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Financial Management

Princeton PMBA Program August 22, 2015 to November 24, 2015

Dr. Richard Michelfelder

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Course Outline - Topics

1. Introductions to Financial Statements

2. Time Value of Money, Discount Rates and Rate of Return

3. Risk, Returns and Cost of Capital 4. Project Investment Decision-making5. Stock and Bond Valuation6. Capital Structure7. Dividend Policy8. Mergers & Acquisitions

1- 3Outline 1 Introduction to Financial Statements

1.1 The Balance Sheet1.2 The Income Statement1.3 The Statement of Cash Flows1.4 Accounting Practice1.5 Income Taxes1.6 Financial Ratios1.7 DuPont Equations1.8 Using Financial Ratios1.9 Measuring Company Performance1.10 The Role of Financial Ratios

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The Balance Sheet

Definition

Financial statements that show the value of the firm’s assets and liabilities at a particular point in

time (from an historic cost accounting, not market value

perspective).

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The Balance Sheet

The Main Balance Sheet Items

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets

Current LiabilitiesPayablesShort-term Debt

+

Long-term Liabilities

+

Shareholders’ Equity

=

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The Balance Sheet

Shareholder’s Equity = Total Assets – Total LiabilitiesShareholders’ Equity: consists of paid

in investment capital plus retain earnings

- may be greater or less than market value of equity- for comparison look at Market-to-Book ratio:

- Stock Market Price (P) /Shareholder’s Equity (B) or P/B ratio

Shareholders’ Equity = Total Assets – Total Liabilities

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Market Value vs. Book Value

Book Values are determined by GAAP (historic cost accounting)

Market Values are determined by current values

Equity and Asset “Market Values” are usually higher than their “Book Values”

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Market Value vs. Book Value

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.

Q: What is the market value of your assets?

A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.

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Market Value vs. Book Value

Example (continued)

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil

Equity = $6 bil

Market Value Balance SheetAssets = $11.5 bil Debt = $4 bil

Equity = $7.5 bil

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Market and Book Value

Review Market to Book Value for S&P 500 Market Trends

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S&P 500 Financials M/B Trend

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The Income Statement

Definition

Financial statement that shows the revenues, expenses, and net income of a firm over a period

of time.

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The Income Statement

Earnings Before Income & Taxes, Depreciation & Amortization (EBITDA)

EBITDA = Total Revenues

- Operating Expenses

Measure of profit less subject to “financial engineering” as EBITDA is gross of interest, taxes, depreciation & amortization.

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The Income StatementPepsico Income Statement 2012 2011

Net Sales $65,492 $66,504Cost of Goods Sold 31,291 31,593Other Expenses (Dep. Intang.) 119 133Selling, Gen. &Adm. expenses 22,281 22,408Depreciation expense 2,689 2,737Operating Profit 9,112 9,633Other Income 91 57Earnings Before Interest & Taxes 9,203 9,690Net Interest Expense (899) (856)Taxable Income 8,304 8,834Income Taxes 2,090 2,372Net Income 6,214 6,462

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Profits vs. Cash FlowsDifferences“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 capitalCF can be low while net income is high

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The Statement of Cash Flows

Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

CF = Cash Inflow – Cash Outflow

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The Statement of Cash Flows Pepsico Statement of Cash Flows 2012 2011

Net Income 6,214 6,462Non-cash expenses

Depreciation 2,689 2,737

Changes in working capital (424) (255)A/R, A/P, Inv, other _____ _____

Cash Flow from operations 8,479 8,944Cash Flow from investments (3,005) (5,618)Cash provided by financing (3,306) (5,135)Effect of Exchange Rate Changes 62 (67)Net Change in Cash Position 2,230 (1,876)

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Accounting Practice

There are many accounting issues subject to subjective judgment. A few examples are:Revenue recognitionOff-balance-sheet financing

• Operating v. capital leases

Expensing v. capitalizing an “expenditure”

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Income Taxes

Taxes have a major impact on financial decisions

Marginal Tax Rate is the tax that the individual pays on each extra dollar of income.

Average Tax Rate is the total tax bill divided by total income.

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Income TaxesExample - Taxes and Cash Flows can be changed by

the use of debt. Firm A pays part of its profits as debt interest. Firm B does not.

Firm A Firm BEBIT 100 100Interest 40 0Pretax Income 60 100Taxes (35%) 21 35Net Income 39 65

Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not.

Firm AEBIT 100Interest 40Pretax Income 60Taxes (35%) 21 Net Income 39

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Income Taxes

If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow)

Firm A Firm B

EBIT 100 100

Interest 40 0

Pretax Income 60 100

Taxes (35%) 21 35

Net Income 39 65

?

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Income Taxes

If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow)

Firm A Firm B

Net Income 39 65

+ Interest 40 0

Net Cash Flow 79 65

Assuming $500 mil. in investment, what is the ROE with no debt and with 50% debt. Firm A ROE = 15.6% and Firm B ROE = 13%.

?

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Corporate Tax Rates (2002)

Taxable Income ($) Tax Rate (%)0-50,000 1550,001-75,000 2575,001-100,000 34100,001-18,333,333 34-39over 18,333,333 35

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Personal Tax Rates (2002)

Single Taxable Income ($)

Married Taxable Income ($) Tax Rate (%)

0-6,000 0-12,000 106,000-27,950 12,000-46,700 1527,950-67,700 46,700-112,850 27

67,700-141,250 112,850-171,950 30141,250-307,050 171,950-307,050 35

over 307,050 over 307,050 38.6

1- 25Financial Ratios (Financial Statement Analysis)

Five General Categories:Valuation

• Value of firm or specific assets

Leverage• Measures use of debt and associated fixed expenses

Liquidity• Measures firm’s access to cash

Profitability• Measures return on investments

Efficiency• Productivity of the use of firm’s assets

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Leverage Ratios

equity+debt termlong

debt termlong=ratiodebt termLong

equity

debt termlong=ratioequity Debt

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Leverage Ratios

Total debt ratio =total liabilities

total assets

Times interest earned =EBIT

interest payments

Cash coverage ratio =EBIT + depreciation

interest payments

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Liquidity Ratios

Net working capital

to total assets ratio=

Net working capital

Total assets

Current ratio =current assets

current liabilities

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Liquidity Ratios

Cash ratio =cash + marketable securities

current liabilities

Quick ratio =cash + marketable securities + receivables

current liabilities

Interval measure =cash + marketable securities + receivables

average daily expenditures from operations

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Efficiency Ratios

Asset turnover ratio =Sales

Average total assets

NW Cturnover =sales

average net working capital

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Efficiency Ratios

Days' sales in inventory =average inventory

cost of goods sold / 365

Inventory turnover ratio =cost of goods sold

average inventory

Average collection period =average receivables

average daily sales

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Profitability Ratios

assets totalaverage

Interest IncomeNet =assetson Return

sales

incomenet =marginprofit Net

equity average

incomenet =equityon Return

sales

interest incomenet =marginprofit Operating

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Profitability Ratios

Plowback ratio =earnings - dividends

earnings

= 1 - payout ratio

Payout ratio =dividends

earnings

ROE*earnings

dividends-earnings=plowback fromequity in Growth

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Market Value Ratios

g-r

1

EPS avg

P=ratio PE Forecasted

1

1

1

0 xEPS

Div

PE Ratio =stock price

earnings per share

Dividend yield =dividend per share

stock price

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Market Value Ratios

Market to book ratio =stock price

book value per share

Price per share = P =Div

r - g01

Tobins Q =market value of assets

estimated replcement cost

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The DuPont Equations

A breakdown of ROE and ROA into component ratios

equity

stock commonfor available earnings=ROE

assets

interest IncomeNet =ROA

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The DuPont Equations

sales

interestIncomeNet x

assets

sales=ROA

assetturnover

Operating profitmargin

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The DuPont Equations

interestIncomeNet

IncomeNet x

sales

interestIncomeNet x

assets

salesx

equity

assets=ROE

leverageratio

assetturnover

Operating profitmargin

debtburden

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MVA & Economic Profit

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

EP = economic profit

= (ROI – r) x (Invested Capital)

Market Value Added = The difference between the market value of common stock and its book value

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Residual Income & EVA

Residual Income or EVA = Net Dollar return after deducting the cost of capital

EVA = Residual Income

= Income Earned - Income Required

= Income Earned – [cost of capital x invested capital]

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

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Measuring Performance

Measures of Company Performance (ranked by MVA)Market to book ratio

MVA ($bil)

Return on assets (%)

EVA ($bil)

GE 6.6 426.6 20.4 5.9Microsoft 8.8 217.2 39.1 5.9Wal-Mart Stores 4.4 206.2 12.8 1.6Merck & Co. 7.1 203.7 24.0 4.8Phillip Morris 2.1 72.0 17.4 6.1ExonMobil 1.9 155.9 10.5 5.4Viacom 1.3 22.6 2.0 -4.4General Motors 0.7 -29.2 5.7 -1.1WorldCom 0.7 -31.8 6.3 -5.4AT&T 0.6 -87.2 4.5 -10.0