Accounting and Finance

P.V. Viswanath

For use with

Fundamentals of Corporate Finance
Brealey, Myers and Marcus, 4th ed.

Key Concepts and Skills

Know the difference between book value and market
value
Know the difference between accounting income
and cash flow
Know the difference between average and marginal
tax rates
Know how to determine a firms cash flow from its
financial statements

P.V. Viswanath

Chapter Outline
The Balance Sheet
The Income Statement
Taxes
Cash Flow

P.V. Viswanath

The Balance Sheet

The balance sheet is a snapshot of the firms
assets and liabilities at a given point in time
Assets are listed in order of liquidity
Ease of conversion to cash
Without significant loss of value
Balance Sheet Identity
Assets = Liabilities + Stockholders Equity

P.V. Viswanath

The Balance Sheet

Current Assets
Cash & Securities
Receivables
Inventories

+
Fixed Assets
Tangible Assets
Intangible Assets

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Current Liabilities
Payables
Short-term Debt

+
Long-term Liabilities

+
Shareholders Equity
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Pepsico Inc. Balance Sheet (in mil. $)

Assets
Current AssetsCashAnd
Cash
Short Term
Investm
ents
Net
Receivables
Inventory
Other Current Assets
Total Current Assets
LongTermInvestments
PropertyPlant andEquipment
Goodwill
IntangibleAssets
Other Assets
Total Assets

28-Dec-02
1,638
207
2,531
1,342
695
6,413
2,611
7,390
3,631
1,588
1,841
23,474

29-Dec-01 Liabilities

28-Dec-02 29-Dec-01
6,052
4,998
Current Liabilities
683
Accounts Payable
5,490
3,484
966
562
354
Short/Current LongTermDebt
2,142
Other Current Liabilities
-
1,160
1,310 Total Current Liabilities
6,052
4,998
752 LongTermDebt
2,187
2,651
5,853 Other long-termliabilities
5,937
5,398
2,871 Total Liabilities
14,176
13,021
6,876 CommonStock &Other Paid-upCapital
30
43
3,374 RetainedEarnings
9,268
8,605
1,467 Total Stockholder Equity
9,298
8,674
1,254
21,695 Tot Liabs & Shareholders' Equity 23,474
21,695

P.V. Viswanath

Market vs. Book Value

The balance sheet provides the book value of the
assets, liabilities and equity.
Market value is the price at which the assets,
liabilities or equity can actually be bought or sold.
Market value and book value are often very
different. Why?
Which is more important to the decision-making
process?

P.V. Viswanath

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 firms 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.

P.V. Viswanath

Market Value vs. Book Value

Example
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil

Market Value Balance Sheet

Assets = $11.5 bil
Debt = $4 bil
Equity = $7.5 bil
P.V. Viswanath

Income Statement
The income statement is more like a video of
the firms operations for a specified period of
time.
You generally report revenues first and then
deduct any expenses for the period
Matching principle GAAP say to show
revenue when it accrues and match the
expenses required to generate the revenue

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Income Statement
Pepsico Inc. (in mil. $)
Income Statement

Dec 02

Dec 01

Revenue

25,112.00 26,935.00

Cost of Goods Sold

10,523.00

Gross Profit

14,589.00 17,098.00

9,837.00

SG&A Expense

8,523.00 11,608.00

Depreciation & Amortization

1,112.00

1,082.00

Operating Income

4,954.00

4,408.00

Nonoperating Income

316

227

Nonoperating Expenses

178

219

Income Before Taxes

4,868.00

4,029.00

Income Taxes

1,555.00

1,367.00

Net Income After Taxes

3,313.00

2,662.00

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Taxes
Marginal vs. average tax rates

Marginal the percentage paid on the next dollar earned

Average the tax bill / taxable income

Income before taxes was $4868 and $4029 and taxes were
$1555 and $1367 for 2002 and 2001 resp. (in mil. $)
The average tax rates were 31.94% and 33.93%.
However, the tax paid on an additional dollar of income in
either year would have been 35%, considering that in 2002,
any income over $18 mil. was taxed at a rate of 35%.
P.V. Viswanath

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Statement of Cashflows
A firms cashflows can be quite different from its
net income. For example:

The income statement does not recognize capital

expenditures as expenses in the year that the capital
goods are paid for. Those expenses are spread over time
as a deduction for depreciation.
The income statement recognizes revenues and expenses
when sales are made, even though the money may not
have been collected (revenues) or paid out (expenses).

P.V. Viswanath

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The Statement of Cashflows

The statement of cashflows shows the firms cash
inflows and outflows from

Operations
Investments and
Financing

The form of this statement is determined by

accounting standards.

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Statement of Cash Flows:

Operating Activities
Operating activities are earnings-related activities.
Generally these relate to Income Statement activities,
and items included in working capital. Included are:

Sales and expenses necessary to obtain sales

Related operating activities, such as extending credit to
customers
investing in inventories
obtaining credit from suppliers
payment of taxes
insurance payments
Other activities that don't easily fit into the other two
categories, such as settlements in lawsuits.

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Statement of Cash Flows:

Investing and Financing Activities
Investing activities relate to the acquisition
and disposal of noncash assets: assets which
are expected to generate income for the
company over a period of time. These include
lending funds and collecting on these loans.
Financing activities relate to the contribution,
withdrawing and servicing of funds to support
business activities.

P.V. Viswanath

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Pepsico Inc. (in mil. $)

Statement of Cash Flows 2002
3,313
Net Income
Operating Activities, Cash Flows Provided By or Used In
1,112
Depreciation
-390
Adjustments To Net Income
-260
Changes InAccounts Receivables
704
Changes InLiabilities
-53
Changes InInventories
201
Changes InOther OperatingActivities
4,627
Total Cash FlowFrom Operating Activities
Investing Activities, Cash Flows Provided By or Used In
-1,437
Capital Expenditures
757
Investments
153
Other Cashflows fromInvestingActivities
-527
Total Cash Flows From Investing Activities
Financing Activities, Cash Flows Provided By or Used In
-1,041
Dividends Paid
-1,734
SalePurchaseof Stock
-404
Net Borrowings
-3,179
Total Cash Flows From Financing Activities
34
Effect Of ExchangeRateChanges
$955
Change In Cash and Cash Equivalents

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An alternate way of defining cashflows

Sometimes we are interested in defining cashflows for other
purposes, such as project evaluation. Or we may interested in how
cash is generated from the use of assets and how it is paid to those
that finance the purchase of the assets
For this purpose, we separate cashflows into flows from assets
and flows to shareholders and creditors.
We are interested in whether cashflows refer to investments, in
the sense that they expand the asset base and are ultimately
reflected in the balance sheet; or to operating returns from the use
of assets, which are reflected in the income statement.
This differs from the GAAP oriented categorization of cashflows
in the Statement of Cashflows.
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Cashflows from Assets

Since increases in working capital are increases in investments, they are
not relevant for the determination of cashflows pertaining to recurring
returns from the use of assets. A definition of Operating Cashflow for
project evaluation purposes becomes:
Operating Cashflow = EBIT + Depreciation Taxes.
The other items that appear in the Cashflows from Operations category
in the Statement of Cashflows, e.g. change in accounts receivable are,
really, short-term investments. We define these separately as Change in
Working Capital.
Finally, we have Net Capital Spending or long-term investments.
Together, we have
Cashflows from Assets = Operating Cashflow Change in Working
Capital Net Capital Spending.

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An alternative definition of cashflows

Assets
Change in WC

Current Assets
Current Liabilities
Fixed Assets

Net Capital
Spending

Liabilities
CF to
Debtholders

Debt

Interest
CF to
Stockholders

Equity
Paid-in capital

Dividends

Retained Earnings
Operating
Cashflow

P.V. Viswanath

Income Statement

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Cash Flow From Assets

Definition:
Cash Flow From Assets = Operating Cash Flow Net
Capital Spending Changes in NWC
Identity:
Since cashflows from assets have to equal cashflows
from liabilities, we have:
Cash Flow From Assets (CFFA) = Cash Flow to Creditors
+ Cash Flow to Stockholders

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An alternative definition of cashflows

Operating Cashflows recurring cashflows generated by the
use of assets
(Net Working Capital) and Net Capital Spending are
investment outlays to build up the assets that generate
cashflows.
Cashflows to Stockholders and Cashflow to Bondholders are
how the investments are funded.
The division of cashflows into operating cashflows and new
investments in assets is important in forecasting future
cashflows. Investments in assets are the drivers and
operating cashflows are the result of this investment.
New investment and forecasted growth in operating
cashflows need to be consistent with each other.
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22

An alternate way of defining cashflows:

Summary
I. The Cashflow identity:
Cashflow from assets = Cashflow to creditors + cashflow to stockholders
II. Cashflow from assets = Operating Cashflow
- Net Capital Spending
- Change in Net Working Capital (NWC)
where
Operating Cashflow = EBIT + Depreciation Taxes
Net Capital Spending = (Net Fixed Assets) + Depreciation (approximately)
III. Cashflow to creditors = Interest paid Net new borrowing
IV. Cashflow to stockholders = Dividends paid Net new equity raised
Because data in the firms public financial statements are aggregated, it is often
difficult to recover the quantities above without access to more detailed firm
accounts.
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Example: US Corporation
Balance Sheet Information

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US Corporation
Income Statement Information

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Cashflow to Assets: Computation

Operating Cash Flow (I/S) = EBIT + depreciation
taxes = $547
Net Capital Spending ( B/S and I/S) = ending net fixed
assets beginning net fixed assets + depreciation =
$130
Changes in Net Working Capital (B/S) = ending NWC
beginning NWC = $330
Cash Flow From Assets (CFFA) = 547 130 330 =
$87

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Cashflow to Stockholders/Creditors
CF to Creditors (B/S and I/S) = interest paid net new
borrowing = $24
CF to Stockholders (B/S and I/S) = dividends paid net new
equity raised = $63
CFFA = 24 + 63 = $87
As we saw before, this is the same amount that we
computed for Cashflow from Assets

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Quick Quiz
What is the difference between book value and market
value? Which should we use for decision making purposes?
What is the difference between accounting income and cash
flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax
rates? Which should we use when making financial
decisions?
How do we determine a firms cash flows? What are the
equations and where do we find the information?

P.V. Viswanath

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