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Finance Chapter 2 Notes Average tax rate - terms is defined as the total tax paid divided by the total taxable income Over the past year, a firm decreased its current assets and increased its current liabilities. As a result, the firm's net working capital: Had to Decrease Financial leverage: increases the potential return to the stockholders. Given a profitable firm, depreciation: Lower Taxes If cash Flow from assets is negative and cash flow to creditors is positive the cashflow to stockholder is negative Cash flow to creditors plus cashflow to stockholders has to equal CFFA Concepts to understand in chapter 2
- Difference of book value and market value
- Difference between Accounting Income and Cash Flow
- Difference between average and marginal tax rates
- How to determine a firms cash flow from its financial statements Cash Flow: Cash flow in finance is how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase
- One of the most important pieces of information derived from a financial statement
- Cash flow in accounting does not provide the same information we are looking for in finance Free cash flow (FCF) and Cash flow from Assets (CFFA) are the same thing. This is a method used for stock evaluation. Free Cash Flow Equation: EBIT - Taxes + Depreciation and Amortization - Capital Expenditure - Change in Net working Capital This equation helps determine how much cash is left to distribute to investors after accounting for growth of firms assets. Basic Free Cash Flow:
- How much cash did the firm generate?
Chapter 2 Notes
Monday, August 30, 2021 12:20 PM
- How much cash did the firm generate? (EBIT - Taxes) + Depreciation = Operating CF After tax earnings does not equal cash flow (CF) Must adjust accounting income for non-cash expenses
- How much cash did the firm spend on fixed assets? (Ending Net FA - Beginning Net FA) + Depreciation = Net Capital Spending Accounts for purchase of new assets , including replacement of depleted assets.
- How much CASH did the firm spend on net working capital. Each year, the net investment working capital is: (Current assets - Current Liabilities) Meaning: how much "additional" cash is needed to finance current assets base above that is supplied by spontaneous current liabilities. The new net investment from one year to the next is (CA 2010 - CL 2010 ) – (CA 2009 – CL 2009 ) = ΔNWC
- Δ = “Change” Cash Flow From Assets Equations: Cash flow from Assets (CFFA )= Operating Cash Flow (OCF) - Net Capital Spending (NCS) - Changes in NWC (ΔNWC) Step 1 is get the OCF which is: EBIT + depreciation – taxes
Book Value - The balance sheet values of the assets, liabilities, and equity. Market Value - True Value; the price at which asset, liabilities or equity can actually be bought or sold. Income Statement - Measures performance over a specified period of time. (Period, quarter, or year). In income statement you report the revenue first and then deduct the expenses for that period. End Result = Net Income = Bottom line
- Dividends paid to shareholders
- Addition to retained earnings Income Statement Equation: Net income = Revenue - Expenses GAAP Matching Principle:
- Recognize revenue when its fully earned
- Match expenses required to generate revenue to the period of recognition. Noncash Items:
- Expenses charged against revenue that do not affect cashflow
- Depreciation = most important.
- Depreciation = most important. Taxes Marginal tax - % tax paid on the next dollar earned. Average tax - total tax bill / taxable income If considered a project that will increase taxable income by $1 million, which tax rate should you use in your analysis?
Chapter 2
Dole Cola Cash Flow Example Pages 37- 39
Income Statement Assumptions given:
- Sales $
- COGS $
- Depreciation $
- Interest Paid $
- Taxes 21%
- Dividends Paid $
Sales – Cogs – Depreciation = EBIT
Ending NWC (2260 – 1710) = 550
Beginning NWC (2130 – 1620) = - 510
Change in NWC is 40 (increase in NWC)
Free Cash Flow
$275 – $400 – $40 = - $165 The Firm needed to raise cash investors since the number was
negative
Cash Flow to stock Holders
Assumption that no new equity
Dividends paid – net new equity
Cash flow to stock holders is $
Cash flow to creditors
Assumption that change in long term debt is unknown
CFFA = CF to SH + CF to creditors
- 165 = 30 + x
- 195 = x CF to creditors = interest paid – net new borrowing
- 195 = 30 - x
- 30
- $
(TAT) Total Asset Turnover = Sales/ Total Assets = 2361/3630 =. Extended Du Pont ROE = Net Income / Total Equity = PM x TAT x EM (Equity Multiplier) ROA = Net Income / Total Assets = (Net Income / sales) x (sales/Total Assets) 13% = 20% x. Asset Performance ---> Return on Assets EM = Total Assets / Total Equity
- EM Captures the financial leverage Equations used on Chapter 3 homework McGraw Net Income
- Income / Sales = profit margin
- Sales x profit margin = income ROA = Return on assets
- Income / Assets = Return on assets ROE = return on equity
- 1) Assets = Liability + equity and solve for Equity
- 2) Income / Equity = Return on equity Receivables turnover = Credit sales ÷ Receivables Payables turnover= Cost of goods sold/Payables balance Days' sales in receivables = 365 days ÷ Receivables turnover Internal growth rate=(ROARetention ratio)/[1-(ROARetention ratio)]**
- Retention ratio=1-payout ratio Return on Equity = return on asset x (1 + debt equity ratio) Return on equity = profit margin x total asset turnover x equity multiplier Return on Assets = ( profit margin x sales) / (intensity ratio x Sales) Return on assets = (profit margin x sales) / total assets Total asset turnover= 1/ capital intensity ratio Inventory turnover = Cost of goods sold / average inventory Equity Multiplier = Total assets / [Total assets - Total debt] You can Increase internal rate growth by decreasing dividend payout ratio to zero Net Income - pay dividends
- additional to retained Dividend payout ratio = (1-b) = DPS/EPS Retention ratio ("b") = (EPS-DPS) / EPS =(addition to retained earnings) / Net Income
Key Concepts
- Know how to calculate expected return
- Know how to calculate standard deviation Understand: ○ The Impact of diversification "Total Risk" for the standard deviation = diversifiable risk | also known as unsystematic risk also asset specific firm unique + non diversifiable risk | also referred as systematic risk or market risk| ○
Expected Returns Expected returns are based on the probabilities of possible outcomes
E(RA) = .25 (-20%) + .5(15%) + .25(35%) = 11.25% E(RB) - .25(30%) + .5(15%) + .25(-10%) = 12.50 % Trick question ** Exam Question** If all you knew where these percentages which one would you pick? Cant decided without knowing the ROE Chapter 11 Notes Thursday, September 9, 2021 11:36 AM
