant, equipment etc.  Also called fixed assets.  Shown on the Balance Sheet at their original cost net of accumulated depreciation.

9. Copyright © 2006 McGraw Hill Ryerson Limited3-9 The Balance Sheet Intangible Assets  Long lived assets such as brand names, patents, copyrights, manpower etc.  These assets have no physical reality, and are thus called intangible assets.

10. Copyright © 2006 McGraw Hill Ryerson Limited3-10 The Balance Sheet Liabilities  L iabilities represent money owed by the firm to its creditors.  These could be:  Current Liabilities  Long Term Debt  Other Long-Term Liabilities

11. Copyright © 2006 McGraw Hill Ryerson Limited3-11 The Balance Sheet Liabilities  Current liabilities are short term obligations which are likely to be paid off rapidly.  Example: Bank debt and accounts payable.  Long term liabilities represent debts that come due after the end of the year.  Example: Long-term debt

12. Copyright © 2006 McGraw Hill Ryerson Limited3-12 The Balance Sheet Shareholders’ Equity  What is left over after all of firm’s obligations (liabilities) have been paid off belongs to the shareholders, and is called shareholders’ equity.  This can be:  Capital  Retained earnings

13. Copyright © 2006 McGraw Hill Ryerson Limited3-13 The Balance Sheet Shareholders’ Equity  Capital represents amounts raised from the sale of the company’s shares to investors.  Retained earnings represents earnings which the management has retained and reinvested in the firm.

14. Copyright © 2006 McGraw Hill Ryerson Limited3-14 Book Value vs Market Value Book Value and Market Value  Book value is determined by GAAP  Market value is the price at which the firm can resell an asset  Typically, market value ≠book value

15. Copyright © 2006 McGraw Hill Ryerson Limited3-15 Book Value vs Market 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. What is the market value of your assets?

16. Copyright © 2006 McGraw Hill Ryerson Limited3-16 Book Value vs Market Value Example Assets= Liabilities + Equity  A ssets = $4 bn + $7.5 bn = $11.5 bn

17. Copyright © 2006 McGraw Hill Ryerson Limited3-17 Market Value vs. Book Value Book Value Balance Sheet Assets = $10 bn Debt = $4 bn Equity = $6 bn Market Value Balance Sheet Assets = $11.5 bn Debt = $4 bn Equity = $7.5 bn

18. Copyright © 2006 McGraw Hill Ryerson Limited3-18 The Income Statement Financial statement which shows the revenues, expenses and net income of a firm.

19. Copyright © 2006 McGraw Hill Ryerson Limited3-19 The Income Statement Structure of the Income Statement

20. Copyright © 2006 McGraw Hill Ryerson Limited3-20 Statement of Cash Flows Financial statement which shows a firm’s cash receipts and cash payments over a period of time.  Note that the Income Statement shows the firm’s accounting profits not its cash flows

21. Copyright © 2006 McGraw Hill Ryerson Limited3-21 Statement of Cash Flows Profit vs. Cash Flows  “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

22. Copyright © 2006 McGraw Hill Ryerson Limited3-22 Statement of Cash Flows The Statement of Cash Flows is divided into three sections:  Cash flow from operating activities  Cash flow from investing Activities  Cash flow from Financing Activities

23. Copyright © 2006 McGraw Hill Ryerson Limited3-23 Statement of Cash Flows Structure of the Statement of Cash Flows

24. Copyright © 2006 McGraw Hill Ryerson Limited3-24 Taxes Corporate Taxes  Corporate tax = Federal tax + Provincial tax  The federal tax rate is 22.12%  13.12% for small businesses  Provincial taxes vary across the country

25. Copyright © 2006 McGraw Hill Ryerson Limited3-25 Taxes Consequences of Deducting Interest  Interest paid by a corporation is a tax deductible expense.  Note that dividends are not.  Thus, interest payments increase the amount of money available to creditors and shareholders.

26. Copyright © 2006 McGraw Hill Ryerson Limited3-26 Taxes Example  Firm A and Firm B both have EBIT of $100  Both pay taxes at 35%  Firm A has debt and pays $40 in interest  Firm B has no debt and pays no interest Create an income statement for these firms and calculate their net income.

27. Copyright © 2006 McGraw Hill Ryerson Limited3-27 Taxes Consequences of Deducting Interest Firm AFirm B EBIT$100$100 Less: Interest 40 0 Pretax Income60100 Less: Taxes (35%) 21 35 Net Income$ 39$ 65

28. Taxes Government’s share (taxes)Stakeholder’s share (interest + net income) Distribution of EBIT: Government’s share + (Creditor’s Share + Shareholder’s Share) Firm B= $35 + ($0 + $65) = $35 + 65 = $100 $21 $79 FIRM A $35 $65 FIRM B Firm A= $21 + ($40 + $39) = $21 + $79 = $100

29. Copyright © 2006 McGraw Hill Ryerson Limited3-29 Taxes Definitions  Marginal Tax Rate - tax paid on each extra dollar of income.  Average Tax Rate - total tax bill divided by total income.

30. Copyright © 2006 McGraw Hill Ryerson Limited3-30 Taxes Personal Taxes  For individual taxpayers, federal and provincial taxes are calculated separately.  Taxes for individuals are progressive.  Dividends are effectively taxed at a lower rate than interest income.

31. Copyright © 2006 McGraw Hill Ryerson Limited3-31 Summary of Chapter 3  Investors and other stakeholders need regular financial information to monitor a firm’s progress.  They find this information on the:  Balance Sheet  Income Statement  Statement of Cash Flows

32. Copyright © 2006 McGraw Hill Ryerson Limited3-32 Summary of Chapter 3  Assets are recorded on the Balance Sheet at book value.  Book value does not equal market value!  Accounting income on an Income Statement is not the same as a firm’s cash flows.

33. Copyright © 2006 McGraw Hill Ryerson Limited3-33 Summary of Chapter 3  Taxes have a major impact on financial decisions.  In Canada, both corporations and individuals must pay taxes on their earnings.