Chapter
9
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2
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9
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Chapter 2 - Outline
• Income Statement (I/S)
• P/E Ratio
• Balance Sheet (B/S)
• Statement of Cash Flows (CFs)
• Tax-Free Investments
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Income Statement
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9 An Income
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Statement
shows
profitability
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Sales - Cost of Goods
Sold (COGS) = Gross
Profit (GP)
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GP - Expenses = Earnings Before Interest and
Taxes (EBIT) or Operating Income (OI)
EDITION
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EBIT - Interest =
Earnings Before
Taxes (EBT)
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EBT - Taxes =
Earnings After
Taxes (EAT) or Net
Income (NI)
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The Statement of Retained
Earnings (Table 2-2)—Page 29
STATEMENT OF RETAINED EARNINGS
For the Year Ended December 31, 2001
Retained Earnings, balance, January 1, 2001
Add: Earnings available to common stockholders, 2001
Deduct: Cash dividends declared in 2001
Retained Earnings, balance, December 31, 2001
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$250,000
100,000
50,000
300,000
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Price-Earnings
Ratio is Applied
to Earnings per
Share
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9 The P/E ratio
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compares market
prices with
accounting
earnings
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9 The P/E ratio is
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one of the most
commonly used
measures of
performance
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9 Generally, a high P/E
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ratio suggests two things
–High expectations
(return)
–High risk
(disappointments)
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9 In examining Table 2-3
Foundations of Financial
Management
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(next slide) you should look
for two things
–P/E ratios for any given firm
can change greatly over time.
–P/E ratios at any point in time
vary greatly from firm to firm
and industry to industry
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9 Limitations
of the
Income
Statement
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Accounting
numbers
(historical cost) do
not reflect
economic changes
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9 There is great
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flexibility in
choosing the
accounting
conventions.
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Next, we examine
the Balance Sheet
for Kramer.
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Balance Sheet
A Balance Sheet (B/S) shows
what a firm owns and what it
owes
Remember the ALOE!
Assets = Liabilities + Owners’ Equity
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PPT 2-3
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Concept of Net Worth (Common
Stockholder Equity)—Page 33
Total Assets
Total Liabilities
Stockholders’ equity
Preferred stock obligation
Net worth assigned to common
Common shares outstanding
Net worth, or book value, per share
$1,000,000
300,000
700,000
50,000
650,000
100,000
$6.50
Note that preferred value is removed
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Price-to-Book
(P/B) is similar to
P/E ratio
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P/B ratio is
commonly used as
a measure of
relative value
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P/B ratio compares
market price with
accounting book
value
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9 Generally, a high P/B
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ratio suggests:
• High market
expectations.
• High risk due to
heightened expectations.
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Limitations of Balance Sheet
• Historical cost is used.
• Table 2-5 shows the large
disparities between market value
per share and historical book value
for a number of publicly traded
companies.
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Next, we turn to
the Statement of
Cash Flow
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9 To create a Statement of
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Cash Flow for Kramer, we
will need:
• Balance sheet for beginning
of year
• Balance sheet for ending of
year
• Income statement for year.
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The Statement of Cash Flows
(CFs) measures the flow of cash
throughout a firm
CF from operating activities PLUS
CF from financing activities PLUS
CF from investing activities
EQUALS
Net increase (decrease) in cash
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Healthy
Operations should
provide cash flow
to the business
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Table 2-8
Cash flows from Investing Activities—Page 38
EDITION
Increase in investments (long-term securities) (Table 2-6)
Increase in plant and equipment (Table 2-6)
Net cash flows from investing activities
($30,000)
(100,000)
($130,000)
Kramer has used cash for the above purposes.
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Financing activities are transactions on the
“right side” of the balance sheet (liabilities
and owners equity) (Table 2-9)—Page 39
Increase in bonds payable (Table 2-6)
Preferred stock dividends paid (Table 2-1)
Common stock dividends paid (Table 2-2)
Net cash flows from financing activities
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$50,000
(10,500)
(50,000)
($10,500)
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Depreciation and
Funds Flow
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Depreciation is the accountant’s way
of allocating the cost of capital
equipment over the life of the
equipment
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You must remember that the
actual expenditure occurs at the
time of purchase—NOT later
when depreciation is written
off.
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Depreciation is a NONCASH expense on the
balance sheet—no
disbursement of funds
actually occurs
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Depreciation
smoothes accounting
earnings, but distorts
cash flows.
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Depreciation
affects cash flows
by providing a tax
benefit that is
spread over time.
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9 Consider a company that
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purchases new
equipment for $500,
which it will write off
(depreciate) over a 5-year
period.
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T 2-10
Table 2-11a
Comparison of accounting and cash flows—Page 40
Year 1
(A)
(B)
Accounting Flows Cash Flows
Earnings before depreciation and taxes (EBDT) .
Depreciation . . . . . . . . . . .
.
.
$1,000
100
$1,000
100
Earnings before taxes (EBT)
Taxes . . . . . . .
.
.
.
.
.
.
.
.
900
300
900
300
Earnings after taxes (EAT) . . . . .
Purchase of equipment . . . . . .
Depreciation charged without cash outlay
Cash flow
. . . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
$600
600
-500
+100
$ 200
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.
.
.
.
.
.
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T 2-10
Table 2-11b
Comparison of accounting and cash flows—Page 41
Year 2
(A)
(B)
Accounting Flows Cash Flows
Earnings before depreciation and taxes (EBDT) .
Depreciation
. . . . . . . . . .
.
.
$1,000
100
$1,000
100
Earnings before taxes (EBT) .
Taxes
. . . . . . .
.
.
900
300
900
300
.
.
.
.
.
.
Earnings after taxes (EAT). . . . .
Depreciation charged without cash outlay
Cash flow . . . . . . . . .
.
.
.
.
.
.
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.
.
.
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.
.
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$ 700
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Free cash flow is a
very important
concept to lenders
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Free Cash Flow =
Cash flow from operating activities
minus: Required capital
expenditures (to maintain
productive capacity)
minus: Required dividends
(necessary to maintain stock price
and satisfy preferred
requirements)
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Income Tax
Considerations
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Income taxes affect financial
decisions.
For instance, there is “double
taxation”of corporate earnings.
This means that the same $ is taxed
twice:
Corporate income tax (on
earnings)
Personal income tax (on
dividends)
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Tax-Free
Investments
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9 Municipal Bonds are:
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–exempt from federal
income tax
–issued by local governments
(or municipalities)
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To compare a municipal to a
taxable bond:
After-tax i rate = Actual i rate x
(1-TR)
Ex., at 28% tax rate (TR), 12%
taxable bond is equivalent to
8.64% municipal bond
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Cost of a Taxdeductible
Expense
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9 All tax-deductible expenses
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provide a tax benefit equal
to:
Corporate tax rate X amount of
deductible expense.
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9 If the expense requires
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actual cash outlays, then the
net (after-tax) cost is:
Expense – tax benefit.
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9 If the expense is non-cash
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(depreciation) then there is only
a tax benefit:
benefit of non-cash expense =
Corporate tax rate X deductible
expense.
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Because depreciation
carries only a tax
benefit, we say that
depreciation offers a
“tax shield”
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This example (Page 43) shows how
taxes reduce deductible expenses
Earnings before interest and taxes
Interest
Earnings before taxes (taxable income)
Taxes (40%)
Earnings after taxes
Difference in earnings after taxes
Corporation A
Corporation B
$400,000
$400,000
100,000
0
300,000
400,000
120,000
160,000
$180,000
$240,000
$60,000
Note that the difference is 100,000(1-.4)—the $40,000 represents tax savings.
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This example (Page 43) shows how
depreciation acts as a tax shield
Corporation A
Corporation B
Earnings before interest and taxes
$400,000
$400,000
Interest
100,000
0
Earnings before taxes (taxable income)
300,000
400,000
Taxes (40%)
120,000
160,000
Earnings after taxes
$180,000
$240,000
+ Depreciation charged without cash outlay
100,000
0
Cash flow
$280,000
$240,000
Difference in earnings after taxes
$40,000
Note that the difference is 100,000(.4)—there was never really any $100,000
expenditure.
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THE END
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