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					BA 180.02 Corporate Finance



         August 26, 2002
 Today’s Agenda


 Financial Decision Making (brief review)
 Accounting Review
 Introduction to Time Value of Money (as
 time permits)
    What is Finance

Finance is concerned with

• Determining value
• Value = What something is worth now
• Making the best decision when that decision
  involves money
    Corporate Financial Management

• How do we use corporate resources efficiently to
  further the goals of the firm?
• What decisions?
      Three Types of Decisions

• Investment Decisions
  – What assets should the firm invest in?
• Financing Decision
  – How should the purchase of assets be financed?
• Managerial Decisions
  –   How large should the firm be?
  –   How fast should it grow?
  –   Should the firm grant credit to a customer?
  –   How should the managers be compensated?
    ACCOUNTING REVIEW

• Understand the firm’s accounting statements
• Explain the inherent limitations of historical
  accounting information for financial decision
  makings
• Understand key features of corporate income
  taxes
• Why is “Cash Flow” important?
  Key Financial Statements
• Balance Sheet
  – An accountant’s snapshot of the firm’s
    accounting value as of a particular date
     • Records a measure of the value of a firms
       assets
     • “Stock” item (reason for being called snapshot)
• Income Statement
  – Accounting creation to measure performance
  – “Flow” measure over a period of time
• Statement of Cash Flows
  – Cash flows are what we care about in finance
  – Accounting version versus financial version
    Balance Sheet
• Assets                           • Liabilities
  – what the firm owns                – current (< 1 year)
  – listed in decreasing                  • examples:
    liquidity                                 – accounts payable
  – Current assets:                           – notes payable
     • Examples:                      – long-term
           – Cash                         • examples:
           – Account Receivables              – Long-term debt
           – Inventories                        (bonds)
  – Fixed assets:                  • Owner’s Equity
     • Examples:                      – residual claim on firm
           – Plant and equipment        value
           – Trademark
         An Example
                                    U.S. COMPOSITE CORPORATION
                                            Balance Sheet
                                            2002 and 2001
                                             (in $ millions)
                                                                Liabilities (Debt)
               Assets              2002     2001           and Stockholder's Equity          2002     2001
Current assets:                                      Current Liabilities:
 Cash and equivalents               $140    $107      Accounts payable                        $213     $197
 Accounts receivable                 294     270      Notes payable                             50        53
 Inventories                         269     280      Accrued expenses                         223      205
 Other                                58      50         Total current liabilities            $486     $455
    Total current assets            $761    $707
                                                     Long-term liabilities:
Fixed assets:                                         Deferred taxes                          $117     $104
  Property, plant, and equipment     $1,423 $1,274    Long-term debt                           471      458
   Less accumulated depreciation       -550   -460      Total long-term liabilities           $588     $562
  Net property, plant, and equipment    873    814
  Intangible assets and other           245    221   Stockholder's equity:
     Total fixed assets              $1,118 $1,035     Preferred stock                            $39    $39
                                                       Common stock ($1 per value)                  55     32
                                                       Capital surplus                             347    327
                                                      Accumulated retained earnings                390    347
                                                        Less treasury stock                        -26    -20
                                                         Total equity                            $805   $725
Total assets                      $1,879   $1,742    Total liabilities and stockholder's equity $1,879 $1,742
  Accounting Measures

• Purpose of Accounting Statements
  – Attempt to standardize reporting structure what is
    a very complicated set of information
  – Accounting statements follow GAAP
• Accounting earnings are NOT the same as
  economic earnings (cash flows). It is the cash
  flows that are important in finance. Why?
    Book vs. Market Value

• The balance sheet provides the book value
• Market value is the price at which assets,
  liabilities or equity can actually be bought or sold
• Market value and book value are usually
  different
• In finance, the book value is of limited
  importance. Financial decision-making involves
  the use of market value
        A Basic Example:
    Delta Corporation has the following book         Solution:
    values listed on its Balance Sheet: Current
    assets of $100, fixed assets of $500, short-
    term debt of $70, and long-term debt of
    $400. The market values of liabilities are the
    same as their book values. However, market
    value of Net Working Capital is $120 and the
    fixed assets are valued at $800 in the
    market. Compare the book vs. market value
    of the shareholder’s equity item of the
    company.


Note that the Balance Sheet only gives the
  accounting value of the firm. The
  financial manager and outside investors
  are more interested in the market value
  of the company, that is, the true (not
  historical) value of the assets, liabilities,
  and equity.
    Key Terms

• Liquidity – measure of the speed and ease with
  which an asset can be converted to cash.
• Depreciation – method used to spread the
  expense of a durable asset over several periods.
       More on Liquidity

Ability to meet the firm’s short-term obligations
   when they come due.


e.g.    Current Assets   =$376.6
     Current Liabilities =$162.7
Working Capital = Current Assets - Current Liabilities
                = $376.6 - $162.7 = $213.9

Current Ratio    = Current Assets / Current Liability
                 =$376.6/$162.7 = 2.315
    Income Statement

• Reports revenues, expenses, and profit (or loss)
  over a specific interval of time (typically a year
  or a quarter)
• Also reports earnings and dividends on a per
  share basis.
  – Used frequently in measures such as price-
    earnings (P/E) ratios and earnings per share
    (EPS).
  GAAP versus Cash Flow Time Line
                          Revenue
                         recognized
                            and
                          matched
                          Expenses


                       Sale of goods
                         on credit

                                                    Time
 Pay     Payroll     Pay                 Collect
 for raw checks    utilities            accounts
 goods issued                          receivable


Cash flowCash flowCash flow            Cash flow
    Income Statements for the XYZ
    Corporation
                                    1999     1998
Sales                              $546.9   $485.8
 Cost of Goods Sold                $286.3   $247.3
Gross Profit                       $260.6   $238.5
Selling & Admin. Expenses          $188.5   $184.2
Depreciation                        $22.7    $20.1
Operating Profit                    $49.4    $34.2
Non Operating Income                 $2.3     $3.7

Earnings Before Interest & Taxes    $51.7    $37.9
(EBIT)
    Income Statements for the XYZ
    Corporation
                                 1999    1998

EBIT                             $51.7   $37.9
Interest Expense                  $7.7    $8.0
Taxable Income                   $44.0   $29.9
Total Income Tax                 $18.1   $11.9
Net Income                       $25.9   $18.0
Preferred Dividends               $1.0    $1.0


Net Income Available to Common   $24.9   $17.0
Stock
  Income Statements for the XYZ
  Corporation
                                 1999    1998



Net Income Available to Common   $24.9   $17.0
            Common Dividends      $4.5    $3.6
             Retained Earnings   $20.4   $13.4
    Income Statements for the XYZ
    Corporation
                                1999    1998


Per Share Data:
Shares Outstanding (millions)    9.00    9.00
Earnings per Share              $2.77   $1.89
Dividends per Share             $0.50   $0.40
     Payout Ratio                0.18    0.21
    Taxes

• Average Tax Rate
  – Total tax bill divided by your taxable income
  – The percentage of your income that goes to pay
    taxes

• Marginal Tax Rate
  – The rate of the extra tax you would pay if you
    earned one more dollar
    Corporate Income Taxes

• Federal income tax rate increases with the level
  of taxable income.
• Marginal tax rate = tax rate applied to the next
  dollar earned.
• Average tax rate = total taxes paid / taxable
  income
• Progressive tax system:
  – Average tax rate is non decreasing in taxable
    income.
    The Corporate Tax Schedule
  Taxable Income ($)        Marginal Tax Rate
•          0-      50,000        15%
•     50,001 -     75,000        25%
•     75,001 -    100,000        34%
•    100,001 -    335,000        39%
•    335,001 - 10,000,000        34%
• 10,000,001 - 15,000,000        35%
• 15,000,001 - 18,333,333        38%
• 18,333,334 +                   35%
    Corporate Tax Example

Assume taxable income = $160,000

• Total taxes= $50,000 x 15% + $25,000 x 25% +
  $25,000 x 34% + $60,000 x 39%
              = $45,650
• Average tax rate= 45,650/160,000 ≈ 0.285
• Marginal tax rate=39%
    Quick Quiz
The taxable income of LaRussa Corp. is $1,000,000.
   Calculate LaRussa’s (a) dollar tax liability, (b)
   average tax rate, and (c) marginal tax rate.

(a) Dollar tax liability =.15(_______) + .25(_______) +
                          .34(_______) + .39(________) +
                          .34(________) = $ ?

(b) Average tax rate = ________/_________ = ___

(c) Marginal tax rate = ___

Why should financial decision-makers be concerned
   about the firm’s marginal rate? Its average rate?
    Quick Quiz
The taxable income of LaRussa Corp. is $1,000,000.
  Calculate LaRussa’s (a) dollar tax liability, (b) average
  tax rate, and (c) marginal tax rate.

(a) Dollar tax liability = .15($50,000) + .25($25,000) +
  .34($25,000) +.39($235,000) +.34($665,000) = $340,000

(b) Average tax rate = $340,000/$1,000,000 = 34%

(c) Marginal tax rate = 34%

Why should financial decision-makers be concerned about
 the firm’s marginal rate? Its average rate?
    Statement of Cash Flows

• Cash flows are more important than accounting
  earnings in financial valuation.
• Determining what is a cash flow item:
     Is there actually money flowing into or out of
     the firm?
• Depreciation and deferred taxes are two key
  accounting items which are NOT cash flows.
       Cash Flow Summary
• I.   The cash flow identity
       CF from assets = CF to creditors + CF to stockholders

   II.Cash flow from assets
        CF from assets = Operating cash flow – Net capital
                  spending – Additions to NWC
     Operating CF        = EBIT + Depreciation – Taxes
     Net capital spending         = Ending net fixed assets – Beginning
                            net fixed assets + Depreciation
     Change in NWC = Ending NWC – Beginning NWC

  III.Cash flow to creditors
        CF to creditors = Interest paid – Net new borrowing

  IV.Cash flow to stockholders
       CF to stockholders = Dividends paid – Net new equity raised
    Sources of Information

• Annual reports
• The Wall Street Journal
• Internet
  – NYSE (www.nyse.com)
  – Nasdaq (www.nasdaq.com)
  – Text (www.mhhe.com/cj)
• SEC
  – EDGAR
  – 10K & 10Q reports
  TIME VALUE OF MONEY

A dollar today is worth more than a dollar in the
future
      1. Introduction

• The time value of money is another way of saying a dollar today is
  worth more than a dollar tomorrow. In other words, interest rates are
  positive. Why?
• Why does money have a time value?
   – Postponement of consumption
   – Expectation of inflation
• The combination of these two factors gives rise to interest rates
• In many financial securities there is also the risk of default
• Riskier securities offer higher interest rates than safe securities, all
  else equal
• For now, we will take the interest rate (rate of return) as given.
     Compounding
• General Formula:
• The general formula for calculating the future value of
  cash flows after t periods is:
• FV = PV*(1+r)t
• Note that there are four variables in the equation:
• PV – present value
• FV – future value
• r – rate of interest per period
• t – number of periods
• We can solve for any one of these four variables given
  values for the other three.
   Next Class

• Read Chapter 5

				
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