0. Introduction. What is finance? What are the two main branches of finance? What are the three main aspects of corporate finance?

Transcription

1 1 0. Introduction What is finance? What are the two main branches of finance? What are the three main aspects of corporate finance?

2 2 1. Financial statements and cash flow A quick review of balance sheet and income statement. Topics include: the balance sheet identity market value vs book value income statement vs cash flow We will also discuss the components of financial cash flows. The fundamental identies are: cash flow from assets = cash flow to creditors + cash flow to stockholders cash flow from assets = operating cash flow net capital spending change in net working capital

3 Balance sheet 3 The balance sheet summarizes the financial position of a firm at a point in time. Assets are on the left, liabilities on the right. Listed in order of decreasing liquidity. What do we mean by liquidity?

4 Balance sheet example 4 U.S. Composite Corporation Balance sheet 2007 and 2006 ($ in millions) Assets Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets Fixed assets: Property, plant and equipment Less accumulated depreciation (550) (460) Net property, plant and equipment Intangible assets and others Total fixed assets Total assets

5 5 Liabilities and Stockholder s Equity Current liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities Long-term liabilities Deferred taxes Long-term debt Total long-term liabilities Stockholder s equity Preferred stock Common stock ($1 par value) Capital surplus Accumulated retained earnings Less treasury stock (26) (20) Total equity Total liabilities and stockholder s equity Notes: The increase in long-term debt reflects the difference between $86 million in new debt and $73 million in retired old debt. The increase in treasury stock reflects the repurchase of $6 million in common stock (at market value). The change in common stock reflects the issuance of 23 million shares of stock at par value of $1 per share. The increase in capital surplus reflects the difference between the price the shares were actually sold for ($1.87) and the par value.

6 Balance sheet 6 Current assets (or liabilities) are assets (or liabilities) with an expected time to conversion to cash of one year or less. Accounts receivable are payments due from the firm s customers. Accounts payable are payments owed to the firm s suppliers. Fixed assets are equal to purchase price less depreciation. Intangible assets include e.g., trademarks and patents. Owners equity reflects the price at which shares were originally sold (or repurchased). Accrued expenses are costs that have been incurred but not yet paid out, e.g., salaries and taxes which are only paid out periodically. Deferred taxes are taxes which have been incurred but will not be paid until later. For example, a company may use an accelerated depreciation schedule for the IRS, but straightline for its accounting statements.

7 Balance sheet identity 7 Assets = Liabilities + Shareholders equity How is the balance sheet like a pie?

8 Figure net working capital 8 NWC = Current Assets - Current Liabilities

9 Net working capital remarks 9 NWC is normally positive in a healthy firm. It measures the short term ability of the firm to pay its bills. What are the disadvantages of having a lot of NWC (excess liquidity)? A very low (or negative) NWC may indicate either financial weakness, or very efficient short-term financial management. Note: This ambiguity is typical of financial statement analysis.

10 Discussion 10 Think of NWC as the balance after totalling the cash in your wallet, the balance in your checking account, bills that come due this month, and your paycheck. You need to maintain liquidity, but additional assets might be better off invested in T-bills or stocks. It may not be so bad to have a negative balance in your checking account if it is covered by a line-of-credit and your cash flows are sufficient to keep you out of trouble.

11 Balance sheet identity revisited 11 Recall the balance sheet identity: Assets = Liabilities + Shareholders equity It is often more useful to think of this with the current accounts netted out (to reflect long-term financing): Fixed assets + NWC = Long-term debt + Equity Note: Interpret figure in terms of this equation:

12 Book value vs. market value 12 Accounting statements always deal with book values. These may or may not be closely correlated to market values. Why do we even care about book values? Good way to think about this is to consider the book vs market values of your car.

13 Book vs market continued 13 Market value of equity referred to as market capitalization Market value of equity plus long-term debt referred to as total capitalization How might you estimate a firm s market capitalization? How might you estimate a firm s total capitalization? How might you estimate the market value of the firm s fixed assets? What determines a firm s market value? Note: Interpret figure using market values

14 Book vs market continued 14 The market-to-book ratio is often considered as a useful measure of historical performance. It describes how much value the firm has created. Stocks with low market-to-book are referred to as value stocks. Stocks with high market-to-book are referred to as growth stocks.

15 Book vs market continued 15 Think about a company which owns a single factory which cost $1 million to build. Suppose, as a result of poor management (or other factors), the market value of the factory is only $500,000. Thus, management has destroyed $500,000 of value. It is a value stock. On the other hand, if the market value of the factory is $2 million, then management has succeeded in creating $1 million of value. It is a growth stock. Note: Why would anyone pay $2 million for a factory that only cost $1 million to build?

16 Book vs market continued 16 You will sometimes hear analysts touting value stocks. The idea is that although the stock is cheap now, the market value is likely to recover down the road. Other analysts will be touting growth stocks. The idea is that the firm has done well in the past, it is likely to continue doing so. The relative performance of growth vs value stocks has varied through time. Thus each camp is right sometimes (like a clock that is right twice a day).

17 Income statement 17 While the balance sheet is a summary of the firm s position at a point in time, the income statement is a summary of change in firm s financial position over some period of time. The basic idea is Income = Revenues - Expenses Expenses are broken down into several parts: product costs period costs depreciation interest taxes.

18 Income statement example 18 U.S. Composite Corporation Income statement 2007 ($in millions) Total operating revenues $2262 Cost of goods sold (1655) Selling, general, and administrative costs (327) Depreciation (90) Operating income $190 Other income 29 EBIT $219 Interest (49) Pretax income $170 Taxes (84) Current: $71 Deferred: $13 Net income $86 Addition to retained earnings $43 Dividends 43

19 Net income 19 Net income is either paid out as a dividend or retained. The part that is retained is added to Retained earnings on the balance sheet. may be held as cash or other liquid assets. may be used to finance new fixed assets. may also go toward repurchasing shares or paying down the principal of the firm s long-term debt. Note: The balance sheet must balance!

20 Example 20 Income statement Revenue 140 COGS 30 Depr 0 Interest 10 Tax 20 ============= NI 80 Dividend: 30 Addition to RE: 50 Balance Sheet CA CL FA LTD TA E D+E Note: In this example, the firm retained $50 and used it to buy new fixed assets.

21 Income statement vs cash flow 21 The income statement does not really reflect cash flow. There are several differences: Revenues are recorded when they accrue (when the sale is made) rather than when the cash actually changes hands. Expenses are recorded using the matching principle: the idea is to try to match revenues up with the costs associated with producing them. Thus, production costs are recognized not when the raw materials are bought or when they are paid for, but rather when the goods are sold.

22 Income statement vs cash flow continued 22 The income statement also includes non-cash items, e.g., depreciation. The cost of fixed investments is not incurred all at once, but rather as they are depreciated. This is related to the matching principle: the benefits of the investment are realized not all at the time of purchase, but rather over the course of the asset s lifetime.

23 Period costs and product costs 23 Whereas economists are frequently interested in fixed vs variable costs, the income statement uses product costs vs period costs. Product costs are the costs directly associated with production. Period costs are typically reported as selling, general and administrative costs. Although these are loosely related to fixed and variable costs, the relationship is not exact.

24 Taxes 24 US corporate tax schedule (federal) Taxable income Marginal tax rate (%) Average tax rate (%) $ 0-50, ,001-75, , , , , ,001-10,000, ,000,001-15,000, ,000,001-18,333, ,333, What is the difference between marginal and average rates? Which is usually more relevant for financial decision making? What is the double taxation issue? Note: Average tax rate for earnings at upper limit of bracket.

25 Depreciation 25 Discuss later in course...

26 Financial statements real world 26 In the real world, financial statements are more complex than the simplified statements we will typically use in this course. See Dell K.

27 Cash flow 27 Cash flow identity: cash flow from assets = cash flow to creditors + cash flow to stockholders Notes: The cash flow identity is similar to the balance sheet identity: The left hand side tells the size of the pie; the right hand side tells how it is divided up. We will be primarily interested in financial cash flows, not accounting cash flows.

28 CFFA 28 cash flow from assets = operating cash flow net capital spending change in net working capital OCF = EBIT + Depreciation Taxes NCS = ending net fixed assets starting net fixed assets + depreciation ChNWC = ending NWC - starting NWC Notes: CFFA is also known as free cash flow.

29 Discussion 29 Remember: the cash flows of interest in finance are not the same as what is recorded in the accounting statement of cash flows. Why is depreciation added into OCF? The reason is that EBIT has subtracted depreciation off, but it is a non-cash item. We just need to undo this subtraction. Note that the accounting definition of OCF is net income + depreciation. This differs from our definition of cash flow in that interest is deducted. We treat interest as a financing expense. That is, it will be part of the cash flow to creditors. The reason for this will be clearer later. Why do we treat depreciation as a positive component of cash flow in NCS? Again, we are simply correcting for the fact that it was written off in the balance sheet, but is not a cash item. NCS reflects the amount of cash actually spent to purchase fixed assets this period.

30 Cash flow to creditors and stockholders 30 cash flow from assets = cash flow to creditors + cash flow to stockholders Cash flow to creditors = interest paid net new borrowing Cash flow to stock holders = dividends paid net new equity raised Note: Remember that financial cash flows are different from the accounting statement of cash flows.

31 Example 31 Rocky Flats Mineral Water (RFMW)* Balance sheet (millions of $) Assets Current assets Fixed assets Total assets Liabilities and Owners Equity Current liabilities Long-term debt Owners equity Retained earnings Total liabilities and owners equity * Their motto: makes your skin glow (in the dark).

32 Example continued 32 Income statement (2005) (millions of $) Net sales 2000 Cost of goods sold 1800 Depreciation 150 EBIT 50 Interest paid 20 Taxable income 30 Taxes 9 Net income 21 Dividends 6 Addition to retained earnings 15

33 Example continued 33 Given the balance sheet and income statement above, compute: Operating cash flow (OCF) Net capital spending (NCS) Change in net working capital (ChNWC) CFFA Cash flow to creditors (CF2Cr) Cash flow to share holders (CF2SH) Check that CFFA = CF2Cr + CF2SH

34 Ethics 34 Accounting statements are not always as reliable as we might like to think... Managers compensation is often dependent on the firm s performance: options target-based bonuses. The idea is to align managers incentives with those of the firm (recall the agency problem). But things don t always work out as desired: Managers may be tempted to massage the books to enhance performance. Short-term results can look good, but in the longer term...

35 Cendant 35 Publicly traded firms have to file audited annual reports, but that doesn t mean that accounting irregularities never slip by the auditors. Companies that deliberately manipulate financial statements may benefit in the short run, but it eventually comes back to haunt them. Cendant Corporation is a good example. Cendant was created when CUC International and HFS, Inc. merged in late The combined company owns such name brands as Century 21 and Coldwell-Bankers. In April 1998, the combined company announced that accounting irregularities had been found in the CUC financial statements and earnings would need to be restated for 1997 and possibly 1995 and 1996 as well. Cendant s stock price dropped 47 percent the day after the announcement was made (it was announced after the market closed). The problems haunted Cendant throughout In July, it was announced that the problem was much worse than originally expected and the stock price plummeted again. By the end of July 1998, the stock price had dropped more than 60 percent below the price before the original announcement. The company also had to take a $76.4 million charge in the third quarter of 1998 for the costs of investigating the accounting irregularities. Criminal charges have been filed against several former executives of CUC International and several class action lawsuits have been filed against Cendant. The stock was trading at about $41 per share prior to the announcement and dropped as low as $7.50 per share in October The price still had not recovered by early September 2000, with a closing price on September 1, 2000 of about $13.