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 SheetPepsiCo Balance Sheet (December 31, 2006) $Millions

The Balance Sheet

The Main Balance Sheet Items

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets

Current LiabilitiesPayablesShort-term Debt

+

Long-term Liabilities

+

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 SheetAssets = $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 35,753COGS -15,762Selling, Gen.&Admin. expenses -11,530Depreciation expense -1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 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.

Firm A Firm BEBIT 100 100Interest 40 0Pretax Income 60 100Taxes (35%) 21 35Net 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 BEBIT 100 100Interest 40 0Pretax Income 60 100Taxes (35%) 21 35Net 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 ($) Tax Rate (%)0-50,000 1550,001-75,000 2575,001-100,000 34100,001-18,333,333 34-39over 18,333,333 35

Personal Tax Rates

Single Taxable Income ($)

Married Taxable Income ($) Tax Rate (%)

0 - 8,025 0–16,050 108,025–32,550 16,050–65,100 15

32,550–78,850 65,100–131,450 2578,850–164,550 131,450–200,300 28164,550–357,700 200,300–357,700 33

over 357,700 over 357,700 35

Personal Tax RatesEx: 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%