HIGH Lighted in BOLD

HIGH Lighted in BOLD

· Ch. 2: Questions 4 & 9 (Questions and Problems section): Microsoft® Excel® template provided for Problem 4.         attached is the excel template that is to be used for problem number 4     I will highlight the questions below.  question 9 can be done either in a word doc or excel

Financial Statements, Taxes, and Cash Flow 2

· A WRITE-OFF by a company frequently means that the value of the company’s assets has declined. For example, in mid-2013, Microsoft announced that it would write off nearly $900 million due to its unsold Surface RT tablet computer inventory. Then, in December 2013, oil and gas giant BP announced that it was writing off $1.08 billion due to a failed Brazilian oil well.

· These write-offs were big, but not record-setting. Possibly the largest write-offs in history were done by the media company Time Warner, which took a charge of $45.5 billion in the fourth quarter of 2002. This enormous write-off followed an earlier, even larger, charge of $54 billion.

· So did stockholders in Microsoft lose $900 million because of the write-offs? The answer is probably not. Understanding why ultimately leads us to the main subject of this chapter: that all-important substance known as cash flow.


· For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com.

· Learning Objectives

· After studying this chapter, you should understand:

LO1 The difference between accounting value (or “book” value) and market value.
LO2 The difference between accounting income and cash flow.
LO3 The difference between average and marginal tax rates.
LO4 How to determine a firm’s cash flow from its financial statements.

· In this chapter, we examine financial statements, taxes, and cash flow. Our emphasis is not on preparing financial statements. Instead, we recognize that financial statements are frequently a key source of information for financial decisions, so our goal is to briefly examine such statements and point out some of their more relevant features. We pay special attention to some of the practical details of cash flow.

· As you read, pay particular attention to two important differences: (1) the difference between accounting value and market value and (2) the difference between accounting income and cash flow. These distinctions will be important throughout the book.

· Page 212.1 The Balance Sheet

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· The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm’s equity) at a given point in time. Figure 2.1illustrates how the balance sheet is constructed. As shown, the left side lists the assets of the firm, and the right side lists the liabilities and equity.

· balance sheet Financial statement showing a firm’s accounting value on a particular date.


· Assets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can be either tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) are also current assets.


· Three excellent sites for company financial information are finance.yahoo.comfinance.google.com, and money.cnn.com.


· The firm’s liabilities are the first thing listed on the right side of the balance sheet. These are classified as either current or long-term. Current liabilities, like current assets, have a life of less than one year (meaning they must be paid within the year) and are listed before long-term liabilities. Accounts payable (money the firm owes to its suppliers) are one example of a current liability.

· A debt that is not due in the coming year is classified as a long-term liability. A loan that the firm will pay off in five years is one such long-term debt. Firms borrow in the long term from a variety of sources. We will tend to use the terms bond and bondholders generically to refer to long-term debt and long-term creditors, respectively.

· Finally, by definition, the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term) is the shareholders’ equity, also called common equity or owners’ equity. This feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders. So, the balance sheet “balances” because the value of the left side always equals the value of the right side. That is, the value of the firm’s assets is equal to the sum of its liabilities and shareholders’ equity:1

· FIGURE 2.1 The Balance Sheet. Left Side: Total Value of Assets. Right Side: Total Value of Liabilities and Shareholders’ Equity.


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· This is the balance sheet identity, or equation, and it always holds because shareholders’ equity is defined as the difference between assets and liabilities.


· As shown in Figure 2.1, the difference between a firm’s current assets and its current liabilities is called net working capital. Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current assets and current liabilities, this means the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period. For this reason, net working capital is usually positive in a healthy firm.

· net working capital Current assets less current liabilities.

· EXAMPLE 2.1 Building the Balance Sheet

· A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the balance sheet look like? What is shareholders’ equity? What is net working capital?

· In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders’ equity is the difference: $600 − 270 = $330. The balance sheet would look like this:


· Net working capital is the difference between current assets and current liabilities, or $100 − 70 = $30.

· Table 2.1 shows simplified balance sheets for the fictitious U.S. Corporation. The assets on the balance sheet are listed in order of the length of time it takes for them to convert to cash in the normal course of business. Similarly, the liabilities are listed in the order in which they would normally be paid.

· The structure of the assets for a particular firm reflects the line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy, fixed asset acquisition, and so on.


· Disney has a good investor relations site at thewaltdisneycompany.com/investors.

· The liabilities side of the balance sheet primarily reflects managerial decisions about capital structure and the use of short-term debt. For example, in 2015, total long-term debt for U.S. was $454 and total equity was $640 + 1,629 = $2,269, so total long-term financing was $454 + 2,269 = $2,723. (Note that, throughout, all figures are in millions of dollars.) Of this amount, $454/2,723 = 16.67% was long-term debt. This percentage reflects capital structure decisions made in the past by the management of U.S.

· TABLE 2.1 Balance Sheets

· Page 23

· There are three particularly important things to keep in mind when examining a balance sheet: liquidity, debt versus equity, and market value versus book value.


· Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Liquidity actually has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.


· Annual and quarterly financial statements (and lots more) for most public U.S. corporations can be found in the EDGAR database at  www.sec.gov .

· Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first. Current assets are relatively liquid and include cash and assets we expect to convert to cash over the next 12 months. Accounts receivable, for example, represent amounts not yet collected from customers on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least liquid of the current assets, at least for many businesses.

· Fixed assets are, for the most part, relatively illiquid. These consist of tangible things such as buildings and equipment that don’t convert to cash at all in normal business activity (they are, of course, used in the business to generate cash). Intangible assets, such as a trademark, have no physical existence but can be very valuable. Like tangible fixed assets, they won’t ordinarily convert to cash and are generally considered illiquid.

· Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress (that is, difficulty in paying debts or buying needed assets). Unfortunately, liquid assets are generally less profitable to hold. For example, cash holdings are the most liquid of all investments, but they sometimes earn no return at all—they just sit there. There is therefore a trade-off between the advantages of liquidity and forgone potential profits.


· To the extent that a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors. Equity holders are entitled to only the residual value, the portion left after creditors are paid. The value of this residual portion is the shareholders’ equity in the firm, which is just the value of the firm’s assets less the value of the firm’s liabilities:

· Shareholders’ equity = Assets − Liabilities

· This is true in an accounting sense because shareholders’ equity is defined as this residual portion. More important, it is true in an economic sense: If the firm sells its assets and pays its debts, whatever cash is left belongs to the shareholders.

· The use of debt in a firm’s capital structure is called financial leverage. The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. As we discuss in later chapters, debt acts like a lever in the sense that using it can greatly magnify both gains and losses. So, financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.


· The values shown on the balance sheet for the firm’s assets are book values and generally are not what the assets are actually worth. Under Generally Accepted Accounting Principles (GAAP), audited financial statements in the United States mostly show assets at historical cost. In other words, assets are “carried on the books” at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today.

· Generally Accepted Accounting Principles (GAAP) The common set of standards and procedures by which audited financial statements are prepared.

· For current assets, market value and book value might be somewhat similar because current assets are bought and converted into cash over a relatively short span of time. In other circumstances, the two values might differ quite a bit. Moreover, for fixed assets, it would be purely a coincidence if the actual market value of an asset (what the asset could be sold for) were equal to its book value. For example, a railroad might own enormous tracts of land purchased a century or more ago. What the railroad paid for that land could be hundreds or thousands of times less than what the land is worth today. The balance sheet would nonetheless show the historical cost.


· The home page for the Financial Accounting Standards Board (FASB) is  www.fasb.org .

· The difference between market value and book value is important for understanding the impact of reported gains and losses. For example, from time to time, accounting rule changes take place that lead to reductions in the book value of certain types of assets. However, a change in accounting rules all by itself has no effect on what the assets in question are really worth. Instead, the market value of an asset depends on things like its riskiness and cash flows, neither of which have anything to do with accounting.

· The balance sheet is potentially useful to many different parties. A supplier might look at the size of accounts payable to see how promptly the firm pays its bills. A potential creditor would examine the liquidity and degree of financial leverage. Managers within the firm can track things like the amount of cash and the amount of inventory the firm keeps on hand. Uses such as these are discussed in more detail in Chapter 3.

· Managers and investors will frequently be interested in knowing the value of the firm. This information is not on the balance sheet. The fact that balance sheet assets are listed at cost means that there is no necessary connection between the total assets shown and the value of the firm. Indeed, many of the most valuable assets a firm might have—good management, a good reputation, talented employees—don’t appear on the balance sheet at all.

· Similarly, the shareholders’ equity figure on the balance sheet and the true value of the stock need not be related. For example, in early 2014, the book value of IBM’s equity was about $20 billion, while the market value was $204 billion. At the same time, Google’s book value was $72 billion, while the market value was $381 billion.

· Page 25For financial managers, then, the accounting value of the stock is not an especially important concern; it is the market value that matters. Henceforth, whenever we speak of the value of an asset or the value of the firm, we will normally mean its market value. So, for example, when we say the goal of the financial manager is to increase the value of the stock, we mean the market value of the stock.

· EXAMPLE 2.2 Market Value versus Book Value

· The Klingon Corporation has net fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the books, but approximately $600 would be realized if all the current accounts were liquidated. Klingon has $500 in long-term debt, both book value and market value. What is the book value of the equity? What is the market value?

· We can construct two simplified balance sheets, one in accounting (book value) terms and one in economic (market value) terms:


· In this example, shareholders’ equity is actually worth almost twice as much as what is shown on the books. The distinction between book and market values is important precisely because book values can be so different from true economic value.

· Concept Questions

· 2.1a   What is the balance sheet identity?

· 2.1b   What is liquidity? Why is it important?

· 2.1c   What do we mean by financial leverage?

· 2.1d   Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

· 2.2 The Income Statement

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· The income statement measures performance over some period of time, usually a quarter or a year. The income statement equation is:


· income statement Financial statement summarizing a firm’s performance over a period of time.

· If you think of the balance sheet as a snapshot, then you can think of the income statement as a video recording covering the period between before and after pictures. Table 2.2 gives a simplified income statement for U.S. Corporation.

· Page 26TABLE 2.2 Income Statement


· The first thing reported on an income statement would usually be revenue and expenses from the firm’s principal operations. Subsequent parts include, among other things, financing expenses such as interest paid. Taxes paid are reported separately. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS).

· As indicated, U.S. paid cash dividends of $103. The difference between net income and cash dividends, $309, is the addition to retained earnings for the year. This amount is added to the cumulative retained earnings account on the balance sheet. If you look back at the two balance sheets for U.S. Corporation, you’ll see that retained earnings did go up by this amount: $1,320 + 309 = $1,629.

· EXAMPLE 2.3 Calculating Earnings and Dividends per Share

· Suppose U.S. had 200 million shares outstanding at the end of 2015. Based on the income statement in Table 2.2, what was EPS? What were dividends per share?

· From the income statement, we see that U.S. had a net income of $412 million for the year. Total dividends were $103 million. Because 200 million shares were outstanding, we can calculate earnings per share, or EPS, and dividends per share as follows:


· When looking at an income statement, the financial manager needs to keep three things in mind: GAAP, cash versus noncash items, and time and costs.


· An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition or realization principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.

· Page 27Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described previously and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The production and other costs associated with the sale of that product will likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some different time.

· As a result of the way revenues and expenses are realized, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.


· A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The most important of these is depreciation. Suppose a firm purchases an asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period.

· noncash items Expenses charged against revenues that do not directly affect cash flow, such as depreciation.

· If the depreciation is straight-line and the asset is written down to zero over that period, then $5,000/5 = $1,000 will be deducted each year as an expense.2 The important thing to recognize is that this $1,000 deduction isn’t cash—it’s an accounting number. The actual cash outflow occurred when the asset was purchased.

· The depreciation deduction is simply another application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So, the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.

· As we will see, for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market value, so we need to learn how to separate the cash flows from the noncash accounting entries. In reality, the difference between cash flow and accounting income can be pretty dramatic. For example, consider the case of Malaysia Airlines: Malaysia Airlines reported a net loss of MYR830 million ($252.8 million) for the first nine months of 2013. Sounds bad, but Malaysia Airlines also reported a positive cash flow of MYR555 million ($169.1 million), a difference of about $421.9 million!


· It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.

· If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.

· The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.

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· The U.S. Securities and Exchange Commission (SEC) requires that most public companies file regular reports, including annual and quarterly financial statements. The SEC has a public site named EDGAR that makes these free reports available at www.sec.gov. We went to “Search for Company Filings” and looked up Google:


· Here is a partial view of what we got:


· The two reports we look at the most are the 10-K, which is the annual report filed with the SEC, and the 10-Q. The 10-K includes the list of officers and their salaries, financial statements for the previous fiscal year, and an explanation by the company of the financial results. The 10-Q is a smaller report that includes the financial statements for the quarter.

· Questions

· 1.  As you can imagine, electronic filing of documents with the SEC has not been around for very long. Go to  www.sec.gov  and find the filings for General Electric. What is the date of the oldest 10-K available on the website for General Electric? Look up the 10-K forms for IBM and Apple to see if the year of the first electronic filing is the same for these companies.

· 2.  Go to  www.sec.gov  and find out when the following forms are used: Form DEF 14A, Form 8-K, and Form 6-K.

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