Chapter 2, Fundamentals by Ross et. al.
3040.03/04 notes by A.P. Palasvirta, Ph.D.
 balance


Stock statement
Organizing the value of assets (right-hand side)


sheet
Different categories at a given time
 Short term
 Long term
Organizing the methods of financing of the assets
(left-hand side)

Different categories at a given time
 Short-term
 Long-term


Debt
equity
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
2



Current Assets
 less than a year
 easily convertible
 secondary mkts
Fixed Assets
 more than a year
 Lumpy
Total Assets
3040.03/04 notes by A.P. Palasvirta, Ph.D.
Current Liabilities
 less than a year
 Long-term Liabilities
 more than a year
 fixed obligations
 Equity
 infinite
 variable
Liabilities & Equity


7/17/2016
3
 Cash

cash & checking accounts at banks
 Marketable

equity & debt securities of other firms
 Accounts

Securities
Receivable
good sold & invoiced but not paid for
 Inventories

Both inputs & outputs
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
4
 plant

value of all physical assets of the firm
 less

& equip
depreciation
loss of value due to wear & tear or innovation
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
5
 Kinds




of assets
value of patents
good guy capital
value of training to employees
management
 Valuation


??
no book value
market value difficult to determine
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
6
 Payables


accounts payable
notes payable
 Accruals



wage accruals
tax accruals
interest accruals
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
7
 Current


Assets - Current Liabilities
19X2
19X1
$761 - 486 = 275
$707 - 455 = 252
 Liquidity

measure
ability to pay current liabilities
 Change
in NWC
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
8
 Cash,
checking
 Receivable

Due from employer
 Inventories
Food
 Gasoline
 Home heating oil

3040.03/04 notes by A.P. Palasvirta, Ph.D.
 Visa
bill
 Accruals
Electricity
 Rent
 Cable
 cell

7/17/2016
9
 Discount

lump-sum payment at term (prin & int)
 Coupon


bonds
interest annuity paid at equal intervals
principal repaid at term
 Mortgage

bonds
bonds
annuity paid including (prin & int)
 Deferred
Tax liabilities
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
10
 Preferred
Stock
 Stockholder equity

Common Stock


Capital Surplus


value of all stock issued at Par
incremental value stock relative to par
Accumulated Retained Earnings

historical sum of retained earnings
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
11
 proportion

increased leverage increases default risk


debt - fixed payments, default & loss of control
equity - residual payments, no default
 measures


of debt to equity finance
of capital structure
debt ratio = total liabilities / total assets
debt to equity ratio = total liabilities / equity
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
12

NWC = Current assets (CA) – current liabilities
(CL)


CA = Cash + marketable securities + receivables +
inventories
CL = Payables + Accruals
 Measure


of the liquidity health of the firm
Higher positive value means higher ability to pay
its obligations
Higher value means firm is investing more in
assets that do not earn a return
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
13

Cash, checking


$204.43
Work
= $653.11
Inventories


Visa bill

Receivable



Food =
$26
Gasoline = $11

=
$894.54
3040.03/04 notes by A.P. Palasvirta, Ph.D.
=
$40.00
Accruals




 CA
Min pymt

 CL
7/17/2016
Electricity =
Rent
=
Cable
=
Cell
=
Tuition
=
=
$53.72
$500.00
$45.98
$52.87
$650.00
$1342.57
14
 Speed

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



of conversion
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
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
15
 Debt

holders
Payment 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
 Equity


Stockholders get residual
Higher risk, higher expected return
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
16
 Balance

All 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

sheet
value
What you can get in secondary markets


Receivables, inventories, fixed assets
Much harder to calculate because fixed assets may
have very small market
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
17
 CA





=
$894.54
Clothing =
$750
Cell
=
$150
Lap top =
$1500
Misc =
$650
Capital = $50,000
 TA
=
$53,944.54
3040.03/04 notes by A.P. Palasvirta, Ph.D.
 CL
=
$1342.57

LT Debt = $24,000.00

Equity = $28,601.97
 TL
7/17/2016
& E = $53,944.54
18


Flow statement
Accounting of cash flows into various categories
over a period of time


Positive cash flows (revenues, sales)
 Revenues from sales
 Income from financial investments
 Royalties, rentals, licensing agreements
Negative cash flows (costs, expenses)
 Cost of goods sold COGS - variable cost


Labor, inputs
Operating costs – fixed costs

Management, marketing
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
19
 Total

(cost of goods sold)


variable over short run
(selling & administrative costs)


Operating Revenues (sales)
fixed over short run
(capital cost allowance) CCA

Allowance as depreciation for tax computation
 Operating

Income
misc income

Revenue from investments, royalties, etc.
 Earnings
before Interest and Taxes (EBIT)
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
20
 Earnings

(Interest expense on fixed liabilities)
 Earnings


non-cash item
 Net

before Taxes
(Taxes)
Capital cost allowance (CCA)


before Interest and Taxes
Income (net cash flow)
Retained earnings
Dividends
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
21
 dividends

earnings distributed as a proportional cash flow
back to the stock holder
 retained

buy assets


earnings
current assets, fixed assets
pay liabilities

lines of credit, bank loans, bonds
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
22
 Operating

Cash flows to providers of capital
 Capital



Spending (Fixed assets)
Purchase of new capital
Repair of existing capital
 Change

Cash Flow
in NWC (Current assets)
NWC = CA – CL
Financing for current assets not financed through
current liabilities
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
23
CF

EBIT

De

Ta
oper
 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

3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
24
CF
Int


D
d
eb
t




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
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
25
CF

Div


E
equity
new

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
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
26
Cap Spending  FA200 x  FA200 x  1  Dep200 x
 Purchases


of fixed assets over the year
New projects
Overhaul or maintenance of old machines
 Measure
the year
of addition of value to the firm over
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
27

NWC

NW

NW
200
x
200
x
20
x

1
 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
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
28

Cash, checking


$204.43
Work
= $653.11
Inventories


Visa bill

Receivable



Food =
$26
Gasoline = $11

=
$894.54
3040.03/04 notes by A.P. Palasvirta, Ph.D.
=
$40.00
Accruals




 CA
Min pymt

 CL
7/17/2016
Electricity =
Rent
=
Cable
=
Cell
=
Tuition
=
=
$53.72
$500.00
$45.98
$52.87
$650.00
$1342.57
29
Marginal
Tax rate
Tax
Average
Tax rate
Income
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
30
 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

3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
31
 Sources

Wages & salaries



Deduction of expenses
Capital gains



Progressive
Taxable income
 Less deductions & exclusions
Rental, proprietorships, & partnerships


of income
Progressive
Fraction of full gains
Corporate

Deductions for expenses, tax breaks
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
32
 Government
allowance for the reduction in
value of assets over time

Depreciation 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
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
33
 Delivery
van initial cost $60,000
3040.03/04 notes by A.P. Palasvirta, Ph.D.
7/17/2016
34
end-of year balance sheets
2,005
2,006
cash
$114
$160
receivables
$445
$688
inventory
$553
$555
CA
$1,112
$1,403
2,005
2,006
payables
$232
$266
S-T debt
$196
$123
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
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
35
income statement
2006
3040.05/06
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)
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
36
 Operating
CF = EBIT + CCA (depreciation) –
taxes

CCA is not a real cash flow




Allowance by the government for reduction in the
value of assets
 Non-cash item
 Because of aging
 Because of new technologies
Adjustment to reduce taxable income
Interest expense not counted
Operating CF = 694 + 65 – 250 = 509
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
37
 Cost

of goods sold
Variable cost over the short run

Variable with level of production
 Labor
 Inputs (raw materials)
 Energy
 Operating

costs
Fixed over short run


Management (administrative)
marketing
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
38
 Investment

Ending FX2006 - FX2005 + CCA = capital spending


Change in fixed assets over the year
Minus the depreciation of the asset during the year
 capital

in fixed assets
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
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
39



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 payables
 The difference must be financed by other forms of
financing
If sales decrease the ΔNWC will be negative
 ΔNWC
= 1014 – 684 = 330
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
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 debt
 836 – 843 + 70 =63
 Does it make sense to include short term debt?
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
41
 Dividends
– New Equity = cash flow to
shareholders



Ending CS2005 - CS2006 + Div = cash flow to
shareholders
Shareholders like bondholders do not want to see
the dividend paid by issuing new stock
Capital gain creates for the shareholder


 CF
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
shareholders = 600 – 640 + 65 = 25
3040.05/06
notes by A.P. Palasvirta, Ph.D.
July 17, 2016
42