Chapter 3
Accounting and Finance
Topics Covered
3.1 The Balance Sheet
3.2 The Income Statement
3.3 The Statement of Cash Flows
3.4 Accounting Practice & Malpractice (Excluded)
3.5 Taxes
The Balance Sheet
Definition
Financial statement that show the value
of the firm’s assets and liabilities at a
particular point in time (from an
accounting perspective).
Balance Sheet
PepsiCo Balance Sheet (December 31, 2006)
$Millions

The Balance Sheet
The Main Balance Sheet Items
Current Assets
Cash & Securities
Receivables
Inventories
+
Current Liabilities
Payables
Short-term Debt
=
+
Long-term Liabilities
Fixed Assets
Tangible Assets
Intangible Assets
+
Shareholders’ Equity
The Balance Sheet
 Common-Size Balance Sheet

All items in the balance sheet are
expressed as a percentage of total
assets.
Common Size Balance Sheet
Market Value vs. Book Value
Book Values are determined by GAAP
Market Values are determined by current values
 Generally Accepted Accounting Principles
(GAAP)
 Procedures for preparing financial statements.
Equity and Asset “Market Values” are usually
higher than their “Book Values”
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.
Market Value vs. Book Value
Example (continued)
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
The Income Statement
Definition
Financial statement that shows the
revenues, expenses, and net income of a
firm over a period of time (from an
accounting perspective).
The Income Statement
Pepsico Income Statement (year end 2006)
Net Sales
COGS
Selling, Gen.&Admin. expenses
Depreciation expense
EBIT
Net interest expense
Taxable Income
Income Taxes
Net Income
35,753
-15,762
-11,530
-1,406
7,055
66
6,989
1,347
5,642
The Income Statement
Earnings Before Income & Taxes (EBIT)
EBIT = Total Revenues - costs – deprecation
=
35,753
– 27,292 – 1,406
= $ 7,055 million
The Statement of Cash Flows
Definition
Financial statement that shows the
firm’s cash receipts and cash payments
over a period of time.
Cash Flows
 Free Cash Flow (FCF)

Cash available for distribution to investors after
firm pays for new investments or additions to
working capital
FCF =
EBIT
- taxes + depreciation
- change in net working capital
- capital expenditures
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.
Taxes
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.
EBIT
Interest
Pretax Income
Taxes (35%)
Net Income
Firm A
100
40
60
21
39
Firm B
100
0
100
35
65
Taxes
FOOD FOR THOUGHT - 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
?
Taxes
FOOD FOR THOUGHT - 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
?
Corporate Tax Rates
Taxable Income ($)
0-50,000
50,001-75,000
75,001-100,000
100,001-18,333,333
over 18,333,333
Tax Rate (%)
15
25
34
34-39
35
Personal Tax Rates
Single Taxable
Income ($)
0 - 8,025
8,025–32,550
32,550–78,850
78,850–164,550
164,550–357,700
over 357,700
Married Taxable
Income ($)
0–16,050
16,050–65,100
65,100–131,450
131,450–200,300
200,300–357,700
over 357,700
Tax Rate (%)
10
15
25
28
33
35
Personal Tax Rates
Ex: If your total income is $40,000,
a) What is your tax bill according to the marginal tax
rates?
b) What is your average tax rate?
a. Tax bill= (0.1x8025)+[0.15x(32250-8025)]+
[0.25x(40000-32250)]=$6343.75
b. Average tax rate = Tax Bill / Total Income
= 6343.75 / 40000=0.159=15.9%