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Fundamentals of Corporate Finance/3e,CH02


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Fundamentals of Corporate Finance 3e

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Fundamentals of Corporate Finance/3e,CH02

  1. 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-1Chapter TwoFinancial Statements,Taxes and Cash Flow
  2. 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-22.1 The Statement of Financial Position2.2 The Statement of Financial Performance2.3 Taxes2.4 Cash Flow2.5 Summary and ConclusionsChapter Organisation
  3. 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-3Chapter Objectives• Understand the difference between book value(from the Statement of Financial Position) andmarket value.• Understand the difference between net profit (fromthe Statement of Financial Performance) and cashflow.• Explain the differences between the average taxrate, the marginal tax rate and the flat rate.• Explain the calculation of cash flow from assets,and cash flow to debtholders and shareholders.
  4. 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-4The Statement of Financial Position• Shows a firm’s accounting value on a particulardate.• Equation:Assets = Liabilities + Shareholders’ Equity• Assets are listed in order of liquidity.• Net working capital = Current Assets – CurrentLiabilities
  5. 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-5The Statement of Financial PositionCurrentAssetsFixed Assets1.Tangiblefixed assets2.Intangiblefixed assetsNetWorkingCapitalCurrent LiabilitiesNon-currentLiabilitiesShareholders’ EquityTotal Value of AssetsTotal Value of Liabilitiesand Shareholders’ Equity
  6. 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-6Liquidity• The speed and ease with which an asset can beconverted to cash without significant loss of value.• Current assets are liquid (e.g. debtors).• The more liquid a business is, the less likely it is toexperience financial distress, but liquid assets areless profitable to hold.
  7. 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-7Debt versus Equity• Creditors have first claim on a firm’s cash flow;equity holders have a residual claim.• Financial leverage is the use of debt in a firm’scapital structure.• Financial leverage increases the potential rewardto shareholders, but also increases the potential forfinancial distress and business failure.
  8. 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-8Market Value versus Book Value• Generally Accepted Accounting Principles (GAAP)require audited financial statements to show assetsat historical cost or book value.• Revaluations of assets to fair value are permitted.• The value of a firm relates to market value, or theprice that could be obtained in the current marketplace.
  9. 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-9Example—Market Value versus BookValueABC Company has fixed assets with a book valueof $1700 but they have been revalued to have amarket value of $2000. Net working capital has abook value of $1000, but if all current accountswere liquidated, the company would collect $1400.ABC Company has $1500 in long-term debt—bothbook value and market value.
  10. 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-10Example—Market Value versus BookValueABC CompanyBook Market Book MarketAssets LiabilitiesNet workingcapital$1000 $1400Long-termdebt$1500 $1500Fixed assets $1700 $2000 Equity $1200 $1900Total $2700 $3400 Total $2700 $3400
  11. 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-11The Statement of FinancialPerformance• Measures a firm’s performance over a period oftime.• Equation:Revenues – Expenses = Profit• The difference between net profit and cashdividends is called retained earnings, which isadded to the retained earnings account in theStatement of Financial Position.
  12. 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-12Example—Statement of FinancialPerformanceSales $2000Costs 1400Depreciation 100EBIT 500Interest 100Taxable Income 400Tax 200Net Profit $200Dividends 80Addition to R/E $120
  13. 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-13Example—Statement of FinancialPositionBeg End Beg EndCash $100 $150 A/P $100 $150A/R 200 250 N/P 200 200Inv 300 300 C/L 300 350C/A $600 $700 NCL $400 $420NFA 400 500 Cap 50 60R/E 250 370$300 $430Total $1000 $1200 Total $1000 $1200
  14. 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-14Recording of Financial StatementEntries• The realisation principle is to recognise revenue atthe time of sale.• Costs are recorded according to the matchingprinciple, that is, revenues are identified and costsassociated with these revenues are matched andrecorded.
  15. 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-15Differences• The figures on the Statement of FinancialPerformance may differ from actual cash inflowsand outflows during a period due to:– Revenues and costs being recorded when they arerealised, not when they are received or paid.– The existence of non-cash items such as depreciation.
  16. 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-16Corporate and Personal Tax RatesPersonal ratesTaxable incomeMarginalTax rate0–6000 Nil6001–20 000 17%20 001–50 000 30%50 001–60 000 42%60 001 + 47%Company ratesPrivate and public companiesTax rate30%
  17. 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-17Tax Rates• The average tax rate is the total tax bill divided bytaxable income, that is, the percentage of incomethat goes in taxes.• The marginal tax rate is the extra tax paid if onemore dollar is earned.• A flat rate is where there is only one tax rate that isthe same for all income levels. An example is thetax rate that applies to companies in Australia.
  18. 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-18Example—Tax Rates• An individual has a taxable income of $28 500.• Total tax liability is $4930 (based on the current taxscales).• The average tax rate is 17.30 per cent.• The marginal tax rate is 30 per cent.
  19. 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-19Cash Flow from Assets• The total cash flow from assets consists of:– operating cash flow—the cash flow that results from day-to-day activities of producing and selling; less– capital spending—the net spending on non-currentassets; less– additions to net working capital (NWC)—the amountspent on net working capital.
  20. 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-20Cash Flow from Assets• Cash flow from assets = cash flow to debtholders +cash flow to shareholders• The cash flow to debtholders includes any interestpaid less the net new borrowing.• The cash flow to shareholders includes dividendspaid out by a firm less net new equity raised.
  21. 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-21Cash Flow SummaryOperating cash flow = Earnings before interestand taxes (EBIT) + Depreciation – TaxesNet capital spending = Ending net fixed assets –Beginning net fixed assets + DepreciationChange in NWC = Ending NWC – BeginningNWC
  22. 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-22Statement of Financial Position(000s)Assets (‘000s) 2003 2004Current assetsCashAccounts receivableInventoryTotalFixed assetsNet plant and equipmentTOTAL ASSETS$ 45260320$ 625985$1 610$ 50310385$ 7451 100$1 845
  23. 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-23Statement of Financial Position(000s)Liabilities and equity (‘000s) 2003 2004Current liabilitiesAccounts payableNotes payableTotalLong-term debtShareholders’ equityOrdinary sharesRetained earningsTotalTOTAL LIABILITIES AND EQUITY$ 210110$ 320$ 205290795$1 085$1 610$ 260175$ 435$ 225290895$1 185$1 845
  24. 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-24Statement of Financial Performance(000s)Net sales $710.00Cost of goods sold 480.00Depreciation 30.00DEBIT $200.00Interest 20.00Taxable income 180.00Tax 53.45Net profit $126.55Dividends 26.55Addition to retained earnings $100.00
  25. 25. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-25Cash Flow From AssetsOperating cash flow:EBIT $ 200.00+ Depreciation + 30.00– Taxes – 53.45 $176.55Change in net working capital:Ending net working capital $ 310.00– Beginning net working capital 305.00 $ 5.00Net capital spending:Ending net fixed assets $ 1,100.00– Beginning net fixed assets – 985.00+ Depreciation + 30.00 $145.00Cash flow from assets: $ 26.55
  26. 26. Copyright  2004 McGraw-Hill AustraliaPty Ltd2-26Cash Flows to Debtholders andShareholdersCash flow to debtholders:Interest paid $ 20.00– Net new borrowing – 20.00 $ 0.00Cash flow to shareholders:Dividends paid $ 26.55– Net new equity raised 0.00 $26.55Cash flow to debtholders and shareholders $26.55