The topics discussed in this chapter are financial statements, taxes and cash flow. On completion of this chapter students will: Know the difference between book value and market value, know the difference between accounting income and cash flow, know the difference between average and marginal tax rates, know how to determine a firm’s cash flow from its financial statements.
Financial statements, taxes and cash flow Chapter Key concepts and skills • Know the difference between book value and market value • Know the difference between accounting income and cash flow • Know the difference between average and marginal tax rates • Know how to determine a firm’s cash flow from its financial statements Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-2 Chapter outline • The balance sheet • The income statement • Taxes • Cash flow Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-3 The balance sheet • The balance sheet is a snapshot of a firm’s assets and liabilities at a given point in time • Assets: The left-hand side: − Current or fixed − In order of decreasing liquidity • Liabilities and owners’ equity: The right-hand side: – Current or long term – In ascending order of when due to be paid • Balance sheet identity Assets = Liabilities + Shareholders’ equity Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-4 The balance sheet (cont.) Figure 2.1 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-5 The balance sheet (cont.) • Net working capital – Current assets minus current liabilities – Usually positive for a healthy firm • Liquidity − Speed and ease of conversion to cash without significant loss of value − Valuable in avoiding financial distress • Debt versus equity − Shareholders’ equity = Assets - Liabilities Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-6 Oz Company balance sheet Table 2.1 Visit au.finance.yahoo.com for more financial statements and balance sheets Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-7 Market value vs book value • Market value is the price at which assets, liabilities or equity can actually be bought or sold • The balance sheet provides the book value of assets, liabilities and equity • Market value and book value are often very different Why? • Which is more important to the decision-making process? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-8 Battler Company Example 2.2 Battler Company Balance sheets Book value versus market value Book Market Assets NWC 400 NFA 700 $1 100 Book Market Liabilities and Shareholders’ equity 600 LTD 000 SE $1 600 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 500 500 600 100 $1 100 $1 600 2-9 The income statement • The income statement measures performance over a specified period of time (period, quarter, year) • Report revenues first and then deduct any expenses for the period • End result = Net income = ‘Bottom line’ – Dividends paid to shareholders – Addition to retained earnings • Income statement equation: Net income = Revenue - Expenses Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-10 Example: Marginal vs average tax rates • Bony Bushman has a taxable income in Australia of $96 000 – What is his tax bill? – What is his average tax rate ? – What is his marginal tax rate? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-17 Example: Marginal vs average tax rates Personal tax rate Taxable income Rate $0-6000 Nil 6001-35000 15% 35001-80000 30% 80001-180000 38% 18000145% Total Tax calculation Taxable income Tax liability 6000 29000 4350 45000 13500 16000 6080 96000 Average tax rate Marginal tax rate Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 23930 24.9270833% 38% 2-18 Taxation of dividends: An imputation system • Major effect is that the double taxation of company profits is negated • Company advises the shareholder of the amount of company tax already paid on the dividend • Shareholder then adds this amount of tax to the cash dividend that they have received and pays personal tax on the grossed-up amount • Shareholder receives a tax (franking) credit equivalent to the amount of tax paid by the company Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-19 Effect of a $700 dividend fully franked at 30% tax rate—Example 2.5 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-20 Cash flow • Cash flow is some of the most important information that a financial manager can derive from financial statements • The difference between the number of dollars that come in and the number that go out • The statement of cash flows does not provide us with the same information that we are looking at here • Cash flow identity Cash flow from assets = Cash flow to creditors + Cash flow to shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-21 Cash flow (cont.) • Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital • Operating cash flow – Cash generated from a firm’s normal business activities • Capital spending – Money spent on fixed assets less money received from the sale of fixed assets • Change in net working capital – Net increase in current assets over current liabilities Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-22 Cash flow (cont.) • Free cash flow – Different from cash flow from assets – Cash that the firm is free to distribute to creditors and shareholders because it is not needed for working capital or fixed asset investments • Cash flow to creditors – A firm’s interest payments to creditors less net new borrowings • Cash flow to shareholders – Dividends paid out by a firm less net new equity raised Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-23 OZ Company example • OCF (I/S) = EBIT + Depreciation – Taxes = $547 • NCS (B/S and I/S) = Ending net fixed assets – Beginning net fixed assets + Depreciation = $130 • Changes in NWC (B/S) = Ending NWC – Beginning NWC = $330 • CFFA = 547 – 130 – 330 = $87 • CF to creditors (B/S and I/S) = Interest paid – Net new borrowings = $24 • CF to stockholders (B/S and I/S) = Dividends paid – Net new equity raised = $63 Copyright © 2011 McGraw-Hill Australia Pty Ltd • CFFA = 24 + 63 = $87 PPTs t/a Essentials of Corporate Finance 2e by Ross et al 2-24 Slides prepared by David E Allen and Abhay K Singh Cash flow summary Table 2.5 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-25 Quick quiz • What is the difference between book value and market value? – Which should we use for decision-making purposes? • What is the difference between accounting income and cash flow? – Which we need to use when making decisions? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-26 Quick quiz (cont.) • What is the difference between average and marginal tax rates? – Which should we use when making financial decisions? • How we determine a firm’s cash flows? – What are the equations and where we find the information? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-27 Apple Isle example Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-28 Apple Isle (cont.) Operating cash flow Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-29 Apple Isle (cont.) Cash flow from assets, cash flow to stockholders and creditors Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-30 Chapter END 2-31 ... PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 2-22 Cash flow (cont.) • Free cash flow – Different from cash flow from assets – Cash. .. David E Allen and Abhay K Singh 2-21 Cash flow (cont.) • Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital • Operating cash flow – Cash generated... at here • Cash flow identity Cash flow from assets = Cash flow to creditors + Cash flow to shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e