Corporate Finance: Chapter 2 PDF

CORPORATE FINANCE; By Stephen Ross, Randolph Westerfield and CHAPTER 2 Bradford Jordan FINANCIAL STATEMENTS AND CASH FLOW Learning Objectives: Differentiate between book value and market values Understanding the information provided by the financial statements ...

CORPORATE FINANCE; By Stephen Ross, Randolph Westerfield and CHAPTER 2 Bradford Jordan FINANCIAL STATEMENTS AND CASH FLOW Learning Objectives: Differentiate between book value and market values Understanding the information provided by the financial statements Know the difference between average and marginal tax Know the difference between accounting income and cash flow CHAPTER OUTLINE The Balance sheet The income statement Taxes Cash flow BALANCE SHEET Balance Sheet: Purpose: Provides a snapshot of a firm's assets, liabilities, and equity at a specific point in time. Structure: Assets: Current (convertible to cash within a year) and Fixed (long- term). Liabilities: Current (due within a year) and Long-Term (due after more than a year). Equity: Residual value after subtracting liabilities from assets. Net Working Capital: Current Assets - Current Liabilities. BALANCE SHEET… Key Concepts: Liquidity: Speed and ease of converting assets to cash without significant loss. Debt vs. Equity: Shareholders' Equity: Residual value of the firm, calculated as: Shareholders’ Equity = Assets − Liabilities Financial Leverage: Using debt in the firm’s capital structure to magnify gains and losses. More debt increases potential rewards and risks, including financial distress. MARKET VALUE VS. BOOK VALUE: Book Value: Historical cost of assets as recorded on the balance sheet, which may not reflect current worth. Market Value: Current worth of assets, considering factors like risk and cash flows. Market value can differ significantly from book value. Importance: Market value is more relevant for financial managers than book value, as it reflects the true economic value of assets and the firm. Example: Klingon Corporation: Book Value: Net fixed assets = $700; Net working capital = $400. Market Value: Net fixed assets = $1,000; Net working capital = $600. Difference: The market value of equity is almost twice the book value, highlighting the discrepancy between book and market values. INCOME STATEMENT OVERVIEW: Purpose: Measures performance over a period, summarizing revenues, expenses, and net income. GAAP: Revenue and expenses are recognized based on accounting principles, not necessarily cash flows. Noncash Items: Such as depreciation, affect accounting income but not cash flow. Costs: Fixed and variable costs are important, with fixed costs remaining constant in the short run and variable costs changing with output levels. TAXES; CORPORATE TAX RATES Corporate tax rates in the U.S. are structured with varying brackets. As of 2015, the tax code includes: 15% on income up to a certain amount 25% on income above the initial threshold but below another limit 34% on income beyond this but below a higher threshold 35% on income over this final threshold In practice, this results in a tiered system where different portions of income are taxed at different rates. Additionally, surcharges can push effective rates higher temporarily.  AVERAGE VS. MARGINAL TAX RATES Average Tax Rate: Total taxes paid divided by total taxable income. Marginal Tax Rate: The rate of tax applied to the next dollar earned. Corporate Tax Brackets Corporations with taxable incomes over $18.33 million face a flat 35% rate, while those in the $335,000 to $10 million range face a 34% rate. For most large corporations, the effective tax rate is 35% unless stated otherwise. Average Tax Rates by Industry Electric Utilities: 33.8% Biotechnology Firms: 4.5% These figures reflect the influence of industry-specific deductions and tax strategies.  CASH FLOW Cash Flow Components Operating Cash Flow (OCF): Cash generated from a firm's normal business operations. Capital Spending: Net expenditure on fixed assets. Change in Net Working Capital (NWC): Difference in current assets minus current liabilities over a period. Operating Cash Flow Calculation To calculate OCF: 1. Start with EBIT (Earnings Before Interest and Taxes). 2. Add back non-cash expenses (e.g., depreciation). 3. Subtract taxes paid. For U.S. Corporation: EBIT = $694 Depreciation = $65 (added back) Taxes = $212 (subtracted) OCF = EBIT + Depreciation - Taxes = $694 + $65 - $212 = $547 This calculation reflects cash generated from business operations, excluding financing costs. Net Capital Spending Net capital spending is the total amount spent on fixed assets minus any sales of such assets. For U.S. Corporation: Beginning Net Fixed Assets = $1,644 Ending Net Fixed Assets = $1,709 Depreciation = $65 Capital Spending = (Ending Net Fixed Assets - Beginning Net Fixed Assets) + Depreciation Net Capital Spending = ($1,709 - $1,644) + $65 = $130 Change in Net Working Capital Calculate by: Subtracting beginning NWC from ending NWC. For U.S. Corporation: Beginning NWC = $1,112 - $428 = $684 Ending NWC = $1,403 - $389 = $1,014 Change in NWC = Ending NWC - Beginning NWC = $1,014 - $684 = $330 Cash Flow from Assets Combines all components: Cash Flow from Assets = Operating Cash Flow - Capital Spending - Change in NWC = $547 - $130 - $330 = $87 CASH FLOW TO CREDITORS AND STOCKHOLDERS Cash Flow to Creditors: Interest paid minus net new borrowing. Cash Flow to Stockholders: Dividends paid minus net new equity raised. For U.S. Corporation: Interest Paid = $70 Net New Borrowing = $46 Cash Flow to Creditors = $70 - $46 = $24 Dividends Paid = $103 Net New Equity Raised = $40 Cash Flow to Stockholders = $103 - $40 = $63 Total Cash Flow to Creditors and Stockholders = $24 + $63 = $87  FREE CASH FLOW Sometimes called cash flow from assets, representing cash available for distribution to creditors and stockholders after investments in working capital and fixed assets. Example: Dole Cola Operating Cash Flow Calculation: Sales = $600 Cost of Goods Sold = $300 Depreciation = $150 Taxes = 34% of (Sales - Cost of Goods Sold - Depreciation - Interest Paid) Net Income = $79 Net Capital Spending: Beginning Net Fixed Assets = $500 Ending Net Fixed Assets = $750 Net Capital Spending = $250 + Depreciation = $400 Change in NWC: Beginning NWC = $2,130 - $1,620 = $510 Ending NWC = $2,260 - $1,710 = $550 Change in NWC = $550 - $510 = $40 Cash Flow from Assets: = Operating Cash Flow - Capital Spending - Change in NWC = -$181 Cash Flow to Stockholders and Creditors: Cash Flow to Stockholders = $30 Cash Flow to Creditors = -$211 These calculations illustrate that cash flow from assets can be negative due to substantial investments in assets, and cash flow to creditors may involve new borrowing.