1. Accounting and Finance
Chapter 3
Accounting and Finance
Topics Covered
3.1 The Balance Sheet
3.2 The Income Statement
3.3 The Statement of Cash Flows
3.4 Accounting Practice & Malpractice (Excluded)
3.5 Taxes

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

3. Balance Sheet
PepsiCo Balance Sheet (December 31, 2006) $Millions

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. The Balance Sheet Common-Size Balance Sheet
All items in the balance sheet are expressed as a percentage of total assets. 3

6. Common Size Balance Sheet

7. Market Value vs. Book Value
Book Values are determined by GAAP
Market Values are determined by current values
Generally Accepted Accounting Principles (GAAP)
Procedures for preparing financial statements.
Equity and Asset “Market Values” are usually higher than their “Book Values” 6

8. 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

9. 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

10. 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

11. Pepsico Income Statement (year end 2006)
The Income Statement
Pepsico Income Statement (year end 2006)
Net Sales ,753
COGS ,762
Selling, Gen.&Admin. expenses ,530
Depreciation expense ,406
EBIT ,055
Net interest expense
Taxable Income 6,989
Income Taxes 1,347
Net Income 5,642 13

12. The Income Statement Earnings Before Income & Taxes (EBIT)
EBIT = Total Revenues - costs – deprecation
= 35,753 – 27,292 – 1,406
= $ 7,055 million 12

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

14. Cash Flows Free Cash Flow (FCF) FCF = EBIT - taxes + depreciation
Cash available for distribution to investors after firm pays for new investments or additions to working capital
FCF = EBIT
- taxes + depreciation
- change in net working capital
- capital expenditures

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 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

20. Personal Tax Rates

21. Personal Tax Rates Ex: If your total income is $40,000,
What is your tax bill according to the marginal tax rates?
What is your average tax rate?
a. Tax bill= (0.1x8025)+[0.15x( )]+
[0.25x( )]=$
b. Average tax rate = Tax Bill / Total Income
= / 40000=0.159=15.9%