The Firm and The Financial Manager

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The Firm and The Financial Manager
1- 1
Corporate Finance and
Applications – Review of
Financial Topics for Case
Studies
Fall 2016
Dr. Richard Michelfelder
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Course Outline - Topics
1. Introductions to Financial Statements
2. Business Financial Planning & Forecasting
3. Risk, Returns and Cost of Capital
4. Project Investment Decision-making
5. Stock and Bond Valuation
6. Capital Structure
7. Dividend Policy
8. Mergers & Acquisitions
Outline 1 Introduction to
Financial Statements
1.1 The Balance Sheet
1.2 The Income Statement
1.3 The Statement of Cash Flows
1.4 Accounting Practice
1.5 Income Taxes
1.6 Financial Ratios
1.7 DuPont Equations
1.8 Using Financial Ratios
1.9 Measuring Company Performance
1.10 The Role of Financial Ratios
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The Balance Sheet
Definition
Financial statements that show
the value of the firm’s assets and
liabilities at a particular point in
time (from an historic cost
accounting, not market value
perspective).
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
The Balance Sheet
The Main Balance Sheet Items
Current Liabilities
Payables
Short-term Debt
Current Assets
Cash & Securities
Receivables
Inventories
+
Fixed Assets
Tangible Assets
Intangible Assets
=
+
Long-term Liabilities
+
Shareholders’ Equity
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The Balance Sheet
Shareholder’s
Equity =Equity =
Shareholders’
TotalTotal
Assets
– Total
Liabilities
Assets
– Total
Liabilities
Shareholders’ Equity: consists of paid in
investment capital plus retain earnings
- may be greater or less than market value of
equity
- for comparison look at Market-to-Book ratio:
- Stock Market Price (P) /Shareholder’s Equity
(B) or P/B ratio
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Market Value vs. Book Value
Book Values are determined by GAAP
(historic cost accounting)
Market Values are determined by current
values
Equity and Asset “Market Values” are usually
higher than their “Book Values”
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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.
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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
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Market and Book Value
Review Market to Book Value for S&P 500
Market Trends
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The Income Statement
Definition
Financial statement that shows
the revenues, expenses, and net
income of a firm over a period of
time.
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The Income Statement
Earnings Before Income & Taxes,
Depreciation & Amortization (EBITDA)
Measure of profit less subject to “financial
engineering” as EBITDA is gross of
interest, taxes, depreciation & amortization.
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The Income Statement
Pepsico Income Statement
Net Sales
Cost of Goods Sold
Other Expenses (Dep. Intang.)
Selling, Gen. &Adm. expenses
Depreciation expense
Operating Profit
Other Income
Earnings Before Interest & Taxes
Net Interest Expense
Taxable Income
Income Taxes
Net Income
2012
2011
$65,492 $66,504
31,291
31,593
119
133
22,281
22,408
2,689
2,737
9,112
9,633
91
57
9,203
9,690
(899)
(856)
8,304
8,834
2,090
2,372
6,214
6,462
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Profits vs. Cash Flows
Differences
“Profits” subtract depreciation (a non-cash expense)
“Profits” ignore cash expenditures on new capital
(the expense is capitalized)
“Profits” record income and expenses at the time of
sales, not when the cash exchanges actually occur
“Profits” do not consider changes in working capital
CF can be low while net income is high
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The Statement of Cash Flows
Definition
Financial statement that shows
the firm’s cash receipts and cash
payments over a period of time.
CF = Cash Inflow – Cash Outflow
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The Statement of Cash Flows
Pepsico Statement of Cash Flows 2012
2011
Net Income
Non-cash expenses
Depreciation
6,214
6,462
2,689
2,737
Changes in working capital
(424)
_____
8,479
(3,005)
(3,306)
62
2,230
(255)
_____
8,944
(5,618)
(5,135)
(67)
(1,876)
A/R, A/P, Inv, other
Cash Flow from operations
Cash Flow from investments
Cash provided by financing
Effect of Exchange Rate Changes
Net Change in Cash Position
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Accounting Practice
There are many accounting issues subject to
subjective judgment. A few examples are:
Revenue
recognition
Off-balance-sheet financing
• Operating v. capital leases
Expensing
v. capitalizing an “expenditure”
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Income 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.
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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
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Income Taxes
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
?
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Income Taxes
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
Assuming $500 mil. in investment, what is the ROE
with no debt and with 50% debt. Firm A ROE =
15.6% and Firm B ROE = 13%.
Financial Ratios (Financial
Statement Analysis)
Five General Categories:
Valuation
• Value of firm or specific assets
Leverage
• Measures use of debt and associated fixed expenses
Liquidity
• Measures firm’s access to cash
Profitability
• Measures return on investments
Efficiency
• Productivity of the use of firm’s assets
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Leverage Ratios
long term debt
Long term debt ratio =
long term debt + equity
long term debt
Debt equity ratio =
equity
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Leverage Ratios
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Liquidity Ratios
Net working capital
to total assets ratio
Net working capital
=
Total assets
current assets
Current ratio =
current liabilities
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Liquidity Ratios
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Efficiency Ratios
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Efficiency Ratios
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Profitability Ratios
net income
Net profit margin =
sales
net income  interest
Operating profit margin =
sales
Net Income  Interest
Return on assets =
average total assets
net income
Return on equity =
average equity
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Profitability Ratios
dividends
Payout ratio =
earnings
earnings - dividends
Plowback ratio =
earnings
= 1 - payout ratio
earnings - dividends
Growth in equity from plowback =
* ROE
earnings
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Market Value Ratios
stock price
PE Ratio =
earnings per share
P0
Div1
1
Forecasted PE ratio =

x
avg EPS1 EPS1 r - g
dividend per share
Dividend yield =
stock price
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Market Value Ratios
Price per share = P0
Div 1
=
r - g
stock price
Market to book ratio =
book value per share
Tobins Q =
m arket value of assets
estim ated replcem ent cost
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The DuPont Equations
A breakdown of ROE and ROA into
component ratios
Net Income  interest
ROA =
assets
earnings available for common stock
ROE =
equity
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The DuPont Equations
sales Net Income  interest
ROA =
x
assets
sales
asset
turnover
Operating profit
margin
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The DuPont Equations
ROE =
assets sales Net Income  interest
Net Income
x
x
x
equity assets
sales
Net Income  interest
leverage asset
ratio turnover
Operating
profit
margin
debt
burden
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MVA & Economic Profit
Market Value Added = The difference
between the market value of common stock
and its book value
Economic Profit = capital invested
multiplied by the spread between return on
investment and the cost of capital.
EP = economic profit
= (ROI – r) x (Invested Capital)
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Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital
EVA = Residual Income
= Income Earned - Income Required
= Income Earned – [cost of capital x
invested capital]
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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Measuring Performance
Measures of Company Performance (ranked by MVA)
Market to MVA
Return on
book ratio
($bil)
assets (%)
GE
Microsoft
Wal-Mart Stores
Merck & Co.
Phillip Morris
ExonMobil
Viacom
General Motors
WorldCom
AT&T
6.6
8.8
4.4
7.1
2.1
1.9
1.3
0.7
0.7
0.6
426.6
217.2
206.2
203.7
72.0
155.9
22.6
-29.2
-31.8
-87.2
20.4
39.1
12.8
24.0
17.4
10.5
2.0
5.7
6.3
4.5
EVA
($bil)
5.9
5.9
1.6
4.8
6.1
5.4
-4.4
-1.1
-5.4
-10.0

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