Chapter 7 an Introduction to Financial Accounting and Valuation

Chapter 7 An Introduction to Financial Accounting and Valuation

Outline Chapter 7 An Introduction Financial Accounting and Valuation A. Financial Accounting Demystified  accounting principles o Generally Accepted Accounting Principles o assumptions: separate entity, continuity, constant units of measure, time periods o principles - cost, consistency, full disclosure, materiality, conservatism  financial statements 1. Balance Sheet . fundamental equation: A = L - Eq . snapshot of nature of assets and claims against them 2. Income Statement . revenues minus expenses . movie picture of how making money, change in balance sheets over time 3. Statement of cash flows . operating, investing and financing activities . movement of cash indicates value of firm  accounting issues o accrual versus cash accounting o cost of inventory . cost of goods sold = opening inventory + purchases - value of closing inventory . average cost / FIFO (higher profits) / LIFO (lower profits) o depreciation . reflect use of asset - Matching Principle . goodwill - account for as asset if acquired / new GAAP does not require depreciation B. Valuing the Enterprise 1. the old man and the tree: a parable of valuation o Salvage value o Current production o Future (undiscounted) production o Market price o Book value o D iscounted future earnings 2. some additional thoughts on valuing businesses o Methods of valuation . Discounted Cash Flow . Comparable approach.

Corporations: Law & Policy Page 1 Chapter 7 – An Introduction to Financial Accounting and Valuation Class Notes

A. Financial Accounting Demystified What is "profit" Accounting answer: Exco buys building for $100,000. It has Income Statement monthly upkeep of $2,000, but finds a Revenues $24,000 tenant who pays monthly rent of Expenses $2,000. At year's end, Exco gets and Upkeep $24,000 refuses offer to sell building for Depreciation $ 5,000 $105,000. Any profit? Net income ($5,000) Economic answer: Change in value Net cash flows $0 Appreciation $5,000 Cost of money - ($3,000) inflation Net change in value $2,000 Cookie Business Balance Sheet (at day's end)

Assets Liabilities You go into business, buying and selling items from your cookie jar. To keep track of your Cash $9 IOU - Mom $10 money-making efforts you kept a journal: Pens $2 Scissors $0 Scissors $5 Total liab $10 Cookie jar - accounting entries Equity Mine $6 Assets Liabilities + Total equity $6 = Equity Total assets $16 Total L + Eq $16 Put $12 in cookie jar $12 $0 $12

Borrow $10 from $22 $10 $12 Mom (put in IOU) Income Statement (day 1)

Buy two $2 felt-tip $22 $10 $12 Net sales $3 pens Operating expenses Buy $5 scissors on $27 $15 $12 Cost of goods sold $2 credit Rent (jar) $2 Selling/adm expenses $0 Sell one of the felt-tip $28 $15 $13 Total operating expenses $4 pens for $3 Operating income ($1) Repay the $5 $23 $10 $13 Interest expense (Mom/scissors) $0 scissors debt Income taxes $0

Corporations: Law & Policy Page 2 Chapter 7 – An Introduction to Financial Accounting and Valuation Pay $2 rent for using $21 $10 $11 Net income ($1) the jar Dividends paid $5 Take our $5 to go to $16 $10 $6 movies Cash Flow Statement (day 1) At the end of the first day, you want to know Operating Activities where you stand. What are your current assets Net income ($1) and liabilities, and how much in the cookie jar is Dec (Inc)) inventories ($7) yours? Did you make any money today? And Total operating activities ($8) where did the money go? In reviewing the financial statements:  Balance sheet: Investing activities -- o how is the rental arrangement for the cookie jar accounted for on Financing activities the balance sheet? Inc (Dec) short-term debt $0 o what would be the effect on the Inc (Dec) long-term debt $10 balance sheet if you bought the Investment by owner $12 cookie jar? Distribution to owner ($5) o what if you sold some of the Total financing activities $17 pens on credit - how would that

affect the balance sheet? o what is the value of your Inc (Dec) cash position $9 inventory - the pens and scissors? what if their price went up? o if you had the only cookie jar in the neighborhood, wouldn't this have value? o suppose you sell a pen to your sister who writes on the kitchen wall and you might be shut down, how account?  Income statement o was the payment you made to yourself, a dividend or compensation for services? o should you amortize the rental payment, which only happens once a month? o suppose you sold a pen on credit, is that a sale? o does the the net income of minus $1 indicate that this is a money-

Corporations: Law & Policy Page 3 Chapter 7 – An Introduction to Financial Accounting and Valuation losing business?

You also contemplate whether your business has any value. Are you making money? Should you continue the business tomorrow? Could you sell it to your sister? For how much? Do the financial statements give an answer? What is "net book value"?

Precision Tools, Inc. Balance Sheet (as of Dec 31)

Assets 2005 2004 Liabilities 2005 2004 Current assets Current liabilities Cash Accounts payable 900,000 825,000 150,000 275,000 Notes payable 600,000 570,000 Accounts receivable 1,380,000 1,145,000 Accrued expenses 250,000 Inventories 1,310,000 1,105,000 payable 235,000 Prepaid expenses Total current liabilities 1,750,000 1,630,000 40,000 35,000 Long term liabilities Total current assets 2,880,000 2,560,000 Notes payable (12.5% 2,000,000 2,000,000 2008) Fixed assets Notes payable (11% Land 2000) --- 355,000 775,000 775,000 Total Liabilities 3,750,000 3,985,000 Buildings 2,000,000 2,000,000 Machinery 1,000,000 Stockholders' Equity 935,000 Common stock (1000 sh) Office equipment Paid-in capital 200,000 225,000 205,000 200,000 Total PP&E 4,000,000 3,915,000 Retained earnings 1,310,000 Less accumulated 1,620,000 1,370,000 920,000 depreciation Total equity 1,510,000 1,120,000 Net fixed assets 2,380,000 2,545,000 Total Liabilities and Equity 5,260,000 5,105,000 Total assets 5,260,000 5,105,000

Analyze the balance sheet:  Do accounts receivable reflect the possibility of delinquent customers? Is there an allowance for doubtful accounts? How might this be computed?

Corporations: Law & Policy Page 4 Chapter 7 – An Introduction to Financial Accounting and Valuation  Does it make any difference that the company's land, a tract in an industrial park, was purchased 15 years ago and is actually worth far more? A comparable tract recently sold for $3.5 million.  What would be the effect of re-valuing the land and buildings to reflect current market value? What accounts would this affect on the balance sheet?  What is the company's financial strength for each of the two years-- o Working capital (current assets minus current liabilities) = . FY2002: 2,880,000 - 1,750,000 = $1,130,000 / FY2001: 2,560,000 - 1,630,000 = $930,000 . What does this tell you? o Current ratio (current assets divided by current liabilities) = . FY2002: 2880/1750 = 1.65 / FY2001: 2560/1630 = 1.57 . What does this tell you? o Liquidity ratio (quick assets [cash, mkt securities, accts rec'ble] divided by current liabilities) = . FY2002: 1530/1750 = 0.87 / FY2001: 1420/1630 = 0.87 . What does this tell you? o Debt-equity ratio (long-term debt divided by equity) . FY2002: 2000/1510 = 1.32 / FY2001: 2335/1120 = 2.08 . What does this tell creditors? o Book value (Assets minus Liaiblities) . FY2002: $1,510,000 / FY2001: $1,120,000 . What does this tell owners?

Precision Tools Inc Income Statement (Year ended Dec 31) 2005 2004 2003 Net sales 7,500,000 7,000,000 6,800,000 Operating expenses Cost of goods sold 4,980,000 4,650,000 4,607,000 Depreciation 250,000 240,000 200,000 Selling and administrative expenses 1,300,000 1,220,000 1,150,000 Research and development 50,000 125,000 120,000

Operating income 920,0000 765,000 723,000 Interest expense 320,000 375,000 375,000 Income before taxes 600,000 390,000 348,000 Income taxes 210,000 136,000 122,000 Net Income 390,000 254,000 226,000 Analyze the income statement:  Can you tell where the business makes its money -

Corporations: Law & Policy Page 5 Chapter 7 – An Introduction to Financial Accounting and Valuation o who are its customers? are they loyal? o who manages and how? are they competent and honest? o who are the suppliers? are they reliable?  What is the financial position of the company? o cost of goods sold (cost of goods divided by net sales) . FY2002 = 4980/7500 = 6.6% / FY2001: 4650/7000 = 6.6% / FY 2000 = 4607/6800 = 6.8% . what does this tell you? o profit margin (net sales minus operating expenses, divided by net sales) . FY2002 = 920/7500 = 12.3% / FY2001: 765/7000 = 10.9% / FY 2000 = 723/6800 = 10.6% . what does this tell you? why has it gone up? is this "window dressing"? o return on equity (net income divided by stockholders' equity as of prior year) . FY2002 = 390/1120 = 34.8% . what does this mean? assuming that long-term government bonds are returning 8.4%, does this suggest anything about the value of Precision Tools?

Precision Tools Inc Statement of Cash Flows (Year ended Dec 31) 2005 2004 From operating Activities Net income 390,000 254,000 Decrease (increase) in accts receivable (235,000) (34,000) Decrease (increase) in inventories (205,000) (28,000) Decrease (Increase) in prepaid expenses (5,000) (3,000) Increase (Decrease) in accounts payable 75,000 25,000 Increase (Decrease) in accrued expenses payable 15,000 7,000 Depreciation 250,000 240,000 Total from Operating Activities 285,000 461,000

From Investing Activities Sales (Purchases) of machinery (65,000) (378,000) Sales (Purchases) of office equipment (20 ,000) (27,000) Total from Investing Activities (85,000) (405,000)

From Financing Activities Increase (Decrease) in short-term borrowings 30,000 (40,000) Increase (Decrease) in long-term borrowings (355,000) ----- Total from Financing Activities (325,000) (40,000)

Corporations: Law & Policy Page 6 Chapter 7 – An Introduction to Financial Accounting and Valuation Increase (Decrease) in Cash Position (125,000) 16,000 Analyze the cash flow statement:  Can you tell whether the business is better off in 2001, compared to 2000? - o are there any danger signs? o what happened to "accounts receivable" and "inventories"? o Why doesn't this "cash bleeding" show up on income statement? o Why did management cut back on "research and development"?  does this suggest anything about the value of Precision Tools?

B. Valuing the Enterprise The Old Man and the Tree: A Parable of Valuation

Once upon a time there was an old man who owned an apple tree. It was a fine tree. With modest care it yielded a crop of apples which he sold for $100 each year. The man wanted money for new pursuits and thought of selling the tree. So he placed an ad in the Business Opportunities section of the Wall Street Journal: "For sale, apple tree - best offer." Six prospective buyers answered the ad, with six methods for valuing the tree:  Salvage value  Current production Adapted from Solomon, Schwartz & Bauman,  Future (undiscounted) production Corporations - Cases and Materials at 143 (4th  Market price ed. 1996).  Book value  Discounted future earnings From this we can draw a moral of the story Present value Year Cash flow (8% (15% discount discount rate) rate) 1 50 $ 46.30 $ 43.48 2 50 $ 42.87 $ 37.81 3 50 $ 39.69 $ 32.88 4 50 $ 36.75 $ 28.59 5 50 $ 34.03 $ 24.86 6 40 $ 25.21 $ 17.29 7 40 $ 23.34 $ 15.04 8 40 $ 21.61 $ 13.08

Corporations: Law & Policy Page 7 Chapter 7 – An Introduction to Financial Accounting and Valuation 9 40 $ 20.01 $ 11.37 10 40 $ 18.53 $ 9.89 11 40 $ 17.16 $ 8.60 12 40 $ 15.88 $ 7.48 13 40 $ 14.71 $ 6.50 14 40 $ 13.62 $ 5.65 15 40 $ 12.61 $ 4.92 Salvage 50 $ 15.76 $ 6.14 Total $ 398.07 $ 273.56

Moral of the story There are several morals. First, you should have noticed that the prospective buyers used essentially three methods to value productive assets --  asset approach o salvage value o book value  income (cash flow) approach o current production o future (undiscounted) production o discounted future earnings  market (comparables) approach o price-earnings ratio o market price

Second, asset valuation methods are useful tools, but valuation is an art that combines methods, good judgment and experience. And experience comes from mistakes. Third, you should listen closely to the experts -- focus not only on what they say, but on what they don't say. Behind their elegance, there is much discordance and uncertainty. One wrong assumption can carry you off track.

Finally, you're never too young or too old to learn.

Remember the financial statements for Precision Tools. What is the company's value, using the following methods  Salvage value  Current production  Future (undiscounted) production  Market price  Book value  Discounted future earnings

Corporations: Law & Policy Page 8 Chapter 7 – An Introduction to Financial Accounting and Valuation Precision Tools, Inc. Balance Sheet (as of Dec 31) Assets 2002 2001 Liabilities 2002 2001 Current assets Current liabilities Cash Accounts payable 900,000 825,000 150,000 275,000 Notes payable 600,000 570,000 Accts receivable 1,380,000 1,145,000 Accrued expenses 250,000 Inventories 1,310,000 1,105,000 payable 235,000 Prepaid expenses Total current liabilities 1,750,000 1,630,000 40,000 35,000 Long term liabilities Total current assets 2,880,000 2,560,000 Notes payable (12.5% 2,000,000 2,000,000 2008) Fixed assets Notes payable (11% Land 2000) --- 355,000 775,000 775,000 Total Liabilities 3,750,000 3,985,000 Buildings 2,000,000 2,000,000 Machinery 1,000,000 Stockholders' Equity 935,000 Common stock (1000 sh) Office equipment Paid-in capital 200,000 225,000 205,000 200,000 Total PP&E 4,000,000 3,915,000 Retained earnings 1,310,000 Less accum 1,620,000 1,370,000 920,000 depreciation Total equity 1,510,000 1,120,000 Net fixed assets 2,380,000 2,545,000 Total Liabilities and Equity 5,260,000 5,105,000 Total assets 5,260,000 5,105,000 Precision Tools Inc Income Statement (Year ended Dec 31) 2002 2001 2000 Net sales 7,500,000 7,000,000 6,800,000 Operating expenses Cost of goods sold 4,980,000 4,650,000 4,607,000 Depreciation 250,000 240,000 200,000 Selling and administrative expenses 1,300,000 1,220,000 1,150,000 Research and development 50,000 125,000 120,000

Operating income 920,0000 765,000 723,000 Interest expense 320,000 375,000 375,000 Income before taxes 600,000 390,000 348,000

Corporations: Law & Policy Page 9 Chapter 7 – An Introduction to Financial Accounting and Valuation Income taxes 210,000 136,000 122,000 Net Income 390,000 254,000 226,000 Precision Tools Inc Statement of Cashflow (Year ended Dec 31) 2002 2001 From operating Activities Net income 390,000 254,000 Decrease (increase) in accts receivable (235,000) (34,000) Decrease (increase) in inventories (205,000) (28,000) Decrease (Increase) in prepaid expenses (5,000) (3,000) Increase (Decrease) in accounts payable 75,000 25,000 Increase (Decrease) in accrued expenses payable 15,000 7,000 Depreciation 250,000 240,000 Total from Operating Activities 285,000 461,000

From Investing Activities Sales (Purchases) of machinery (65,000) (378,000) Sales (Purchases) of office equipment (20 ,000) (27,000) Total from Investing Activities (85,000) (405,000)

From Financing Activities Increase (Decrease) in short-term borrowings 30,000 (40,000) Increase (Decrease) in long-term borrowings (355,000) ----- Total from Financing Activities (325,000) (40,000) Increase (Decrease) in Cash Position (125,000) 16,000 Salvage value: $5,215,000 - $3,750,000 = $1,465,000

Assets 2002 Salvage Liabilities 2002 Current assets Current liabilities Cash - 100% 150,000 150,000 Accounts payable Accts receivable - 75% 1,380,000 1,035,000 900,000 Inventories - 50% 1,310,000 655,000 Notes payable Prepaid expenses - 75% 600,000 40,000 30,000 Accrued expenses payable Total current assets 2,880,000 1,870,000 250,000 Total current liabilities 1,750,000 Fixed assets Long term liabilities Land - FMV minus selling 775,000 Notes payable (12.5% 2,000,000 expense 1,000,000 2008)

Corporations: Law & Policy Page 10 Chapter 7 – An Introduction to Financial Accounting and Valuation Buildings 2,000,000 2,000,000 Notes payable (11% 2000) Machinery - 30% 1,000,000 300,000 --- Office equipment - 20% 225,000 45,000 Total Liabilities 3,750,000 Total PP&E 4,000,000 3,345,000 Less accum depreciation 1,620,000 0 Net fixed assets 2,380,000 3,345,000

Total assets 5,260,000 5,215,000 Current production: $7,500,000 (FY 2001 Net sales)

Future (undiscounted) production: $75,000,000 (assuming ten more years)

Market price: who last offered? market price of individual share?

Book value: $1,510,000 (from balance sheet)

Stockholders' Equity 2002 Common stock (1000 sh) Paid-in capital 200,000 Retained earnings 1,310,000 Total equity 1,510,000

Discounted future earnings 2002 Net income $390,000 Depreciation $250,000 Bonuses $120,000 Net cash flows $760,000 Adjusted free cash flow $500,000

Discount rate 33% Growth rate 8% Capitalization rate (discount minus growth) 25% Capitalization multiplier 4

Discounted cash flow $2,000,000

Corporations: Law & Policy Page 11 Chapter 7 – An Introduction to Financial Accounting and Valuation