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


Cash cash & checking accounts at banks

Marketable Securitiesequity & debt securities of other firms

Accounts Receivablegood sold & invoiced but not paid for

InventoriesBoth inputs & outputs


plant & equipvalue of all physical assets of the firm

less depreciation loss of value due to wear & tear or

innovation


Kinds of assetsvalue of patentsgood guy capitalvalue of training to employeesmanagement

Valuation ??no book valuemarket value difficult to determine


Payablesaccounts payablenotes payable

Accrualswage accruals tax accruals interest accruals


Current Assets - Current Liabilities19X2 $761 - 486 = 27519X1 $707 - 455 = 252

Liquidity measureability to pay current liabilities

Change in NWC


Cash, checking Receivable

Due from employer Inventories

Food Gasoline Home heating oil

Visa bill Accruals

Electricity Rent Cable cell


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


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


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


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


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


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


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


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


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


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


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)


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


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


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


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


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


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


Purchases of fixed assets over the yearNew projectsOverhaul or maintenance of old machines

Measure of addition of value to the firm over the year


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


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


MarginalTax rate

AverageTax rate

Income

Tax


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


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


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


Delivery van initial cost $60,000


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


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


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


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


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?


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

Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.

Documents

Transcript of Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.