UCD BBS CORPORATE FINANCE
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UCD BBS
CORPORATE FINANCE
Additional Readings
Handout 1 : Understanding Income Statements
http://www.ameritradefinancial.com/educationv2/fhtml/learning/uincomestates.fhtml
A company's income statement is a record of its earnings or losses for a given period. It shows all of the money a company earned (revenues) and all of the money a company spent (expenses) during this period. It also accounts for the effects of some basic accounting principles such as depreciation.
The income statement is important for investors because it's the basic measuring stick of profitability. A company with little or no income has little or no money to pass on to its investors in the form of dividends. If a company continues to record losses for a sustained period, it could go bankrupt. In such a case, both bond and stock investors could lose some or all of their investment. On the other hand, a company that realizes large profits will have more money to pass on to its investors.
In this section, we will cover the following:
• Example of an Income Statement
• Earnings Before Interest and Taxes
• The Importance of the Income Statement to Investors
Example of an Income Statement
The income statement shows revenues and expenditures for a specific period, usually the fiscal year. Income statements differ by how much information they provide and the style in which they provide the information. Here is an example of a hypothetical income statement, with revenues in black and expenditures in red (and parentheses):]
Wilma's Widgets Income Statements for the Years Ending
1998 and 1999
Sales
Less Cost of Goods Sold
Gross Profit on Sales
Less General Operating Expenses
Less Depreciation Expense
Operating Income
Other Income
Earnings Before Interest and Tax
Less Interest Expense
Less Taxes
Net Earnings (Available Earnings for Dividends)
Less Preferred and/or Common Dividends
Paid
Retained Earnings
1998
$900,000 (250,000)
650,000
(120,000)
(30,000)
500,000
50,000
550,000
(30,000)
(50,000)
470,000
(70,000)
400,000
1999
$990,000
(262,500)
727,500
(127,500)
(30,000)
570,000
30,000
600,000
(30,000)
(54,500)
515,500
(80,000)
435,500
Now, as perplexing as those numbers might seem at first, you will become comfortable with them very quickly once we explain what all this financial jargon really means. Let us start by looking at the first term that was calculated - gross profit on sales.
Gross Profit on Sales
Gross profit on sales (also called gross margin) is the difference between all the revenue the company earns and the sales of its products minus the cost of what it took to produce them. Let us move on to clarify how to calculate this important number.
Gross Profit on Sales = Net Sales - Cost of Goods Sold
Simple, yes, but let's be sure we know what the terms sales and costs of goods sold means to the accountants.
Net sales are the total revenue generated from the sale of all the company's products or services minus an allowance for returns, rebates, etc. Sometimes on an income statement, you might see the terms "gross sales" and "returns," "rebates" or "allowances." Gross sales are the total revenue generated from the company's products or services before returns or rebates are deducted. Net sales on the other hand have all these expenses deducted.
Cost of goods sold is what the company spent to make the things it sold. Cost of goods sold includes the money the company spent to buy the raw materials needed to produce its products, the money it spent on manufacturing its products and labor costs.
When you subtract all the money a company spent in the production of its goods and services (cost of goods sold) from the money made from selling them (net sales), you have calculated their gross profit on sales.
Gross profit on sales is important because it reveals the profitability of a company's core business. A company with a high gross profit has more money left over to pump into research and development of new products, a big marketing campaign, or better yet - to pass on to its investors. Investors should also monitor changes in gross profit percentages. These changes often indicate the causes of decreases or increases in a company's profitability. For instance, a
decrease in gross profit could be caused by an industry price war that has forced the company to sell its products at a lower price. Poor management of costs could also lead to a decreased gross profit.
Operating Income
Operating income is a company's earnings from its core operations after it has deducted its cost of goods sold and its general operating expenses. Operating income does not include interest expenses or other financing costs. Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains.
Operating income is particularly important because it is a measure of profitability based on a company's operations. In other words, it assesses whether or not the foundation of a company is profitable. It ignores income or losses outside of a company's normal domain. It also excludes extraordinary events, such as lawsuits or natural disasters, which in a typical year would not affect the company's bottom line.
An easy way to calculate operating income is as follows:
Operating Income = Gross profit - General Operating Expenses - Depreciation Expense
General operating expenses are normal expenses incurred in the day-to-day operation of running a business. Typical items in this category include sales or marketing expenses, salaries, rent, and research and development costs.
Depreciation is the gradual loss in value of equipment and other tangible assets over the course of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term asset to all of the periods for which the asset will be used.
Earnings Before Interest and Taxes
Earnings before interest and taxes (EBIT) is the sum of operating and non-operating income. This is typically referred to as "other income" and "extraordinary income" (or loss). As its name indicates, it is a firm's income excluding interest expenses and income tax expenses. EBIT is calculated as follows:
EBIT = Operating Income +(-) Other Income (Loss) +(-) Extraordinary Income (Loss)
Since we already know what operating income is, let's take a closer look at what other income and extraordinary income mean.
Other income generally refers to income generated outside the normal scope of a company's typical operations. It includes ancillary activities such as renting an idle facility or foreign currency gains. This income may happen on an annual basis, but it is considered unrelated to the company's typical operations.
Extraordinary income (or loss) occurs when money is gained (or lost) resulting from an event that is deemed both unusual and infrequent in nature. Examples of such extraordinary happenings could include damages from a natural disaster or the early repayment of debt.
Many companies may not have either other income or extraordinary income in a given year. If this is the case, then earnings before income and taxes is the same as operating income. Regardless of how it is calculated, EBIT is especially relevant to bondholders and other debtors who use this figure to calculate a firm's ability to "cover" or pay its interest payments with its income for the year.
Net Earnings (or Loss)
Net earnings or net income is the proverbial bottom line. It measures the amount of profit a company makes after all of its income and all of its expenses. It also represents the total dollar figure that may be distributed to its shareholders. Net earnings are also the typical benchmark of success. Just a reminder, however, many companies report net losses rather than net earnings. How do we calculate net earnings?
Net Earnings = Earnings Before Interest and Taxes - Interest Expense - Income Taxes
Interest expense refers to the amount of interest a company has paid to its debtors in the current year. Meanwhile, income taxes are federal and state taxes based upon the amount of income a company generates. Often a company will defer its taxes and pay them in later years. Net earnings are particularly important to equity investors because it is the money that is left over after all other expenses and obligations have been paid. It is the key determinant of what funds are available to be distributed to shareholders or invested back in the company to promote growth.
Retained Earnings
Retained earnings are the amount of money that a company keeps for future use or investment. Another way to look at it is as the earnings left over after dividends are paid out. Generally, a company has a set policy regarding the amount of dividends it will pay out every year. In this case, 70% of net earnings become retained earnings.
Calculation of retained earnings:
Retained Earnings = Net Earnings - Dividends
To better understand retained earnings, we need to explain the nature of dividends. Dividends are cash payments made to the owners or stockholders of the company. A profitable year allows them to make such payments, although there generally are no obligations to make dividend payments. When a company has both common and preferred stockholders, the company has two different types of dividends to pay.
Every publicly traded company has common stockholders. Dividend payments to common stockholders are optional and up to each company to decide how (or if) it will make such payments. A firm may decide to plow all of its earnings into new investments to promote future growth. Preferred stockholders are in line before common stockholders if a dividend is declared. However, not all companies have preferred stockholders.
As an investor, it is important to know what a company does with its net earnings. An investor needs to know the company's dividend and retained earnings policies to decide whether the company's objectives are in line with the investor's. If the company pays dividends it is income- oriented. If it retains earnings for future expansion, it is growth-oriented.
Knowing the sources of income and expenses is necessary when reading an income statement. Two helpful mnemonic devices have been created out of the major components of the income statement.
Income Statement Mnemonics
Although these mnemonics may not account for every line on an income statement, these two will help you remember the major parts, and the order in which they appear. The word "SONAR" identifies the major sales and earnings. The word "EDIT" summarizes major expenditures.
As you look vertically down the first row of letters, you should discover the spelling of "SONAR." The vertical set of letters in the second column spells out "EDIT."
S = Sales (gross)
E = Less expenses (general operating expenses and D = Less depreciation
cost of goods sold)
O = Operating income (before interest and taxes)
I = Less interest
T = Less taxes
N = Net earnings
A = Available earnings for common stock
R = Retained earnings
Let's conclude with a review of the importance of the income statement for investors.
The Importance of the Income Statement to Investors
The income statement provides the investor with much insight to the company's revenues and expenses. You can identify where the company spends much of its income and compare that to similar companies. You can also compare a company's performance with previous years. Most importantly, the income statement tells an investor if the business is profitable. If the company continually makes substantial profits, it indicates to bondholders that it is a stable company. The savvy investor will compare income statements of similar companies.
Handout 2
Understanding Balance Sheets
http://www.ameritradefinancial.com/educationv2/fhtml/learning/ubalsheets.fhtml
In this section, we will learn the importance of balance sheets to you as an investor. We will cover what they represent, how to understand them and how they are presented. We will also provide some useful equations and an example of a balance sheet.
This section will cover the following topics:
• Understanding the Balance Sheet
• Why Should the Balance Sheet Be Important to You?
• The Basic Concept Behind a Balance Sheet
Understanding the Balance Sheet
In order to make an informed investment decision, you should review a company's balance sheet. Let's look at what a balance sheet entails.
The balance sheet is one of the most important financial statements of a company . It is reported to investors at least once per year. It may also be presented quarterly, semiannually or monthly. The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders' equity). The name, balance sheet, is derived from the fact that these accounts must always be in balance. Assets must always equal the sum of liabilities and shareholders' equity.
Why Should the Balance Sheet Be Important to You?
The balance sheet is the fundamental report of a company's possessions, debts and capital invested. Before investing in any company, an investor can use the balance sheet to examine the following:
• Can the firm meet its financial obligations?
• How much money has already been invested in this company?
• Is the company overly indebted?
• What kind of assets has the company purchased with its financing?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance. In this section, you will learn the basic building blocks necessary to do such analysis. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.
The Basic Concept Behind a Balance Sheet
The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore, the following equation must hold true:
Total Liabilities Shareholders' Equity Total Assets
What Are Assets?
Assets = Liabilities + Shareholders' Equity
$30,000
$50,000
$80,000
Assets are economic resources that are expected to produce economic benefits for its owners. Assets can be buildings and machinery used to manufacture products. They can be patents or copyrights that provide financial advantages for their holder. Let us begin with a look at a few of the important types of assets that exist.
Current assets are assets that are usually converted to cash within one year. Bondholders and other creditors closely monitor a firm's current assets since interest payments are generally made from current assets. They include several forms of current assets:
• Cash is known and loved by all. It is the most basic current asset. In addition to currency, bank accounts without restrictions, checks and drafts are also considered cash due to the ease in which one can turn these instruments into currency.
• Cash equivalents are not cash but can be converted into cash so easily that they are considered equal to cash. Cash equivalents are generally highly liquid, short-term investments such as U.S. government securities and money market funds.
• Accounts receivable represent money clients owe to the firm. As more and more business is being done today with credit instead of cash, this item is a significant component of the balance sheet.
• A firm's inventory is the stock of materials used to manufacture their products and the products themselves before they are sold. A manufacturing entity will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm's inventory generally will consist only of products purchased that have not been sold yet.
Now that we have looked at some of the most important short-term assets, let us move forward to examine long-term assets.
Long-Term Assets
Long-term assets are grouped into several categories. The following are some of the common terms you may encounter:
Fixed assets are those tangible assets with a useful life greater than one year. Generally, fixed assets refer to items such as equipment, buildings, production plants and property. On the balance sheet, these are valued at their cost. Depreciation is subtracted from all except land. Fixed assets are very important to a company because they represent long-term illiquid investments that a company expects will help it generate profits.
Depreciation is the process of allocating the original purchase price of a fixed asset over the course of its useful life. It appears in the balance sheet as a deduction from the original value of the fixed assets.
Intangible assets are non-physical assets such as copyrights, franchises and patents. To estimate their value is very difficult because they are intangible. Often there is no ready market for them. Nevertheless, for some companies, an intangible asset can be the most valuable asset it possesses.
Remember that every company will have different assets depending on its industry. However, it is important to know and understand the major accounts that will appear on most balance sheets. Now, we will talk about what the company owes to others: its liabilities
What Are Liabilities?
Liabilities are obligations a company owes to outside parties. They represent rights of others to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.
Current liabilities are those obligations that are usually paid within the year, such as accounts payable, interest on long-term debts, taxes payable, and dividends payable. Because current liabilities are usually paid with current assets, as an investor it is important to examine the degree to which current assets exceed current liabilities.
The most pervasive item in the current liability section of the balance sheet is accounts payable. Accounts payable are debts owed to suppliers for the purchase of goods and services on an open account. Almost all firms buy some or all of their goods on account. Therefore, you will often see accounts payable on most balance sheets.
Long-term debt is a liability of a period greater than one year. It usually refers to loans a company takes out. These debts are often paid in installments. If this is the case, the portion to be paid off in the current year is considered a current liability.
That wraps up our short review of liabilities. You only have one piece left of the balance sheet left to learn - shareholders' equity. Remember that assets minus liabilities equals shareholders' equity.
What Is Shareholders' Equity?
Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners . Shareholders' equity generally reflects the amount of capital the owners invested plus any profits that the company generates that are subsequently reinvested in the company. This reinvested income is called retained earnings . Now that we understand the major components, let us move forward to examine a sample balance sheet.
Example of a Balance Sheet
Below you will see an example of a balance sheet and the various components that you have been studying earlier. The most important lesson to learn in viewing this example is that the basic balance sheet equation holds true.
Assets = Liabilities + Shareholders' Equity
The following balance sheet is arranged vertically starting with assets and then proceeding to detail liabilities and shareholders' equity. Note that the balance sheet gives a snapshot of the assets, liabilities and equity for a given day. In our case, that is December 31. Often a balance sheet shows information for two successive periods as the one below. This gives the investor a better perspective of the company's operations by showing areas of growth.
Pete's Potato & Pasta, Inc.
Balance Sheet Ending December 31st
ASSETS
Current Assets
Cash and cash
equivalents
Accounts receivable
Inventory
Total Current Assets
Fixed Assets
Plant and machinery
Less depreciation
Land
Intangible Assets
TOTAL ASSETS
1998
$10,000
35,000
25,000
70,000
$20,000
- 12,000
8,000
2,000
88,000
1999
10,000
30,000
20,000
60,000
20,000
- 10,000
8,000
1,500
79,500
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Accounts payable
Taxes payable
Long-term bonds issued
TOTAL LIABILITIES
SHAREHOLDERS' EQUITY
Common stock
Retained earnings
TOTAL SHAREHOLDERS' EQUITY
LIABILITIES & SHAREHOLDERS' EQUITY $ 88,000
15,500
4,000
10,000
29,500
40,000
10,000
50,000
79,500
As you can see, total liabilities and shareholders' equity equals total assets.
Tying It All Together
You have now learned the basic construction of a balance sheet and should have a clearer understanding of its importance. The basic financial statement reveals what a company owns, what a company owes to others, and the investments its owners made. It details how a company finances its operations and what assets the company has acquired with this financing.
The key to understanding the balance sheet is in the most basic and fundamental of all accounting equations: Assets must equal liabilities plus shareholders' equity. All of our further balance sheet analysis will be based upon that building block.
Handout 3
Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations
According to theWeighted Average Cost of Capital (WACC), you know that the best capital structure for a corporation is when the WACC is minimized. This is partly derived from two famous Nobel prize winners, Franco Modigliani and Merton Miller who developed the M&M Propositions I and II.
M&M Proposition I
M&M Proposition I states that the value of a firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities.
In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up for 30%. In the second diagram, it is the exact opposite. This is the case because the assets of both capital structures are the exactly same.
M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is irrelevant. The value of the firm is determined by Real Assets and not its capital structure.
M&M Proposition II
M&M Proposition II states that the value of the firm depends on three things:
1) Required rate of return on&
2022-07-11