Transcript Review of Accounting Learning Objectives: • Use of the balance sheet, the income • • • • statement, and the statement of cash flows by managers. Calculation of depreciation. How.

Review of
Accounting
Learning Objectives:
• Use of the balance sheet, the income
•
•
•
•
statement, and the statement of cash
flows by managers.
Calculation of depreciation.
How depreciation affects cash flow.
How taxes affect a firm’s value.
Calculation of marginal and average
tax rates.
The Firm’s Financial Statements
• Annual report includes:
 Income Statement
 Balance Sheet
 Statement of Cash Flows
 Accompanying Notes
Income Statement
ACME CORPORATION
For the Year Ended December 31, 2009
Net Sales
Cost of goods sold
Gross profit
Depreciation Expense
S&A Expenses
Operating Income (EBIT)
Interest expense
Income before taxes
Income taxes (40%)
$15,000,000
5,000,000
10,000,000
2,000,000
800,000
7,200,000
1,710,000
5,490,000
2,306,000
Net income
$3,184,000
Earnings per Share (4,000,000 shares)
$0.80
Common Dividends paid
Increase in Retained Earnings
$400,000
$2,784,000
The Firm’s Financial Statements
• Annual report includes:
Balance Sheet
The Firm’s Financial Statements
 Balance Sheet
Assets =
Current Assets:
• Cash
Liabilities +
Owners’ Equity
Current Liabilities:
 A/P
• Inventory
• A/R
 Accruals
 S-T Debt
Fixed Assets:
 Land
Long Term Liabilities:
 Bonds
 Plant
 Equipment
Less: Ac. Dep.
 L-T Bank Debt
 Mortgages
 Preferred Stock
Owners’ Equity:
 Common Stock
 Capital in Excess

of Par
 Retained Earnings
Balance Sheet
ACME CORPORATION
Balance Sheet
ACME CORPORATION
December 31
2009
2010
Change
$9,000,000
700,000
17,300,000
9,000,000
1,000,000
37,000,000
14,000,000
(6,000,000)
8,000,000
$10,000,000
1,000,000
10,000,000
8,000,000
1,000,000
30,000,000
28,000,000
(8,000,000)
20,000,000
1,000,000
300,000
-7,300,000
-1,000,000
0
-7,000,000
14,000,000
-2,000,000
12,000,000
Total assets $45,000,000 $50,000,000
5,000,000
Assets:
Cash
Accounts receivable
Inventory
Marketable Securities
Prepaid Expenses
Total current assets
Fixed Assets, Gross
less Accumulated Depr.
Fixed Assets, Net
Balance Sheet
ACME CORPORATION
Assets = Liabilities + Owner’s Equity
2009
2010
Change
Assets:
2009
Cash
Accounts receivable
Inventory
Marketable Securities
Prepaid Expenses
Total current assets
Fixed Assets, Gross
less Accumulated Depr.
Fixed Assets, Net
2010
Change
$4,000,000
3,000,000
2,000,000
9,000,000
15,000,000
24,000,000
1,000,000
3,000,000
12,000,000
10,000,000
25,000,000
26,000,000
-3,000,000
-1,000,000
-1,000,000
-5,000,000
4,216,000
-784,000
-1,000,000
2,000,000
2,000,000
2,784,000
6,784,000
5,784,000
Total liabilities & equity $45,000,000 $50,000,000
5,000,000
$9,000,000 $10,000,000
Liabilities &1,000,000
Equity:
700,000
1,000,000
300,000
Accounts Payable
17,300,000 10,000,000
-7,300,000
Notes payable
9,000,000
8,000,000
-1,000,000
Accrued Expenses
1,000,000
1,000,000
0
Total current liabilities
37,000,000 30,000,000
-7,000,000
Long-term debt
14,000,000 28,000,000 14,000,000
Total liabilities
(6,000,000) (8,000,000) -2,000,000
Preferred Stock
8,000,000 20,000,000 12,000,000
Common stock
Total assets $45,000,000 $50,000,000
5,000,000
Capital in Excess
of Par
Retained earnings
Total common equity
Total equity
$7,000,000
4,000,000
3,000,000
14,000,000
10,784,000
24,784,000
2,000,000
1,000,000
10,000,000
7,216,000
18,216,000
20,216,000
The Firm’s Financial Statements
Income Statement:
Revenues - Expenses = Net Income
Sales
Investment Income
Gains
Interest Received
Dividends Received
COGS
Salaries
Depreciation Exp.
Taxes
Other Expenses
Interest Paid
The Firm’s Financial Statements
Income Statement:
Revenues - Expenses = Net Income
Dividends
Δ Retained
Earnings
The Firm’s Financial Statements
Annual report includes:
Statement of Cash Flow
The Firm’s Financial Statements
Statement of Cash Flows
Cash Inflow - Cash Outflow = Change in Cash
From Operations:
Cash Sales +
Depreciation Exp. +
Collection of A/R +
Decrease inventory +
Payments to Suppliers Salaries Increase A/R Decrease Payables Decrease Accruals -
The Firm’s Financial Statements
Statement of Cash Flows
Cash Inflow - Cash Outflow = Change in Cash
From Investing:
Sale of Fixed Assets + Purchase of fixed assets -
Purchase of other firms -
14
Statement of Cash Flows
Cash Inflow - Cash Outflow = Change in Cash
From Financing:
Sale of stock +
Issue of LT debt +
or notes payable +
Buy back stock Repay LT debt Pay dividends Pay interest 15
Market Value & Book Value can be very different.
Book Value is recorded initially at cost.
Changes in book value (depreciation)
follow specified accounting rules.
16

Factors that determine the disparity
between market and book:
 Time since acquisition
More time, more difference
Inflation: Higher inflation, more difference
Tangible versus intangible assets
Intangible assets, more difference
As with assets, the market value of liabilities
may diverge from the book value, but
the relationship is less complex.
The main factor that determines the difference
between market and book values for liabilities
of a healthy firm is:
“the time until a liability must be paid off ”
At maturity, the market value will equal the
book value.
Market vs. Book Value of Equity
Total Market Value of Equity is the market
price per share times the number of
shares outstanding.
Book Value of equity reflects the changes in other
asset and liability accounts since it is the
account that can change to enforce the balance
sheet identity.
Stockholders’ Equity = Assets - Liabilities
DEPRECIATION
 Accounting depreciation is the
allocation of an asset’s initial cost
over time.

Allowable depreciation expense is
determined by established
accounting rules.
CALCULATION OF DEPRECIATION
Depreciable basis
 Total amount to be depreciated over the accounting
life of the asset.
 Equal to cost of the asset plus any setup and delivery
costs incurred.
Straight line depreciation
 Basis divided by accounting life with equal
amounts of depreciation allocated to each time
period (except for half-year convention).
MACRS (Modified Accelerated Cost
Recovery System)
 Specified percent charged each year.
Federal Income Taxation
 Marginal and Average Tax Rates


Marginal = Tax Rate on the next dollar of income.
Average = Taxes paid divided by taxable income.
Progressive Tax System


Average tax rate increases with the level of
taxable income.
Marginal tax rate is greater than the average tax
rate. (The current corp. tax rate schedule is not
strictly progressive.)
THE TAX SYSTEM EXPLAINED IN COFFEE
• Suppose that every day, ten men go out for COFFEE AND CONVERSATION
and the bill for all ten comes to $100...
• If they paid their bill the way we pay our taxes, it would go something like this...
• The first four men (the poorest) would pay nothing.
• The fifth would pay $1.
• The sixth would pay $3.
• The seventh would pay $7.
• The eighth would pay $12.
• The ninth would pay $18.
• The tenth man (the richest) would pay $59.
The ten men drank COFFEE every day and seemed quite happy with the arrangement, until
one day, the owner threw them a curve ball. "Since you are all such good customers," he said,
"I'm going to reduce the cost of your daily coffee bill by $20". Unlimited coffee for the ten
men would now cost just $80.
The group still wanted to pay their bill the way we pay our taxes. So the first four men
were unaffected. They would still drink for free. But what about the other six men? How
could they divide the $20 windfall so that everyone would get his fair share?
They realized that $20 divided by six is $3.33. But if they subtracted that from
everybody's share, then the fifth man and the sixth man would each end up being paid to
drink THEIR COFFEE.
THE TAX SYSTEM EXPLAINED IN COFFEE
So, the owner suggested that it would be fair to reduce each man's bill
by a higher percentage the poorer he was, to follow the principle of the
tax system they had been using, and he proceeded to work out the
amounts he suggested that each should now pay.
• At a bill of $80, in order to follow the principle of the tax system they had
been using, and he proceeded to work out the amounts he suggested that
each should now pay.
•
•
•
•
•
•
Now, the first four men along with the fifth would pay nothing.
The sixth now paid $2 instead of $3 (33% saving).
The seventh now paid $5 instead of $7 (28% saving).
The eighth now paid $9 instead of $12 (25% saving).
The ninth now paid $14 instead of $18 (22% saving).
The tenth now paid $49 instead of $59 (16% saving).
THE TAX SYSTEM EXPLAINED IN COFFEE
Each of the six was better off than before. And the first four continued to
drink for free. But, once outside the bar, the men began to compare their
savings. "I only got a dollar out of the $20 saving," declared the sixth
man. He pointed to the tenth man AND SAID, "but he got $10!“ "Yeah,
that's right," exclaimed the fifth man. "I only saved a dollar too. It's unfair
that he got ten times more benefit than me!“ "That's true!" shouted the
seventh man. "Why should he get $10 back, when I got only $2? The
wealthy get all the breaks!“ "Wait a minute," yelled the first four men in
unison, "we didn't get anything at all. This new tax system exploits the
poor!“ The nine men surrounded the tenth and beat him up.
The next night the tenth man didn't show up for COFFEE AND
CONVERSATION so the nine sat down and had their COFFEE without
him. But when it came time to pay the bill, they discovered something
VERY important. They didn't have enough money between all of them for
even half of the bill!
THE TAX SYSTEM EXPLAINED IN
COFFEE
And that, my dear students is exactly how our tax
system works. The people who already pay the
highest taxes will naturally get the most benefit
from a tax reduction. Tax them too much, attack
them for being wealthy, and they just may not show
up anymore. In fact, they might start drinking coffee
overseas, where the atmosphere is somewhat
friendlier. For those who understand this, no
explanation is needed. For those who do not
understand, no explanation is possible because
you never will get it.
Income
% of Total Income Tax Paid
Top 1%
40%
Top 10%
71%
Top 50%
97%
From 2009 IRS Data
Accounts Receivable Tax
Building Permit Tax
CDL License Tax
Cigarette Tax
Corporate Income Tax
Dog License Tax
Federal Income Tax
Federal Unemployment Tax (FUTA)
Fishing License Tax
Food License Tax
Fuel Permit Tax
Gasoline Tax
Hunting License Tax
Inheritance Tax
Inventory Tax
IRS Interest Charges (tax on top of tax)
IRS Penalties (tax on top of tax)
Liquor Tax
Luxury Tax
Marriage License Tax
Medicare Tax
Property Tax
Real Estate Tax
Service charge taxes
Social Security Tax
Road Usage Tax (Truckers)
Sales Taxes
Recreational Vehicle Tax
School Tax
State Income Tax
State Unemployment Tax (SUTA)
Telephone Federal Excise Tax
Telephone Federal Universal Service Fee Tax
Telephone Federal, State and Local Surcharge Tax
Telephone Minimum Usage Surcharge Tax
Telephone Recurring and Non-recurring Charges Tax
Telephone State and Local Tax
Telephone Usage Charge Tax
Utility Tax
Vehicle License Registration Tax
Vehicle Sales Tax
Watercraft Registration Tax
Well Permit Tax
Workers Compensation Tax
Not one of these taxes existed 100
years ago...
and our nation was the most
prosperous in the world.
We had absolutely no national debt...
We had the largest middle class in the
world... And there was only one wageearner per family
What happened?
Can you spell
'politicians!'
Differential Tax Treatment
of Interest and Dividends
Interest paid on corporate debt is a tax
deductible expense.
Dividends paid to common and preferred
stockholders is not tax deductible.
Dividends received by a corporation
from another corporation have at
least a 70% exclusion from taxable
income.
32
Differential Tax Treatment
of Interest and Dividends
Dividend Income
Corp “B” owns 100
shares of Common
Stock in Corp “A”
Corp “A”
Corp “A” pays a
$2/share dividend
to shareholders.
Corp “B”
$200
30% or $60 is Taxable
70% or $140 is Tax Free
Corp. “B” pays marginal tax rate of 25%
$60 x .25 = $15
Federal Taxes on dividend income
33
Who Pays all the Bills?
The Taxpayer that’s Who
Don’t
(Just Us)
Income
Top 1%
Top 10%
Top 50%
% of Total Income Tax Paid
40%
71%
97%
From 2008 IRS Data
forget
Who
pays
the
bills.
Homework Questions and Problems
1. Explain the difference between debt and equity. Why must the two equal total
assets?
2. Ajax Inc. had profits of $200,000 for the year. Their retained earnings account grew
from $800,000 at the beginning of the year to $950,000 by year end. How much did
the firm pay out in dividends?
3. Calculate earnings per share for the following:
Net income
$500,000
Interest expense:
$ 50,000
Common Dividends paid
$100,000
Common shares outstanding
100,000
4. Working capital includes both current and non-current assets. Do you agree or
disagree with this statement? Explain.
5. Explain why common stockholders are paid after preferred stockholders.
6. Are retained earnings and cash the same thing?
36
Analysis of Financial
Statements
37
Learning Objectives
• How financial ratio analysis helps
managers assess the firm’s health.
• Compute profitability, liquidity, debt,
asset activity, and market value ratios.
• Compare financial information over
time and among companies.
38
Ratio Analysis
 Financial managers use ratios to
interpret the raw numbers on financial
statements.
 Relative measures allow comparison
over time and to other firms.
 Ratios are used by financial managers,
other business managers, creditors,
and investors.
39
Ratio Analysis
Five Categories of Ratios
•
•
•
•
•
Profitability ratios
Liquidity ratios
Debt ratios
Asset activity ratios
Market value ratios
40
Ratio Analysis
Profitability Ratios
• Measure the overall effectiveness of the
firm’s management.
41
Ratio Analysis
Profitability Ratios
Gross Profit Margin =
Gross Profit
Sales
How effective is the firm at generating
revenue in excess of its cost of goods
sold?
42
Balance Sheet
Excalibur Corporation
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Net Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Gross
Profit
Margin
=
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Bonds
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Gross Profit
Sales
Gross Profit Margin =
$575
$1,450
= 39.7%
43
Ratio Analysis
Profitability Ratios
Operating Profit Margin =
Operating Income
Sales
How effective is the firm in keeping costs
of production low?
44
Balance Sheet
Excalibur Corporation
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term Debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Operating
Operating Income
Profit
=
Sales
Margin
Oper. Profit Margin =
$330
$1,450
= 22.8%
45
Ratio Analysis
Profitability Ratios
Note: Net Income equals Earnings Available to CS
when there is no preferred stock.
Net Profit Margin =
Net Income
Sales
How much net profit is being generated
from each dollar of sales?
46
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Net
Operating Income
$330
Net Income
Profit
=
Interest Expense
60
Sales
Margin
Income Before Taxes
$270
Taxes (40%)
108
$162
Net Income
$162
Net
Profit
Margin
=
= 11.2%
Common Dividends Paid
100
$1,450
Addition to Retained Earnings $62
47
Ratio Analysis
Profitability Ratios
Return on Assets =
Net Income
Total Assets
How effectively is the firm generating net
income from its assets ?
48
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40)
108
Net Income%
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Return on
Assets
ROA =
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
=
Net Income
Total Assets
$162 = 6.4%
$2,530
49
Ratio Analysis
Profitability Ratios
Return on Equity =
Net Income
Common Equity
How well is the firm generating return to
its equity providers?
50
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Return on Equity =
ROE =
$162
$1,700
Net Income
Common Equity
= 9.53%
51
Ratio Analysis
Liquidity Ratios
 Measure the ability of the firm to
meet its short-term financial obligations.
Current Assets
Current Ratio =
Current Liabilities
Are there sufficient current assets to pay off
current liabilities? What is the cushion of
safety?
52
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Current Ratio =
Current Assets
Current Liabilities
Current Ratio = $1,230 = 5.35x
$230
53
Ratio Analysis
Liquidity Ratios
• Measure the ability of the firm to meet
its short-term financial obligations.
Acid-Test Ratio =
Current Assets - Inventory
Current Liabilities
What happens to the firm’s ability to repay current
liabilities after what is usually the least liquid of the
current assets is subtracted?
54
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Acid-Test Ratio =
Current Assets - Inventory
Current Liabilities
Acid-Test Ratio =
$1,230 -$625
= 2.63x
$230
55
Ratio Analysis
Debt Ratios
 Measure the relative size of the
firm’s debt load and the firm’s
ability to pay off the debt.
56
Ratio Analysis
Debt Ratios
Debt Ratio =
Total Debt
Total Assets
What proportion of the firm’s assets is
financed with debt?
57
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Debt Ratio =
Total Debt
Total Assets
Debt Ratio = $230 + $600 = 33%
$2,530
58
Ratio Analysis
Debt Ratios
Total Debt
Debt to
=
Common Equity
Equity Ratio
What is the proportion of debt relative to
equity financing for the firm?
59
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Debt to
Equity Ratio
=
Total Debt
Common Equity
D/E = $230 + $600 = 48.8%
$1,700
60
Ratio Analysis
Debt Ratios
Times Interest Earned Ratio =
Operating Income
Interest Expense
What is the firm’s ability to repay interest
payments from its operating income?
61
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Excalibur Corporation
Total Liabilities and
Sales
$1,450
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Times
Operating Income
Operating Income
$330
Interest
=
Interest Expense
60
Interest Expense
Earned
Ratio
Income Before Taxes
$270
Taxes (40%)
108
$330
Net Income
$162
TIE Ratio =
= 5.50x
Common Dividends Paid
100
$60
Addition to Retained Earnings $62
62
Ratio Analysis
Asset Activity Ratios
• Help assess how effectively the firm is
using assets to generate sales.
63
Ratio Analysis
Asset Activity Ratios
Average Collection Period =
Accounts Receivable
Avg. Daily Credit Sales
How long does it take for the firm on
average to collect its credit sales from
customers?
64
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Additional Info:
We assume all
sales are credit
sales.
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Average
Accounts Receivable
Collection =
Avg. Daily Credit Sales
Period
ACP =
$430
$1,450/365
= 108.24 days
Days in a
year
65
Ratio Analysis
Asset Activity Ratios
Inventory Turnover Ratio =
Sales
Inventory
Is inventory efficiently translating into
sales for the firm?
66
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Inventory
Turnover =
Ratio
Inventory Turnover =
Sales
Inventory
$1450 = 2.3x
$625
67
Ratio Analysis
Asset Activity Ratios
Sales
Fixed Asset Turnover Ratio = Net Fixed Assets
How effective is the firm in using its fixed
assets to help generate sales?
68
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Fixed Asset
Turnover
Ratio
Sales
= Net Fixed Assets
Fixed Asset Turnover =
$1,450
= 1.12x
$1,300
69
Ratio Analysis
Asset Activity Ratios
Total Asset Turnover Ratio =
Sales
Total Assets
How effective is the firm in using its
overall assets to generate sales?
70
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term Debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Total Asset
Turnover =
Ratio
Total Asset Turnover =
Sales
Total Assets
$1,450
$2,530
= 0.57x
71
Ratio Analysis
Market Value Ratios
Price to Earnings Ratio =
Market Price per Share
Earnings per Share
How much are investors willing to pay per
dollar of earnings of the firm?
(Indicator of investor’s attitudes toward future
prospects of the firm and of the firm’s risk.)
72
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Additional Info:
100 shares
$20.00 per
share
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
P/E
= Market Price/Share
Ratio
EPS
P/E ratio =
$20.00
= 12.35x
$162/100
73
Ratio Analysis
Market Value Ratios
Market to Book Ratio =
Market Price per Share
Book Value per Share
How much are investors willing to pay per
dollar of book value?
74
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Additional Info:
100 shares
$20.00 per
share
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Market
to
=
Book
M/B =
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term Debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Price/Share
Common Equity/ # shares
$20.00
$1,700/100
= 1.18x
75
EBITDA
EBITDA stands for Earnings Before
Interest, Taxes, Depreciation, and
Amortization.
It is often of great interest to financial
analysts although FASB does not
require that this number be reported.
It measures the amount of cash thrown
off from the operations of the company.
76
Ratio
Industry Excalibur
Profitability
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
38%
20%
12%
9.0%
13.4%
39.7%
22.8%
11.2%
6.4%
9.5%
Excalibur is good at keeping
operating costs down, but not as
good at total costs. ROA and ROE
are low mainly due to productivity
problems.
77
Summary of Excalibur Corporation Ratios
Ratio
Liquidity
Current Ratio
Acid-Test Ratio
Industry
Excalibur
5.00x
3.00x
5.35x
2.63x
Looking at the current ratio it appears
that Excalibur is more liquid than the
industry.... however when looking at
Acid Test (a better measure) they are
not as liquid indicating that inventory
levels are probably too high.
78
Ratio
Industry Excalibur
Debt
Debt Ratio
35%
Times Interest Earned 7.00x
Debt to Equity
49%
33%
5.50x
48%
While the debt ratio is close to the industry
average, Excalibur is not able to cover
interest payments as easily as the industry.
This indicates Excalibur may have too much
debt relative to what they can realistically
afford.
79
Ratio
Industry Excalibur
Asset Activity
Avg. Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
90 days
3.00x
1.00x
0.75x
108 days
2.32x
1.12x
.57x
Collection policies need examining, as Excalibur is
slower than average at collecting receivables.
Inventories are being sold more slowly than the
industry average, again indicating inventories that
are too high. Excalibur is very efficient at converting
Fixed Assets to Sales (fixed assets are productive).
However, overall assets are not productive
indicating Current Assets (e.g. inventories) are not
as productive as for the industry.
80
Ratio
Market Value
Price Earnings
Market to Book
Industry Excalibur
18.0
2.5
12.35
1.18
Excalibur’s Investors are not willing to
pay as much per dollar of earnings or
per dollar of book value as they are for
shares in other firms in the industry.
This signals that they consider the firm’s
prospects to be worse than the average.
However, the firm is still selling for more
than its accounting book value.
81
Relationships Among Ratios:
The Du Pont System
• Ratio Analysis generally involves an
examination of related ratios.
• Comparison of these relationships over time
helps to identify the company’s strengths and
weaknesses.
82
Relationships Among Ratios:
The Du Pont System
The Du Pont Equation
Return
=
on
Assets
Net
Profit x
Margin
Net Inc.
Assets
= Net Inc. x
Sales
Total
Asset
Turnover
Sales
Assets
83
Relationships Among Ratios:
The Du Pont System
The Modified Du Pont Equation
Return
=
on
Equity
Net
Profit x
Margin
Net Inc.
=
Equity
Net Inc.
Sales
Total
x
Asset
Turnover
x
Sales
Assets
Equity
Multiplier
x
Assets
Equity
84
Homework Questions & Problems:
Use the following information to answer the questions.
Elton Corporation
Income Statement
for the year ending 12/31/XX
(in thousands of dollars)
Net sales
Operating Costs
Depreciation
Interest Expense
$ 2,700
(2,350)
(
EBT
Income Tax (40%)
(
Net Income
$
Dividends to Common Stock = $
58
70)
52)
( 150)
130
78
85
Homework Questions & Problems:
Elton Corporation
Balance Sheet
12/31/XX
(in thousands of dollars)
Cash
Accounts Receivable
$ 150
250
Inventory
Total Current Assets
600
$1,000
Total Fixed Assets
1,500
Total Assets
$2,500
Accounts Payable
$100
Notes Payable
Other Current Liabilities
Total Current Liabilities
250
50
$400
Long Term Debt
Common Stock
Retained Earnings
Total Liab. & Equity
1,100
800
200
$2,500
Number of shares outstanding = 10,000 shares
Price per Share = $100
86
Homework Questions & Problems:
1. Calculate each of the following ratios. Be sure to give the complete equation as well as the
solution:
a. Current ratio
b. Quick ratio
c. Total Debt/Total Asset Ratio
d. Inventory Turnover Ratio
e. ROE
f. TIE
g. EPS
h. Net Profit Margin
i. Market to Book Ratio
j. Total Assets Turnover Ratio
2. Show the Modified DuPont Equation for the company.
87
Homework Questions & Problems:
3. Given these industry ratios:
Net Profit Margin
Debt/Asset
Total Asset Turnover
ROA
4.3%
40%
1.1
4.73%
Use the DuPont equation to compare the performance of Elton Corp to the industry
average. What can you say about their(a) profitability, (b) expense control, (c) asset
management, and (d) debt management.
4. A firm expects to have net income of $85,000. If preferred dividends paid are 42,000,
common stock dividends paid are $20,000, and shares of common stock outstanding are
10,000, what is the EPS?
88
Homework Questions & Problems:
5. Fill in the missing data based on the information provided for years 2009 and 2010.
ABC CORPORATION
Balance Sheet Changes and Classification
Of Key Accounts between 2009 and 2010
Account
Long-term debt
Accounts receivable
Common stock
Cash
Retained earnings
Accruals
Inventory
Accounts payable
Net fixed assets
2009
$960
$640
$200
$640
$960
$50
$840
$1,150
$1,800
2010
$800
$500
$300
$500
$800
$200
$600
$1,000
$2,000
Change
Source/Use
89
Forecasting for
Financial Planning
90
Learning Objectives:
• The importance of forecasting to business
success.
• The financial forecasting process.
• Preparation of pro forma financial
statements.
• The importance of analyzing forecasts.
91
Why is forecasting important?
Mistakes are costly:
– If you produce too much of a product, or a
product that no one wants to buy, you still
must pay for materials, labor, and storage.
– If you produce too little of a product, you will
lose sales and possibly market share.
92
Forecasting Approaches
Financial managers concentrate on
three general approaches to financial
forecasting:
• Experience
• Probability
• Correlation
93
Experience
• Managers who have been in the business
for a long time have developed a sense for
the patterns in sales, expenses, consumer
demand factors, etc.
– Example: Editors who work for book
publishers regularly read submitted
manuscripts and make judgments about
whether their company should buy the rights
to publish the books.
94
Probability
• Past history often tells us a lot about
what will happen in the future.
• Managers can use this information to
estimate the future.
– Example: In the past, a 7-11 manager has
found that she will lose 1% of candy
inventory to shoplifters. She can use this
information to estimate future losses and
also to design better controls.
95
Correlation
• Correlation is a measure of the relative
movement of two variables relative to each other.
– Example: If interest rates go up, a real estate agent
knows that home sales will tend to fall (because the
higher cost of financing makes it harder for buyers to
qualify for mortgages).
– Example: Sales of umbrellas are higher in rainy
seasons.
96
The Sales Forecasting Process
Marketing
(sales estimate)
Top Management
(policy, strategy)
Finance
Department
Production
(capacity, schedules)
Accounting
(financial statements,
depreciation, taxes)
SALES
FORECAST
97
Forecast future sales based on past
sales growth
Sales
Plot of Past Sales
00 01
02 03 04
05 06 07 08
09
Time
98
Forecast future sales based on past
sales growth
Sales
Trend Line
00 01
02 03 04
05 06 07 08
09
Time
99
Forecast future sales based on past
sales growth
Sales Estimates for
next 2 years
Sales
Growth Rate
00 01
02 03 04
05 06 07 08
09
Time
100
Forecast future sales based on
past sales growth
Also include the effects of any events which are
expected to impact future sales (new products or
economic conditions)
Sales
New Product
Introduced
00 01
02 03 04
05 06 07 08
09
Time
101
 Forecast future sales based on past sales
growth
• Also include the effects of any events which are expected
to impact future sales (new products or economic
conditions)
Sales
New Product
Introduced
00 01
02 03 04
05 06 07 08
09
Time
102
Sales Growth Imposes Costs on the Firm
Will require additional resources
– Current Assets: Inventory, A/R, Cash
– Fixed Assets: Plant and Equipment
2009
2010
103
Pro Forma Financial Statements
• Pro forma financial statements are forecasts of
the firm’s future financial statements based on
a certain set of assumptions about sales
trends and the relationships between sales
and various financial variables, and between
other financial statement variables relative to
each other.
104
Producing Pro Formas
Example Data for Marginal Product Inc.
 Sales will increase from $5million to $8 million.
 Production is at full capacity (24 hrs. per day).
 Dividend payout will be 70% of NI.
 Spontaneous balance sheet accounts. increase in
a constant proportion to sales.
105
Producing Pro Formas
Step 1:
Determining Sales Growth
$8 - $5
= 60%
$5
Income Statement
Marginal Product Inc.
figures in 000s
Current
Sales $5,000
COGS 4,133
EBIT
867
Int
200
EBT
667
Tax (.40) 267
NI
400
Projected
$8,000
Note: The projected sales
will be determined after input
from many different units or
departments of the firm.
106
Producing Pro Formas
Step 2:
Income Statement
Marginal Product Inc.
figures in 000s
Current
Sales $5,000
COGS 4,133
EBIT
867
Int
200
EBT
667
Tax (.40) 267
NI
400
Projected
$8,000
6,613
1,387
200
1,187
475
712
Calculate projected Net
Income. New COGS =
Old COGS x 1.6 = 6,613
Note: There is no increase yet
in the interest charges since
Marginal Product’s managers
have not yet decided how they
will finance the growth.
107
Producing Pro Formas
Step 3:
Forecast increase in
assets (% of sales)
Balance Sheet
Marginal Product Inc.
figures in 000,000s
Assets
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
Projected
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
Projected
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
108
Producing Pro Formas
Step 3:
Forecast increase in assets (% of sales). If
sales increase by 60%, so too will any asset
that remains a constant percent of sales.
Balance Sheet
Marginal Product Inc.
Assets
Current
Current Assets
Net Fixed Assets
Total
figures in 000,000s
Projected
$2.5
3.0
$5.5
$2.5(1+.60) = $4.0
$4.0
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
Projected
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
109
Producing Pro Formas
Step 3:
Forecast increase in
assets (% of sales)
Balance Sheet
Marginal Product Inc.
Assets
Current
Current Assets
Net Fixed Assets
Total
figures in 000,000s
Projected
$2.5
3.0
$5.5
+$3.30
$3.0(1+.60) = $4.8
$4.0
4.8
$8.8
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
Projected
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
110
Producing Pro Formas
Step 4:
Forecast increase in
spontaneous liabilities.
Balance Sheet
Marginal Product Inc.
figures in 000,000s
Assets
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
Projected
$4.0
4.8
$8.8
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
$1.0(1+.60)
$1.60
Long =
Term
Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.6
111
Producing Pro Formas
Step 4:
Forecast increase in
spontaneous liabilities.
Balance Sheet
Marginal Product Inc.
Assets
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
figures in 000,000s
Projected
$4.0
4.8
$8.8
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current
$0.5(1+.60)
= Liabilities
$0.80
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.6
.8
112
Producing Pro Formas
Step 5:
Forecast increase in
retained earnings.
Balance Sheet
Marginal Product Inc.
figures in 000,000s
Assets
Current
Projected
Liabilities
Current
New retained earnings
Current Assets
$2.5
$4.0
Accounts Payable
=Old
retained
earnings
Net Fixed Assets
3.0
4.8
Accrued Expenses
+ additions
earnings
Total
$5.5
$8.8to ret.Notes
Payable
Current Liabilities
=1.5 + [NI x (1-div. payout)]
Term Debt
=1.5 + [.712 x (1-.7)]Long
= 1.7
$1.0
0.5
0.0
$1.5
$2.0
Common Stock
0.5
Retained Earnings 1.5
Common Equity
$2.0
Total Claims
$5.5
Projected
$1.6
.8
1.7
113
Producing Pro Formas
Step 6:
Hold other accounts constant
to see how much additional
funds will be needed.
Balance Sheet
Marginal Product Inc.
figures in 000,000s
Assets
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
Projected
$4.0
4.8
$8.8
Liabilities
Current
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total Claims
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.6
.8
0.0
2.4
2.0
.5
1.7
2.2
$6.6
114
Producing Pro Formas
Step 7:
Additional funds needed
(AFN) = projected assets
minus projected claims
Balance Sheet
Marginal Product Inc.
figures in 000,000s
Assets
Current Projected
Current Assets
$2.5
$4.0
Net Fixed Assets
3.0
4.8
Total
$5.5
$8.8
AFN
= $8.8 - 6.6
= $2.2 mill.
Liabilities
Current
Projected
Accounts Payable $1.0
$1.6
Accrued Expenses 0.5
.8
Notes Payable
0.0
0.0
Current Liabilities $1.5
2.4
Long Term Debt
$2.0
2.0
Common Stock
0.5
.5
Retained Earnings 1.5
1.7
Common Equity
$2.0
2.2
Total Claims
$5.5
$6.6
115
Producing Pro Formas
Step 7:
Additional funds needed
(AFN) = projected assets
minus projected claims
Balance Sheet
Marginal Product Inc.
Raise $2.2Current
million Projected
Using:
Liabilities
figures in 000,000s
Assets
Current
Current Assets
Net Fixed Assets
Total
AFN
= $8.8 - 6.6
= $2.2 mill.
$2.5
3.0
$5.5
Projected
$4.0
4.8
$8.8
Notes Payable, and/or
LT
Accounts Payable $1.0
$1.6
Debt,Expenses
and/or Common
Stock
Accrued
0.5
.8
Notes Payable
0.0
0.0
Current Liabilities $1.5
2.4
Long Term Debt
$2.0
2.0
Common Stock
0.5
.5
Retained Earnings 1.5
1.7
Common Equity
$2.0
2.2
Total Claims
$5.5
$6.6
116
Producing Pro Formas
Summary
• Determine sales growth.
• Calculate projected net income.
• Project assets needed to support the new
sales level.
• Project increases in spontaneous asset and
liability accounts.
• Project addition to retained earnings.
• Determine the difference between projected
assets and projected liabilities & equity.
117
Financing feedback
 If outside financing is required, the new debt or
equity may affect your original projections of the
amount of the addition to retained earnings (due
to increased interest or dividends on the income
statement).
 In this case, the pro forma should be recast with
the new information to make final projections of
AFN.
118
Homework Questions
1. Briefly discuss the three general approaches to
forecasting.
2. Why is forecasting important?
3. Distinguish between the cash budget and the
capital budget.
119
4.
Given the following data on the Sands Corporation, project the balance sheet for the coming year using
the percentage of sales technique:
Current Sales: $650,000
Next year’s sales: $925,000
After-tax profits: 6% of Sales
Dividend payout ratio: 40%
Current retained earnings: $200,000
Accounts receivable as a percent of sales: 10%
Cash as a percent of sales: 5%
Inventory as a percent of sales: 32%
Net fixed assets as a percent of sales: 38%
Accounts payable as a percent of sales: 6%
Accruals as a percent of sales: 12%
Next year’s common stock: $200,000
Sands Corporation
Balance Sheet
December 31, 2005
ASSETS
Cash
Accounts receivable
Inventory
Net fixed assets
(a)
(b)
(c)
(d)
Total
(e)
LIABILITIES AND EQUITIES
Accounts payable
(f )
Notes payable
Accruals
Common stock
Retained earnings
Total
(g)
(h)
(i )
(j )
(k)
120
Risk and Return
121
Learning Objectives
 Define risk, risk aversion, and riskreturn tradeoff.
 Measure risk.
 Identify different types of risk.
 Explain methods of risk reduction.
 Describe how firms compensate for
risk.
 Discuss the CAPM.
122
Expected Return
• Expected return is the mean of the
probability distribution of possible returns.
• Future returns are not known with
certainty. The standard deviation is a
measure of this uncertainty.
123
Expected Return
• Expected return is the mean of the probability
distribution of possible returns.
• Future returns are not known with certainty
• To calculate expected return, compute the
weighted average of possible returns
m = S(Vi x Pi)
where
m
= Expected return
Vi = Possible value of return
during period i
Pi = Probability of V
occurring during period i 124
Expected Return Calculation
Example:
You are evaluating Zumwalt Corporation’s
common stock. You estimate the following
returns given different states of the economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
Return
.10
.20
.40
.30
–5%
5%
10%
20%
=
=
=
=
k=
– 0.5%
1.0%
4.0%
6.0%
10.5%
Expected rate of return on
the stock is 10.5%
125
Risk and Rates of Return
• Risk is the potential for unexpected events to
occur.
• If two financial alternatives are similar except
for their degree of risk, most people will
choose the less risky alternative because
they are risk averse i.e. they don’t like risk.
• Risk averse investors will require higher
expected rates of return as compensation for
taking on higher levels of risk.
126
Measurement of Investment Risk
Example:
You evaluate two investments: Zumwalt
Corporation’s common stock and a one year
Gov't Bond paying a guaranteed 2%.
There is risk in owning Zumwalt
stock, no risk in owning the T-bills
Probability
of Return
Probability
of Return
T-Bill
Zumwalt Corp
100%
40%
30%
20%
10%
2%
Return
–5% 5% 10% 20% Return
127
Measurement of Investment Risk
• Standard Deviation (s) measures the dispersion of
returns. It is the square root of the variance.
s = SQRT( S P(V - m)2)
S= s2 = variance
Example:
s2 = .005725 = 0.5725%
Compute the standard deviation on
s Zumwalt
= SQRT ofcommon
0.005725
stock. the mean (m) was previouslys computed
as 10.5%
= .07566 = 7.566%
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
.10
.20
.40
.30
Return
(- 5% ( 5% ( 10% ( 20% -
10.5%)2
10.5%)2
10.5%)2
10.5%)2
= .24025%
= .0605%
= .001%
= .27075%
s = 7.566%
128
Risk and Rates of Return
 Risk of a company's stock can be separated into two
parts:
– Firm Specific Risk - Risk due to factors within the firm
Market
- Risk
to overall market
pricerelated
will most Risk
likely fall
if adue
major
―Stock
conditions contract is discontinued unexpectedly.
government
Stock price is likely to rise if overall stock
market is doing well.
 Diversification: If investors hold stock in many companies, the
firm specific risk will be cancelled out.
 Even if investors hold many stocks, cannot eliminate the market
related risk
129
Risk and Rates of Return
• Risk and Diversification
– If an investor holds enough stocks in portfolio
(about 15-20) company specific (diversifiable)
risk is virtually eliminated
Variability
of Returns
b
Market Related
Risk
# of stocks in Portfolio
130
Risk and Rates of Return
• Risk and Diversification
– If an investor holds enough stocks in portfolio
(about 20) company specific (diversifiable) risk
is virtually eliminated
Variability
of Returns
Firm Specific Risk
# of stocks in Portfolio
131
Risk and Rates of Return
• Risk and Diversification
– If an investor holds enough stocks in portfolio
(about 20) company specific (diversifiable) risk
is virtually eliminated
Variability
of Returns
Total Risk
# of stocks in Portfolio
132
Risk and Rates of Return
• Market risk is the risk of the overall market, so to
measure we need to compare individual stock
returns to the overall market returns.
• A proxy for the market is usually used: An index of
stocks such as the S&P 500
• Market risk measures how individual stock returns
are affected by this market
• Regress individual stock returns on the returns of the
market index
133
Risk and Rates of Return
• Regress individual stock returns on Market index
PepsiCo
Return
15%
10%
5%
-15%
-10%
-5%
S&P
Return
5%
10%
15%
-5%
-10%
-15%
134
Risk and Rates of Return
Regress individual stock returns on Market index. Plot ordered pairs every 6
months for ten years starting in January 1999.
PepsiCo
Return
15%
10%
5%
-15%
-10%
-5%
Jan 1999
PepsiCo-0.37%
S&P
-1.99%
S&P
Return
5%
10%
15%
-5%
-10%
-15%
135
Risk and Rates of Return
• Regress individual stock returns on Market index
PepsiCo
Return
15%
10%
5%
-15%
-10%
Plot
Remaining
Points
-5%
S&P
Return
5%
10%
15%
-5%
-10%
-15%
136
Risk and Rates of Return
Regress individual stock returns on Market
index returns
PepsiCo
Return
15%
10%
Best Fit
Regression
Line
-15%
-10%
5%
-5%
S&P
Return
5%
10%
15%
-5%
-10%
-15%
137
Risk and Rates of Return
Regress individual stock returns on Market
index returns
PepsiCo
Return
15%
10%
-5%
-15%
Slope =
-10%
rise 5.5%
=
= 1.1
run 5%
-5%
5%
S&P
Return
5%
10%
15%
-5%
-10%
-15%
138
Risk and Rates of Return
Market Risk is measured by Beta
Beta is the slope of the regression (characteristic)
line.
139
Risk and Rates of Return
• Market Risk is measured by Beta
– Beta is the slope of the regression (characteristic) line
PepsiCo
Return
15%
10%
5%
-15% -10%
-5%
S&P
Return
5%
10%
15%
-5%
-10%
Slope = 1.1 = Beta (b)
-15%
140
Risk and Rates of Return
• Interpreting Beta

Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk

Beta < 1
Low Risk Company
Return on stock will be less affected by the market than
average

Beta > 1
High Market Risk Company
Stock return will be more affected by the market than
average
141
The Capital Asset Pricing Model
Investors adjust their required rates of
return to compensate for risk.
The CAPM measures required rate of return
for investments, given the degree of market
risk measured by beta.
Security Market Line
kj = kRF + bj ( kM – kRF )
where:
Kj = required rate of return on the jth security
KRF = risk free rate of return
KM = required rate of return on the market
Bj = Beta for the jth security
142
CAPM Example
• Suppose that the required return on the market
is 12% and the risk free rate is 5%.
Security Market Line
kj = kRF + bj ( kM – kRF )
143
CAPM Example
• Suppose that the required return on the market
is 12% and the risk free rate is 5%.
kj = 5% + bj (12% – 5% )
15%
10%
5%
Risk Free Rate
Beta
.50
1.0
1.5
144
CAPM Example
• Suppose that the required return on the market
is 12% and the risk free rate is 5%.
kj = 5% + bj (12% – 5% )
Risk &
Return on
market
15%
10%
5%
Risk Free Rate
Beta
.50
1.0
1.5
145
CAPM Example
• Suppose that the required return on the market
is 12% and the risk free rate is 5%.
15%
10%
SML
Market
Connect Points for
Security Market Line
5%
Beta
.50
1.0
1.5
146
CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is 5%.
If beta = 1.2
kj = 13.4
kj = 5% + bj (12% – 5% )
15%
13.4%
10%
Company kj
SML
Market
5%
Beta
.50
1.0 1.2
1.5
147
Homework
1. You hold a diversified portfolio of stocks and are considering
investing in the XYZ Company. The firm’s prospects look good and
you estimate the following probability distribution of possible
returns:
Probability
70%
20%
10%
Return
15%
9%
20%
The return on the market is 13.5% and the risk free rate is
7%. You have calculated XYZ’s beta from past returns as 1.3 and
you believe this will be the future beta.
a. What is the expected return for XYZ?
b. What is the required return for XYZ according to the CAPM?
148
Homework
2. Assume your existing portfolio is valued at $9,000 and its beta is 1.0.
You plan to buy an additional $3,000 of a particular stock that has a
beta of 1.8 (without selling any other stock). What is the beta of the
new portfolio?
3. Distinguish between business risk and financial risk.
4. What is risk aversion? How does the assumption of risk aversion
affect the risk/return tradeoff?
5. Compare diversifiable and nondiversifiable risk. What are some
examples of each type of risk?
149
The Time Value
of Money
Learning Objectives
• The “time value of money” and its
importance to business.
• The future value and present value
of a single amount.
• The future value and present value
of an annuity.
• The present value of a series of
uneven cash flows.
The Time Value of Money
• Money grows over time when it earns
interest.
• Therefore, money that is to be received at
some time in the future is worth less than
the same dollar amount to be received
today.
• Similarly, a debt of a given amount to be
paid in the future are less burdensome
than that debt to be paid now.
1. Future Value of Single Sum
?
$
PV
i
N
CPT
FV
2. Future Value of an Annuity
$
$
?
$
Today
PMT
i
N
CPT
FV
3. Sinking Fund
?
?
?
$
Today
FV
i
N
CPT
PMT
155
4. Present Value Single
Payment
$
?
FV
i
N
CPT
PV
156
5. Present Value of the Annuity
?
PMT
$
i
$
N
$
CPT
PV
157
6. Amortized Loans
$
?
PV
i
?
N
?
CPT
PMT
158
Financial Calculator Solution - FV
Example: You invest $200
at 10%. How much is it
worth after 5 years?
1) Calculator Enter:
N
= 5
I/YR = 10
PV
= -200
CPT FV = ?
2) Using Formula:
FV = $200 (1.10)5 = $322.10
322.10
Do all these homework problems on your overhead
homework sheets: use your calculator and show the
keys you would press and circle your answer:
If you would have bought Berkshire Hathaway stock 20 years ago and spent
$10,000 for your investment, how much would you have today if the average
annual compounded rate of return was 18%?
How long it will take for $2,500 to become $8,865 if it is deposited and earns 5%
per year compounded annually? (Calculate to the closest year).
If you deposit a lump sum of $1,200 today into a savings account offering annual
interest of 5% compounded monthly, how much will you have in the account at
the end of three years?
If you deposit $100 in the bank today at an annual rate of 5.5% compounded
annually, how long will it take to double in value?
Your Aunt Matilda Mae makes you the following offer: $14,000 upon
undergraduate graduation now or $15,200 upon MBA graduation in 2 years.
Which offer should you take if current rates are 4%.
Annuities
• An annuity is a series of equal cash flows
spaced evenly over time.
• For example, you pay your landlord an
annuity since your rent is the same amount,
paid on the same day of the month for the
entire year.
Jan
Feb
$500
Mar
$500
Dec
$500
$500
$500
161
Future Value of an Annuity
0
$0
1
2
$100
$100
3
$100
You deposit $100 each year (end of year)
into a savings account.
How much would this account have in it at
the end of 3 years if interest were earned at
a rate of 2% annually?
162
Future Value of an Annuity
Using the Calculator:
Don’t forget to clear your
calculator of the previous
problem!
N=3
I/Y = 2
PV = -$200
CPT FV = $212.24
$212.24
Do all these homework problems on your overhead
homework sheets: use your calculator and show the
keys you would press and circle your answer:
What is the future value of an ordinary annuity of $1,000 each year for 10
years, assuming a 4% compounding rate?
What is the future value of an annuity due of $1,000 each year for 10 years
assuming a 4% compounding rate?
Dan plans to fund his IRA with a contribution of $ 200 per month for the
next 10 years. If Dan can earn 6% per year on his contributions, how much
will he have at the end of the 10th year?
James plans to fund his IRA with a lump-sum today of $10,000 and 20
annual deposits of $2,000 for the next 25 years. If he can earn 5%
compounded annually, how much will he have at the end of 25 years?
Future Value of an Annuity Due
0
$100
1
$100
2
3
$100
FVA=?
You deposit $100 each year (beginning of year) into a savings
account.
How much would this account have in it at the end of 3 years if
interest were earned at a rate of 8% annually?
165
Annuity Due:
Calculator Solution
Example: You receive $100 per
year for 3 years. How much is it
worth after 3 years if you can
earn 4% annually?
N=3
I/Y = 4
PMT = -$100
CPT FV = $312.16
Do all these homework problems on your overhead
homework sheets: use your calculator and show the
keys you would press and circle your answer:
*NOW ASSUME ALL PAYMENTS ARE AT THE BEGINNING OF THE PERIOD*
What is the future value of an ordinary annuity of $1,000 each year for 10
years, assuming a 4% compounding rate?
What is the future value of an annuity due of $1,000 each year for 10 years
assuming a 4% compounding rate?
Dan plans to fund his IRA with a contribution of $ 200 per month for the
next 10 years. If Dan can earn 6% per year on his contributions, how much
will he have at the end of the 10th year?
James plans to fund his IRA with a lump-sum today of $10,000 and 20
annual deposits of $2,000 for the next 25 years. If he can earn 5%
compounded annually, how much will he have at the end of 25 years?
Financial Calculator Solution – PV of a
Single Sum
You Expect to receive $100 in EIGHT years. If
can invest at 3%, what is it
worth today?
Calculator Enter:
N =8
I/YR = 3
FV = 100
CPT PV = ?-78.94
-78.94
168
Present Value of an Annuity
Calculator Solution
0
-257.71
1
$100
2
3
$100
$100
PV=?
Enter:
N
=3
I/YR = 8
PMT = 100
CPT PV = ?-257.71
-257.71
N I/Y PV PM FV
169
Present Value of an Annuity Due
How much would the following cash flows be worth
to you today if you could earn 8% on your deposits?
0
$100
$100.00
$92.60
$85.73
$278.33
1
$100
2
3
$100
278.33
BGN
N=3
PMT = -100
I/Y = 8
CPT PV = 278.33
170
Amortized Loans
• A loan that is paid off in equal
amounts that include principal as
well as interest.
• Solving for loan payments.
171
Amortized Loans
You borrow $5,000 from your parents to purchase a used car. You agree to
make payments at the end of each year for the next 5 years. If the
interest rate on this loan is 6%, how much is your annual payment?
0
$5,000
1
2
$?
$?
ENTER:
N
=5
I/Y = 6
PV = 5,000
CPT PMT = ?-1,186.98
3
4
5
$?
$?
$?
–1,186.98
N I/Y PV PMT FV
172
Do all these homework problems on your overhead
homework sheets: use your calculator and show the
keys you would press and circle your answer:
1. Calculate the present value of annual payments of $3,000 per year for ten years at
8%:
a. Ordinary Annuity
b. Annuity Due
2. How much will you have at the end of the 6th year if you invest $5,000 annually for
six years at 7% annual rate, if you:
a. Start one year from today
b. Start today
3. A bank agrees to give you a loan of $12,000,000 and you have to pay $1,309,908 per
year (end of year) for 26 years. What is your rate of interest? What would the
payments be if this were a monthly payment loan?
4. You have found the perfect burial plot. Of course, you don't plan to need it for 60
years. The plot costs $12,000 today and burial plot prices are increasing at 4% per year.
How much do you need to deposit at the beginning of each of the next 60 years to pay
for the plot if you can earn 11% on your deposit?