Corporate Finance

CORPORATE FINANCE - Chapter 1
THE TIME VALUE OF MONEY
An enterprise must select the best combination on investment, financing and dividends. The
decision to purchase new plants and equipments and to introduce a new product in the market
requires the use of capital allocating techniques. The firm must determine whether future benefits
are sufficiently large to justify current outlays.
The first step towards making capital allocating decisions is to develop the mathematical tools of
the time value of money. The passage of time between the outflows and inflows in a typical
investment situation results in different current values associated with cash flows that occur at
different points in time.
It is not rational to assess an investment by adding up all the cash inflows and outflows and by
comparing the values without considering when the cash flows occur.
A monetary unit received in the future is worth less than a monetary unit received at
present for four primary reasons:
a) the presence of positive rates of inflation reduces the purchasing power of a monetary unit
through time;
b) the opportunity cost of lost earnings as the monetary unit could have been invested and
earned a return between now and a certain time point in the future;
c) the uncertainty of future values due to the risk of default or nonperformance of

investments;
d) human preferences typically involve impatience or the preference to consume goods and
services now rather than in the future.
Interest is the cost of borrowing money. Interest rates represent the price paid to use money for
some period of time. Interest rates are meant to compensate lenders and savers for foregoing the
use of money for some interval of time. Lenders of capital receive interest, and borrowers pay
interest due to the positive time value of money.
For example a lender who provides 1000 lei today at a 10% interest per year is paid back 1100
lei at the end of the year. The 100 lei compensate the lender for not making an alternative
investment, for giving up personal consumption or for the risk that the money might not have
been repaid.
Managers are often confronted to investment options with different length lives, different sized
investments, differing financing terms, differing tax implications, etc. In all cases the cash flows
associated with an investment are converted to similar terms and then converted to their
equivalent values at a common point in time by using tools and techniques that collectively
comprise the concepts known as the Time Value of Money.
1). Future Values of Present Sums. Simple and compound interest.
Consider an initial value V0 deposited in an accumulating account at an annual interest rate r.

Assuming that the interest earnings are never withdrawn, after one period the account will be
worth the initial principal plus interest earnings V1 = V0 + r V0 = V0 (1 + r)
For the second period of time the amount will be worth its initial value at the beginning of the
period V0 (1 + r) plus the interest r V0 (1 + r).
V2 = V0 (1 + r) + r V0 (1 + r) = V0 (1 + r)2
………………………………….
Vn = V0 (1 + r)n
Suppose that 100000 lei is invested at 10% interest per annum. Compare the cumulative amount
after 5 years by using the simple and compound interest methods.
a). Simple interest
Year Principal Interest earned amount Cumulative amount

1
2
3
4
5
b). Compound interest
Year Principal Interest earned amount Cumulative amount

1
2
3
4
5
FV = 100000(1+0.1)5 = 161051
FV = PV (1 + r)n
n = the final period in time
FV = future value
PV = present value
r = the interest rate per period of time

2). Present Values of Future Sums
This is the first basic principle in finance. The present value of a delayed payoff may be found by
multiplying the payoff by a discount factor which is less than 1.
Calculate the present value of 100 lei to be received 1,2,3,4 and 5 years from now at 7% interest.
Year 1 2 3 4 5
Discount factor
Present value
3). Analyzing Investments
Money is invested now for an expected return sometime in the future.
Net cash flows for three hypothetical investments are shown in the next table. Each investment
has a life of 4 years and brings a total net cash flow of 120000 lei. The discount rate is 8%.
Year Investment A Investment B Investment C

Net Discount Present Net Discount Present Net Discount Present
cash flow factor value cash flow factor value cash flow factor value
1 30000 15000 45000

2 30000 25000 35000
3 30000 35000 25000
4 30000 45000 15000
Total
These three situations illustrate the importance of the flow of funds for an investment. All three
investments show a total undiscounted return of 120000 lei.
Though the total sum is the same, investment C receives most of its flow in the early years,
investment A receives the same amount each year and investment B receives most of its money
in the later years.
4). Significance of the discount rate
The discount rate or the normal rate of return for a project is determined according to the
formula:
r = Rf + the risk premium
The risk free rate Rf is composed of the minimum real rate of return in the economy Rr and the
inflation premium Rr ri, where ri is the rate of inflation.
Rf = Rr + Rr ri
The initial cost of an investment project is of 50000 lei. The project generates in the following
year a cash flow of 70000 lei with a probability of 30% and of 48000 lei with a probability of
70%. The average discounted cash flow equals the cost of investment. Determine the risk
premium of the project knowing that the risk free rate is 4%.
Wrap-up for Chapter 1
Investing means: spending money now (t0) to buy assets that will yield cash flow(s) in the future
(t1), (t2), (t3) …
Timing of the cash flow(s) matters!
E.g. How much will £100 invested at 4% be worth in 15 or 30 years’ time?
Interest is a key factor affecting the time value of money, for example: investing £100 for 10
years at 8% yields £216 and investing £100 for 10 years at 2% yields £122.
One-period investment: present value (PV), future value (FV), rate of return (r)
You are investing a given amount (present value, PV) now (t0) at the rate of return (r) for one
year. After a year (t1) you receive the amount invested (PV) plus the income (r • PV): this is the
future value (FV) of the investment. Hence:
(1) FV = PV + r • PV = PV • (1+r)
And by rearranging and solving for PV yields
(2) PV = FV • [1/(1+r)]
And by rearranging and solving for r yields
(3) (1+r) = FV/PV or r = [(FV/PV) – 1]
EXAMPLES:
Q: What is the FV of £150 invested at 7% for one year?
A: FV = £150 • (1 + 0.07) = £160.5

Q: What is the rate of return (r) on £150 invested for one year if the FV (value in t1) is £180?
A: £180 = £150 • (1 + r) hence: r = [(£180/£150) – 1] = 0.2 = 20%
Q: What is the PV of £180 paid next year (t1) if r = 5%?
A: £180 = PV • (1 + 0.05) hence: PV = £180 • [1/(1+ 0.05)] = £180 • 0.952 = £171.4
Multi-period investment with compounding of interest
You are investing an amount at the rate r for three years. Annual interest payments (PV • r) are
reinvested at the rate r for the remainder of the three-year period (compounding). After three
years you get: FV = PV•(1 + r)•(1 + r)•(1 + r) = PV•(1 + r)3. Hence, for n-period investments
with compounding:
(1) FV = PV • (1+r)n (1+r)n is called compound factor
(2) PV = FV • [1/(1+r)n] 1/(1+r)n is called discount factor
(3) (1+r)n = FV/PV and r = [(FV/PV)1/n – 1]
EXAMPLES
Q: What is the FV of £150 invested for 4 years at 7%?
A: FV = £150 • (1 + 0.07)4 = £150 • 1.311 = £196.6
Q: What is the rate of return (r) on £150 invested for 4 years, if the FV is £180?
A: £180 = £150 • (1 + r)4 hence: r = [(£180/£150)1/4 – 1] = (1.20.25 -1) = 0.047 = 4.7%
Q: What is the PV of £180 paid after 10 years (t10) if r = 5%?
A: £180 = PV • (1 + 0.05)10 hence: PV = £180 • [1/(1+ 0.05)10] = £180 • 0.614 = £110.5

INVESTMENT CRITERIA
Capital budgeting is the planning process used to determine whether a firm’s long term
investments such as new machinery, replacement machinery, new plants, new products and
research and development projects are worth pursuing.
Capital budgeting methods are divided into two categories:
a) simplified or traditional methods such as the accounting rate of return, the payback period, etc.
 Accounting rate of return (ARR)
 Payback period (PP): time it takes to recover initial capital expenses through cash flow
generated by the project
E.g.
Years 0 1 2 3 4 5
Total cash flow from project (£ mill): -1.4 0.2 0.6 0.8 0.6 0.4
Cumulative cash flow (£ mill) -1.4 -1.2 -0.6 0.2 0.8 1.2
PP (in years) = 2 + 0.6 / (0.2 - (-0.6)) = 2.75
PP (in months) = (2 + 0.6 / (0.2 - (-0.6))) • 12 = 33
PP (in years and months) = 2y 9m
b) discount based methods such as net present value, internal rate of return, profitability index,
modified internal rate of return, discounted payback period, etc.
There are two equivalent decision rules for capital investment:
1) Net present value rule: accept investments with positive net present values.
2) Rate of return rule: accept investments that offer rates of return in excess of their opportunity
cost of capital.
The rate of return of an investment is simply the profit as a proportion of the initial outlay:
1. Net Present Value NPV
The net present value is the total present value of a time series of cash flows. This method uses
the time value of money in order to appraise long term projects. Future cash inflows and
outflows are discounted back to their present value and then are summed up.
t = the time of the cash flow
r = the discount rate
CFt = the net cash flow at time t (inflow minus outflow)
Usually the first cash flow CFo is a negative one, a cash outflow that equals the initial required
investment which is the funding of the project.
If It means Then
NPV > 0
NPV < 0
NPV = 0
The discount rate is often referred to as the hurdle rate or the opportunity cost of capital. The
opportunity cost of capital for a project is the expected rate of return demanded by investors in
common stocks and other securities subject to the same risk as the project. For example, if the
capital required for a project A can earn a certain percent elsewhere we will use this discount rate
in the NPV calculation to allow a direct comparison to be made between project A and the
alternative. When you discount the project’s expected cash flow at its opportunity cost of
capital, the resulting present value is the amount that investors (including your own company’s
shareholders) would be willing to pay for the project.
As an alternative to the opportunity cost of capital the firm’s weighted average cost of capital
after tax is often used as a discount factor. The WACC is the minimum return that a company
must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital,
or they will invest elsewhere. The WACC is calculated taking into account the relative weights
of each component of the capital structure.
As a conclusion, the selection of the discount rate is dependent on the use to which it will be put.
If the intent is simply to determine whether a project will add value to the company, using the
firm’s weighted average cost of capital may be appropriate. If trying to decide between
alternative investments in order to maximize the value of the firm, the opportunity cost of capital
would probably be a better choice.
The concept of net present value allows efficient separation of ownership and management of the
corporation. A manager who invests only in assets with positive net present values serves the
best interest of each one of the firm’s owners. Each shareholder wants three things:
a) to be as rich as possible, that is to maximize current wealth;
b) to transform that wealth into whatever time pattern of consumption he or she desires,
providing they have free access to competitive capital markets;
c) to choose the risk characteristics of that consumption plan. They can also choose the risk
characteristics of their consumption plan by investing in more or less risky securities.
Managers of the corporation have just one fundamental task: to maximize net present value.
eg. A corporation must decide whether to adopt an investment project. The project implies costs
and incoming cash flows over five years. The immediate cash outflow is 50000 lei (the
investment initial cost), while the other cash outflows for the following years are expected to be
5000 lei per year. Starting with the following year the expected cash inflows are 40000 lei per
year. The required rate of return is 10%. Using the NPV criteria decide whether this project
should be adopted.
2. Profitabily Index PI
The Profitability Index (PI), also known as value investment ratio (VIR), is the ratio of payoff to
investment of a proposed project. It is a useful tool for ranking projects because it allows
managers to quantify the amount of value created per unit of investment.
The ratio is calculated as follows:
A profitability index of 1 indicates breakeven. Any value lower than one would indicate that the
project's PV is less than the initial investment. As the value of the profitability index increases,
so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:
 If PI > 1 then accept the project;

 If PI < 1 then reject the project .
For example, given the initial cost of the investment in some new machines of 35000 lei, the life
of the machines of 5 years and the following yearly cashflows: 18000 lei, 12000 lei, 10000 lei,
9000 lei, 6000 lei, calculate the NPV at 10% and the PI.
Then, compute the PI of investmenta A, B and C from the previous course. Knowing that the
projects are mutually exclusive, decide for the best one.
3. Internal Rate of Return IRR
The internal rate of return is the annualized effective compounded return rate which can be
earned on the invested capital. It is an indicator of the efficiency or quality of an investment as
opposed to the net present value, which indicates the magnitude of an investment.
The IRR is compared to any alternate cost of capital including an appropriate risk premium
(investing in other projects, buying bonds, putting money in a bank account, etc). If the IRR is
greater than the rate of return that could be earned by alternate investments of equal risk then the
project is a good investment.
In general if the IRR is greater than the project’s cost of capital the project will add value for the
company. Given a series of cash flows involved in a project, the IRR is that rate for which the
net present value of all cash flows from a particular project equals zero.
So, the IRR is the discount rate that will bring a series of cash flows (positive and negative) to a
net present value (NPV) of zero (or to the current value of cash invested). Furthermore, the IRR
may be regarded as the flip side of Net Present Value (NPV), where NPV is the discounted
value of a stream of cash flows, generated from an investment. IRR thus computes the break-
even rate of return showing the discount rate, below which an investment results in a positive
NPV.
eg. With an initial investment cost of 200000 lei, a project delivers in the following five years
cash inflows as follows 40000, 45000, 50000, 60000 and 80000 lei. The residual value of the
project at the end of the period is 30000 lei. Determine the IRR and decide whether the project
should be implemented, knowing that the opportunity cost of capital is 13%.
4. Modified Internal Rate of Return MIRR
While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at
the IRR, the modified IRR assumes that postive cash flows are reinvested at the firm's cost of
capital, and the intial outlays are financed at the firm's financing cost. Therefore, MIRR more
accurately reflects the cost and profitability of a project.
RISK, RETURN AND CAPITAL MARKET EQUILIBRIUM
Securities derive their value from the cash flow they are expected to generate. Since the cash
flow will be received over future periods, there is need to discount these future flows in order to
determine a present value or price for the security.
Assuming that we are valuing the security over a single holding period (say, a year) we can
illustrate the process of valuation with a particularly simple model:
(1)
The model indicates that the present value or current price P0 of the security is the cash flow
(dividends or coupons) received over the period plus the expected price at the end of the period
P1, discounted back at the discount rate r.
The discount rate is alternatively referred to as a required return and is composed of two
elements:
r = Rf + the risk premium (2)
a) a risk free return Rf , which is generally considered to comprise a real return component and
an inflation premium. The real return Rr is the basic investment compensation that investors
demand for forgoing current consumption; that is the compensation for saving. Investors also
require a premium to compensate for inflation. The real return and inflation premium are a basic
return demanded by all investors, so the risk free return is a return component required of all
securities.
b) a risk premium which is made up of the following elements: (1) interest rate risk, (2)
purchasing power risk, (3) business risk and (4) financial risk. The premium that investors
require to compensate the risk will differ across securities as the perceived exposure to the risk
elements is high or low for the security.
By rearranging equation (1) we can obtain directly the discount rate r. In this form it is usual to
think of the discount rate as a return expected by investors, that is, an expected return.
(3)
We can also use equation (3) for calculating the return earned on a security over a past period
(realized return). This time we would insert a realized return for the cash flow and an actual
ending period price rather than expected values of these variables.
In calculating the return for a common stock, it is helpful to think of the realized return as
consisting of a yield component – dividend divided by beginning-of-period-price – and a capital
gain component, which is the percentage change in price over the period.
(4)
Eg 1. We assume that a stock was selling at 60 lei a share at the beginning of the period, paid a 3
lei dividend and sold at 70 lei at the end of the period. Then, the return realized over the period
is:
Di  ( Pit  Pit 1 )
rit =  100 =
Pit 1
So, the realized return of the stock of…… % is derived from a ……….% yield component and
from a ………% capital gain.
The estimated or expected return of a portfolio of securities is merely a weighted average of the
expected returns of the individual securities of which the portfolio is composed.
(5)
(6)
wi = the security’s proportion of the portfolio;
ri = the expected return of security i (average return of a period/time interval);

rit = the realized return of stock i at time t;
N = the total number of securities comprised in the portfolio;
T = the total number of observations (time moments).
Eg 2. What is the expected return of a portfolio of which stock A with an expected return of 10%
constitutes 60% and of which stock B with an expected return of 12% constitutes 40%?
In addition to determining the rate of return it is also important to assess the risk or uncertainty
that may be associated with earning the return.
The variance of return and standard deviation of return are alternative statistical measures that
are proxies for the uncertainty or risk of return. These statistics in effect measure the extent to
which returns are expected to vary around an average over time. Extensive variations around the
average would indicate great uncertainty regarding the return to be expected.
The variance is merely the average of the squared deviations of the individual returns from the
average.
(7)
Standard deviation = (8)
Eg 3. The realized returns over a three year period for a stock i are presented in the following
table: What is the expected return and risk of this stock?
Year 1 2 3
Return 4% 7% 9%
Eg 4. Your company holds a portfolio composed of two stocks A and B. During the first 5
months of the year the prices of stocks A and B had the following evolution:
Month 1 2 3 4 5
Stock A 54 53 61 63 64
Stock B 81 80 78 80 76
Company A pays a dividend of 10 lei in March and company B pays a dividend of 15 lei in May.
What is the return and risk expected by your company knowing that stock A represents 60% in
the portfolio and the stocks are independent?
CAPITAL MARKET THEORY AND TOOLS OF PORTFOLIO MANAGEMENT
While standard deviation and variance measure the riskiness of a security in an absolute sense,
there is also need to consider the riskiness of a security within the context of an overall portfolio
of securities.
The riskiness of a portfolio will depend on how a security blends with the existing securities and
contributes to the overall risk of a portfolio. The covariance is a statistic that measures the
riskiness of a security relative to others in a portfolio of securities.
In essence the way securities vary with each other affects the overall variance, hence the risk of
the portfolio.
Eg.
If the securities move counter to each other than the covariance is a negative value. If the
securities move consistently in tandem than the covariance is positive.
To facilitate interpretation it is useful to standardize the covariance. Dividing the covariance
between two securities by the product of the standard deviation of each security produces a
variable with the same properties as the covariance but scaled to a range of -1 to +1. The
measure is called the correlation coefficient.
Negative correlation is desirable in a security because such a security has great risk reducing
potential in a portfolio context. Anyway in pragmatic settings it is difficult to find negatively
correlated securities.
So the variance or risk of a portfolio is not simply a weighted average of the variances of the
individual securities in the portfolio. There is also need to consider the relationship between each
security in the portfolio and every other security as measured by the covariance of returns.
For a portfolio of two securities i and j the risk measured by the portfolio variance is calculated
as follows:
where wi and wj are the proportions that securities i and j represent in the portfolio.
The risk of a portfolio measured by the variance is a weighted average of the variances of the
individual securities plus the covariance between each security and every other security in the
portfolio.
By diversifying the portfolio (increasing the number of securities) investors manage to

substantially reduce the risk. Diversification works because prices of different stocks do not
move exactly together. Yet most of the stocks that the investor can actually buy are tied together
in a web of positive covariances which set the limit to the benefits of diversification.
The risk that potentially can be eliminated by diversification is called diversifiable risk, specific
risk, unsystematic risk or residual risk. This specific risk stems from the fact that many of the
perils that surround an individual company are peculiar to that company and perhaps its
immediate competitors.
But there is also some risk that can’t be avoided regardless of how much the portfolio is
diversified. This risk is generally known as market risk, systematic risk or undiversifiable risk.
Market risk stems from the fact that there are other economy wide perils which threaten all
businesses. That is why stocks have a tendency to move together. And that is why investors are
exposed to market uncertainties no matter how many stocks they hold.
Eg. The realized returns over a year for stocks A and B are presented in the following table.
What is the expected return and risk of a portfolio of which stock A represents 40% and stock b
60%?
Month 1 2 3 4 5 6 7 8 9 10 11 12
Stock 5% -3% -4% 7% 9% -4% 8% -5% 1% 7% 1% -5%
A
Stock -10% 5% -4% 15% 2% 7% -5% 8% -5% 3% 3% 4%
B
CORPORATE FINANCE – Chapter 4
ACCOUNTING STATEMENTS AND CASH FLOW
1. The balance sheet
The balance sheet is the accountant’s picture of the firm’s accounting value at a certain moment.
The two sides of the balance sheet (assets on the left and liabilities plus stockholder’s equity on
the right) illustrate what the firm owns and how it is financed.
The accounting definition that underlines the balance sheet and describes the balance is:
Assets ≡ Liabilities + Stockholder’s equity
a) The assets in the balance sheet are listed in order by the length of time it normally takes to
convert them to cash. The asset side depends on the nature of the business and how management
chooses to conduct it. Management must make decisions about cash versus marketable securities,
credit versus cash sales, whether to make or buy commodities, whether to lease or purchase
items, the types of business in which to engage, and so on.
Current assets are the most liquid and include cash and those assets that will be turned into cash
within a year from the date of the balance sheet. Accounts receivable is the amount not yet
collected from customers for goods and services sold to them. Inventory is composed of raw
materials to be used in production, work in process and finished goods.
Fixed assets are the least liquid kind of assets. Tangible fixed assets include property, plant and
equipment. These assets do not convert to cash from normal business activity and they are not
usually used to pay expenses, such as payroll. Some fixed assets are not tangible. We include
here the value of a trademark or the value of a patent.
So, accounting liquidity refers to the ease and quickness with which assets can be converted to
cash. The more liquid a firm’s assets, the less likely the firm is to experience problems meeting
short-term obligations. Thus, the probability that a firm will avoid financial distress can be linked
to the firm’s liquidity. Unfortunately, liquid assets frequently have lower rates of return than
fixed assets (cash for example don’t generate any investment income).
To the extent to which a firm invests in liquid assets, it sacrifices an opportunity to invest in
more profitable investment vehicles.
b) The liabilities and the shareholder’s equity are listed in the order in which they must be paid.
They reflect the two types and proportions of financing, which depend on management’s choice
of capital structure, as between debt and equity and between current debt and long-term debt.
Liabilities are obligations of the firm that require a payout of cash within a stipulated time
period. Many liabilities involve contractual obligations to repay a stated amount and interest over
a period. Liabilities are debts and are frequently associated with nominally fixed cash burdens,
called debt service.
The stockholder’s equity is defined as the difference between the assets and the liabilities of the
firm. Actually equity is what stockholders would have remaining after the firm discharged its
obligations. Stockholders’ equity is a claim against the firm’s assets that are residual and not
fixed. In general terms, when the firm borrows, it gives its creditors first claim on the firm’s cash
flow. Creditors can sue the firm if the firm defaults on its bond contracts. This may lead the firm
to declare itself bankrupt.
c) Value versus cost. The accounting value of a firm’s assets is frequently referred to as the
carrying value or the book value of the assets. The terms carrying value and book value are
unfortunate. They specifically say value when in fact the accounting numbers are based on cost.
This misleads many readers of financial statements to think that the firm’s assets are recorded at
the true market values. Market value is the price at which willing buyers and sellers trade the
assets. It would be only a coincidence if accounting value and market value were the same. In
fact, management’s job is to create a value for the firm that is higher than its cost.
The same balance sheet offers different information to different analysts. It depends on what the
analyst wishes to extract. A banker may look at a balance sheet for evidence of accounting
liquidity and working capital. A supplier may also note the size of accounts payable and
therefore the general promptness of payments. Many users of financial statements, including
managers and investors, want to know the value of the firm not its cost. This isn’t found on the
balance sheet. In fact, many of the true resources of the firm do not appear on the balance sheet:
good management, proprietary assets, favorable economic conditions, and so on.
2. The Income Statement
The income statement measures performance over a specific period of time, usually a year. The
accounting definition of income is:
Revenue – Expenses ≡ Income
The income statement includes several sections. The operations section reports the firm’s
revenues and expenses from principal operations. Among other things, the nonoperating section
of the income statement includes all financing costs, such as interest expense. Usually a second
section reports as a separate item taxes on income, meanwhile the last section reveals the net
income and its destination. Net income is sometimes expressed per share of common stock
(earnings per share EPS).
3. Net Working Capital and Financial Cash Flow
Net working capital is current assets minus current liabilities. Net working capital is positive
when current assets are greater than current liabilities. This means the cash that will become
available over the next year is greater than the cash that must be paid out.
Current assets – Current liabilities = Net Working Capital
In addition to investing in fixed assets a firm can invest in net working capital. This is called the
change in net working capital and is the difference between the net working capital in two
running years. The change in the net working capital is usually positive in a growing corporation.
The most important item that can be extracted from financial statements is the actual cash flow.
Cash flow is not the same as the net working capital. For example, increasing inventory requires
the use of cash. Because both inventory and cash are current assets, the net working capital is not
affected by this process, meanwhile the cash flow decreases.
Just as we established that the value of a firm’s assets is always equal to the value of the
liabilities and the value of the equity, the cash flows from the firm’s assets (that is, its operating
activities), CF(A), must equal the cash flows to the firm’s creditors CF(B) and equity investors
CF(S):
CF(A) ≡ CF(B) + CF(S)
The first step in determining cash flows of the firm is to figure out the cash flow from operations.
Operating cash flow, defined as earnings before interest and depreciation minus taxes measures
the cash generated from operations not counting capital spending or working capital
requirements. It is generated by business activities, including sales of goods and services.
Operating cash flow reflects tax payments but not financing, capital spending or changes in net
working capital.
Another component of cash flow involves changes in fixed assets. The net change in fixed assets
equals the acquisition of fixed assets minus the sales of fixed assets. The result is the cash flow
used for capital spending. Finally cash flows are also used for making investments in net
working capital, i.e. additions to net working capital.
Total cash flow = Operating cash flow – Capital spending – Additions to net working capital
CONFIRMING PAGES
CHAPTER
Financial Statements
2 and Cash Flow
OPENING CASE
I
n November 2009, mortgage giant Fannie Mae announced that it was reviewing a potential write-
off of $5.2 billion in low-income housing tax credits. A so-called write-off occurs when a company
decides that the reported value of one or more of its assets is too high and needs to be reduced
to more accurately represent the company’s finances. In Fannie Mae’s case, the write-off came
about because Fannie Mae owned potentially valuable tax credits, but the company was unlikely
to be profitable enough to use them, so their value was overstated. Fannie Mae’s case was unique
because the Treasury Department would not allow Fannie Mae to sell the tax credits, an option the
company had explored.
While Fannie Mae’s write-off is large, the record holder is media giant Time Warner, which took a
charge of $45.5 billion in the fourth quarter of 2002. This enormous write-off followed an earlier, even
larger, charge of $54 billion.
So, did the stockholders in these companies lose billions of dollars when these assets were writ-
ten off? Fortunately for them, the answer is probably not. Understanding why ultimately leads us to
the main subject of this chapter, that all-important substance known as cash flow.
2.1 THE BALANCE SHEET

The balance sheet is an accountant’s snapshot of the firm’s accounting value on a particular
date, as though the firm stood momentarily still. The balance sheet has two sides: On the
left are the assets and on the right are the liabilities and stockholders’ equity. The balance
sheet states what the firm owns and how it is financed. The accounting definition that un-
derlies the balance sheet and describes the balance is
Assets ⬅ Liabilities Stockholders’ equity
We have put a three-line equality in the balance equation to indicate that it must always
hold, by definition. In fact, the stockholders’ equity is defined to be the difference between
the assets and the liabilities of the firm. In principle, equity is what the stockholders would
have remaining after the firm discharged its obligations.
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TABLE 2.1
The Balance Sheet of the U.S. Composite Corporation
U . S . C O M P O S I T E C O R P O R AT I O N
Balance Sheet
2009 a n d 2010
( i n $ m i l l i o n s)
LI A B I LI T I E S ( D E B T ) A N D
ASSE T S 2009 2010 S T O C K H O LD E R S ’ E Q U I T Y 2009 2010
Current assets: Current liabilities:

Cash and equivalents $ 107 $ 140 Accounts payable $ 197 $ 213
Accounts receivable 270 294 Notes payable 53 50
Inventories 280 269 Accrued expenses 205 223
Other 50 58 Total current liabilities $ 455 $ 486
Total current assets $ 707 $ 761
Long-term liabilities:
Fixed assets: Deferred taxes $ 104 $ 117
Property, plant, and equipment $ 1,274 $1,423 Long-term debt* 458 471
Less accumulated depreciation 460 550 Total long-term liabilities $ 562 $ 588
Net property, plant, and equipment $ 814 $ 873
Stockholders’ equity:
Intangible assets and others 221 245
Preferred stock $ 39 $ 39
Total fixed assets $ 1,035 $1,118
Common stock ($1 par value) 32 55
Capital surplus 327 347
Accumulated retained earnings 347 390
Less treasury stock† 20 26
Total equity $ 725 $ 805
Total liabilities and

Total assets $1,742 $1,879 stockholders’ equity‡ $1,742 $1,879
*Long-term debt rose by $471 million 458 million $13 million. This is the difference between $86 million new debt and $73 million in retirement of old debt.
†
Treasury stock rose by $6 million. This reflects the repurchase of $6 million of U.S. Composite’s company stock.
‡
U.S. Composite reports $43 million in new equity. The company issued 23 million shares at a price of $1.87. The par value of common stock increased by $23 million,
and capital surplus increased by $20 million.
Table 2.1 gives the 2009 and 2010 balance sheets for the fictitious U.S. Composite Two excellent sources
Corporation. The assets in the balance sheet are listed in order by the length of time it for company financial
normally would take an ongoing firm to convert them to cash. The asset side depends on information are
finance.yahoo.com and
the nature of the business and how management chooses to conduct it. Management must money.cnn.com.
make decisions about cash versus marketable securities, credit versus cash sales, whether
to make or buy commodities, whether to lease or purchase items, the types of business in
which to engage, and so on. The liabilities and the stockholders’ equity are listed in the
order in which they would typically be paid over time.
The liabilities and stockholders’ equity side reflects the types and proportions of financ-
ing, which depend on management’s choice of capital structure, as between debt and equity
and between current debt and long-term debt.
When analyzing a balance sheet, the financial manager should be aware of three con-
cerns: accounting liquidity, debt versus equity, and value versus cost.
Accounting Liquidity
Accounting liquidity refers to the ease and quickness with which assets can be converted
to cash. Current assets are the most liquid and include cash and those assets that will be
turned into cash within a year from the date of the balance sheet. Accounts receivable are
CHAPTER 2 Financial Statements and Cash Flow 21
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Annual and quarterly

amounts not yet collected from customers for goods or services sold to them (after adjust-
financial statements ment for potential bad debts). Inventory is composed of raw materials to be used in produc-
for most public U.S. tion, work in process, and finished goods. Fixed assets are the least liquid kind of assets.
corporations can be
found in the EDGAR
Tangible fixed assets include property, plant, and equipment. These assets do not convert
database at to cash from normal business activity, and they are not usually used to pay expenses such
www.sec.gov. as payroll.
Some fixed assets are not tangible. Intangible assets have no physical existence but can
be very valuable. Examples of intangible assets are the value of a trademark or the value of
a patent. The more liquid a firm’s assets, the less likely the firm is to experience problems
meeting short-term obligations. Thus, the probability that a firm will avoid financial dis-
tress can be linked to the firm’s liquidity. Unfortunately, liquid assets frequently have lower
rates of return than fixed assets; for example, cash generates no investment income. To the
extent a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable
investment vehicles.
Debt versus Equity

Liabilities are obligations of the firm that require a payout of cash within a stipulated time
period. Many liabilities involve contractual obligations to repay a stated amount and inter-
est over a period. Thus, liabilities are debts and are frequently associated with nominally
fixed cash burdens, called debt service, that put the firm in default of a contract if they are
not paid. Stockholders’ equity is a claim against the firm’s assets that is residual and not
fixed. In general terms, when the firm borrows, it gives the bondholders first claim on the
firm’s cash flow.1 Bondholders can sue the firm if the firm defaults on its bond contracts.
This may lead the firm to declare itself bankrupt. Stockholders’ equity is the residual dif-
ference between assets and liabilities:
Assets Liabilities ⬅ Stockholders’ equity
This is the stockholders’ share in the firm stated in accounting terms. The accounting value
of stockholders’ equity increases when retained earnings are added. This occurs when the
firm retains part of its earnings instead of paying them out as dividends.
The home page for the

Value versus Cost
Financial Accounting The accounting value of a firm’s assets is frequently referred to as the carrying value or
Standards Board
(FASB) is
the book value of the assets.2 Under generally accepted accounting principles (GAAP),
www.fasb.org. audited financial statements of firms in the United States carry the assets at cost.3 Thus the
terms carrying value and book value are unfortunate. They specifically say “value,” when
in fact the accounting numbers are based on cost. This misleads many readers of financial
statements to think that the firm’s assets are recorded at true market values. Market value
is the price at which willing buyers and sellers would trade the assets. It would be only a
coincidence if accounting value and market value were the same. In fact, management’s job
is to create value for the firm that exceeds its cost.
Many people use the balance sheet, but the information each may wish to extract is not
the same. A banker may look at a balance sheet for evidence of accounting liquidity and
working capital. A supplier may also note the size of accounts payable and therefore the
1
Bondholders are investors in the firm’s debt. They are creditors of the firm. In this discussion, the term bondholder means the
same thing as creditor.
2
Confusion often arises because many financial accounting terms have the same meaning. This presents a problem with jargon
for the reader of financial statements. For example, the following terms usually refer to the same thing: assets minus liabilities, net
worth, stockholders’ equity, owners’ equity, book equity, and equity capitalization.
3
Generally, GAAP require assets to be carried at the lower of cost or market value. In most instances, cost is lower than market
value. However, in some cases when a fair market value can be readily determined, the assets have their value adjusted to the
fair market value.
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general promptness of payments. Many users of financial statements, including managers

and investors, want to know the value of the firm, not its cost. This information is not found
on the balance sheet. In fact, many of the true resources of the firm do not appear on the
balance sheet: good management, proprietary assets, favorable economic conditions, and
so on. Henceforth, whenever we speak of the value of an asset or the value of the firm, we
will normally mean its market value. So, for example, when we say the goal of the financial
manager is to increase the value of the stock, we mean the market value of the stock.
Market Value versus Book Value

2.1
The Cooney Corporation has fixed assets with a book value of $700 and an appraised market value of
about $1,000. Net working capital is $400 on the books, but approximately $600 would be realized if all
EXAMPLE
the current accounts were liquidated. Cooney has $500 in long-term debt, both book value and market
value. What is the book value of the equity? What is the market value?
We can construct two simplified balance sheets, one in accounting (book value) terms and one in
economic (market value) terms:
COON EY CO R PO R AT I O N
B al a nc e S he et s
M a r k e t Va l ue ver sus B o ok Va l ue
As s e t s Li ab i l i t i es a nd Sh ar eh ol d er s’ Eq ui t y
BOOK M ARK ET BOOK M A RK ET
Net working capital $ 400 $ 600 Long-term debt $ 500 $ 500

Net fixed assets 700 1,000 Shareholders’ equity 600 1,100
$1,100 $1,600 $1,100 $1,600
In this example, shareholders’ equity is actually worth almost twice as much as what is shown on the
books. The distinction between book and market values is important precisely because book values
can be so different from true economic value.
2.2 T H E I N C O M E S TAT E M E N T
The income statement measures performance over a specific period of time, say, a year.
The accounting definition of income is:
Revenue Expenses ⬅ Income
If the balance sheet is like a snapshot, the income statement is like a video recording of
what the people did between two snapshots. Table 2.2 gives the income statement for the
U.S. Composite Corporation for 2010.
The income statement usually includes several sections. The operations section reports
the firm’s revenues and expenses from principal operations. One number of particular im-
portance is earnings before interest and taxes (EBIT), which summarizes earnings before
taxes and financing costs. Among other things, the nonoperating section of the income
statement includes all financing costs, such as interest expense. Usually a second section
reports as a separate item the amount of taxes levied on income. The last item on the in-
come statement is the bottom line, or net income. Net income is frequently expressed per
share of common stock, that is, earnings per share.
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TABLE 2.2 U . S . C O M P O S I T E C O R P O R AT I O N
The Income Statement Income Statement
of the U.S. Composite 2010
Corporation ( i n $ m i l l i o n s)
Total operating revenues $2,262

Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $ 190
Other income 29
Earnings before interest and taxes (EBIT) $ 219
Interest expense 49
Pretax income $ 170
Taxes 84
Current: $71
Deferred: $13
Net income $ 86
Addition to retained earnings: $ 43
Dividends: 43
Note: There are 29 million shares outstanding. Earnings per share and dividends per share can be calculated as follows:
Net income
Earnings per share ____________________
Total shares outstanding
$86
___
29
$2.97 per share
Dividends
Dividends per share ____________________
Total shares outstanding
$43
___
29
$1.48 per share
When analyzing an income statement, the financial manager should keep in mind GAAP,
noncash items, time, and costs.
Generally Accepted Accounting Principles

Revenue is recognized on an income statement when the earnings process is virtually
completed and an exchange of goods or services has occurred. Therefore, the unrealized
appreciation from owning property will not be recognized as income. This provides a
device for smoothing income by selling appreciated property at convenient times. For
example, if the firm owns a tree farm that has doubled in value, then, in a year when its
earnings from other businesses are down, it can raise overall earnings by selling some
trees. The matching principle of GAAP dictates that revenues be matched with expenses.
Thus, income is reported when it is earned, or accrued, even though no cash flow has
necessarily occurred (for example, when goods are sold for credit, sales and profits are
reported).
Noncash Items
The economic value of assets is intimately connected to their future incremental cash flows.
However, cash flow does not appear on an income statement. There are several noncash
items that are expenses against revenues, but that do not affect cash flow. The most impor-
tant of these is depreciation. Depreciation reflects the accountant’s estimate of the cost of
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equipment used up in the production process. For example, suppose an asset with a five-
year life and no resale value is purchased for $1,000. According to accountants, the $1,000
cost must be expensed over the useful life of the asset. If straight-line depreciation is used,
there will be five equal installments and $200 of depreciation expense will be incurred each
year. From a finance perspective, the cost of the asset is the actual negative cash flow in-
curred when the asset is acquired (that is, $1,000, not the accountant’s smoothed $200-per-
year depreciation expense).
Another noncash expense is deferred taxes. Deferred taxes result from differences be-
tween accounting income and true taxable income.4 Notice that the accounting tax shown
on the income statement for the U.S. Composite Corporation is $84 million. It can be bro-
ken down as current taxes and deferred taxes. The current tax portion is actually sent to the
tax authorities (for example, the Internal Revenue Service). The deferred tax portion is not.
However, the theory is that if taxable income is less than accounting income in the current
year, it will be more than accounting income later on. Consequently, the taxes that are not
paid today will have to be paid in the future, and they represent a liability of the firm. This
shows up on the balance sheet as deferred tax liability. From the cash flow perspective,
though, deferred tax is not a cash outflow.
In practice, the difference between cash flows and accounting income can be quite dra-
matic, so it is important to understand the difference. For example, Sirius XM Radio re-
ported a net loss of about $413 million for the third quarter of 2009. That sounds bad, but
Sirius XM also reported a positive cash flow of $116 million from operating activities for
the same quarter!
Time and Costs

It is often useful to think of all of future time as having two distinct parts, the short run
and the long run. The short run is that period of time in which certain equipment, re-
sources, and commitments of the firm are fixed; but the time is long enough for the firm
to vary its output by using more labor and raw materials. The short run is not a precise
period of time that will be the same for all industries. However, all firms making deci-
sions in the short run have some fixed costs, that is, costs that will not change because of
fixed commitments. In real business activity, examples of fixed costs are bond interest,
overhead, and property taxes. Costs that are not fixed are variable. Variable costs change
as the output of the firm changes; some examples are raw materials and wages for laborers
on the production line.
In the long run, all costs are variable. Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting costs usually fit into a classification that
distinguishes product costs from period costs. Product costs are the total production costs
incurred during a period—raw materials, direct labor, and manufacturing overhead—and
are reported on the income statement as cost of goods sold. Both variable and fixed costs
are included in product costs. Period costs are costs that are allocated to a time period;
they are called selling, general, and administrative expenses. One period cost would be the
company president’s salary.
2.3 TA X E S
Taxes can be one of the largest cash outflows that a firm experiences. For example,
for the fiscal year 2009, ExxonMobil’s earnings before taxes were about $34.8 billion.
Its tax bill, including all taxes paid worldwide, was a whopping $15.1 billion, or about
43.4 percent of its pretax earnings. The size of the tax bill is determined through the tax
4
One situation in which taxable income may be lower than accounting income is when the firm uses accelerated depreciation
expense procedures for the IRS but uses straight-line procedures allowed by GAAP for reporting purposes.
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TABLE 2.3 TAXA B LE I N C O M E TA X R AT E

Corporate Tax Rates
$ 0–50,000 15%
50,001–75,000 25
75,001–100,000 34
100,001–335,000 39
335,001–10,000,000 34
10,000,001–15,000,000 35
15,000,001–18,333,333 38
18,333,334 35
code, an often amended set of rules. In this section, we examine corporate tax rates and
how taxes are calculated.
If the various rules of taxation seem a little bizarre or convoluted to you, keep in mind
that the tax code is the result of political, not economic, forces. As a result, there is no rea-
son why it has to make economic sense.
Corporate Tax Rates

Corporate tax rates in effect for 2010 are shown in Table 2.3. A peculiar feature of
taxation instituted by the Tax Reform Act of 1986 and expanded in the 1993 Omnibus
Budget Reconciliation Act is that corporate tax rates are not strictly increasing. As
shown, corporate tax rates rise from 15 percent to 39 percent, but they drop back to
34 percent on income over $335,000. They then rise to 38 percent and subsequently fall
to 35 percent.
According to the originators of the current tax rules, there are only four corporate rates:
15 percent, 25 percent, 34 percent, and 35 percent. The 38 and 39 percent brackets arise
because of “surcharges” applied on top of the 34 and 35 percent rates. A tax is a tax is a tax,
however, so there are really six corporate tax brackets, as we have shown.
Average versus Marginal Tax Rates

In making financial decisions, it is frequently important to distinguish between av-
erage and marginal tax rates. Your average tax rate is your tax bill divided by your
taxable income, in other words, the percentage of your income that goes to pay taxes.
Your marginal tax rate is the tax you would pay (in percent) if you earned one
more dollar. The percentage tax rates shown in Table 2.3 are all marginal rates. Put
another way, the tax rates apply to the part of income in the indicated range only, not
all income.
The difference between average and marginal tax rates can best be illustrated with a
simple example. Suppose our corporation has a taxable income of $200,000. What is the
tax bill? Using Table 2.3, we can figure our tax bill as:
.15($ 50,000) $ 7,500
.25($ 75,000 50,000) 6,250
.34($100,000 75,000) 8,500
.39($200,000 100,000) 39,000
$61,250
The IRS has a great Our total tax is thus $61,250.

Web site! In our example, what is the average tax rate? We had a taxable income of $200,000 and
(www.irs.gov)
a tax bill of $61,250, so the average tax rate is $61,250/200,000 30.625%. What is the
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marginal tax rate? If we made one more dollar, the tax on that dollar would be 39 cents, so
our marginal rate is 39 percent.
D e e p i n t h e H e a r t o f Ta x e s
2.2
Algernon, Inc., has a taxable income of $85,000. What is its tax bill? What is its average tax rate? Its
marginal tax rate?
EXAMPLE
From Table 2.3, we see that the tax rate applied to the first $50,000 is 15 percent; the rate applied to
the next $25,000 is 25 percent, and the rate applied after that up to $100,000 is 34 percent. So Algernon
must pay .15 $50,000 .25 25,000 .34 (85,000 75,000) $17,150. The average tax rate is
thus $17,150/85,000 20.18%. The marginal rate is 34 percent because Algernon’s taxes would rise by
34 cents if it had another dollar in taxable income.
Table 2.4 summarizes some different taxable incomes, marginal tax rates, and average
tax rates for corporations. Notice how the average and marginal tax rates come together at
35 percent.
With a flat-rate tax, there is only one tax rate, so the rate is the same for all income
levels. With such a tax, the marginal tax rate is always the same as the average tax rate. As
it stands now, corporate taxation in the United States is based on a modified flat-rate tax,
which becomes a true flat rate for the highest incomes.
In looking at Table 2.4, notice that the more a corporation makes, the greater is the
percentage of taxable income paid in taxes. Put another way, under current tax law, the av-
erage tax rate never goes down, even though the marginal tax rate does. As illustrated, for
corporations, average tax rates begin at 15 percent and rise to a maximum of 35 percent.
It will normally be the marginal tax rate that is relevant for financial decision making.
The reason is that any new cash flows will be taxed at that marginal rate. Because financial
decisions usually involve new cash flows or changes in existing ones, this rate will tell us
the marginal effect of a decision on our tax bill.
There is one last thing to notice about the tax code as it affects corporations. It’s easy
to verify that the corporate tax bill is just a flat 35 percent of taxable income if our taxable
income is more than $18.33 million. Also, for the many midsize corporations with taxable
incomes in the range of $335,000 to $10,000,000, the tax rate is a flat 34 percent. Because
we will normally be talking about large corporations, you can assume that the average and
marginal tax rates are 35 percent unless we explicitly say otherwise.
Before moving on, we should note that the tax rates we have discussed in this section
relate to federal taxes only. Overall tax rates can be higher once state, local, and any other
taxes are considered.
(1) (2) ( 3) ( 3) / ( 1)
TABL E 2.4
TAXABL E I NCOM E M ARGI NAL TA X RATE TO TA L TA X AVE RA G E TA X R AT E Corporate Taxes
and Tax Rates
$ 45,000 15% $ 6,750 15.00%
70,000 25 12,500 17.86
95,000 34 20,550 21.63
250,000 39 80,750 32.30
1,000,000 34 340,000 34.00
17,500,000 38 6,100,000 34.86
50,000,000 35 17,500,000 35.00
100,000,000 35 35,000,000 35.00
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2.4 N E T W O R K I N G C A P I TA L
Net working capital is current assets minus current liabilities. Net working capital is posi-
tive when current assets are greater than current liabilities. This means the cash that will
become available over the next 12 months will be greater than the cash that must be paid
out. The net working capital of the U.S. Composite Corporation is $275 million in 2010
and $252 million in 2009:
Current assets Current liabilities Net working capital

($ millions) ($ millions) ($ millions)
2010 $761 $486 $275
2009 707 455 252
In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net work-
ing capital. This is called the change in net working capital. The change in net working
capital in 2010 is the difference between the net working capital in 2010 and 2009; that is,
$275 million 252 million $23 million. The change in net working capital is usually
positive in a growing firm.
2.5 FINANCIAL CASH FLOW

Perhaps the most important item that can be extracted from financial statements is the ac-
tual cash flow of the firm. There is an official accounting statement called the statement of
cash flows. This statement helps to explain the change in accounting cash and equivalents,
which for U.S. Composite is $33 million in 2010. (See Section 2.6.) Notice in Table 2.1 that
cash and equivalents increase from $107 million in 2009 to $140 million in 2010. However,
we will look at cash flow from a different perspective, the perspective of finance. In finance,
the value of the firm is its ability to generate financial cash flow. (We will talk more about
financial cash flow in Chapter 8.)
The first point we should mention is that cash flow is not the same as net working capi-
tal. For example, increasing inventory requires using cash. Because both inventories and
cash are current assets, this does not affect net working capital. In this case, an increase in
a particular net working capital account, such as inventory, is associated with decreasing
cash flow.
Just as we established that the value of a firm’s assets is always equal to the value of the
liabilities and the value of the equity, the cash flows received from the firm’s assets (that
is, its operating activities), CF(A), must equal the cash flows to the firm’s creditors, CF(B),
and equity investors, CF(S):
CF(A) ⬅ CF(B) CF(S)
The first step in determining cash flows of the firm is to figure out the cash flow from
operations. As can be seen in Table 2.5, operating cash flow is the cash flow generated by
business activities, including sales of goods and services. Operating cash flow reflects tax
payments, but not financing, capital spending, or changes in net working capital.
I N $ M I LLI O N S
Earnings before interest and taxes $219

Depreciation 90
Current taxes 71
Operating cash flow $238
Another important component of cash flow involves changes in fixed assets. For example,
when U.S. Composite sold its power systems subsidiary in 2010, it generated $25 in
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U.S. COM P O S I T E C O R P O R AT I O N
TABLE 2.5
F i n a n c i a l C a sh Fl o w Financial Cash Flow
2010 of the U.S. Composite
( i n $ m i l l i o n s) Corporation
Cash Flow of the Firm

(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending 173
(Acquisitions of fixed assets minus sales of fixed assets)
Additions to net working capital 23
Total $ 42
Cash Flow to Investors in the Firm

Debt $ 36
(Interest plus retirement of debt minus long-term debt financing)
Equity 6
(Dividends plus repurchase of equity minus new equity financing)
Total $ 42
cash flow. The net change in fixed assets equals the acquisition of fixed assets minus sales
of fixed assets. The result is the cash flow used for capital spending:
Acquisition of fixed assets $198
Sales of fixed assets 25
Capital spending $173 ($149 24 Increase in property,
plant, and equipment Increase
in intangible assets)
We can also calculate capital spending simply as:

Capital spending Ending net fixed assets Beginning net fixed assets
Depreciation
$1,118 1,035 90
$173
Cash flows are also used for making investments in net working capital. In U.S. Com-
posite Corporation in 2010, additions to net working capital are:
Additions to net working capital $23
Note that this $23 is the change in net working capital we previously calculated.
Total cash flows generated by the firm’s assets are the sum of:

Capital spending 173
Additions to net working capital 23
Total cash flow of the firm $ 42
The total outgoing cash flow of the firm can be separated into cash flow paid to creditors
and cash flow paid to stockholders. The cash flow paid to creditors represents a regrouping
of the data in Table 2.5 and an explicit recording of interest expense. Creditors are paid an
amount generally referred to as debt service. Debt service is interest payments plus repay-
ments of principal (that is, retirement of debt).
An important source of cash flow is the sale of new debt. U.S. Composite’s long-
term debt increased by $13 million (the difference between $86 million in new debt and
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$73 million in retirement of old debt).5 Thus, an increase in long-term debt is the net effect
of new borrowing and repayment of maturing obligations plus interest expense.
C A S H FLO W PA I D T O C R E D I T O R S
Interest $ 49
Retirement of debt 73
Debt service 122
Proceeds from long-term debt sales 86
Total $ 36
Cash flow paid to creditors can also be calculated as:

Cash flow paid to creditors Interest paid Net new borrowing
Interest paid (Ending long-term debt
Beginning long-term debt)
$49 (471 458)
$36
Cash flow of the firm also is paid to the stockholders. It is the net effect of paying divi-
dends plus repurchasing outstanding shares of stock and issuing new shares of stock.
C A S H FLO W T O S T O C K H O LD E R S
Dividends $43
Repurchase of stock 6
Cash to stockholders 49
Proceeds from new stock issue 43
Total $ 6
In general, cash flow to stockholders can be determined as:

Cash flow to stockholders Dividends paid Net new equity raised
Dividends paid (Stock sold
Stock repurchased)
To determine stock sold, notice that the common stock and capital surplus accounts went
up by a combined $23 20 $43, which implies that the company sold $43 million worth
of stock. Second, Treasury stock went up by $6, indicating that the company bought back
$6 million worth of stock. Net new equity is thus $43 6 $37. Dividends paid were $43,
so the cash flow to stockholders was:
Cash flow to stockholders $43 (43 6) $6,
which is what we previously calculated.

Some important observations can be drawn from our discussion of cash flow:
1. Several types of cash flow are relevant to understanding the financial situation
of the firm. Operating cash flow, defined as earnings before interest and depre-
ciation minus taxes, measures the cash generated from operations not counting
capital spending or working capital requirements. It is usually positive; a firm is
in trouble if operating cash flow is negative for a long time because the firm is
5
New debt and the retirement of old debt are usually found in the “notes” to the balance sheet.
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not generating enough cash to pay operating costs. Total cash flow of the firm
includes adjustments for capital spending and additions to net working capital. It
will frequently be negative. When a firm is growing at a rapid rate, the spending
on inventory and fixed assets can be higher than cash flow from sales.
2. Net income is not cash flow. The net income of the U.S. Composite Corporation
in 2010 was $86 million, whereas cash flow was $42 million. The two numbers
are not usually the same. In determining the economic and financial condition of
a firm, cash flow is more revealing.
A firm’s total cash flow sometimes goes by a different name, free cash flow. Of course,
there is no such thing as “free” cash (we wish!). Instead, the name refers to cash that the
firm is free to distribute to creditors and stockholders because it is not needed for work-
ing capital or fixed asset investments. We will stick with “total cash flow of the firm” as
our label for this important concept because, in practice, there is some variation in exactly
how free cash flow is computed; different users calculate it in different ways. Nonetheless,
whenever you hear the phrase “free cash flow,” you should understand that what is being
discussed is cash flow from assets or something quite similar.
2 . 6 T H E A C C O U N T I N G S TAT E M E N T
OF CASH FLOWS
As previously mentioned, there is an official accounting statement called the statement
of cash flows. This statement helps explain the change in accounting cash, which for U.S.
Composite is $33 million in 2010. It is very useful in understanding financial cash flow.
The first step in determining the change in cash is to figure out cash flow from operating
activities. This is the cash flow that results from the firm’s normal activities producing and
selling goods and services. The second step is to make an adjustment for cash flow from
investing activities. The final step is to make an adjustment for cash flow from financing
activities. Financing activities are the net payments to creditors and owners (excluding
interest expense) made during the year.
The three components of the statement of cash flows are determined below.
Cash Flow from Operating Activities

To calculate cash flow from operating activities we start with net income. Net income can
be found on the income statement and is equal to $86 million. We now need to add back
noncash expenses and adjust for changes in current assets and liabilities (other than cash
and notes payable). The result is cash flow from operating activities.
U.S. COMP O SI T E C O RP O RATI O N

Ca s h F l o w f ro m O pe ra t i ng A ct i vi t i e s
2010
( i n $ m i l l i on s)
Net income $ 86
Depreciation 90
Deferred taxes 13
Change in assets and liabilities
Accounts receivable 24
Inventories 11
Accounts payable 16
Accrued expense 18
Other 8
Cash flow from operating activities $202
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THE REAL WORLD PUTTING A SPIN ON CASH FLOWS

One of the reasons why cash flow analysis is popular is the difficulty in manipulating, or spinning, cash flows. GAAP
accounting principles allow for significant subjective decisions to be made regarding many key areas. The use of cash
flow as a metric to evaluate a company comes from the idea that there is less subjectivity involved, and, therefore, it
is harder to spin the numbers. But several recent examples have shown that companies can still find ways to do it.
In November 2009, the SEC settled charges against SafeNet, Inc. and some of its former officers, employees,
and accountants, in connection with earnings management and options backdating schemes. This case repre-
sented the SEC’s first enforcement action brought under Regulation G of Sarbox. Of course other companies have
spun financial results without legal action. For example, in March 2007, rental car company Avis Budget Group was
forced to revise its first quarter 2007 operating cash flow by more than $45 million. The company had improperly
classified the cash flow as an operating cash flow rather than an investing cash flow. This maneuver had the effect
of increasing operating cash flows and decreasing investing cash flows by the same amount.
Tyco used several ploys to alter cash flows. For example, the company purchased more than $800 million of
customer security alarm accounts from dealers. The cash flows from these transactions were reported in the
financing activity section of the accounting statement of cash flows. When Tyco received payments from custom-
ers, the cash inflows were reported as operating cash flows. Another method used by Tyco was to have acquired
companies prepay operating expenses. In other words, the company acquired by Tyco would pay vendors for
items not yet received. In one case, the payments totaled more than $50 million. When the acquired company was
consolidated with Tyco, the prepayments reduced Tyco’s cash outflows, thus increasing the operating cash flows.
Dynegy, the energy giant, was accused of engaging in a number of complex “round trip trades.” The round trip
trades essentially involved the sale of natural resources to a counterparty, with the repurchase of the resources
from the same party at the same price. In essence, Dynegy would sell an asset for $100, and immediately repur-
chase it from the buyer for $100. The problem arose with the treatment of the cash flows from the sale. Dynegy
treated the cash from the sale of the asset as an operating cash flow, but classified the repurchase as an investing
cash outflow. The total cash flows of the contracts traded by Dynegy in these round trip trades totaled $300 million.
Adelphia Communications was another company that apparently manipulated cash flows. In Adelphia’s case,
the company capitalized the labor required to install cable. In other words, the company classified this labor ex-
pense as a fixed asset. While this practice is fairly common in the telecommunications industry, Adelphia capital-
ized a higher percentage of labor than is common. The effect of this classification was that the labor was treated
as an investment cash flow, which increased the operating cash flow.
In each of these examples, the companies were trying to boost operating cash flows by shifting cash flows to a
different heading. The important thing to notice is that these movements don’t affect the total cash flow of the firm,
which is why we recommend focusing on this number, not just operating cash flow.
We should also note that, for 2008, the total number of financial restatements fell nearly 30 percent from 2007,
which had itself experienced a 31 percent decline in restatements from 2006. While this is a positive trend, restate-
ments due to cash flow misclassification increased in prevalence over the same period.
Cash Flow from Investing Activities

Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets
and sales of fixed assets (i.e., net capital expenditures). The result for U.S. Composite is below.
U . S . C O M P O S I T E C O R P O R AT I O N
C a sh Fl o w f r o m I n ve st i n g A c t i vi t i e s
2010

Cash flow from investing activities $173
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Cash Flow from Financing Activities

Cash flows to and from creditors and owners include changes in equity and debt.
Ca s h F l o w f r o m Fi n a n c i n g A c t i vi t i e s
2010
Retirement of long-term debt $73

Change in notes payable 3
Dividends 43
Cash flow from financing activities $ 4
The statement of cash flows is the addition of cash flows from operations, cash flows
from investing activities, and cash flows from financing activities, and is produced in
Table 2.6. When we add all the cash flows together, we get the change in cash on the bal-
ance sheet of $33 million.
TABLE 2.6
St a t em e n t o f C a sh Fl o w s Statement of
2010 Consolidated Cash Flows
( i n $ m i l l i o n s) of the U.S. Composite
Corporation
Operations
Net income $ 86
Depreciation 90
Deferred taxes 13
Changes in assets and liabilities
Inventories 11
Accounts payable 16
Accrued expenses 18
Other 8
Total cash flow from operations $202
Investing activities
Total cash flow from investing activities $173
Financing activities
Retirement of long-term debt $ 73
Dividends 43
Total cash flow from financing activities $ 4
Change in cash (on the balance sheet) $ 33
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There is a close relationship between the official accounting statement called the state-
ment of cash flows and the total cash flow of the firm used in finance. Going back to the pre-
vious section, you should note a slight conceptual problem here. Interest paid should really
go under financing activities, but unfortunately that is not how the accounting is handled.
The reason is that interest is deducted as an expense when net income is computed. As a
consequence, a primary difference between the accounting cash flow and the financial cash
flow of the firm (see Table 2.5) is interest expense. The Real World box on page 32 discusses
some ways in which companies have attempted to “spin the numbers” in the accounting
statement of cash flows.
SUMMARY AND CONCLUSIONS
Besides introducing you to corporate accounting, the purpose of this chapter has been to teach you
how to determine cash flow from the accounting statements of a typical company.
1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be classified as:
a. Cash flow from operations.
b. Cash flow from changes in fixed assets.
c. Cash flow from changes in working capital.
2. Calculations of cash flow are not difficult, but they require care and particular attention to detail
in properly accounting for noncash expenses such as depreciation and deferred taxes. It is
especially important that you do not confuse cash flow with changes in net working capital and
net income.
CONCEPT QUESTIONS
1. Liquidity What does liquidity measure? Explain the trade-off a firm faces between high liquid-
ity and low liquidity levels.
2. Accounting and Cash Flows Why is it that the revenue and cost figures shown on a standard
income statement may not be representative of the actual cash inflows and outflows that oc-
curred during the period?
3. Accounting Statement of Cash Flows Looking at the accounting statement of cash flows, what
does the bottom line number mean? How useful is this number for analyzing a company?
4. Cash Flows How do financial cash flows and the accounting statement of cash flows differ?
Which is more useful when analyzing a company?
5. Book Values versus Market Values Under standard accounting rules, it is possible for a com-
pany’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this
happen with market values? Why or why not?
6. Cash Flow from Assets Suppose a company’s cash flow from assets was negative for a
particular period. Is this necessarily a good sign or a bad sign?
7. Operating Cash Flow Suppose a company’s operating cash flow was negative for several
years running. Is this necessarily a good sign or a bad sign?
8. Net Working Capital and Capital Spending Could a company’s change in net working capital
be negative in a given year? (Hint: Yes.) Explain how this might come about. What about net
capital spending?
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9. Cash Flow to Stockholders and Creditors Could a company’s cash flow to stockholders be
negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash flow
to creditors?
10. Firm Values Referring back to the Fannie Mae example used at the beginning of the chapter,
note that we suggested that Fannie Mae’s stockholders probably didn’t suffer as a result of the
reported loss. What do you think was the basis for our conclusion?
QUESTIONS AND PROBLEMS

1. Building a Balance Sheet Brees, Inc., has current assets of $7,500, net fixed assets of $28,900,
current liabilities of $5,900, and long-term debt of $18,700. What is the value
of the shareholders’ equity account for this firm? How much is net working capital? Basic
(Questions 1–10)
2. Building an Income Statement Tyler, Inc., has sales of $753,000, costs of $308,000, deprecia-
tion expense of $46,000, interest expense of $21,500, and a tax rate of 35 percent. What is the net
income for the firm? Suppose the company paid out $67,000 in cash dividends. What is the addi-
tion to retained earnings?
3. Market Values and Book Values Klingon Cruisers, Inc., purchased new cloaking machinery
three years ago for $7 million. The machinery can be sold to the Romulans today for $5.2 mil-
lion. Klingon’s current balance sheet shows net fixed assets of $4.5 million, current liabilities of
$1.8 million, and net working capital of $750,000. If all the current assets were liquidated today,
the company would receive $2.7 million cash. What is the book value of Klingon’s assets today?
What is the market value?
4. Calculating Taxes The Conard Co. had $285,000 in taxable income. Using the rates from Table
2.3 in the chapter, calculate the company’s income taxes. What is the average tax rate? What is
the marginal tax rate?
5. Calculating OCF Williams, Inc., has sales of $25,300, costs of $9,100, depreciation expense
of $1,700, and interest expense of $950. If the tax rate is 40 percent, what is the operating cash
flow, or OCF?
6. Calculating Net Capital Spending Martin Driving School’s 2009 balance sheet showed net
fixed assets of $4.7 million, and the 2010 balance sheet showed net fixed assets of $5.3 million.
The company’s 2010 income statement showed a depreciation expense of $760,000. What was
the company’s net capital spending for 2010?
7. Building a Balance Sheet The following table presents the long-term liabilities and stockhold-
ers’ equity of Information Control Corp. one year ago:
Long-term debt $35,000,000

Preferred stock 4,000,000
Common stock ($1 par value) 11,000,000
Capital surplus 26,000,000
Accumulated retained earnings 75,000,000
During the past year, Information Control issued 8 million shares of new stock at a total price of
$29 million, and issued $6 million in new long-term debt. The company generated $7 million in
net income and paid $2.5 million in dividends. Construct the current balance sheet reflecting the
changes that occurred at Information Control Corp. during the year.
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8. Cash Flow to Creditors The 2009 balance sheet of Maria’s Tennis Shop, Inc., showed long-
term debt of $2.4 million, and the 2010 balance sheet showed long-term debt of $2.5 million. The
2010 income statement showed an interest expense of $195,000. What was the firm’s cash flow
to creditors during 2010?
9. Cash Flow to Stockholders The 2009 balance sheet of Maria’s Tennis Shop, Inc., showed
$730,000 in the common stock account and $6.2 million in the additional paid-in surplus account.
The 2010 balance sheet showed $775,000 and $6.9 million in the same two accounts, respec-
tively. If the company paid out $400,000 in cash dividends during 2010, what was the cash flow to
stockholders for the year?
10. Calculating Total Cash Flows Given the information for Maria’s Tennis Shop, Inc., in the pre-
vious two problems, suppose you also know that the firm’s net capital spending for 2010 was
$810,000, and that the firm reduced its net working capital investment by $85,000. What was the
firm’s 2010 operating cash flow, or OCF?
Intermediate 11. Cash Flows Ritter Corporation’s accountants prepared the following financial statements for
(Questions 11–25) year-end 2010.
R I T T E R C O R P O R AT I O N
Income Statement
2010
Revenue $780
Expenses 620
Depreciation 50
EBT $110
Tax 39
Net income $ 71
Dividends $ 22
R I T T E R C O R P O R AT I O N
Balance Sheets
D e c e m b e r 31
2009 2010
Assets
Cash $ 38 $ 45
Other current assets 143 140
Net fixed assets 320 408
Total assets $501 $593
Liabilities and Equity
Accounts payable $140 $143
Long-term debt 0 40
Stockholders’ equity 361 410
Total liabilities and equity $501 $593
a. Explain the change in cash during the year 2010.

b. Determine the change in net working capital in 2010.
c. Determine the cash flow generated by the firm’s assets during the year 2010.
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12. Cash Flow Identity Freeman, Inc., reported the following financial statements for the last two
years. Construct the cash flow identity for the company. Explain what each number means.
2010 INCOME STATEMENT
Sales $565,200
Cost of goods sold 274,025
Selling & administrative 124,733
Depreciation 54.576
EBIT $111,866
Interest 19,296
EBT $ 92,570
Taxes 48,137
Net income $ 44,433
Dividends $ 9,600
Addition to retained earnings $ 34,833
Fr e e m a n , I n c .
Ba l a n c e Sh e e t a s o f D e c e m b e r 31, 2009
Cash $ 13,320 Accounts payable $ 9,504

Accounts receivable 18,994 Notes payable 14,508
Inventory 13,794 Current liabilities $ 24,012
Current assets $ 46,108 Long-term debt $136,800
Net fixed assets $344,426 Owners’ equity $229,722
Total assets $390,534 owners’ equity $390,534
Fr e e m a n , I n c .
Ba l a n c e Sh e e t a s o f D e c e m b e r 31, 2010
Cash $ 14,306 Accounts payable $ 10,512

Accounts receivable 21,099 Notes payable 16,466
Inventory 22,754 Current liabilities $ 26,978
Current assets $ 58,159 Long-term debt $152,000
Net fixed assets $406,311 Owners’ equity $285,492
Total assets $464,470 owners’ equity $464,470
13. Financial Cash Flows The Stancil Corporation provided the following current information:
Proceeds from long-term borrowing $12,000

Proceeds from the sale of common stock 3,000
Purchases of fixed assets 15,000
Purchases of inventories 2,100
Payment of dividends 6,000
Determine the cash flows from the firm and the cash flows to investors of the firm.
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14. Building an Income Statement During the year, the Senbet Discount Tire Company had gross
sales of $870,000. The firm’s cost of goods sold and selling expenses were $280,000 and $155,000,
respectively. Senbet also had notes payable of $650,000. These notes carried an interest rate of
6 percent. Depreciation was $86,000. Senbet’s tax rate was 35 percent.
a. What was Senbet’s net income?
b. What was Senbet’s operating cash flow?
15. Calculating Total Cash Flows Schwert Corp. shows the following information on its 2010
income statement: sales $193,000; costs $96,500; other expenses $5,100; depreciation
expense $13,800; interest expense $10,400; taxes $23,520; dividends $12,500. In addi-
tion, you’re told that the firm issued $6,000 in new equity during 2010, and redeemed $7,500 in
outstanding long-term debt.
a. What was the 2010 operating cash flow?
b. What was the 2010 cash flow to creditors?
c. What was the 2010 cash flow to stockholders?
d. If net fixed assets increased by $28,000 during the year, what was the addition to NWC?
16. Using Income Statements Given the following information for O’Hara Marine Co., calculate the
depreciation expense: sales $43,000; costs $26,000; addition to retained earnings $5,600;
dividends paid $1,300; interest expense $1,900; tax rate 35 percent.
17. Preparing a Balance Sheet Prepare a 2010 balance sheet for Jarrow Corp. based on the fol-
lowing information: cash $175,000; patents and copyrights $730,000; accounts payable
$435,000; accounts receivable $240,000; tangible net fixed assets $3,650,000; inventory
$405,000; notes payable $160,000; accumulated retained earnings $1,980,000; long-term
debt $2,140,000.
18. Residual Claims Huang, Inc., is obligated to pay its creditors $12,500 very soon.
a. What is the market value of the shareholders’ equity if assets have a market value of $15,100?
b. What if assets equal $10,200?
19. Marginal versus Average Tax Rates (Refer to Table 2.3.) Corporation Growth has $86,000 in
taxable income, and Corporation Income has $8,600,000 in taxable income.
a. What is the tax bill for each firm?
b. Suppose both firms have identified a new project that will increase taxable income by
$10,000. How much in additional taxes will each firm pay? Why is this amount the same?
20. Net Income and OCF During 2010, Raines Umbrella Corp. had sales of $835,000. Cost of goods
sold, administrative and selling expenses, and depreciation expenses were $620,000, $120,000,
and $85,000, respectively. In addition, the company had an interest expense of $68,000 and a tax
rate of 35 percent. (Ignore any tax loss carryback or carryforward provisions.)
a. What was Raines’s net income for 2010?
b. What was its operating cash flow?
c. Explain your results in (a) and (b).
21. Accounting Values versus Cash Flows In the previous problem, suppose Raines Umbrella
Corp. paid out $45,000 in cash dividends. Is this possible? If spending on net fixed assets and net
working capital was zero, and if no new stock was issued during the year, what was the change
in the firm’s long-term debt account?
22. Calculating Cash Flows Cusic Industries had the following operating results for 2010; sales
$25,700; cost of goods sold $18,400; depreciation expense $3,450; interest expense $790;
dividends paid $1,100. At the beginning of the year, net fixed assets were $19,280, current
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assets were $5,100, and current liabilities were $3,400. At the end of the year, net fixed assets
were $23,650, current assets were $5,830, and current liabilities were $3,580. The tax rate for
2010 was 40 percent.
a. What was net income for 2010?
b. What was the operating cash flow for 2010?
c. What was the cash flow from assets for 2010? Is this possible? Explain.
d. If no new debt was issued during the year, what was the cash flow to creditors? What was
the cash flow to stockholders? Explain and interpret the positive and negative signs of your
answers in (a) through (d).
23. Calculating Cash Flows Consider the following abbreviated financial statements for Weston
Enterprises:
W E ST ON E NT E RPR I S E S WE S T O N E N T E R P R I S E S
2 0 0 9 a n d 2 0 1 0 Pa r t i a l Ba l a n c e S h e e t s 2010 I n c o m e S t a t e m e n t
Assets Liabilities and Owners’ Equity Sales $10,900

Costs 4,680
2009 2010 2009 2010
Depreciation 930
Current assets $ 740 $ 795 Current liabilities $ 330 $ 360
Interest paid 390
Net fixed assets 3,600 3,800 Long-term debt 2,000 2,150
a. What was owners’ equity for 2009 and 2010?

b. What was the change in net working capital for 2010?
c. In 2010, Weston Enterprises purchased $1,900 in new fixed assets. How much in fixed assets
did Weston Enterprises sell? What was the cash flow from assets for the year? (The tax rate
is 35 percent.)
d. During 2010, Weston Enterprises raised $440 in new long-term debt. How much long-term
debt must Weston Enterprises have paid off during the year? What was the cash flow to
creditors?
Use the following information for Ingersoll, Inc., for Problems 24 and 25 (assume the tax rate
is 35 percent):
2009 2010
Sales $ 26,115 $ 28,030

Depreciation 3,750 3,755
Cost of goods sold 8,985 10,200
Other expenses 2,130 1,780
Interest 1,345 2,010
Cash 13,695 14,010
Accounts receivable 18,130 20,425
Short-term notes payable 2,645 2,485
Long-term debt 45,865 53,510
Net fixed assets 114,850 117,590
Accounts payable 14,885 13,950
Inventory 32,235 33,125
Dividends 3,184 3,505
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24. Financial Statements Draw up an income statement and balance sheet for this company for
2009 and 2010.
25. Calculating Cash Flow For 2010, calculate the cash flow from assets, cash flow to creditors,
and cash flow to stockholders.
Challenge 26. Cash Flows You are researching Time Manufacturing and have found the following account-
(Questions 26–28) ing statement of cash flows for the most recent year. You also know that the company paid
$231 million in current taxes and had an interest expense of $120 million. Use the accounting
statement of cash flows to construct the financial statement of cash flows.
T I M E M A N U FA C T U R I N G
S t a t e m e n t o f C a sh Fl o w s
Operations
Net income $401
Depreciation 221
Deferred taxes 43
Changes in assets and liabilities
Inventories 51
Accounts payable 41
Accrued expenses 21
Other 5
Total cash flow from operations $676
Investing activities
Sale of fixed assets 53
Total cash flow from investing activities $362
Financing activities
Retirement of long-term debt $240
Dividends 198
Total cash flow from financing activities $265
Change in cash (on balance sheet) $ 49
27. Net Fixed Assets and Depreciation On the balance sheet, the net fixed assets (NFA) account
is equal to the gross fixed assets (FA) account, which records the acquisition cost of fixed
assets, minus the accumulated depreciation (AD) account, which records the total depreciation
taken by the firm against its fixed assets. Using the fact that NFA FA AD, show that the
expression given in the chapter for net capital spending, NFAend NFAbeg D (where D is
the depreciation expense during the year), is equivalent to FAend FAbeg.
28. Tax Rates Refer to the corporate marginal tax rate information in Table 2.3.
a. Why do you think the marginal tax rate jumps up from 34 percent to 39 percent at a taxable
income of $100,001, and then falls back to a 34 percent marginal rate at a taxable income
of $335,001?
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b. Compute the average tax rate for a corporation with exactly $335,001 in taxable income. Does
this confirm your explanation in part (a)? What is the average tax rate for a corporation with
exactly $18,333,334? Is the same thing happening here?
c. The 39 percent and 38 percent tax rates both represent what is called a tax “bubble.”
Suppose the government wanted to lower the upper threshold of the 39 percent marginal
tax bracket from $335,000 to $200,000. What would the new 39 percent bubble rate have
to be?
W H AT ’ S O N T H E W E B ?
1. Change in Net Working Capital Find the most recent abbreviated balance sheets for General
Dynamics at finance.yahoo.com. Enter the ticker symbol “GD” and follow the “Balance Sheet”
link. Using the two most recent balance sheets, calculate the change in net working capital.
What does this number mean?
2. Book Values versus Market Values The home page for Coca-Cola Company can be found at
www.coca-cola.com. Locate the most recent annual report, which contains a balance sheet for
the company. What is the book value of equity for Coca-Cola? The market value of a company
is the number of shares of stock outstanding times the price per share. This information can
be found at finance.yahoo.com using the ticker symbol for Coca-Cola (KO). What is the market
value of equity? Which number is more relevant for shareholders?
3. Cash Flows to Stockholders and Creditors Cooper Tire and Rubber Company provides finan-
cial information for investors on its Web site at www.coopertires.com. Follow the “Investors”
link and find the most recent annual report. Using the consolidated statements of cash flows,
calculate the cash flow to stockholders and the cash flow to creditors.
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C A S H F L O W S AT E A S T C O A S T YA C H T S
Because of the dramatic growth at East Coast Yachts, Larissa decided that the company should be
CLOSING CASE reorganized as a corporation (see our Chapter 1 Closing Case for more detail). Time has passed and,
today, the company is publicly traded under the ticker symbol “ECY”.
Dan Ervin was recently hired by East Coast
Yachts to assist the company with its short- E A S T C O A S T YA C H T S
term financial planning and also to evaluate the 2008 I n c o m e S t a t e m e n t
company’s financial performance. Dan gradu- Sales $617,760,000
ated from college five years ago with a finance Cost of goods sold 435,360,000
degree, and he has been employed in the trea-
Selling, general, and administrative 73,824,000
sury department of a Fortune 500 company
Depreciation 20,160,000
since then.
EBIT $ 88,416,000
The company’s past growth has been some-
Interest expense 11,112,000
what hectic, in part due to poor planning. In an-
EBT $ 77,304,000
ticipation of future growth, Larissa has asked
Taxes 30,921,600
Dan to analyze the company’s cash flows. The
company’s financial statements are prepared Net income $ 46,382,400
by an outside auditor. Below you will find the
most recent income statement and the balance Dividends $ 17,550,960
sheets for the past two years. Retained earnings $ 28,831,440
E A S T C O A S T YA C H T S
Balance Sheet
2009 2010 2009 2010
Current assets Current liabilities

Cash and equivalents $ 10,752,000 $ 11,232,000 Accounts payable $ 23,701,440 $ 24,546,000
Accounts receivable 19,116,000 20,208,000 Notes payable 20,220,000 18,725,000
Inventories 17,263,200 22,656,000 Accrued expenses 5,472,000 6,185,000
Other 1,108,800 1,184,000 Total current liabilities $ 49,393,440 $ 49,456,000
Total current assets $ 48,240,000 $ 55,280,000
Fixed assets Long-term debt $ 129,360,000 $146,560,000

Property, plant, and equipment $408,816,000 $ 462,030,000 Total long-term liabilities $ 129,360,000 $146,560,000
Less accumulated depreciation (94,836,000) (114,996,000)
Net property, plant, and equipment $313,980,000 $ 347,034,000
Intangible assets and others 6,840,000 6,840,000 Stockholders’ equity
Total fixed assets $320,820,000 $ 353,874,000 Preferred stock $ 3,000,000 $ 3,000,000
Common stock 30,000,000 40,800,000
Capital surplus 12,000,000 31,200,000
Accumulated retained earnings 157,306,560 186,138,000
Less treasury stock (12,000,000) (48,000,000)
Total equity $ 190,306,560 $213,138,000
Total liabilities and shareholders’

Total assets $369,060,000 $ 409,154,000 equity $ 369,060,000 $409,154,000
42 PART 1 Overview
ros30689_ch02_020-043.indd 42 6/10/10 6:55 PM

CONFIRMING PAGES
Larissa has also provided the following information. During the year, the company raised
$40 million in new long-term debt and retired $22.8 million in long-term debt. The company also
sold $30 million in new stock and repurchased $36 million. The company purchased $60 million in
fixed assets, and sold $6,786,000 in fixed assets.
Larissa has asked Dan to prepare the financial statement of cash flows and the accounting state-
ment of cash flows. She has also asked you to answer the following questions:
1. How would you describe East Coast Yachts’ cash flows?
2. Which cash flows statement more accurately describes the cash flows at the company?
3. In light of your previous answers, comment on Larissa’s expansion plans.
ros30689_ch02_020-043.indd 43 6/10/10 6:55 PM

CORPORATE FINANCE
DEPRECIATION METHODS
Depreciation is the process by which a company allocates an asset's cost over the duration of its
useful life. Each time a company prepares its financial statements, it records a depreciation
expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased
to the current fiscal year. The purpose of recording depreciation as an expense is to spread the
initial price of the asset over its useful life. For intangible assets - such as brands and intellectual
property - this process of allocating costs over time is called amortization.
Depreciation refers to prorating a tangible asset's cost over that asset's life.
Each country adapts and combines the „classical” depreciation systems and develops its own
depreciation methods which are correlated to that country’s fiscal policy. The law in Romania
recognizes 3 depreciation methods: straight-line depreciation; declining-balance depreciation and
accelerated depreciation.
1. The straight-line method requires that the same depreciation norm be used for a constant
depreciation basis for the entire life-time of the fixed asset. This method is derived from the
straight-line system. This method is considered to be the simplest one. It requires simple
computation and the cost of the asset is attributed constantly over the entire life-time of the asset.
The straight line method takes an estimated scrap value of the asset at the end of its life and
subtracts it from its original cost. The result is then divided by management's estimate of the
number of useful years of the asset. The company expenses the same amount of depreciation
each year.
Straight line depreciation = (Original costs of asset – Scrap value)/Estimated asset life
Example:
2. The declining-balance method recognizes a higher depreciation cost earlier in an asset’s life-
time. This method writes-off depreciation costs more quickly than the straight-line method.
Generally, the purpose behind this is to minimize taxable income. The depreciation norm given
by the straight-line method is adjusted by the following coefficients:
a) 1,5 if the life-time of the fixed asset is from 2 to 5 years;

b) 2 if the life-time of the fixed asset is from 5 to 10 years;
c) 2,5 if the life-time of the fixed asset is longer than 10 years.
The yearly depreciation charge is used in two ways:

-without taking into account obsolescence;
-by taking into account obsolescence.
Obsolescence is the state of being which occurs when an object, service or practice is no longer
wanted even though it may still be in good working order. Obsolescence frequently occurs
because a replacement has become available that is superior in one or more aspects. Typically,
obsolescence is preceded by a gradual decline in popularity.
1. The declining-balance method without taking into account obsolescence
When determining the yearly charge without taking into account obsolescence we should
proceed as follows:
-in the first year, the norm is applied to the innitial value of the fixed asset;
-for the following years, the same norm is used but each year it is applied to the net book-value
from the previous one. This procedure is repeated as long as the yearly charge remains higher
than the one determined using the straight line method. When the yearly charge computed like
this becomes equal to or smaller than the one determined using the straight line method, we
switch and from that year on, the straight line method will be used for the net book-value.
Example: Determine the annual depreciation for a fixed asset with a 5000lei value and a lifetime
of 9 years.
The depreciation norm:
1 1
Nd  2   100  2   100  22,22%
Ul 9
-lei-
No. of Annual depreciation Net book value

years
1 5.000 x 22,22% = 1.111 3.889
2 3.889 x 22,22% = 864 3.025
3 3.025 x 22,22% = 672 2.353
4 2.353 x 22,22% = 523 1.830
5 1.830 x 22,22% = 407 1.423
6 356 1.067
7 356 711
8 356 355
9 355 -
2. The declining-balance method taking into account obsolescence
When determining the yearly charge, taking into account obsolescence, the following factors
need to be considered:
-the innitial value for the first year and the net book-value for all the following years of the
lifetime;
-the standard life time, as given in the directory;
-the declining-balance depreciation norm;

-the time period for which the yearly charge will be computed, i.e. the time period for full
depreciation, further divided in the two components: declining-balance and straight-line.
Example: For a fixed asset having an initial cost of 4.000 lei and a standard lifetime of 20 years,
we are given the following:
-its declining balance depreciation norm is 12,5%;
-the time period for which the yearly charge will be computed is 12 years
-this 12 year time period for full depreciation is divided into two components: 4 years on
declining-balance and 8 years on straight-line;
Determine its annual depreciation by using the declining-balance method taking into account
obsolescence.
-lei-
Year Annual depreciation Net book value
1 4.000 x 12,5% = 500 3.500
2 3.500 x 12,5% = 438 3.062
3 3.062 x 12,5% = 383 2.679
4 2.679 x 12,5% = 335 2.344
5 293 2.051
6 293 1.758
7 293 1.465
8 293 1.172
9 293 879
10 293 586
11 293 293
12 293 -
3. The accelerated depreciation method uses a combined approach. For the first year, it is
allowed to use any depreciation norm that does not exceed 50%. For the following years a new
depreciation norm is computed using the straight line approach. This norm is then applied to the
net book-value of the fixed asset after the first year. This depreciation method recognized by the
Romanian law is in fact a straight-line method, but uses two different depreciation norms for the
first and the following years.
Example: Determine the annual depreciation of a fixed asset with a 6000 lei value and a 7 year
life time by using the accelerated depreciation method.
-lei-
Year Annual depreciation Net book value
1 6.000 x 50% = 3.000 3.000
2 500 2.500
3 500 2.000
4 500 1.500
5 500 1.000
6 500 500
7 500 -
CORPORATE FINANCE
THE CAPITAL STRUCTURE OF THE CORPORATION
The capital structure of a corporation refers to a mix of a company's long-term debt, specific
short-term debt, common equity and preferred equity. The capital structure is how a firm
finances its overall operations and growth by using different sources of funds.
After analyzing a number of factors, a firm establishes a target capital structure it believes is
optimal, which is then used as a guide for raising funds in the future. This target might change
over time as conditions vary, but at any given moment the firm’s management has a specific
capital structure in mind, and individual financing decisions should be consistent with this target.
If the actual proportion of debt is below the target level, new funds will probably be raised by
issuing debt, whereas if the proportion of debt is above the target, stock will probably be sold to
bring the firm back in line with the target debt/equity ratio.
Capital structure policy involves a trade-off between risk and return. Using more debt raises the
riskiness of the firm’s earnings stream, but a higher proportion of debt generally leads to a higher
expected rate of return. A higher risk associated with greater debt tends to lower the stock’s
price. Therefore, the optimal capital structure is the one that strikes a balance between risk and
return to achieve the ultimate goal of maximizing the price of the stock.
Capital structure decisions are influenced by six primary factors:
 The first is the firm’s business risk, or the riskiness that would be inherent in the firm’s
operations if it used no debt. The greater the firm’s business risk, the lower the account of
debt that is optimal.
Eg.
 The second key factor is the firm’s tax position. A major reason for using debt is that
interest is tax deductible, which lowers the effective cost of debt. However, if much of a
firm’s income is already sheltered from taxes by accelerated depreciation for example, its
tax rate will be low, and debt will not be as advantageous as it would be to a firm with a
higher effective tax rate.
 The third important consideration is financial flexibility, or the ability to raise capital on
reasonable terms under adverse conditions. Corporate treasures are aware that a steady
supply of capital is necessary for stable operations, which, in turn, are vital for long-run
success. When money is tight in the economy, or when a firm is experiencing operating
difficulties, a strong balance sheet is needed to obtain funds from suppliers of capital.
Thus, it might be advantageous to issue equity to strengthen the firm’s capital base and
financial stability.
Eg.
 The fourth debt-determining factor has to do with managerial attitude (conservatism or

aggressiveness) with regard to borrowing. Some managers are more aggressive than
others, hence some firms are more inclined to use debt in an effort to boost profits. This
factor does not affect the optimal, or value-maximizing capital structure, but it does
influence the target capital structure a firm actually establishes.
 Growth Rate. Firms that are in the growth stage of their cycle typically finance that
growth through debt, borrowing money to grow faster. The conflict that arises with this
method is that the revenues of growth firms are typically unstable and unproven. As such,
a high debt load is usually not appropriate. More stable and mature firms typically need
less debt to finance growth, as its revenues are stable and proven. These firms also
generate cash flow, which can be used to finance projects when they arise.
 Market conditions can have a significant impact on a company's capital-structure

condition.
These six points largely determine the target capital structure, but operating conditions can cause
the actual capital structure to vary from the target at any given time.
THE COST OF CAPITAL
The cost of capital is the term used in the field of financial investment to refer to the cost of a
company’s funds, both debt and equity. So, the cost of capital includes the cost of debt and the
cost of equity.
The Cost of Equity
In financial theory, the cost of equity is the return that stockholders require for a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:
A firm's cost of equity represents the compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership.
Eg. Estimate the cost of equity capital for Pinnacle West Corp in May 2010, when its stock was
selling for about 49USD per share. Dividend payments for the next year were expected to be 1.6
USD a share. In the case of Pinnacle West, analysts in 2010 were forecasting an annual dividend
growth rate of 6.6%.
r = the return that stockholders require for a company
= dividend yield + the expected rate of dividend growth
=
The Cost of Debt
The cost of debt is the effective rate that a company pays on its current debt. This can be
measured in either before- or after-tax returns; however, because interest expense is deductible,
the after-tax cost is seen most often.
The Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the calculation of a firm's cost of capital in which each
category of capital is proportionately weighted. All capital sources - common stock, preferred
stock, bonds and any other long-term debt - are included in a WACC calculation.
The WACC equation is the cost of each capital component multiplied by its proportional weight
and then summing:
where:
rE = cost of equity
rD = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Eg. A firm has 2 million USD debt and 100000 shares at 30 USD each. If they can borrow at 8%
and the stockholders require 15% return, what is the company’s WACC?
CORPORATE FINANCE
SUPPLY CHAIN AND INVENTORY MANAGEMENT
Supply chain management refers to the management of a network of interrelated businesses

involved in the provision of product and service packages required by the end customers. Supply
chain management spans all movement and storage of raw materials, work-in-process inventory,
and finished goods from point of origin to point of consumption.
Supply chain execution means managing and coordinating the movement of materials,
information and funds across the supply chain, through a bi-directional flow. As such, the
following problems are addressed:
 Distribution Network Configuration, refers to the number, location and network

missions of suppliers, production facilities, distribution centers, warehouses, cross-docks
and customers.
 Distribution Strategy deals with questions of operating control, delivery scheme, mode
of transportation and transportation control.
 Trade-Offs in Logistical Activities refers to the coordination and optimization of the
activities within the distribution strategy in order to achieve the lowest total logistics cost.
 Information has to be shared through the supply chain, including demand signals,
forecasts, inventory, transportation, potential collaboration, etc.
 Inventory Management deals with the quantity and location of inventory, including raw
materials, work-in-process and finished goods.
 Cash-Flow supervision provides a proper arrangement of payment terms and
methodologies for exchanging funds across entities within the supply chain1.
According to Butilcă D., a supply chain encompasses all activities associated with the transfer /
movement of goods from raw material stage until they reach the end consumer. Supply chain
also includes all types of companies engaged in the transport and storage of materials, and
processing information related to all these. Therefore, companies that adopt supply chain
management seek ways to integrate logistics, procurement, operations and marketing functions
with other members of the supply chain in order that materials, information, half-finished,
finished products have a smooth flow from point of origin to the point of consumption at low cost
and high customer service .
Supply chain management is based on partnerships and cooperation. Supply chain management
requires the sharing of sensitive information about customers, demand, company strategic plans,
transactions, etc. Supply chain management involves communication and joint involvement, and
1
Adapted from Wikipedia.com
therefore often use teams working beyond organizational and functional boundaries to coordinate
the movement of products to market. In other words, in order to achieve its true potential, supply
chain management requires integration not only between the departments of an organization but
also with its external partners.
The purpose of supply chain management is customer satisfaction, to achieve a higher

performance for the organization, and to identify ways in which companies continue to learn,
innovate and grow. Furthermore, the objectives of supply chain management may be synthesized
as follows: waste reduction, time compression, responsiveness and flexibility.
In general, supply chain management issues are:
 Lack of indicators in the supply chain;

 Inadequate definition of customer service;
 Inaccurate data delivery status;
 Inefficient information systems.
These issues seem to be even more pregnant among the Romanian companies. The scope for
studying and measuring performance indicators at strategic, tactical and operational level is
correct decision making, so that they can support each other in achieving the objectives and
overall goals of an organization.
Butilcă D. has concluded that companies using a combination of tools and indicators to measure
financial performance have a significantly higher efficiency of assets and markets, and that the
adoption of non-financial instruments improves the performance of current and future business.
As such, while financial performance involves important tools for strategic decisions, the control
of daily production and distribution operations are better managed with non-financial
instruments2.
The word inventory (or stock) describes the goods and materials that a business holds for the
ultimate purpose of resale. Inventory management refers to specifying the size and placement
of stocked goods in order to protect the regular and planned course of production against the
random disturbance of running out of materials or goods. The purpose of inventory management
is also to optimize important indicators and activities such as asset management, inventory
forecasting, inventory valuation, inventory visibility, demand forecasting, quality management,
returns and defective goods, etc. Furthermore, the management of the inventories, with the
primary objective of determining/controlling stock levels within the physical distribution system,
functions to balance the need for product availability against the need for minimizing stock
holding and handling costs3.
2
Butilcă D, Performance in Supply Chain Management, Cluj-Napoca, 2012
3
Adapted from Wikipedia.
Besides economies of scale, inventories are kept because of the time lags in the supply chain and
the uncertainties in demand, supply and movement of goods. Inventories are usually divided into
three categories:
 Raw materials: materials and components scheduled for use in making a product;
 Work in process: materials and components that have begun their transformation to
finished goods;
 Finished goods: goods ready for sale to customers.
In order to set up an inventory control and management system the ideal inventory level must be
determined. There are several factors that impact the optimum inventory level:
 amount of capital and financing available;

 consumer demand and projected sales;
 inventory carrying costs: ordering, financing, receiving, storing, handling, insurance,
deterioration, obsolescence costs, physical damage, tax expenses.
 quantity discounts (discounts for making few larger orders instead of numerous
smaller ones)
 storage space.
According to Bodenstab C., for every inventory situation there exists a theoretical optimum
inventory level (TOI). It would be handy to be able to determine this quantity, either for a given
item, or for an entire group of items as it would provide a base point against which to measure
the actual inventory of a company. Unfortunately determining the theoretical optimum inventory
(TOI) is not a simple or direct process.
The process to determine the TOI is to plot out the classical "saw tooth" graphs that result from
simulating the reordering process. In general the process is similar to the graph shown in the
figure below. The vertical axis is the amount of inventory that is on hand at any point in time,
and the horizontal axis is the passage of time.
The interpretation of this saw tooth graph is that the inventory starts to decrease with time as the
product is sold. At some point (determined by the order frequency) a reorder is triggered. Then
the product arrives and is put in stock. The saw tooth rises up to the peak only to start down
again. The quantity that is never penetrated by the saw tooth is the safety stock. In the real world
the safety stock will be penetrated whenever the demand for the item exceeds the forecast (that is
what the safety stock is for). Conversely, there will be an equal number of times that the saw
tooth does not get down to the safety stock because the demand was less than the forecast.
Consequently on the average the safety stock will be a layer of inventory that on the average will
always be part of the TOI.
The other part of the TOI is the average of the height of the saw tooth. In other words, the TOI
will be made up of the safety stock plus half the height of the saw tooth. This assertion is based
on the fact that on the average half of the saw tooth quantity of stock will be around at any time.
At times there will be the full amount of the height, and other times it will be right at the bottom,
but on the average it will be half the amount. In our example above the safety stock is 20 units,
and half of the saw tooth is 10 units, making the TOI 30 for this particular situation4.
Two approaches have had a major impact on inventory management: Material Requirements
Planning (MRP) and Just-In-Time (JIT and Kanban).
1. Material requirements planning (MRP) is a production planning and inventory control

system used to manage manufacturing processes. Most MRP systems are software-based. It is
used to plan manufacturing, purchasing and delivering activities. Materials are scheduled more
closely, thereby reducing inventories, and delivery times become shorter and more predictable.
Its primary use is with products composed of many components, the project being a long-term
one, taking one to three years to develop.
2. Just in time inventory management (JIT and Kanban) is an approach which works to
eliminate inventories rather than optimize them. To meet JIT objectives, the process relies on
signals or Kanban (看板) between different points in the process, which tell production when to
make the next part. The philosophy of JIT is simple: inventory is waste, so JIT inventory systems
expose hidden costs of keeping inventory, but are therefore not a simple solution for a company
to adopt. The inventory of raw materials and work-in-process falls to that needed in a single day.
Suppliers may have to make several deliveries a day or move close to the user plants in order to
support this plan.
4
Adapted from Bodenstab C., http://www.nbds.com/pages/chpapr22.htm
CORPORATE FINANCE
BREAK EVEN POINT AND ANALYSIS
The break-even point (BEP) is the point at which cost or expenses and revenue are equal:
there is no net loss or gain, and one has "broken even". A profit or a loss has not been made.
E.g. If a business sells less than 200 chairs each month, it will register a loss, if it sells more,
it will have some profit. With this information, the business managers will then need to see if
they expect to be able to make and sell 200 chairs per month.
If they think they cannot sell that many, to ensure viability they could:
 Try to reduce the fixed costs (by renegotiating rent for example, or keeping better
control of telephone bills or other costs)
 Try to reduce variable costs (the price it pays for the chairs by finding a new supplier)
 Increase the selling price of their chairs.
Any of these would reduce the break even point. In other words, the business would not need
to sell so many chairs to make sure it could pay its costs.
The break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total
Revenue (TR) and Total Costs (TC) as:
TR = TC
p * X = FC + vc * X
p * X – vc * X = FC
( p – vc ) * X = FC
 X=
where:
FC is Total Fixed Costs,
p is Unit Sale Price, and
vc is Unit Variable Cost.
The quantity p – vc is of interest in its own right, and it is called the Unit Contribution
Margin (C), being the marginal profit per unit, or alternatively the portion of each sale that
contributes to Fixed Costs. Thus the break-even point can be more simply computed as the
point where Total Contribution = Total Fixed Cost:
In currency units (sales proceeds) to reach break-even, one can use the above calculation and
multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution
Margin over Price) to compute it as:

Margin of Safety
In break even analysis, the margin of safety is the extent to which actual or projected sales
exceed the break-even sales. It may be calculated simply as the difference between actual or
projected sales and the break even sales, as follows:
MOS = Budgeted Sales – Break-even Sales

MOS = (Budgeted Sales – Break-even Sales) / Budgeted Sales.
The margin of safety represents the strength of the business. It enables a business to know
what is the exact amount it has gained or lost and whether they are over or below the break
even point.
Furthermore, the margin of safety is a measure of risk. It represents the amount of drop in
sales which a company can tolerate. The higher the margin of safety, the more a company can
withstand fluctuations in sales. A drop in sales greater than the margin of safety will cause
net loss for that period.
E.g. Use the following information to calculate the margin of safety:

Sales price per unit p = 40m.u.
Variable cost per unit vc = 32m.u.
Total fixed cost FC = 7000m.u.
Budgeted Sales 40000m.u.
Breakeven Sales Units =

Budgeted Sales Units =
Margin of Safety =
Break Even Analysis

By inserting different prices into the formula, one would obtain a number of break even
points, one for each possible price charged. The figure represents the total cost curve (TC in
the diagram) which shows the total cost associated with each possible level of output, the
fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the
various total revenue lines (R1, R2, and R3) which show the total amount of revenue received
at each output level, given the price one will be charging.
The break even points (A,B,C) are the points of intersection between the total cost curve (TC)
and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can
be read off the horizontal axis and the break even price at each selling price can be read off
the vertical axis.
Target Income Sales

Target Income Sales are the sales necessary to achieve a given Target Income (or Targeted
Income). It can be measured either in units or in currency (sales proceeds), and can be
computed as follows:
Applicability of BEP
The break-even point is one of the simplest yet least used analytical tools in management. It
helps to provide a dynamic view of the relationships between sales, costs and profits. A better
understanding of break-even, for example, is expressing break-even sales as a percentage of
actual sales—can give managers a chance to understand when to expect to break even (by
linking the percent to when in the week/month this percent of sales might occur).
The break-even point is a special case of Target Income Sales, where Target Income is 0
(breaking even). This is very important for financial analysis.
Limitations
 Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you
nothing about what sales are actually likely to be for the product at these various
prices.
 It assumes that fixed costs (FC) are constant. Although this is true in the short run, an
increase in the scale of production is likely to cause fixed costs to rise.
 It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales. (i.e. linearity)
 It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning of
the period and the quantity of goods held in inventory at the end of the period).
 In multi-product companies, it assumes that the relative proportions of each product
sold and produced are constant (i.e., the sales mix is constant).
Case study no.1 - a fictional company Oil Change Co. (a company that provides oil changes
for automobiles). The amounts and assumptions used in Oil Change Co. are also fictional.
Expense Behavior
At the heart of break-even point or break-even analysis is the relationship between expenses
and revenues. It is critical to know how expenses will change as sales increase or decrease.
Some expenses will increase as sales increase, whereas some expenses will not change as
sales increase or decrease.
Variable expenses increase when sales increase. They also decrease when sales decrease. At
Oil Change Co. the following items have been identified as variable expenses. Next to each
item is the variable expense per car or per oil change:
Motor oil $ 5.00
Oil filter 3.00
Grease, washer fluid 0.50
Supplies 0.20
Disposal service 0.30
Total variable expenses per
$ 9.00
car
The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional
car is serviced. For the reasons shown in the above list, Oil Change Co.'s variable expenses
will be $9 if it services one car, $18 if it services two cars, $90 if it services 10 cars, $900 if it
services 100 cars, etc.
Fixed expenses do not increase when sales increase. Fixed expenses do not decrease when
sales decrease. In other words, fixed expenses such as rent will not change when sales
increase or decrease. At Oil Change Co. the following items have been identified as fixed
expenses. The amount shown is the fixed expense per week:
Labor including payroll taxes and benefits $1,200
Rent and utilities for the building it uses 700
Depreciation, office and professional, training,
500
other
Total fixed expenses per week $2,400
Mixed Expenses. Some expenses are part variable and part fixed. These are often referred to
as mixed or semi-variable expenses. An example would be a salesperson's compensation that
is composed of a salary portion (fixed expense) and a commission portion (variable expense).
Mixed expenses could be split into two parts. The variable portion can be listed with other
variable expenses and the fixed portion can be included with the other fixed expenses.
Revenues or Sales
Revenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil
Change Co. charges one flat fee of $24 for performing the oil change service. For $24 the
company changes the oil and filter, adds needed fluids, adds air to the tires, and inspects
engine belts. At the present time no other service is provided and the $24 fee is the same for
all automobiles regardless of engine size. As the result of its pricing, if Oil Change Co.
services 10 cars its revenues (or sales) are $240. If it services 100 cars, its revenues will be
$2,400.
Contribution Margin
An important term used with break-even point or break-even analysis is contribution margin.
In equation format it is defined as follows:
Contribution Margin = Revenues – Variable Expenses
The contribution margin for one unit of product or one unit of service is defined as:
Contribution Margin per Unit = Revenues per Unit – Variable Expenses per Unit
Furthermore, at Oil Change Co. the contribution margin per car (or per oil change) is
computed as follows:
Contribution Margin per car = Revenues per car – Variable Expenses per car
Contribution Margin per car = $24 – $9
Contribution Margin per car = $15
The contribution margin per car lets you know that after the variable expenses are covered,
each car serviced will provide or contribute $15 toward the Oil Change Co.'s fixed expenses
of $2,400 per week. After the $2,400 of weekly fixed expenses has been covered the
company's profit will increase by $15 per car serviced.
Break-even Point In Units

The break-even point in units for Oil Change Co. is the number of cars it needs to service in
order to cover the company's fixed and variable expenses. The break-even point formula is to
divide the total amount of fixed costs by the contribution margin per car:
Break-even Point in Cars per Week = Fixed Expenses per week ÷ Contribution Margin
per car
Break-even Point in Cars per Week = $2,400 per week ÷ $15 per Car
Break-even Point in Cars per Week = 160 Cars per Week
It's always a good idea to check your calculations. The following schedule confirms that the
break-even point is 160 cars per week:
Oil Change Co.
Projected Net Income
For a Week
Sales (160 cars serviced at $24 per car) $ 3,840
Variable Expenses (160 cars at $9 per
– 1,440
car)
Contribution Margin 2,400
Fixed Expenses – 2,400
Net Income $ 0
Case study no.2 – Navigation Software

C.B. is a software engineer and an experienced programmer. He has always been fond of
navigation, so he has developed a navigation software in his spare time. C.B. decided to start
his own business and he is currently selling his navigation software CD online on
TakticAlSofT.com. His start up cost estimations are the following:
* Software Cost - 4000 pounds
* Site design and hosting - 1250 pounds
* Other projecting costs - 950 pounds.
C.B. has also budgeted 3600 pounds for the marketing activities.
By carefully studying the market, C.B. has decided to have a 65 pounds selling price for each
CD he produces.
C.B. estimates the unit variable costs as follows:
* 2,50 pounds for each produced CD;
* 5.25 pounds for each user guide he produces;
* 2.25 pounds distribution costs.
C.B. would start selling his software at the beginning of the year and he expects his monthly
sales to be the following:
Feb Mar Apr May Jun July Aug Sept Oct Nov Dec Ian
15 20 25 45 40 35 25 10 10 45 15 25
C.B. intends to access a 10000 pounds bank loan for the start up of his business.
Exercise:
Use the graphs below in order to point the consequences of each policy modification
on behalf of TakticAlSofT.com upon its break even point.
(a) C.B. decides to reduce his prices in order to reboost his sales.
(b) C.B. identifies a new supplier that would produce his CDs at £1.25 instead of
£2.50.
(c) Software incompatibilities lead to a £1,750 increase in the programming costs.
(d) The initial strong sales are encouraging, so C.B. decides to replace the original
version with a new premium version, that would be sold at £85.
Source : adapted from www.bized.co.uk/virtual/usbank/business/planning/case_study.htm

and Fişe de lucru Educaţie antreprenorială, www.educaţieeconomică.ro.
THE BREAK-EVEN POINT
Cluj-Napoca
-2013-
Types of Costs
Essentially, there are two types of costs that a business faces:

 Variable costs which vary proportionally with sales
 hourly wages
 utility costs
 raw materials
 etc.
 Fixed costs which are constant over a relevant range of
sales
 executive salaries
 lease payments
 depreciation
 etc.
Operating Break-even
 The operating break-even point is defined as

that level of sales (either units or dollars) at
which EBIT is equal to zero:
Sales  VC  FC  0
Q P  v  FC  0
where VC is total variable costs, FC is total fixed

costs, Q is the quantity, p is the price per unit,
and v is the variable cost per unit
The Operating Break-even in Units
 We can find the operating break-even point in
units by simply solving for Q:
FC FC
Q 
*

p  v CM$ / unit
where CM$/unit is the contribution margin per
unit sold (i.e., CM$/unit = p - v)
 The contribution margin per unit is the amount

that each unit sold contributes to paying off the
fixed costs
The Operating Break-even in M.U.
 We can calculate the operating break-even
point in sales dollars by simply multiplying the
break-even point in units by the price per unit:
BE$  Q *  p
 Note that we can substitute the previous

definition of Q* into this equation:
FC FC FC
BE$  p 
p v  p  v CM %
p
where CM% is the contribution margin as a % of
the selling price, i.e. contribution margin ratio.
Operating Break-even: an Example
 Suppose that a company has fixed costs of
$100,000 and variable costs of $5 per unit.
What is the break-even point if the selling
price is $10 per unit?
100,000
Q*   20,000 units
10  5
BE$  20,000  10  $200,000
100,000
BE$   $200,000
10  5
10
Targeting Profit
We can use break-even analysis to find the sales
required to reach a target level of profit
Note that the only difference is that we have

defined the break-even point as Pr being equal
to something other than zero
Targeting Pr: an Example
 Suppose that we wish to know how many
units the company (from the previous
example) needs to sell such that Pr is equal
to $500,000:
100,000  500,000
Q*   120,000 units
10  5
BE$  120,000  10  $1,200,000
100,000  500,000
BE$   $1,200,000
10  5
10
 Thank you!
CORPORATE FINANCE
DIVIDENDS AND DIVIDEND POLICIES
The dividend policy is the trade-off between retaining earnings on the one hand and paying out
cash and issuing new shares on the other.
Types of Dividends
The dividend is set by the firm’s board of directors. Dividends come in different forms:
a) cash dividends;
b) stock dividends;
c) stock split;
d) share repurchase.
Stock dividends and stock splits are very much alike. Both increase the number of shares but the
company’s assets, profits and total value are unaffected. So, both reduce value per share. The
distinction between them is technical. A stock dividend is shown in the accounts as a transfer
from retained earnings to equity capital, whereas a split is shown as a reduction in the par value
of each share. When a firm wants to pay cash to its shareholders it usually declares a cash
dividend. The alternative is to repurchase its own stocks. The required shares are usually kept in
the company’s treasury and can be resold if the company needs money.
Method of Dividend Payments
The announcement of the dividend states that the payment will be made to all those stockholders
who are registered on a particular record date.
When dividend has been declared it becomes a debt of the firm and cannot be rescinded.
Dividends are normally paid quarterly and, if conditions permit, the dividend is increased once a
year.
Eg.
Dividend policy
There are three parties of economists upholding three dividend theories:
a) the middle-of-the road party claims that given the investment decision of the firm, the
dividend policy is irrelevant. Increasing and decreasing dividends have no effect on stock price.
Representants: Miller and Modigliani (1961); Black and Scholes (1974); Miller and Scholes
(1978)
The middle-of-the-road party supports the dividend irrelevance theory. Miller and Modigliani
showed that as long as the firm is realizing the returns expected by the market, it doesn’t matter
whether that return comes back to the shareholders now as dividend or is reinvested and leads to
an appreciation in dividend or price.
The shareholder can create his own dividend by selling the stock when he needs cash. This
theory is based on some unrealistic assumption such as no transaction costs, no taxes, perfect
information and cost of equity not affected by the dividend policy.
b) the rightists claim that if the firm increases the level of dividends the stock price will also
increase.
Representants: Graham and Dodd (1951); Gordon (1963); Lintner (1962).

The rightists support the bird-in-the-hand theory. Gordon argued that the dividend-in-the hand is
worth more than the present value of a future dividend.
c) the leftists claim that if the firm increases the level of dividends the stock price will decrease.
Representant: Michael Brennan (1970)
The leftists support the differential theory or tax preference theory. Dividends received are
taxable in the current period meanwhile taxes on capital gains are deferred into the future when
the stock is actually sold. In addition the tax on capital gain is usually lower than the tax rate on
dividends (ordinary income).
Dividend policy in practice
In practice investors prefer to have the firm retain and reinvest earnings if they can earn a higher
risk adjusted return.
a) the residual dividend policy, when a company uses residual or leftover equity to fund
dividend payments.
Residual dividend policy steps:

Dividends = Net Income – Target Equity Ratio × Capital Needed
Eg.
Under the residual dividend model, the better the firm’s investment opportunities, the lower the
dividend paid.
Following the residual dividend policy rigidly would lead to fluctuating dividends, something
investors don’t like.
b) the stable (predictable) dividend policy according to which firms try to keep the dividend
constant. It is never reduced. However it may be increased if management is certain that future
earnings will support such a high dividend.
Stable dividend policy steps:
Eg.
The greatest danger in adopting a stable dividend policy is that once it is established it cannot be
changed without seriously affecting investors’ attitude and the financial standing of the
company.
CORPORATE FINANCE
FINANCIAL ANALYSIS
The objective of financial analysis is to rearrange data from financial statements into financial ratios that
provide information about the main areas of financial performance such as:
1. Short-term solvency measures the ability of a firm to meet its short-run financial obligations. If a
corporation has sufficient cash flow it is able to avoid defaulting on its financial obligations and thus
avoid experiencing financial distress.
Accounting liquidity measures short-term solvency and is often associated with net working capital, the
difference between current assets and current liabilities (debts that are due within one year from the data
of the balance sheet). The basic source from which to pay current liabilities is current assets.
𝑇𝑜𝑡𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

a) current ratio = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The current ratio of a company is the ratio of its current assets (cash, inventory, accounts receivable) to
its current liabilities (obligations coming due within the next period).
If a firm is having financial difficulty it may not be able to pay its bills (accounts payable) on time or it
may need to extend its bank credit (notes payable). As a consequence current liabilities may rise faster
than current assets and the current ratio may fall as a sign of financial trouble.
Eg. A current ratio below 1 indicates that the firm has more obligations coming due in the next year than
assets it can expect to turn to cash it’s an indicator for liquidity risk.
The current ratio should be calculated over several years for a historical perspective and it should be
compared to the current ratios of other firms with similar operating activities.
𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
b) quick ratio = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The quick or acid test ratio is a variant of the current ratio. It distinguishes current assets that can be
quickly converted into cash (cash, marketable securities) from those that cannot (inventory, accounts
receivable). As such, quick assets are those current assets that are quickly convertible into cash. They are
obtained by subtracting inventories from current assets. It is important to determine a firm’s ability to pay
off current liabilities without relying on the sale of inventories.
2. Ratios of activity are constructed to measures how effectively the firm’s assets are being managed. By
comparing assets with sales we can find out how quickly assets are used to generate sales.
𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛 𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠

a) total asset turnover = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
This ratio is intended to indicate how effectively a firm is using its assets. If the asset turnover ratio is
high the firm is presumably using its assets effectively in generating sales. If the ratio is low, the firm is
not using its assets up to their capacity and must either increase sales or dispose of some of the assets.
𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠

b) receivables turnover = , can be interpreted as measuring the speed with
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
which the firm turns accounts receivable into cash.
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
average collection period = 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 represents the number of days it takes the
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
company to convert receivables into cash.
The receivables turnover ratio and the average collection period provide some information on the success
of the firm in managing its investment in accounts receivable. The actual value of these ratios reflects the
firm’s credit policy. If a firm has a liberal credit policy the amount of its receivables will be higher than
would otherwise be the case. One common rule of thumb that financial analysis use is that the average
collection period of a firm should not exceed the time allowed for payment in the credit terms by more
than 10 days.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

c) inventory turnover = , can be interpreted as measuring the speed with which
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
the firm turns inventory into sales.
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
days in inventory = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 is an efficiency ratio that measures the average number
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
of days the company holds the inventory before selling it.
The inventory ratios measure how quickly inventory is produced and sold. They are significantly affected
by the production technology of goods being manufactured. (It takes longer to produce a gas turbine
engine than a loaf of bread.) The ratios also are affected by the perishability of the finishing goods.
The ratio of days in inventory is the number of days it takes to get goods produced and sold. It is called
shelf life for retail and wholesale trade firms. A large increase in the ratio of days in inventory could
suggest an ominously high inventory of unsold finished goods or a change in the firm’s product mix to
goods with longer production periods.
The method of inventory valuation (FIFO, LIFO and average cost or weighted average cost) can
materially affect the computed inventory ratios. Thus, financial analysts should be aware of the different
inventory valuation methods and how they might affect ratios.
3. Financial leverage is related to the extent to which a firm relies on debt financing rather than equity.
Measures of financial leverage are tools in determining the probability that the firm will default on its
debt contracts. The more debt a firm has the more likely it is that the firm will become unable to fulfill its
contractual obligations. In other words, too much debt can lead to a higher probability of insolvency and
financial distress.
On the positive side debt is an important form of financing and provides a significant tax advantage
because interest payments are tax deductible. If the firm uses debt, creditors and equity investors may
have conflicts of interest. Creditors may want the firm to invest in less risky ventures than those the
equity investors prefer.
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
a) debt ratio = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
debt-equity ratio = 𝑇𝑜𝑡𝑎𝑙 measures debt as a proportion of equity in the firm.
𝑒𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
equity multiplier = 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
Debt ratios provide information about protection of creditors from insolvency and the ability of firms to
obtain additional financing for potentially attractive investment opportunities. The accounting value of
debt may differ substantially from its market value because no adjustment is made for the current level of
interest rates which may be higher or lower than when the debt was originally issued or risk.
𝐸𝐵𝐼𝑇
b) interest coverage = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
This ratio emphasizes the ability of the firm to generate enough income to cover interest expense. Interest
expense is an obstacle that a firm must surmount if it is to avoid default. The ratio of interest coverage is
directly connected to the ability of the firm to pay interest. The higher the interest coverage ratio, the
more secure is the firm’s capacity to make interest payments from earnings.
𝑎),𝑏)
A large debt burden is a problem only if the firm’s cash flow is insufficient to make the required
debt service payments. This is related to the uncertainty of future cash flows. Firms with predictable cash
flows are frequently said to have more debt capacity than firms with high uncertain cash flows. One
possible way to do this is to calculate the standard deviation of cash flows relative to the average cash
flow.
4. Profitability ratios measure the extent to which a firm is profitable. Accounting profits are the
difference between revenues and costs. However the real profitability of a firm is difficult to
conceptualize and to measure.
Many business opportunities involve sacrificing current profits for future profits. All new products require
large start-up costs and as a consequence produce law initial profits. Thus current profits can be a poor
reflection of true future profitability. Another problem with accounting based measures of profitability is
that they ignore risk. It would be false to conclude that two firms with identical current profits were
equally profitable if the risk of one was greater than the other.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
a) net profit margin = 𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝐸𝐵𝐼𝑇
gross profit margin = 𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
Profit margins express profits as a percentage of total operating revenue. They reflect the firm’s ability to
produce a project or service at a low cost or a high price.
b) net return on assets = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐸𝐵𝐼𝑇
gross return on assets = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
ROA is an indicator of how profitable a company is relative to its total assets. ROA provides
insight on the idea of how efficient management is at using its assets to generate earnings.
One of the interesting aspects of return on assets (ROA) is how some financial ratios can be linked
together to compute ROA. One implication of this is usually referred to as the DuPont system of financial
control. This system highlights the fact that ROA can be expressed in terms of the profit margin and asset
turnover. The basic components of the system are as follows:
ROA = Profit margin x Asset turnover

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
ROA (net) = 𝑇𝑜𝑡𝑎𝑙 x
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐸𝐵𝐼𝑇 𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

ROA (gross) = 𝑇𝑜𝑡𝑎𝑙 x
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Firms can increase ROA by increasing profit margins and asset turnover.
c) return on equity = 𝑆𝑕𝑎𝑟𝑒 𝑕𝑜𝑙𝑑𝑒 𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
ROE = Profit margin x Asset turnover x Equity multiplier
ROA
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

ROE = 𝑇𝑜𝑡𝑎𝑙 x x 𝑇𝑜𝑡𝑎𝑙
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
ROE points out the amount of net income returned as a percentage of shareholders’ equity. As
such, ROE measures a corporation’s profitability by revealing how much profit a company
generates with the money shareholders have invested.
𝐶𝑎𝑠𝑕 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
d) payout ratio = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
retention ratio = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
retained earnings = net income – dividends
The payout ratio is the proportion of net income paid out in cash dividends and the retention ratio is the
proportion of net income retained by the corporation for future investments.

Corporate Finance

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CORPORATE FINANCE - Chapter 1

THE TIME VALUE OF MONEY

c) the uncertainty of future values due to the risk of default or nonperformance of

1). Future Values of Present Sums. Simple and compound interest.

Consider an initial value V0 deposited in an accumulating account at an annual interest rate r.

a). Simple interest

Year Principal Interest earned amount Cumulative amount

b). Compound interest

Year Principal Interest earned amount Cumulative amount

n = the final period in time

r = the interest rate per period of time

3). Analyzing Investments

Money is invested now for an expected return sometime in the future.

Year Investment A Investment B Investment C

1 30000 15000 45000

4). Significance of the discount rate

r = Rf + the risk premium

Timing of the cash flow(s) matters!

E.g. How much will £100 invested at 4% be worth in 15 or 30 years’ time?

And by rearranging and solving for PV yields

And by rearranging and solving for r yields

(3) (1+r) = FV/PV or r = [(FV/PV) – 1]

Q: What is the FV of £150 invested at 7% for one year?

A: FV = £150 • (1 + 0.07) = £160.5

A: £180 = £150 • (1 + r) hence: r = [(£180/£150) – 1] = 0.2 = 20%

Q: What is the PV of £180 paid next year (t1) if r = 5%?

A: £180 = PV • (1 + 0.05) hence: PV = £180 • [1/(1+ 0.05)] = £180 • 0.952 = £171.4

Multi-period investment with compounding of interest

(1) FV = PV • (1+r)n (1+r)n is called compound factor

(2) PV = FV • [1/(1+r)n] 1/(1+r)n is called discount factor

(3) (1+r)n = FV/PV and r = [(FV/PV)1/n – 1]

Q: What is the FV of £150 invested for 4 years at 7%?

A: FV = £150 • (1 + 0.07)4 = £150 • 1.311 = £196.6

A: £180 = £150 • (1 + r)4 hence: r = [(£180/£150)1/4 – 1] = (1.20.25 -1) = 0.047 = 4.7%

Q: What is the PV of £180 paid after 10 years (t10) if r = 5%?

A: £180 = PV • (1 + 0.05)10 hence: PV = £180 • [1/(1+ 0.05)10] = £180 • 0.614 = £110.5

Capital budgeting methods are divided into two categories:

 Accounting rate of return (ARR)

1. Net Present Value NPV

t = the time of the cash flow

r = the discount rate

CFt = the net cash flow at time t (inflow minus outflow)

a) to be as rich as possible, that is to maximize current wealth;

The ratio is calculated as follows:

Rules for selection or rejection of a project:

 If PI > 1 then accept the project;

3. Internal Rate of Return IRR

4. Modified Internal Rate of Return MIRR

RISK, RETURN AND CAPITAL MARKET EQUILIBRIUM

r = Rf + the risk premium (2)

wi = the security’s proportion of the portfolio;

ri = the expected return of security i (average return of a period/time interval);

N = the total number of securities comprised in the portfolio;

T = the total number of observations (time moments).

Standard deviation = (8)

CAPITAL MARKET THEORY AND TOOLS OF PORTFOLIO MANAGEMENT

By diversifying the portfolio (increasing the number of securities) investors manage to

ACCOUNTING STATEMENTS AND CASH FLOW

1. The balance sheet

Assets ≡ Liabilities + Stockholder’s equity

2. The Income Statement

Revenue – Expenses ≡ Income

3. Net Working Capital and Financial Cash Flow