Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.
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Transcript of Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.
Chapter 2, Fundamentals by Ross et. al.
3040.03/04 notes by A.P. Palasvirta, Ph.D.
balance sheetStock statementOrganizing the value of assets (right-hand
side) Different categories at a given time
Short termLong term
Organizing the methods of financing of the assets (left-hand side) Different categories at a given time
Short-termLong-term
Debt equity
204/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Current Assets less than a year easily convertible
secondary mkts Fixed Assets
more than a year Lumpy
Total Assets
Current Liabilities less than a year
Long-term Liabilities more than a year fixed obligations
Equity infinite variable
Liabilities & Equity
304/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Cash cash & checking accounts at banks
Marketable Securitiesequity & debt securities of other firms
Accounts Receivablegood sold & invoiced but not paid for
InventoriesBoth inputs & outputs
404/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
plant & equipvalue of all physical assets of the firm
less depreciation loss of value due to wear & tear or
innovation
504/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Kinds of assetsvalue of patentsgood guy capitalvalue of training to employeesmanagement
Valuation ??no book valuemarket value difficult to determine
604/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Payablesaccounts payablenotes payable
Accrualswage accruals tax accruals interest accruals
704/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Current Assets - Current Liabilities19X2 $761 - 486 = 27519X1 $707 - 455 = 252
Liquidity measureability to pay current liabilities
Change in NWC
804/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Cash, checking Receivable
Due from employer Inventories
Food Gasoline Home heating oil
Visa bill Accruals
Electricity Rent Cable cell
904/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Discount bonds lump-sum payment at term (prin & int)
Coupon bonds interest annuity paid at equal intervalsprincipal repaid at term
Mortgage bondsannuity paid including (prin & int)
Deferred Tax liabilities
1004/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Preferred Stock Stockholder equity
Common Stock value of all stock issued at Par
Capital Surplus incremental value stock relative to par
Accumulated Retained Earnings historical sum of retained earnings
1104/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
proportion of debt to equity finance increased leverage increases default risk
debt - fixed payments, default & loss of control equity - residual payments, no default
measures of capital structuredebt ratio = total liabilities / total assetsdebt to equity ratio = total liabilities /
equity
1204/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
NWC = Current assets (CA) – current liabilities (CL) CA = Cash + marketable securities +
receivables + inventories CL = Payables + Accruals
Measure of the liquidity health of the firmHigher positive value means higher ability
to pay its obligationsHigher value means firm is investing more
in assets that do not earn a return
1304/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Cash, checking $204.43
Receivable Work =
$653.11 Inventories
Food = $26 Gasoline = $11
CA = $894.54
Visa bill Min pymt = $40.00
Accruals Electricity = $53.72 Rent = $500.00 Cable = $45.98 Cell = $52.87 Tuition = $650.00
CL = $1342.57
1404/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Speed of conversion How quickly assets can be coverted to cash
Cash to fixed assets How quickly liabilities must be converted to
cash Payables to equity (infinite term)
Assets and liabilities ordered by liquidity Most liquid assets to least liquid
Those most easily converted to cash on top Those hardest to covert into case on bottom
Most liquid liabilities to least liquid Those coming due first on top Those which never become due on bottom
1504/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Debt holdersPayment schedule fixed by contract
Priority of payment makes debt less risky Less risk (to debt holders) means lower costs Interest cost deductible before taxes Risk to firm managers
Non payment leads to loss of control Bankruptcy judge controls firm Managers/owners no longer control assets
EquityStockholders get residualHigher risk, higher expected return
1604/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Balance sheetAll items book value
Book values are easy to calculate Assets are valued at what was paid minus
depreciation (for tax purposes) Liabilities are valued at principal remaining Equity = total assets – total liabilities
Market valueWhat you can get in secondary markets
Receivables, inventories, fixed assets Much harder to calculate because fixed assets
may have very small market
1704/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
CA = $894.54
Clothing = $750 Cell = $150 Lap top = $1500 Misc = $650 Capital = $50,000
TA = $53,944.54
CL = $1342.57
LT Debt = $24,000.00
Equity = $28,601.97
TL & E = $53,944.54
1804/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Flow statementAccounting of cash flows into various
categories over a period of time Positive cash flows (revenues, sales)
Revenues from sales Income from financial investmentsRoyalties, rentals, licensing agreements
Negative cash flows (costs, expenses)Cost of goods sold COGS - variable cost
Labor, inputs Operating costs – fixed costs
Management, marketing
1904/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Total Operating Revenues (sales) (cost of goods sold)
variable over short run (selling & administrative costs)
fixed over short run (capital cost allowance) CCA
Allowance as depreciation for tax computation
Operating Incomemisc income
Revenue from investments, royalties, etc.
Earnings before Interest and Taxes (EBIT)
2004/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Earnings before Interest and Taxes (Interest expense on fixed liabilities)
Earnings before Taxes (Taxes)Capital cost allowance (CCA)
non-cash item
Net Income (net cash flow) Retained earningsDividends
2104/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
dividendsearnings distributed as a proportional cash
flow back to the stock holder
retained earningsbuy assets
current assets, fixed assetspay liabilities
lines of credit, bank loans, bonds
2204/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Operating Cash FlowCash flows to providers of capital
Capital Spending (Fixed assets)Purchase of new capitalRepair of existing capital
Change in NWC (Current assets)NWC = CA – CLFinancing for current assets not financed
through current liabilities
2304/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Depreciation is not a cash flow Deduction for reducing taxable income
Interest expense is not deducted not an operating expense finance expense
Operating cash flows should be positive Support interest payments to debt holders Support dividend payments to stockholders
TaxDepEBITCFoper
2404/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Change in debt can be positive or negative New financing through debt (negative) Paying off existing debt (positive)
Cash flow to debt holders should be positive Bond holders do not want to see interest paid
through the issue of new debt Cash flow to debt holders may be negative
Debt used to finance new project Principal repayment not cash flow to debt holder
DIntCFdebt
2504/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Change in equity can be positive or negative financing through new equity issue (negative) Repurchase of stock (positive)
Should be positive Stock holders do not want to see their dividend being
paid from a new issue of stock May be negative
New issue being used to finance new project
newequity EDivCF
2604/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Purchases of fixed assets over the yearNew projectsOverhaul or maintenance of old machines
Measure of addition of value to the firm over the year
2704/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Additions to current assets not financed through additions to current liabilities Negative value for NWC financing (more
sales) Need more inventories, cash, receivables But need more long-term financing for these
needs Positive value for NWC financing (less sales)
Need less inventories, cash, receivables Cash flow returned to firm for use elsewhere
1200200200 xxx NWCNWCNWC
2804/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Cash, checking $204.43
Receivable Work =
$653.11 Inventories
Food = $26 Gasoline = $11
CA = $894.54
Visa bill Min pymt = $40.00
Accruals Electricity = $53.72 Rent = $500.00 Cable = $45.98 Cell = $52.87 Tuition = $650.00
CL = $1342.57
2904/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
MarginalTax rate
AverageTax rate
Income
Tax
3004/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Progressive tax rates Marginal tax rate increases with income Average tax rate increases with income Marginal tax rate > average tax rate
Proportional Marginal and average tax rate constant with
income Regressive
Marginal tax rate decreases with income Average tax rate decreases with income
3104/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Sources of incomeWages & salaries
Progressive Taxable income
Less deductions & exclusionsRental, proprietorships, & partnerships
Deduction of expensesCapital gains
Progressive Fraction of full gains
Corporate Deductions for expenses, tax breaks
3204/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Government allowance for the reduction in value of assets over timeDepreciation of assets
Lowers book value of assets on balance sheet Allows reduction of taxable income
Government sets the CCA rate for classes of assets Buildings 4% Motorized equipment 30% Pollution control equip 50% Leasehold improvements straight line
3304/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
Delivery van initial cost $60,000
3404/19/233040.03/04 notes by A.P. Palasvirta, Ph.D.
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 35
end-of year balance sheets
2,005 2,006 2,005 2,006
cash $114 $160 payables $232 $266
receivables $445 $688 S-T debt $196 $123
inventory $553 $555
CA $1,112 $1,403 CL $428 $389
L-T debt $408 $454
liabilities $836 $843
common shares $600 $640
retained earnings $1,320 $1,629
fixed assets $1,644 $1,709 owner equity $1,920 $2,269
total assets $2,756 $3,112 total $2,756 $3,112
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 36
income statement
2006
net sales $1,509
cogs ($750)
CCA ($65)
EBIT $694
interest pd ($70)
EBT $624
taxes ($250)
CCA $65
net income $439
retained $374
dividend ($65)
Operating CF = EBIT + CCA (depreciation) – taxesCCA is not a real cash flow
Allowance by the government for reduction in the value of assetsNon-cash itemBecause of agingBecause of new technologies
Adjustment to reduce taxable income Interest expense not countedOperating CF = 694 + 65 – 250 = 509
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 37
Cost of goods soldVariable cost over the short run
Variable with level of productionLabor Inputs (raw materials)Energy
Operating costsFixed over short run
Management (administrative) marketing
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 38
Investment in fixed assetsEnding FX2006 - FX2005 + CCA = capital
spending Change in fixed assets over the year Minus the depreciation of the asset during the
year
capital spending = 1709-1644 + 65 Depreciation added just shows that the firm must
spend at least 65 to keep the assets at the same book value
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 39
Ending NWC2006 - NWC2005 = ΔNWC Investment in new net working capital When sales grow, your requirements for
current assets increase New cash requirements, additional receivables,
higher levels of inventories Some of these assets are financed by increases in
current liabilities such as accruals and payablesThe difference must be financed by other forms
of financing If sales decrease the ΔNWC will be negative
ΔNWC = 1014 – 684 = 330April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 40
Interest Pd – net new borrowing = Cash flow to creditors Ending L-T Debt2005 - L-T Debt2006 + Int pd =
cash flow to creditors Bondholders are interest in this being
positive Bondholders do not want new debt to paying
interest payments to old debt holders
Cash flow to creditors = 408 – 454 + 70 = 24
Including S-T debt836 – 843 + 70 =63Does it make sense to include short term debt?
April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 41
Dividends – New Equity = cash flow to shareholdersEnding CS2005 - CS2006 + Div = cash flow to
shareholdersShareholders like bondholders do not want
to see the dividend paid by issuing new stock
Capital gain creates for the shareholder Increase in investment net of depreciation
should increase the value of the firm Price appreciation of stock is at market value not
book value, not on balance sheet
CF shareholders = 600 – 640 + 65 = 25 April 19, 20233040.05/06 notes by A.P. Palasvirta, Ph.D. 42