CH 3 PPT

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Created by
Babu G. Baradwaj, Ph.D
Lawrence L. Licon, Ph.D
Chapter 3 Financial Statements, Cash Flows, and Taxes
Copyright 2008 John Wiley & Sons
CHAPTER 3
Financial Statements,
Cash Flows, and Taxes
Quick Links
Financial Statements and Accounting Principles
The Balance Sheet
Market Value vs. Book Value
The Income Statement
Statement of Retained Earnings
Cash Flows
Federal Income Tax
Exhibits
Financial Statements and

Accounting Principles
Annual Reports
Annual Report Used by
management to communicate with

firms shareholders and public
Annual Report comprised of three
sections:
financial summary related to the
past years performance
information about the company, its
products, and its activities
audited financial statements
4
including historical
financial data

Generally Accepted Accounting Principles (GAAP)
These are accounting rules and
standards that companies need to

adhere to when they prepare financial
statements and reports.
Prepared by the Financial Accounting
Standards Board (FASB) and authorized
by the SEC.

Five Important Accounting Principles
The Assumption of Arms Length Transaction:
Two parties involved in an economic

transaction arrive at a decision
independently and rationally.
The Cost Principle:
Transactions are recorded at the cost

at which they occurred.

Five Important Accounting Principles
The Realization Principle:
Revenue is recognized when transaction

is completed, while cash may not be
collected until a later time.
The Matching Principle:
Expenses related to generating any

revenue are matched.
The Going Concern Assumption:
It is assumed that a company will continue
to operate for the predictable future.

International GAAP
Uniform accounting rules and procedures
promoted by the International Accounting

Standards Board.
All European Union firms required to
comply with International Accounting

Standards (IAS) since 2007
SEC does not recognize IAS, and requires
foreign firms listed on U.S. stock

exchanges to use U.S. GAAP

Criticisms of U.S. GAAP
It is too complicated and detail oriented,
and leaves no room for accountants to

use their judgment.
It can easily be circumvented by sharp
financial managers and accountants.
The Balance Sheet

This financial statement identifies all the assets and
liabilities of a firm at a point in time.
Left side of the balance shows all assets
the firm owns and uses to generate

revenues
Right side represents the liabilities of the
firm money that the firm has borrowed

from both creditors and shareholders
Go to Exhibit 3.1
10
The Balance Sheet

Balance sheet also lists the capital raised from
its shareholders.
Assets listed in order of their liquidity

Liabilities listed in order in which they must be
paid
Shareholders of the firms common equity are
listed last
Will be paid with whatever remains after
paying all other suppliers of funds
11
The Balance Sheet

Current Assets and Liabilities
Current assets include all assets likely to be
converted to cash within a year (or within an

operating cycle)
These include cash and marketable
securities, accounts receivables, and

inventory
12
The Balance Sheet

Current Assets and Liabilities
Current Liabilities include all liabilities that
have to be paid within a year

Bank loans and other borrowings with
less than a years maturity, accounts
payables, accrued wages and taxes
Net Working Capital = Difference between
amount of current assets and current

liabilities
13
The Balance Sheet

Inventory Accounting
Inventory (least liquid of current assets)
reported in one of two ways on balance sheet

FIFO (First in first out) refers to practice of
recognizing a sale as being made up of

inventory purchased earlier and having
lowest cost
LIFO (Last in last out) calls for firm to
attribute any sale made to the most recently

acquired and most expensive inventory
14
The Balance Sheet

Inventory Accounting
FIFO reporting leads to higher current asset
value and higher net income.
Firms may switch from one to another only
under extraordinary circumstances and not

frequently.
15
The Balance Sheet

Long-Term Assets
Real assets firm acquires to produce its
products and generate cash flows

Land, buildings, plant and equipment.
Intangible assets also listed here

Goodwill, patents, copyrights, etc.
16
The Balance Sheet

Long-Term Assets
All long-term real assets are depreciated

Intangible assets are amortized
Depreciating assets allow a firm to lower
taxable income and reduce taxes
Firms are allowed to depreciate assets
using straight line method or accelerated

depreciation method allowed by IRS
17
The Balance Sheet

Long-Term Liabilities
Long-term debt of the company

Including bank loans, mortgages, and bonds
with a maturity of one year or longer
18
The Balance Sheet

Equity There are two sources of equity funds:
Common Equity:
Common equity represents the true

ownership of the firm.
Preferred Equity:
The other source of equity capital is
preferred stock
Has features that make it a
combination of a fixed income security
and an equity security.
19
The Balance Sheet

More Balance Sheet Accounts
Retained earnings:
Results from funds the firm has
reinvested from its earnings

These funds are not cash- they already
have been put to work
Treasury stock:
This account reflects the value of the
shares that the firm has repurchased
from investors
20

Asset Valuation
All assets are traditionally reported at their
historical costs
Balance sheet does not reflect current
market value of the assets - only their
acquired costs
21

Asset Valuation
Better information is provided to management
and investors by adopting a marking to market
approach - reporting assets at their current
market value.
Downside is the difficulty in estimating market
values of assets
When both liabilities and assets are
reported at their current market values,

their difference represents true market
value of shareholders equity
22

The Income Statement: Overview
Measures the profitability of a firm for any
reporting period
Revenues represent value of products and
services sold by firm - include both cash and
credit sales.
Expenses range from cost of producing
goods for sale and asset utilization costsdepreciation or amortization.
Net income = Difference between the firms
revenues and expenses.
23
Go to Exhibit 3.2

The Income Statement: Depreciation
The cost of any physical asset, such as plant
or machinery, is written off over its lifetime. This
is called depreciation and is a non cash
expense.
Firms use one of these for depreciating
an asset:
Straight line method
Accelerated depreciation method
Firms allowed to use one for internal purposes
and another for tax purposes
24

The Income Statement: Amortization
Amortization expenses are related to the
writing off of the value of intangible

assets, such as:
Goodwill, Patents, Licenses, etc.
It is also a noncash expense like depreciation
25

Nonrecurring and Extraordinary Items
Nonrecurring expenses are associated with
the closing down of unprofitable operations,

or restructuring of a firms operations.
Extraordinary Items refer to income or
expenses associated with events that are

not expected to happen on a regular basis.
26

Bottom Line Accounts
Earnings before interest, taxes, depreciation and
amortization (EBITDA)
earnings generated from operations prior to
payment of expenses not directly connected
to production of products
After netting out the expenses related to
depreciation and amortization, we arrive at

earnings before interest and taxes (EBIT).
27

Bottom Line Accounts
Earnings before taxes (EBT) represents the
taxable income for the period
Subtracting taxes from EBT yields net
income or net income after taxes

This amount tells us amount available to
management to pay dividends, pay off
debt, or reinvest in firm
28
Statement of Retained Earnings

This financial statement shows the
changes in this account (Retained

Earnings) from one period to the next.
This account will show changes whenever
a firm reports a loss or profit and when a

cash dividend is declared.
Go to Exhibit 3.3
29
Cash Flows
Net Cash Flow versus Net Income
While accountants focus on net income,
shareholders would be more interested

in net cash flows.
These two are not the same, because of
the presence of noncash revenues and

expenses.
30
Cash Flows
Cash Flow Statement
Helps to measure cash outflows and cash
inflows generated during any period
Indicates cash flows resulting from:

operating activities, investing activities,
and financing activities
Sum of cash flows measures net cash
flows of firm during a given period

It is the bottom line of this financial
statement
Go to Exhibit 3.4
31
Cash Flows
Operating Activities
Cash inflows result from producing and
selling goods and services
Cash outflows are tied to the purchase of
raw materials, inventory, salaries and

wages, utilities, rent, interest and other
related expenses.
Go to Exhibit 3.5
32
Cash Flows
Investing Activities
Cash inflows and outflows arise out of the
acquisition and selling of real assets

necessary to operate the business
Investing activities.
Also result from:

buying and selling of financial assets
(bonds, stocks)
Making and collecting loans
Selling and settling insurance contracts
33
Cash Flows
Financing activities
Cash Inflows- when a firm issues debt or equity
securities, or borrows money from banks or

other lenders
Cash Outflows- if they pay interest or
dividends on the investors funds, or pay

off debt or purchase treasury stock
34
Federal Income Tax

Corporate Income Tax Rates
It is a progressive tax schedule with rates
ranging from 15 percent to 39 percent

the higher a firms taxable income, the
higher the tax liability
Go to Exhibit 3.6
35
Federal Income Tax

Average versus Marginal Tax Rates
Average tax rate = total taxes paid divided
by taxable income for the period
Marginal tax rate = tax rate paid on the
last dollar earned or the next dollar earned
36
Federal Income Tax

Dividends and interest payments
Current U.S. tax code allows interest
payments on debt issued by firms to be tax

deductible
Dividends paid on firms preferred stock or
common stock are not deductible for tax

purposes- they are paid from after-tax
income
The result is a lower cost of debt financing
relative to the cost of equity financing
37
Exhibit 3.1: Diaz Mfg. Balance

Sheets
38
Exhibit 3.2: Diaz Mfg. Income

Statements
39
Exhibit 3.3: Diaz Mfg Statement of

Retained Earnings
40
Exhibit 3.4: Diaz Mfg Statement of

Cash Flows
41
Exhibit 3.5: Interrelations among

the Financial Statements
42
Exhibit 3.6: Corporate Tax Rates

for 2007
43

CH 3 PPT

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Fundamentals of Corporate

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

Copyright 2008 John Wiley & Sons

Financial Statements and

management to communicate with

Financial Statements and

These are accounting rules and

standards that companies need to

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

Financial Statements and

The Assumption of Arms Length Transaction:

Two parties involved in an economic

Transactions are recorded at the cost

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

Financial Statements and

The Realization Principle:

Revenue is recognized when transaction

Expenses related to generating any

Copyright 2008 John Wiley & Sons

Financial Statements and

Uniform accounting rules and procedures

promoted by the International Accounting

All European Union firms required to

comply with International Accounting

SEC does not recognize IAS, and requires

foreign firms listed on U.S. stock

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

Financial Statements and

It is too complicated and detail oriented,

and leaves no room for accountants to

It can easily be circumvented by sharp

financial managers and accountants.

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

The Balance Sheet

the firm owns and uses to generate

Right side represents the liabilities of the

firm money that the firm has borrowed

Copyright 2008 John Wiley & Sons

The Balance Sheet

Assets listed in order of their liquidity

Shareholders of the firms common equity are

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

The Balance Sheet

Current assets include all assets likely to be

converted to cash within a year (or within an

securities, accounts receivables, and

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons

The Balance Sheet

Current Liabilities include all liabilities that

have to be paid within a year

Net Working Capital = Difference between

amount of current assets and current

Chapter 3 Financial Statements, Cash Flows, and Taxes

Copyright 2008 John Wiley & Sons