Solutions manual for corporate finance 10th edition by ross by Horngrenn

Chapter02-FinancialStatementsan dCashFlow SOLUTIONS MANUAL for Corporate Finance 10th Edition by Ross Download at: http://downloadlink.org/p/solutions-manual-for-corporate-finance-10thedition-by-ross/ TEST BANK for Corporate Finance 10th Edition by Ross Download at: http://downloadlink.org/p/test-bank-for-corporate-finance-10th-editionby-ross/

Ch a p ter 2 FINAN CIAL ST ATE M ENT S AN D CAS H FL OW S L IDES 2.1 Ke y C oncepts and Sk il ls 2.2 C hapter Outli ne 2.3 S ources of In formation 2.4 The B alanc e S heet 2.5 U.S. C ompos it e C orpora ti on Balanc e S heet 2.6 Balan ce S heet An al ysis 2.7 Liqui dit y 2.8 Debt versus Equi t y 2.9 Value versus Cos t 2.10 The Income St atem ent 2.11 U.S.C .C . Income St atem ent 2.12 U.S.C .C . Income St atem ent 2.13 U.S.C .C . Income St atem ent 2.14 U.S.C .C . Income St atem ent 2.15 In come St atement Anal ysis 2.16 GAAP 2.17 Non-C as h Items 2.18 Time and C osts 2.19 Tax es 2.20 Mar ginal versus Av era ge R ates 2.21 Net W orking C apit al 2.22 U.S.C .C . Balance S he et 2.23 Financial C ash Flow 2.24 U.S.C .C . Financial C ash Flow 2.25 U.S.C .C . Financial C ash Flow 2.26 U.S.C .C . Financial C ash Flow 2.27 U.S.C .C . Financial C ash Flow

Chapter02-FinancialStatementsan d2.28 C a s U.S.C hFlow .C . Financial C ash Flow

2.29 U.S.C .C . Financial C ash Flow 2.30 U.S.C .C . Financial C ash Flow 2.31 The S tatement of C ash Fl ows 2.32 U.S.C .C . C ash Flow fro m Operati ons 2.33 U.S.C .C . C ash Flow fro m Investi n g 2.34 U.S.C .C . C ash Flow fro m Financin g 2.35 U.S.C .C . S tatement of Cash Flows 2.36 C ash Flow Mana gement 2.37 Quick Quiz

Chapter02-FinancialStatementsan dCashFlow

CHAPT E R WEB S IT ES Secti on We b Address 2.1 finance. ya hoo.com mone y. cnn.com www.sec. gov www.fasb.o r g www.ifrs.or g 2.3 www.irs. gov

CHAPT E R OR GANI Z ATIO N 2.1 The B alanc e S heet Liqui dit y Debt versus Equi t y Value versus Cos t 2.2 The Income St atem ent Gener all y A cc epted Ac c ounti ng P rincipl es Noncash Items Time and C osts 2.3 Tax es C orporate Tax R ates Avera ge versus M ar ginal Tax R ates 2.4 Net W orking C apit al 2.5 Financial C ash Flow 2.6 The Accounti n g S tateme nt of Cash Flows C ash Flow from Op erati ng A cti vit ies C ash Flow from Inv esti ng A cti vit ies C ash Flow from Financi ng A cti vit ies 2.7 C ash Flow Mana gement

ANNOT ATE D CHAPT E R OUTL INE

Chapter02-FinancialStatementsan dSlC id ase h F2l .0 o wChap t er 2 Ti tl e Sl id e

Sl id e 2 .1 Key Concepts and Ski ll s Sl id e 2 .2 Chap t er Outl ine

Chapter02-FinancialStatementsan dCashFlow

Sl id e 2 .3 So urces o f I nform atio n This sl id e co nta ins hyp er lin ks t o co mmon l y us ed so ur ces of fin an ci al dat a . 2.1. The B alanc e S heet

Sl id e 2 .4 The Balance Sheet The balanc e she et provides a snapshot of the firm’ s financial posi ti on at a specific point in t im e. Thus, it is comm onl y r efe rr ed to as a “stock ” statement, wher eas the in come statement would be consi dered a “flow ” statement si nce it covers a period of ti me. The balanc e she et i denti ty is: Assets ≡ Liabili ti es + S tockholder’s Equit y

Sl id e 2 .5 U.S. Com posit e Corpo rat io n Ba la nce Sheet Assets: The Left - Hand S ide Assets are divi ded int o se veral c ate gories. M ake su re that st udents re call the differ ence b etwe en c urrent and fix ed assets , a s well as tan gibl e and int angibl e ass ets. Assets are li sted in orde r of how long it t ypicall y t akes for the sp ecific assettobeconvertedtoc ash, wit h thos e taking the shortesttimebeing listed first. Liabili ti es and Equit y: T he R ight -H and S ide This porti on of the balan ce sheet repr esents t he so urces of funds used to finance the pu rch ase of a ssets. Lectu re Tip : It may be h elpf ul t o review sl ides 4 throu gh 7 from C hapter 1, whi ch highl ight t he general composi ti on of a bal ance sheet. S ince sources and uses m ust e qual, t he balanc e she et i s an equali t y: Assets = Li abil it ies + S tockholder’s Equit y

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip: Students so meti mes fi nd it dif fi cult to see the relat ionsh ip betw een the decisi ons made by fi nanc ial managers and the values that subsequentl y appear on t he fi rm’s bal ance sheet. One w ay to help th em see the “bi g picture” is t o emphasize that all fi nance decisi ons are eit her investment d e cisi ons or fi nancing decisi ons. Inve stment decisi ons i nvolve the purchase and sale of any assets (not j ust f inancial ass e ts). Inv estment decisi ons show up on the left -hand si de of t he balance sheet. Financing decisi ons i nvolve the cho ice of w hether to borrow money to buy the assets or t o iss ue new ownershi p shares. Financing decisi ons show up on the right -hand si de of t he ba lance sheet.

Sl id e 2 .6 Ba la nce Sheet Anal ys is There are thr ee prima r y c oncerns that ne ed to be a ddressed wh en anal yz in g a b alance sh eet : l iqui dit y, debt ve rsus eq uit y, and mark et value versus hist orical cost. A. Liqui dit y

Sl id e 2 .7 Li q ui di ty Liqui dit y is a m easur e of how easil y an ass et can be convert ed to cash. S ince assets ar e li sted in ascendin g ord er of how l ong it takes to b e converted to c ash, t he y a re, b y definiti on, li sted in descendin g ord er of li quidi t y (i.e., mos t l iqui d li sted first). Liabili t y o rd er, howev er, r efle cts ti me to maturit y. It i s im portant t o point out t o st udents t hat l iqui dity has two components: (1) how lon g it takes to c onvert to cash and (2) the value that m ust be reli nquis hed to convert t o cash qui ckl y. An y ass et can be conv erted to cash qui ckl y if you ar e w il li ng to l ower the pric e e nough. It i s also i mportant t o point out t hat owning more l iqui d assets makes it easier to m e et short -term obli gati ons; howeve r, the y also provid e lower returns. C onsequentl y, too m uch li quidi t y can be j ust as detrimental t o shareholder wealt h max im iz ati on as too litt le liquidi t y.

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip: Discuss the cash that Appl e has on i ts Balance Sh eet. At one point,itwasestimatedthat Apple had more cash on hand than the U.S. Government.ShouldApple keep thi s much cash?

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip: Some students get a li ttl e confus ed w hen they try to underst and that excessi v e cash holdi ngs can be undesir able. Occasionally, theyleavean accounti n g principl es class w it h thebeliefthatalarge current rati o is, in and of it self , a good thi ng. Short -term credit ors li ke a company to have a large current rati o, but that doesn’t mean that excess cash i s good f or t he fi rm. Y ou may w ish to menti on that a cash balance is a use of funds and, therefore, has an opport un it y cost. Ask w hat a company could do w it h cashifitwerenotsittingidle. It could be paid to stockholders, investedin productiveassets,or us e d to r educe debt . Student s need tounderstandthat achangeinafi rm’s cas h account is not the sam e as cashflow,regardless ofwhatthe“ Stat ement of C ash Flow s” may imply. B. Debt versus Equi t y

Sl id e 2 .8 Deb t vers us Eq ui ty Inte rest and p rincipal pa yments on debt have to be paid befor e cash ma y b e paid t o st ockholders. The comp an y’s gains and los ses are magni fied as the comp an y incr eas es the amount of debt i n the capit al st ructure. This i s wh y w e c all the use of de bt financial levera ge. The balanc e she et i denti ty c an be r ewrit ten to il lust rate th at owners’ equit y is j ust wh at i s left after all debts ar e paid. Owners’ Equit y = Assets - Li abil it ies Therefo re, equit y holde rs are r efe rred to as residua l claim ants. Lectu re Tip: Y ou may fi nd it useful at t his po int t o spend a few minutes reinf orcing t he c oncepts of ow ners’ equit y and retai ned earni ngs. T he st udents s hould r ecall that ow ners’ equit y consi sts of the common st oc k accou nt, pai d -in sur plus, retained earni ngs and treasury stock. It is i mpo rtant to remind st udents that t he fi rm’s net income belongs to t he ow ners. It can eit her be pai d out i n dividends or r einvested i n the firm. Wh en it is r einvested in t he fi rm, it becomes addi ti onal equity investment and show s up i n the retai ned earni ngs accoun t.

Chapter02-FinancialStatementsan d C a s h F l o w C. Value versus Cos t

Sl id e 2 .9 Va l ue vers us Co st

Chapter02-FinancialStatementsan dCashFlow

Under cu rrent a ccounti n g st andards, finan cial st ate ment s are reported on an hist orical cost ( i.e., book value) b a sis . However, book values ar e gene rall y not all t hat useful fo r m aking d ecisi ons about t he future b ecaus e of the hist orical natur e of the numbers. Also, som e of the most im port ant assets and li abi li ti es do not show up on the balanc e sheet. For ex ampl e, the people t hat work for a firm can be v er y valu able assets, but the y are not i ncluded on the balance sh eet. Thi s is esp eciall y true in servi ce ind ustries. Lectu re Tip: Ac counti ng, or hi stor ical , costs are not very import ant t o fi nancial managers, w hil e market va lues are. Some students have dif fi cult y recogniz ing t hat t he passage of ti me and changing circumstances w il l al most alw ays mean that the price an asset w ould f etch if s old today is qu it e dif f erent f rom it s book value. Someti mes an exa mple or t w o of f amili ar instan ces are enough to make the point . For example, point ing o ut t he dif ferences betw een mark et values and hi stor ical costs of us ed cars and houses may help. Some students recogn ize t he dif ference b etw ee n book values and market values, but d o not understand w hy market values are the more import ant numbers f or decisi on -making. T he simpl est answ er is that market value represents t he cash pri ce people are w il li ng and able to pay. After a ll , it is cash that must ul ti mately be paid or received for inv e stments, i nterest, pr incipal, di vidends and so f orth. T he key, part icularl y in l ater chapters, is to recogniz e that market values ar e a bett e r measure of opport unit y costs . 2.2. The Income St atem e nt

Sl id e 2 .10 The I ncom e Stat em ent As menti oned earlie r, the income statement measu res flows ove r a pe riod of tim e. S pecificall y, it measures revenu es coll ect e d relative to the costs associated wit h thos e r ev enues (matchin g prin cipl e). The dif fer ence between thes e two is the firmâ&#x20AC;&#x2122;s income. Thus, the income statement takes the foll owing fo rm :

Chapter02-FinancialStatementsan dCashFlow R evenue – Ex penses

= In come

Sl id e 2 .11 – Sl id e 2 .14 U.S.C.C. Incom e Stat em ent

Chapter02-FinancialStatementsan dCashFlow

This s eries of sli des walk s through the v arious sect ions o f the income statemen t, poi nti ng out t hat t he gener al oper ati on of the business i s refle cted in the top porti on, with non -operati n g im pacts (includin g tax es) being r efle cted in the low er porti on. The “bott om l ine” is net i ncome, which provides a measure of th e over all earnin gs of the firm. Lectu re Tip : Pre viousl y, it w as not ed that investment decisi ons are refl ected on the left -hand side of t he balance sheet , and fi nancing decisi ons are refl ected o n the right -hand si de of t he balance she et. Y ou could al so point out that the i ncome stat emen t reflects investment decisi ons i n the “t op half ,” from sal es to EBIT . Financing decisi ons are refl ected in the “bot tom half ,” from EBIT to net income and earni n gs per shar e.

Sl id e 2 .15 I ncom e St at em ent Ana lysi s As wit h the balance sh eet , t here a re thi n gs to reme mber when tr yin g to int erpret t he income stat e ment: GAAP , non -cash i t ems, and ti mi ng. A. Gener all y A cc epted Ac c ounti ng P rincipl es

Sl id e 2 .16 GAAP R emember that GAAP r e quire that we r eco gniz e r evenue wh en it is earned, not wh en the c ash i s receiv ed, and w e match costs to revenues (i.e., the matchi ng principl e ) . Thus, inco me is reported when it is earned, not wh en cash i s a ctuall y gener a ted from the transacti on. C onsequentl y, net i ncom e is NOT c ash flow. A rec ent developm ent i s the in tegr ati on of Inte rna ti onal Financial R eporting S tandards ( IF R S ) wit h GAAP pol icies (see se cti on below).

Chapter02-FinancialStatementsan dCashFlow

B. Non-C ash Items

Sl id e 2 .17 No n - Cas h I t em s The matchin g principl e a lso creates the re co gnit ion of non cash it ems. For ex ampl e, whe n we purch ase a m ach ine , the cash flow occurs imm ediatel y, but we re co gniz e the ex pense of the machin e over tim e as it is us ed in t he producti on proc ess (i.e., depre ciation). The lar gest non - cash ded ucti on for most firms i s depreci ati on ; however, othe r noncash it ems include amorti z ati on and defe rred tax es . Non-cash ex pense s reduce t ax es and net i ncome , but do not actuall y rep resent a cash outflow . Non-cash d educ ti ons are part of the reason t hat n et i ncome is not equivalent t o cas h flow. Lectu re Tip: In Mar ch 2 004, Global C r ossi ng reported record quart erly earni ngs of $24.88 bil li on on revenues of $719 mi ll ion . T hese earni ngs came abo ut because GAAP r egard ing non -cash it ems relat ed to t he fi rm’s emergen ce from bankru ptcy. Accordi ng to T he Wall Street Journ al Onli ne (Global C r ossing Scores A Bankrupt cy Bonanza, Ma rch 11, 2004 ), $8 bil li on of t he prof it w as from t he abil it y to eliminate the li abil it ies associated wi th contra cts w it h equipment vendors t hat w ere reneg oti ated during bankrupt cy. Another $16 bil li on came from eli mina ti ng the common and preferr ed shares that pr eviousl y exi sted. Most of the remainder of the “pr ofi t” came from t he li abil it ies associat ed w it h contra cts betw een Globa l C rossi ng and other phone companies that w ere eli minated during t he bankrupt cy proc ee dings . If these non-cash “ revenu es” w ere eli minated from the ca lculati ons, t hen the fir m woul d have had a net l oss of approximately $3 mill ion. C learly, GAAP don’t al w ays provide a clear view of earnings.

Chapter02-FinancialStatementsan dCashFlow

E th ics Note: Publi cly traded fi rms have to f il e audit ed annual report s, but that does not mean that â&#x20AC;&#x153; accounti ng irr egular it iesâ&#x20AC;? never sl ip by the audit ors . C ompanies that deli berately manipulat e fi nancial stat ements may benefi t i n the shor t run, but it eventual ly comes bac k to haunt them. C endant C orporat ion is a g ood example. C endant w as cr eated when C UC Interna ti onal and HFS, Inc. merg ed in l ate 1997. The combined compan y ow ns busi nesses in t he real estat e and tr avel i ndust ries. In April 1998, the combined company announc ed that accounti ng irr egular it ies ha d been found in t he C UC f inancial s tatements an d earni ngs w ould need to be restat ed for 1997 and possi bly 1995 and 1996 as well. C endantâ&#x20AC;&#x2122;s stock pri ce dropped 47 p ercent t he day aft er th e a nnouncement w as made (it w as announced aft er the mark et clos ed ). T h e probl ems haunted C enda nt t hroughout 1998. In July, it w as announced that the problem was much w orse than ori ginal ly expe cted, and the stock p rice plummeted again. B y the end of July, the stock pri ce had dropp ed more than 60 perc ent below the price before the origi nal announcement. T he company also h ad to t ake a $76.4 mill ion charge in t he thi rd quart er of 1998 for the costs of investi gati ng the accounti ng irr egular it ies. Cr iminal charges have been fi led against severa l f ormer exe cuti ves of C UC Internat ion al , and several class acti on l aw suit s have been fi led against C endant. T he stock w as t radi ng around $41 per shar e pri or t o the announcement and dr opp ed to as low as $7.50 per shar e in October 1998. The price star ted to rebound, but as of June 2005 ($21.85 ) w as st il l onl y about half of w hat it had been pri or. Further, the company w a s spl it int o four segments i n October 2005, possi bly a result of the prior actions discussed above. Other companies, suc h as Enron, WorldC om, e tc. have fared much w orse. There w ere a st ring o f accounti ng probl ems at t he star t of thi s century , and these, along w it h the terrori st at tacks, have led to much of t he market decli ne duri ng th e early 2000s.

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip : Students so meti mes fai l t o grasp t he dist inction betw een the e co nomic li fe of an asset, the useful li fe of an asset for accounti ng purposes, an d the useful li fe of an asset f or t ax purposes. “Economic lif e” refers to t he period o f t ime that the asset is expected to g ener ate cash f low s and must be consi dered w hen capit a l budgeting decisi ons are made. “ Usef ul l if e” for accounti ng purposes is l argely determined b y the fi rm’s accountant s, w it h guidance from GAAP, and it aff ects t he depreciat ion exp ense on the balance sheets and in come stat eme nts that are used for busi ness p urposes. “ Useful li fe” for t ax purposes is determined by the Int e rnal Revenue S ervic e an d is b ased on dif ferent ass et categori es. T his i s al so i mportant for capit al budgeti ng because it dete rmines the tax consequ en ces of depreciat ion, w hich affec ts cash fl ow . C. Time and C osts

Sl id e 2 .18 Tim e and Co st s W e need to pl an for both short -run cash flows and long-run cash flows.Intheshortrun,s ome costs are fix ed regar dless ofoutput, andothercostsare va riab le. For ex ampl e, fix ed as sets a re gen erall y fix ed in t he short run, whil e input s such as labor and r aw materials ar e variabl e. In the long run, all costs are variable . It i s im portant t o identif y thes e costs when doin g a cap it al budgeti n g anal ysis . Additi onall y, ac countant s t ypicall y classif y costs as pr oduct costs and period costs , r ather t han fix ed and variable. Lectu re Tip : Dist ingui shing betw een fi xed and va riabl e costs can have import ant i mplications f or esti mating cash flow s. It is someti mes helpf ul t o rem ind st udents t hat variable costs are cash outf low s that vary w it h the level of output , w hil e fi xed costs do not. Another import ant t hing to poi nt out is t hat t he defi nit ion of short run and l ong run varies for dif ferent t ypes of busi nesses. 2.3. Tax es

Chapter02-FinancialStatementsan dSlC id ase h F2l .19 o w Ta x es Cli ck on th e web

sur f er icon to g o to th e IRS web s it e. Yo u can sho w th e stud en ts ho w to s ear ch fo r t he mo st up -to - date tax i nf or mati on . The tax code is constantly ch an gin g with t he decis ions o f Congress. S ince corporati ons pa y tax es, w e need to be awa re of th e se chan ges.

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip : T he text not es the ev er -changing nat ure of t he tax code. T his can be il lust rated by the chang es in t he Investment T ax C redit (ITC ) betw een 19 62 and 1986. 1962 – Seven p ercent IT C created to st imulat e capit al i nvestment 1966 – ITC suspended 1967 – Seven p er cent IT C reinst ated 1969 – ITC eli minated 1971 – Seven p ercent IT C reinst ated 1975 – C redit increased to 10 percent 1986 – ITC eli minated Tax rates aff ect t he firm’ s cash flow and, th ere for e, the firm’s valu e. S ince we want t o max im iz e firm value, we ne ed to i ncl ude tax es in o ur decisi ons. Mar ginal tax rate – rat e p aid on nex t dol lar of income Avera ge tax rate = tax bil l / tax able income S ince decisi ons cre ate in cremental i ncom e, we w a nt t o use the mar ginal rate in our de cisi ons. A. C orporate Tax R ates It’s im portant t o point ou t t o st udents t hat corporat ions (and indi viduals) do not pa y a flat rate on their in come, but corporate rates ar e not s trictl y in cre asing eit he r. R ates a re pr ogr essi ve to a point , then decli ne to a p oint , such that the lar gest fir ms end up pa yin g a rate (mar ginal = avera ge) of 35 p er cent. The ave ra ge rate rises to t he mar ginal rate at $50 mi ll ion of tax able income. The “sur cha r ges ” at 39% and 38 % offs et t he ini ti al l ower margin al rates. B. Avera ge versus M ar ginal Tax R ates

Sl id e 2 .20 Mar gi na l vers us Aver ag e Ra tes This s li de provides an in - class ex ampl e for c alcula ti ng tax es and rates, wit h the answ ers gi ven in t he notes to t he sli de.

Chapter02-FinancialStatementsan dCashFlow

Note that the tax code pr esented is gene rall y sim pli fied. To see a more ac curat e re flecti on of the ave ra ge rate b y ind ustr y, ch eck out Table 2.5.

Chapter02-FinancialStatementsan dCashFlow

Lectu re Tip : It is us eful to st ress t he sit uati ons i n w hich margi nal tax rates are relevant an d thos e in w hich average tax rates are relevant. For purpos es of computing a company ’s total tax li abil it y, the average tax rate is t he correct rat e to apply to before tax profi ts. How ever, in e valuat ing t he cash f low s that w ould be generated from a new inv estment, t he marginal tax rat e is t he appropri ate rate to us e. T his i s because the new investment w il l generate cash f low s that w il l be taxed above the c ompany’s exist ing pr ofi t. Lectu re Tip : T he op -ed p age of t he March 11, 199 8 , iss ue of T he Wall Street Journal contai ns an art icle guarant eed to generate class discussi on. Enti tl ed “ Aboli sh t he C orporat e Income T ax,” the author provides a qui ck ov erview of the sit uati on that brought the current income ta x int o being i n the early 1900s, and contends that the corporat e and pe rsonal income tax system s began li fe as “ tw o separat e and completely uncoordi nated tax s ystems.” Wit h the passage of t ime, the tax code has, of cours e, b ecome extrem ely complex, and the author il lust rates thi s by noti ng that , “ C hrysler C orporat ion’s tax returns comprise stacks of pape r si x feet hi gh, prepared by mor e than 50 accountant s w ho do nothi n g else.” And, he point s out , “ the Internal Revenue S ervic e, mea nw hil e, has a team of audi tors w ho do nothi ng but monit or C hrysler’s returns.” Given the co mplexit y and w asted eff ort, t he author suggests that the rati onal t hing t o do is to abol ish t he corpor ate income tax. Do you agree? 2.4. Net W orking C apit al

Sl id e 2 .21 Net Work i ng Ca pi tal The diffe renc e betw een a firm’s curr ent assets and it s current li abil it ies.

Sl id e 2 .22 U.S.C.C. Bal ance Sheet S ince a firm ne ed s curr en t assets (e. g., inventor y) t o gen erat e sales, as the firm grows, so gen erall y does it s net workin g c apit al.

Chapter02-FinancialStatementsan d C a2.5. s h FFinancial low C ash Flow

Sl id e 2 .23 Fi na ncial Cas h Fl ow C ash i s the li feblood of a busi ness and is, t herefo r e, the most im portant it em t hat can be ex tracte d from financial st at eme nts.

Chapter02-FinancialStatementsan dCashFlow

W e gen erate cash flow fr om assets, t hen use thi s cash flow to rew ard credit ors and st ockhold er s. In conjunction wit h the balance sh eet i denti t y, we know that t he c ash fl ow from assets m ust, t he refor e, equal t he cash flows to credit ors and st o ckholders: C F(A) C F (B) + C F (S) S tated ex pli cit l y, t he c as h flow identit y is C ash Flow from Ass ets = C ash Flow to C redit ors + C ash Flow to S tockholders

Sl id e 2 .24 – Sl id e 2 .30 U.S.C.C. Fina nci al Ca sh Flo w These sli des provide a w alkt hrough o f the c alcula ti on of the components of cash flow. C FFA = oper ati ng cash fl ow – net capit al spendin g – chan ges in n et working capit al Operati n g c ash flow (OC F) = E B IT + dep reci ati on – tax es Net capit al spendin g ( NCS ) = purchas es of fix ed a ssets – sales of fix ed assets or NC S = ending n et fix ed assets – beginni n g net fix e d assets + depreci ati on C hanges in NW C = endi ng NW C – be ginni ng N W C C ash Flow to C redit ors a nd S tockholders C ash flow to credit ors = i nterest paid + r eti rement of debt – proceeds from new d ebt or C ash flo w to credit ors = i nterest paid – net ne w bo rrowin g = int erest paid – ( ending long-te rm debt – be ginni ng lon gte rm debt) C ash flow to st ockholder s = divi dends paid + stoc k repurch ases –

Chapter02-FinancialStatementsan dCashFlow proceeds from new sto

ck iss

ues or C ash flow to st ockholder s = divi den ds paid – net new equit y raised = divi dends paid – (endin g comm on st ock, AP IC & Tr easur y stock – beginni n g comm on st o ck, AP IC & Tr easur y sto ck)

Chapter02-FinancialStatementsan dCashFlow

It i s im portant t o point out t hat chan ges in ret aine d earnin gs ar e not included in “net new equ it y raised. ” Lectu re Tip : T extbooks make fi nancial stat ement analysis s eem reasonabl y str aight forw ard. However, it is no t al w ays as easy to class if y the numbers t hat appear on the consol idat ed fi nancial stat ements of an actual corporat ion. C onsi der the 20 11Mc Graw -Hil l Annual Report .Y ou can go to the McGraw -Hill w eb si te (htt p://w w w .mcgraw -hil l.com) a nd look under investor relat ions t o get t he ful l annual repo rt f or 20 11 (or the most r ecent one a vail able). T he fol low ing q uesti ons may ari se from l ooking a t t he fi nancial stat ements: 1. How do you account f or “ prepubli cati on costs ,” “ investments and other assets ,” and “goodw il l and ot her int angibl e assets ” ? Are they included in n et capital spending , or are they ac counti ng numbers w it h no real i mpact on cash fl ow s ? 2. How shoul d the “ot her li abil it ies” be accounted for? Again, w hich accounts trul y provide changes in cash fl o w s , and w hich accounts are just used for accounti ng purposes wi thout an actual change in cash flow s ? 3. How do “ accumulated other comprehensi ve inc ome” and “ unearned compensat ion on rest ricted st ock” aff ect cash fl ow s? T he cash f low identit y does not appear t o hold w hen appli ed in a reasonabl e fashi on based on the infor mation pr ovided . It is import ant t o poi nt out that f inancial managers have a lot more inf ormati on avail able to them than w hat i s provided in t he consol idat ed st atements of an annual r eport . T he manager w il l have the infor mation ava il able to compute cash f low from assets , and if it is do ne caref ull y, the cash f low identit y w ill hold. 2.6. The Accounti n g S tateme nt of Cash Flows

Sl id e 2 .31 The Statem ent o f Cas h Flo ws There is an o fficial a ccou nti ng statement c all ed the St atement of Cash Flows, which ex plains t he chan ge in t he cash acco unt on the

Chapter02-FinancialStatementsan d C a s h F l o w firm â&#x20AC;&#x2122;s balance sh eets betw een

t wo periods. The statem e nt t ypicall y has thr ee components: cash flows f rom operati n g a cti vit ies, cash flows f rom investi ng acti vit ies, and c ash flows from finan cin g acti vit ies. It i s helpful t o thi nk of c a sh i nflows and outflows: S ources and Us es of c ash

Chapter02-FinancialStatementsan dCashFlow

Acti vit ies that bring in ca sh are sourc es . Firms r aise cash b y sell in g assets, borrowin g mone y, or sell ing se curities. Acti vit ies that i nvolve ca sh out flows are uses . Fir ms us e cash t o bu y ass ets, pa y off d ebt, repurch ase stock , o r pa y divi dends. There are som e m echani cal R ules for det ermini ng S ources and Us es: S ources: Decr ease in asset ac coun t In cre ase in l iabili ti es or e quit y ac count Uses: In cre ase in asset account Decr ease in l iabili ti es or equit y a ccount A. C ash Flow from Op erati ng A cti vit ies

Sl id e 2 .32 U.S.C.C. Cas h Fl o w fr om Op er ati o ns Operati n g Acti vit ies + Net Inc ome + Depr eciation Defer red T ax es + Dec reas e in cur rent ass et accounts ( ex cept cash) + Incr ease in curr ent l iabili t y accounts ( ex cept not es pa yable ) - Incr ease in curr ent asset accounts ( ex cept cash) - Dec reas e in curr ent l iab il it y accounts ( ex cept not es pa yable ) It m a y b e good to not e that cash flow f rom oper ati ons effe cti vel y ac counts for int erest ex pense sinc e it is s ubtracted prior to net i ncome; howeve r, thi s flow is m ore gen erall y r elated to finan cin g acti vit ies. B. C ash Flow from Inv esti ng A cti vit ies

Sl id e 2 .33 U.S.C.C. Cas h Fl o w fr om I nvest i ng

Chapter02-FinancialStatementsan d C a s h F l o w Inv estm ent Acti vit

ies + Ending n et fix ed assets - Be ginni n g net fix ed as sets + Depr eciation

Chapter02-FinancialStatementsan dCashFlow

C. C ash Flow from Financi ng A cti vit ies

Sl id e 2 .34 U.S.C.C. Cas h Fl o w fr om Fi na nci ng Financin g A cti vit ies C hange in not es p a yabl e C hange in l on g-te rm d ebt C hange in comm on st ock - Dividends

Sl id e 2 .35 U.S.C.C. Sta tem ent of Cash Flo ws P utt ing it all together: Net cash flow from op erati n g acti vit ies Net cash flow from i nv esti ng a cti vit ies Net cash flow from fin ancin g acti vit ies = Net i ncr ease (dec re ase) in cash over the p eriod 2.7. C ash Flow Mana gement

Sl id e 2 .36 Ca sh Flo w Ma na g em ent The comm on assum pti on is that cash flow is a bett er metric to ev aluate , as opposed to earnin gs, whi ch can b e more e asil y m a nipul ated b y subj e cti ve decisi ons all owed b y GA AP (gener all y acc epted a ccounti ng p rincipl es). W hil e thi s ma y be t rue, fi rms can st il l “mana ge ” c ash flows, particula rl y b y, for ex ampl e, classif yin g it ems as operati n g r ather t han investi ng c ash flows. This wil l not change th e tot al cash flow, but it ma y make the firm’s op erati o ns seem st ron ger than th e y a ctuall y are. Non etheless, since tot al cash flow is unchan ged b y thi s “man a gem ent ,” it is t hus a bett er measure th an ea rnin gs.

Sl id e 2 .37 Qui ck Qui z

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