Fundamentals of Corporate Finance Third Canadian Edition prepared

Fundamentals of Corporate Finance Third Canadian Edition prepared by: Sujata Madan Mc. Gill University Copyright © 2006 Mc. Graw Hill Ryerson Limited

Chapter 3 Accounting and Finance n The Balance Sheet n The Income Statement n The Statement of Cash Flows n Taxes Copyright © 2006 Mc. Graw Hill Ryerson Limited 2

The Balance Sheet n Financial statement which shows the value of the firm’s assets and liabilities at a particular time. Copyright © 2006 Mc. Graw Hill Ryerson Limited 3

The Balance Sheet Current Liabilities Payables Short-term Debt Current Assets Cash & Securities Receivables Inventories = + Fixed Assets Tangible Assets Intangible Assets + Long-term Liabilities + Shareholders’ Equity Copyright © 2006 Mc. Graw Hill Ryerson Limited 4

The Balance Sheet n Structure of the Balance Sheet Copyright © 2006 Mc. Graw Hill Ryerson Limited 5

The Balance Sheet n Current Assets w w These are the most liquid assets These could be: § § Cash and Marketable Securities Accounts Receivable Inventories Other Current Assets Copyright © 2006 Mc. Graw Hill Ryerson Limited 6

The Balance Sheet n Non-Current Assets w w Long-term assets which are unlikely to be turned into cash soon These could be: § § § Net Fixed Assets Intangible Assets Other Assets Copyright © 2006 Mc. Graw Hill Ryerson Limited 7

The Balance Sheet n Net Fixed Assets w Long lived assets such as buildings, plant, equipment etc. w Also called fixed assets. w Shown on the Balance Sheet at their original cost net of accumulated depreciation. Copyright © 2006 Mc. Graw Hill Ryerson Limited 8

The Balance Sheet n Intangible Assets w Long lived assets such as brand names, patents, copyrights, manpower etc. w These assets have no physical reality, and are thus called intangible assets. Copyright © 2006 Mc. Graw Hill Ryerson Limited 9

The Balance Sheet n Liabilities w Liabilities represent money owed by the firm to its creditors. w These could be: § § § Current Liabilities Long Term Debt Other Long-Term Liabilities Copyright © 2006 Mc. Graw Hill Ryerson Limited 10

The Balance Sheet n Liabilities w Current liabilities are short term obligations which are likely to be paid off rapidly. § w Example: Bank debt and accounts payable. Long term liabilities represent debts that come due after the end of the year. § Example: Long-term debt Copyright © 2006 Mc. Graw Hill Ryerson Limited 11

The Balance Sheet n Shareholders’ Equity w What is left over after all of firm’s obligations (liabilities) have been paid off belongs to the shareholders, and is called shareholders’ equity. w This can be: § § Capital Retained earnings Copyright © 2006 Mc. Graw Hill Ryerson Limited 12

The Balance Sheet n Shareholders’ Equity w Capital represents amounts raised from the sale of the company’s shares to investors. w Retained earnings represents earnings which the management has retained and reinvested in the firm. Copyright © 2006 Mc. Graw Hill Ryerson Limited 13

Book Value vs Market Value n Book Value and Market Value w Book value is determined by GAAP w Market value is the price at which the firm can resell an asset w Typically, market value ≠book value Copyright © 2006 Mc. Graw Hill Ryerson Limited 14

Book Value vs Market Value n 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. What is the market value of your assets? Copyright © 2006 Mc. Graw Hill Ryerson Limited 15

Book Value vs Market Value n Example Assets= Liabilities + Equity Assets = $4 bn + $7. 5 bn = $11. 5 bn Copyright © 2006 Mc. Graw Hill Ryerson Limited 16

Market Value vs. Book Value Balance Sheet Assets = $10 bn Debt = $4 bn Equity = $6 bn Market Value Balance Sheet Assets = $11. 5 bn Debt = $4 bn Equity = $7. 5 bn Copyright © 2006 Mc. Graw Hill Ryerson Limited 17

The Income Statement n Financial statement which shows the revenues, expenses and net income of a firm. Copyright © 2006 Mc. Graw Hill Ryerson Limited 18

The Income Statement n Structure of the Income Statement Copyright © 2006 Mc. Graw Hill Ryerson Limited 19

Statement of Cash Flows n Financial statement which shows a firm’s cash receipts and cash payments over a period of time. w Note that the Income Statement shows the firm’s accounting profits not its cash flows Copyright © 2006 Mc. Graw Hill Ryerson Limited 20

Statement of Cash Flows n Profit vs. Cash Flows w w “Profits” subtract depreciation (a non-cash expense) “Profits” ignore cash expenditures on new capital (the expense is capitalized) “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur “Profits” do not consider changes in working capital Copyright © 2006 Mc. Graw Hill Ryerson Limited 21

Statement of Cash Flows n The Statement of Cash Flows is divided into three sections: § Cash flow from operating activities § Cash flow from investing Activities § Cash flow from Financing Activities Copyright © 2006 Mc. Graw Hill Ryerson Limited 22

Statement of Cash Flows n Structure of the Statement of Cash Flows Copyright © 2006 Mc. Graw Hill Ryerson Limited 23

Taxes n Corporate Taxes w Corporate tax = Federal tax + Provincial tax § The federal tax rate is 22. 12% q 13. 12% § for small businesses Provincial taxes vary across the country Copyright © 2006 Mc. Graw Hill Ryerson Limited 24

Taxes n Consequences of Deducting Interest w Interest paid by a corporation is a tax deductible expense. § w Note that dividends are not. Thus, interest payments increase the amount of money available to creditors and shareholders. Copyright © 2006 Mc. Graw Hill Ryerson Limited 25

Taxes n Example w w Firm A and Firm B both have EBIT of $100 Both pay taxes at 35% Firm A has debt and pays $40 in interest Firm B has no debt and pays no interest Create an income statement for these firms and calculate their net income. Copyright © 2006 Mc. Graw Hill Ryerson Limited 26

Taxes n. Consequences Firm A of Deducting Interest Firm B EBIT $100 Less: Interest 40 Pretax Income 60 100 Less: Taxes (35%) 21 Net Income $ 39 $ 65 0 Copyright © 2006 Mc. Graw Hill Ryerson Limited 35 27

Taxes Government’s share (taxes) FIRM A Stakeholder’s share (interest + net income) FIRM B $21 $35 $79 $65 Distribution of EBIT: Government’s share + (Creditor’s Share + Shareholder’s Share) Firm A = $21 + ($40 + $39) = $21 + $79 = $100 Firm B = $35 + ($0 + $65) = $35 + 65 = $100 Copyright © 2006 Mc. Graw Hill Ryerson Limited 28

Taxes n Definitions w Marginal Tax Rate - tax paid on each extra dollar of income. w Average Tax Rate - total tax bill divided by total income. Copyright © 2006 Mc. Graw Hill Ryerson Limited 29

Taxes n Personal Taxes w For individual taxpayers, federal and provincial taxes are calculated separately. w Taxes for individuals are progressive. w Dividends are effectively taxed at a lower rate than interest income. Copyright © 2006 Mc. Graw Hill Ryerson Limited 30

Summary of Chapter 3 w Investors and other stakeholders need regular financial information to monitor a firm’s progress. w They find this information on the: § Balance Sheet § Income Statement § Statement of Cash Flows Copyright © 2006 Mc. Graw Hill Ryerson Limited 31

Summary of Chapter 3 w Assets are recorded on the Balance Sheet at book value. w Book value does not equal market value! w Accounting income on an Income Statement is not the same as a firm’s cash flows. Copyright © 2006 Mc. Graw Hill Ryerson Limited 32

Summary of Chapter 3 w Taxes have a major impact on financial decisions. w In Canada, both corporations and individuals must pay taxes on their earnings. Copyright © 2006 Mc. Graw Hill Ryerson Limited 33