Saudi Electronic University The Payback Period and Discounted Payback Period Questions

Description


‫المملكة العربية السعودية‬
‫وزارة التعليم‬
‫الجامعة السعودية اإللكترونية‬
Kingdom of Saudi Arabia
Ministry of Education
Saudi Electronic University
College of Administrative and Financial Sciences
Assignment 2
Principles of Finance (FIN 101)
Due Date: 08/08/2022 @ 23:59
Course Name: Principles of Finance
Student’s Name:
Course Code: FIN 101
Student’s ID Number:
Semester: Summer
CRN:
Academic Year:2021-22-Summer Semester
For Instructor’s Use only
Instructor’s Name:
Students’ Grade: /15
Level of Marks: High/Middle/Low
General Instructions – PLEASE READ THEM CAREFULLY








The Assignment must be submitted on Blackboard (WORD format only) via
allocated folder.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well presented, marks may be
reduced for poor presentation. This includes filling your information on the cover
page.
Students must mention question number clearly in their answer.
Late submission will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Learning Outcomes:
1. Explain the relationship between risk and return. (2.1)
2. Evaluate the cost of capital for decisions related to financing the operations of a
corporation. (2.3)
3. Measure financial corporate performance. (2.4)
Assignment Question(s): (6 x 2.5 = 15 Marks)
1. You are currently thinking about investing in a stock valued at $25.00 per share.
The stock recently paid a dividend of $2.25 and its dividend is expected to grow at
a rate of 5 percent for the foreseeable future. You normally require a return of 14
percent on stocks of similar risk. Is the stock overpriced, underpriced, or correctly
priced?
2. Critical Thinking Question: What does it mean when a company has a very high
P/E ratio? Give examples of industries in which you believe high P/E ratios are
justified.
3. Nonconstant growth: Diaz Corp. is expected to grow rapidly at a rate of 35 percent
for the next seven years. The company’s first dividend, to be paid three years from
now, will be $5. After seven years, the company (and the dividends it pays) will
grow at a rate of 8.5 percent. What is the value of Diaz stock with a required rate
of return of 14 percent?
4. Calculate and interpret net present value (NPV), internal rate of return (IRR),
payback period, discounted payback period, and profitability index (PI) of a single
capital project.
5. Critical Thinking Question: Your manager just finished calculating your
company’s weighted average cost of capital. He is relieved because he says that he
can now use that cost of capital to evaluate all projects that the company is
considering for the next 4 years. Evaluate that statement.
6. WACC for a company: Contemporary Products Ltd currently has $200 million of
market value debt outstanding. The 9 percent coupon bonds (semiannual pay) have
a maturity of 15 years, a face value of $1000 and are currently priced at $1,024.87
per bond. The company also has an issue of 2 million preference shares outstanding
with a market price of $20. The preference shares offer an annual dividend of
$1.20. Contemporary Products also has 14 million ordinary shares outstanding
with a price of $20.00 per share. The company is expected to pay a $2.20 ordinary
dividend 1 year from today, and that dividend is expected to increase by 7 percent
per year forever. If the corporate tax rate is 40 percent, then what is the company’s
weighted average cost of capital?
Answers:
Chapter 1: The Financial Manager and
the Firm
Learning Objectives
1. IDENTIFY THE KEY FINANCIAL DECISIONS
FACING THE FINANCIAL MANAGER OF ANY
BUSINESS FIRM.
2. IDENTIFY THE BASIC FORMS OF BUSINESS
ORGANIZATION IN THE UNITED STATES AND
THEIR RESPECTIVE STRENGTHS AND
WEAKNESSES.
Learning Objectives
3. DESCRIBE THE TYPICAL ORGANIZATION OF
THE FINANCIAL FUNCTION IN A LARGE
CORPORATION.
4. EXPLAIN WHY MAXIMIZING THE CURRENT
VALUE OF THE FIRM’S STOCK IS THE
APPROPRIATE GOAL FOR MANAGEMENT.
5. DISCUSS HOW AGENCY CONFLICTS AFFECT
THE GOAL OF MAXIMIZING SHAREHOLDER
VALUE.
Learning Objectives
6. EXPLAIN WHY ETHICS IS AN APPROPRIATE
TOPIC IN THE STUDY OF CORPORATE
FINANCE.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Capital Budgeting: decide which long-term
assets to acquire
• Financing: decide how to pay for short-term and
long-term assets
• Working Capital: decide how to manage shortterm resources and obligations
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Capital Budgeting
Choose the long-term assets that will yield the greatest
net benefits for the firm.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Financing
Finance assets with the optimal combination of shortterm debt, long-term debt, and equity.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Working Capital Management
Adjust current assets and current liabilities as needed
to promote growth in cash flow.
Cash Flows Between the Firm and Its
Stakeholders and Owners
How the Financial Manager’s Decisions
Affect the Balance Sheet
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Poor decisions about capital budgeting,
financing, or working capital may lead to
bankruptcy or business failure
Basic Forms of Business Organization
o BUSINESS STRUCTURE
• Sole Proprietorship
• Partnership
• Corporation
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Owned by a single person who is financially
responsible for the actions and obligations of
the business
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Advantages
easiest to create
easiest to control
easiest to dissolve
right to all profit
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Disadvantages
owner’s personal assets at risk
owner’s unlimited liability for firm obligations
equity only from owner or business profit
business income taxed as personal income
difficult to transfer ownership
Basic Forms of Business Organization
o PARTNERSHIP
• A business owned by more than one person; one
or more of them financially responsible for the
actions and obligations of the business
Basic Forms of Business Organization
o PARTNERSHIP
• Advantages vs. sole proprietorship
limited protection of owners’ personal assets
owners’ limited liability for firm obligations
more sources of equity
more sources of expertise
Basic Forms of Business Organization
o PARTNERSHIP
• Disadvantages vs. proprietorship
shared control
shared profit
harder to dissolve
Basic Forms of Business Organization
o CORPORATION
• A business owned by more than one person;
none of them financially responsible for the
actions and obligations of the business. The
corporation is responsible for its obligations and
actions.
Basic Forms of Business Organization
o CORPORATION
• Advantages
protects personal assets
no shareholder liability for business
easiest to change ownership
greatest access to sources of funds
Basic Forms of Business Organization
o CORPORATION
• Disadvantages
most difficult and expensive to establish
dilutes individual control over the firm
overall higher taxes on income for shareholders
Basic Forms of Business Organization
o HYBRID FORMS OF BUSINESS ORGANIZATION
• Limited Liability Partnerships (LLPs)
• Limited Liability Companies (LLCs)
• Professional Companies (PCs)
All have the limited liability of a corporation and tax
advantage of a partnership.
Organization of the Financial Function
o CHIEF EXECUTIVE OFFICER (CEO)
• Chief manager in the firm
• Ultimate power to make decisions and ultimate
responsibility for decisions
• Reports directly to the board-of-directors who
protect shareholder’s interests
Simplified Corporate Organization
Chart
Organization of the Financial Function
o CHIEF FINANCIAL OFFICER (CFO)
• The V.P. of Finance/CFO is responsible for the
quality of the financial reports received by the
CEO
Organization of the Financial Function
o KEY FINANCIAL REPORTS
• The Treasurer manages and reports on the
collection and disbursement of cash
• The Risk Manager manages and reports on
activities to limit the firm’s risks in financial and
commodity markets
Organization of the Financial Function
o KEY FINANCIAL REPORTS
• The Controller is the firm’s accountant and
prepares its financial reports
• The Internal Auditor controls and reports on
activities to limit the firm’s exposure to internal
threats such as fraud and inefficient use of
resources
Organization of the Financial Function
o EXTERNAL AUDITOR
• Conducts an independent audit of a firm’s
financial activities
• Provides an opinion about whether the financial
reports the firm prepared are reasonably
accurate and conform to generally accepted
accounting principles
The Goal of the Firm
o DO NOT MAXIMIZE MARKET SHARE
• Giving away goods or services for free will
maximize a firm’s market share for a while, but
the firm will not be able to pay its bills and stay
in business
The Goal of the Firm
o DO NOT MAXIMIZE PROFIT
• Accounting profit differs from economic profit
• Profit earned may not equal cash received
Cash not received can’t be used to pay bills
• The strategy ignores the timing of future cash
flows
• The strategy ignores the risks associated with
having to wait for cash flows
The Goal of the Firm
o MAXIMIZE SHAREHOLDERS’ WEALTH!
• Future cash flows are considered
• The timing of future cash flows is considered
• The risks associated with having to wait to for
cash flows are considered
The Goal of the Firm
o MAXIMIZE SHAREHOLDERS’ WEALTH!
• Maximizing the price of a firm’s stock will
maximize the value of a firm and the wealth of
its shareholders (owners)
The Goal of the Firm
o ITS ALL ABOUT CASH FLOW!
• Positive residual cash flow may be paid to firm
owners as dividends or invested in the firm
• The larger the positive residual cash flow, the
greater the value of a firm
• Negative residual cash flow – over the long run leads to bankruptcy or closing a business
Agency Conflicts
o AGENCY RELATIONSHIP
• An agency relationship is created when the
owner (a principal) of a business hires an
employee (an agent)
• The owner surrenders some control over the
enterprise and its resources to the employee
• Separating ownership from control creates the
potential for agency conflicts
Agency Conflicts
o AGENCY RELATIONSHIP
• An agency relationship exists between
stockholders (principals) and the firm’s hired
management (agents)
• In large corporations, shared ownership among
many shareholders may result in relatively little
control over management
Agency Conflicts
o OWNERSHIP AND CONTROL
• Shareholders own the corporation, but
managers control the firm’s assets and may use
them for their own benefit
Major Factors Affecting Stock Prices
Agency Conflicts
o AGENCY COSTS
• Arise from (incurring and preventing) conflictsof-interests between a firm’s owners and its
managers
• May reduce positive residual cash flow, stock
price, and shareholder wealth
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Managers tend to focus on wealth maximization
when their compensation depends on stock
price
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Today, the firm’s stock trades at $0.95 per share.
The CEO has an option to buy 2.5 million
shares from the firm for $1.15 per share at any
time, beginning one year from today. If the
stock price rises to $3.15, the option will be
worth $5 million.
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Want to keep their jobs
• Oversight by the board of directors
• Oversight by large blockholders
• Potential takeover of the firm
• The legal and regulatory environment.
Agency Conflicts
o SARBANES-OXLEY AND REGULATORY REFORM
• Better corporate governance reduces agency
costs by requiring
more effective monitoring of managers’ activities
programs that promote appropriate behavior by
managers
penalties for executives who do not fulfill their fiduciary
responsibilities
Corporate Governance Regulations
Designed to Reduce Agency Costs
Ethics in Corporate Finance
o WHAT ARE ETHICS?
• Ethics
society’s standards for judging whether an action is
right or wrong
• Business Ethics
society’s standards for acceptable behavior applied to
business and financial markets
Ethics in Corporate Finance
o EXAMPLES OF ETHICAL CONFLICT IN BUSINESS
• Agency Cost
employee’s unacceptable use of employer’s computer
• Conflict of Interest
mortgage contract which a home-buyer is unlikely to
fulfill but earns a mortgage broker more money
• Information Asymmetry
seller knows about prior damage to the vehicle but the
potential buyer does not
Ethics in Corporate Finance
o BUSINESS BEHAVIOR
• Regulation and market forces are not enough to
maintain integrity in the marketplace
• Business norms must be based on ethical
beliefs, customs, and practices
Ethics in Corporate Finance
o CONSEQUENCES OF UNETHICAL BEHAVIOR
• Inefficiency in the economy and costs to society
• High legal and social costs
• Problems such as the recent financial crisis in
the U.S.
Ethics in Corporate Finance
o ETHICAL BEHAVIOR
• Sometimes, it is difficult to judge whether
behavior is ethical or not
Was the manager too careful?
Did the manager take too much risk?
Was it an honest mistake?
Was it against policy, but well-intentioned?
A Framework for the Analysis of Ethical
Conflicts
Chapter 2: The Financial System and
the Level of Interest Rates
Learning Objectives
1. DESCRIBE THE ROLE OF THE FINANCIAL
SYSTEM IN THE ECONOMY AND THE TWO
BASIC WAYS IN WHICH MONEY FLOWS
THROUGH THE SYSTEM.
2. DISCUSS DIRECT FINANCING AND THE
IMPORTANT ROLE THAT INVESTMENT BANKS
PLAY IN THIS PROCESS.
Learning Objectives
3. DESCRIBE THE PRIMARY, SECONDARY, AND
MONEY MARKETS, EXPLAINING THE SPECIAL
IMPORTANCE OF SECONDARY AND MONEY
MARKETS TO BUSINESS ORGANIZATIONS.
4. EXPLAIN WHAT AN EFFICIENT MARKET IS
AND WHY MARKET EFFICIENCY IS
IMPORTANT TO FINANCIAL MANAGERS.
Learning Objectives
5. EXPLAIN HOW FINANCIAL INSTITUTIONS
SERVE THE NEEDS OF CONSUMERS, SMALL
BUSINESSES, AND CORPORATIONS.
6. COMPUTE THE NOMINAL AND THE REAL
RATES OF INTEREST, DIFFERENTIATING
BETWEEN THEM.
The Financial System
o FINANCIAL MARKETS AND INSTITUTIONS
• Financial markets include markets for trading
financial assets such as stocks and bonds
• Financial institutions include banks, credit
unions, insurance companies, and finance
companies
The Financial System
o THE FINANCIAL SYSTEM AT WORK
• The financial system is competitive
• Money is borrowed in small amounts and
loaned in large amounts
• The system directs money to the best
investment opportunities in the economy
• Lenders earn profit from the spread between
lending and borrowing rates
The Financial System
o MOVE FUNDS FROM LENDER TO BORROWER
• The primary function of a financial system is to
efficiently transfer funds from lender-savers to
borrower-spenders
• Basic mechanisms by which funds are
transferred in the financial system
Direct Financing
Indirect Financing
The Flow of Funds Through the
Financial System
Direct Financing
o DIRECT TRANSFER OF FUNDS
• lender-saver contracts with a borrower-spender
• minimum transaction $1 million
• investment banks and money center banks help
with origination, underwriting and distribution
of new debt and equity
Direct Financing
o DIRECT TRANSFER OF FUNDS
• Underwriting is a service to assist firms in
selling their debt or equity securities in a direct
financing market
Types of Financial Markets
o WHOLESALE AND RETAIL MARKETS
• Primary Market
wholesale market where firms’ new securities are
issued and sold for the first time
• Secondary Market
retail market where previously issued securities are
resold (traded)
Types of Financial Markets
o MARKETABILITY AND LIQUIDITY
• Marketability
ease with which a seller or buyer for an asset can be
found
• Liquidity
ease with which an asset can be converted into cash
without loss of value
Types of Financial Markets
o MARKETABILITY AND LIQUIDITY
• Financial markets increase marketability and
liquidity of securities
• Financial markets lower the costs of making
transactions and make participants more willing
and able to pay higher prices
Types of Financial Markets
o BROKERS AND DEALERS
• A broker brings a seller and a buyer together but
does not buy or sell in the transaction
broker does not take on risk
• A dealer participates in trades as a buyer or
seller using her own inventory of securities
dealer takes on risk
Types of Financial Markets
o EXCHANGES & OVER-THE-COUNTER MARKETS
• Exchange
location where sellers and buyers meet to conduct
transactions
– New York Stock Exchange (NYSE)
– Chicago Board Options Exchange (CBOE)
– Saudi Stock Exchange (TADAWUL)
Types of Financial Markets
o EXCHANGES & OVER-THE-COUNTER MARKETS
• Over-the-Counter Market
dealers conduct transactions over the phone or via
computer.
– National Association of Securities Dealers Automated
Quotations (NASDAQ)
Types of Financial Markets
o MONEY AND CAPITAL MARKETS
• Money Market
market for low-risk securities with maturities of less than one year.
-Treasury Bills (T-bills): are short-term debt instruments issued
by the U.S Treasury. T-bills are issued for a term of one year of
less. T-bills are considered the world’s safest debt as they are
backed by the full faith and credit of the United States
government.
-Commercial Paper: Commercial paper is an unsecured, shortterm debt instrument issued by a corporation, typically for the
financing of accounts receivable, inventories and meeting shortterm liabilities. Maturities on commercial paper rarely range any
longer than 270 days. Commercial paper is usually issued at a
discount from face value and reflects prevailing market interest
rates.
o
Types of Financial Markets
o MONEY AND CAPITAL MARKETS
• Capital Market
market for securities with maturities longer than one
year
– bonds
– common stock
Selected Money Market and Capital
Market Instruments June 2010
Market Efficiency
o EFFICIENT MARKET
• Current prices of securities incorporate the
knowledge and expectations of all participants
• Security prices are correct: securities are not
over-valued or under-valued.
• Participants are confident they pay or receive
the intrinsic (fair) value of a security
Market Efficiency
o MARKET EFFICIENCY
• Operational Efficiency
extent to which transaction costs are minimized
• Informational Efficiency
extent to which security prices reflect all relevant
information
Market Efficiency
o EFFICIENT MARKET HYPOTHESIS
• A theory about how efficiently the stock market
processes and incorporates information
available from
private sources of information
public sources of information
historical stock prices
Market Efficiency
o EFFICIENT MARKET HYPOTHESIS
• Strong-Form Efficiency
Security prices always reflect all information, from
every source. Even inside, or confidential information,
is reflected.
Market Efficiency
o EFFICIENT MARKET HYPOTHESIS
• Semi-strong-Form Efficiency
Security prices always reflect all public information.
Inside, or confidential information, is not reflected.
Market Efficiency
o EFFICIENT MARKET HYPOTHESIS
• Weak-Form Efficiency
Security prices always reflect the information in past
prices. No other information is reflected.
Market Efficiency
o EFFICIENT MARKET HYPOTHESIS
• Public markets, such as the NYSE are more
efficient than private markets due to the
information provided by a large number of
participants and effective regulation
Financial Institutions and Indirect
Financing
o INDIRECT FINANCING
• An institution is both a borrower and lender
borrows money from a saver
lends money to a borrower
must repay funds to the saver – whether or not it is
repaid by the borrower
– Examples: banks & insurance companies
Financial Institutions and Indirect
Financing
o FINANCIAL INSTITUTIONS
• Provide lending and borrowing opportunities at
the retail level for small customers and
wholesale level for large customers
• Efficiently collect funds in small amounts and
lend them in larger amounts
• Tailor loan amounts and contract terms to fit the
needs of consumers, corporations, and small
businesses
Cash Flows Between the Firm and the
Financial System
The Determinants of Interest Rate
Levels
o INTEREST RATE
• The fee for borrowing money expressed as a
percentage of a loan
real rate of interest
– interest rate that would exist in the absence of inflation
(deflation)
nominal rate of interest
– interest rate adjusted for inflation (deflation)
The Determinants of Interest Rate
Levels
o REAL RATE OF INTEREST
• Determinants of the real rate of interest
expected return on productive assets
time preference for consumption
The Determinants of Interest Rate
Levels
o EQUILIBRIUM RATE OF INTEREST
• Is a function of supply and demand
savers supply more funds at higher rates
spenders borrow (demand) less at higher rates
• Is the interest rate at which the quantity of
funds supplied equals the quantity of funds
demanded
The Determinants of the Equilibrium
Rate of Interest
The Determinants of Interest Rate
Levels
o INFLATION AND LOAN CONTRACTS
• Lenders want the interest rates in loan contracts
to include compensation for the inflation
predicted to occur over the life of the contract
• Compensation for expected inflation adjusts
loan rates to offset the higher prices for goods
and services expected to exist when a loan is
repaid and a lender spends the money
The Determinants of Interest Rate
Levels
o FISHER EQUATION & NOMINAL INTEREST RATE
• The Fisher Equation
o
i  r  P  rP
e
e
(2.1)
Where:
i = nominal interest rate
r = real rate of interest
∆Pe = expected annualized price-level change
r∆Pe = adjustment for expected price-level
change
The Determinants of Interest Rate
Levels
o FISHER EQUATION & NOMINAL INTEREST RATE
• Simplified Fisher Equation
i  r  P
e
(2.2)
The Determinants of Interest Rate
Levels
o FISHER EQUATION EXAMPLE
r  0.04
P  0.10
e
i?
i  r  P  rP
e
e
 0.04  0.10  (0.04 x 0.10)
 0.1440 or 14.40%
The Determinants of Interest Rate
Levels
o SIMPLIFIED FISHER EQUATION EXAMPLE
r  0.04
Pe  0.10
i  r  Pe
 0.04  0.10
 0.14 or 14%
i?
The Determinants of Interest Rate
Levels
o REAL RATE OF INTEREST EXAMPLE
i  0.14
P  0.10
e
i  r  P
e
0.14  r  0.10
0.14 – 0.10  r
0.04  r
r ?
The Determinants of Interest Rate
Levels
o CYCLICAL & LONG-TERM INTEREST RATES
• Interest rates tend to rise and fall with changes
in the rate of inflation
• Rates tend to rise when the growth rate of the
economy increases and tend to fall when the
growth rate of the economy slows
The Determinants of Interest Rate
Levels
o INTEREST RATE, BUSINESS CYCLE & INFLATION
• Interest rates tend to follow the business cycle
• Interest rates tend to increase during an
economic expansion
• Interest rates tend to decrease during an
economic contraction
Relation Between Annual Inflation
Rate and Long-Term Interest Rate
Chapter 3: Financial Statements, Cash
Flows, and Taxes
Learning Objectives
1. DISCUSS GENERALLY ACCEPTED
ACCOUNTING PRINCIPLES (GAAP) AND THEIR
IMPORTANCE TO THE ECONOMY.
2. EXPLAIN THE BALANCE SHEET IDENTITY AND
WHY A BALANCE SHEET MUST BALANCE.
3. DESCRIBE HOW MARKET-VALUE BALANCE
SHEETS DIFFER FROM BOOK-VALUE BALANCE
SHEETS.
Learning Objectives
4. IDENTIFY THE BASIC EQUATION FOR THE
INCOME STATEMENT AND THE INFORMATION IT
PROVIDES.
5. UNDERSTAND THE CALCULATION OF CASH
FLOWS FROM OPERATING, INVESTING, AND
FINANCING ACTIVITIES REQUIRED IN THE
STATEMENT OF CASH FLOWS.
6. EXPLAIN HOW THE FOUR MAJOR FINANCIAL
STATEMENTS DISCUSSED IN THIS CHAPTER ARE
RELATED.
Learning Objectives
7. IDENTIFY THE CASH FLOW TO A FIRM’S
INVESTORS USING ITS FINANCIAL
STATEMENTS.
8. DISCUSS THE DIFFERENCE BETWEEN
AVERAGE AND MARGINAL TAX RATES.
Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Provide stakeholders a foundation for evaluating
the financial health of a firm
creditors
employees
management
stockholders
Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Provide stakeholders a foundation for evaluating
the financial health of a firm.
customers
general Public
regulators
suppliers
Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Evaluate a firm’s internal environment
efficiency
effectiveness
risk level
Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Evaluate a firm’s interaction with the external
environment
corporate citizenship
social responsibility
assessment of the external environment
response to the external environment
Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Provide information about the performance of
the firm
stakeholders want to compare actual vs. potential
performance
Financial Statements and Accounting
Principles
o GAAP
• Generally Accepted Accounting Principles
(GAAP)
accounting rules and standards that public companies
must adhere to when they prepare financial statements
and reports
established by the Financial Accounting Standards
Board (FASB) and authorized by the Securities and
Exchange Commission (SEC)
Financial Statements and Accounting
Principles
o INTERNATIONAL GAAP
• Uniform accounting rules and procedures
promoted by the International Accounting
Standards Board
• Firms in the European Union are moving
toward a “European GAAP”
• Economic and political pressure is building in
the United States and Europe to develop a
unified accounting system
Financial Statements and Accounting
Principles
o GAAP
• Guidelines, not rules
Firms have discretion about how their financial
information is presented.
No two firms are required to have identical statements.
Financial Statements and Accounting
Principles
o GAAP
• Guidelines, not rules.
Alternative terms on financial statements
– balance sheet, statement of financial condition
– income statement, statement of operations, profit and loss
statement
– cost-of-goods-sold, cost-of -sales, cost-of-revenue, cost-ofservices-sold
Financial Statements and Accounting
Principles
o FIVE IMPORTANT ACCOUNTING PRINCIPLES
1. Assumption of Arm’s Length Transaction
Parties involved in an economic transaction arrive at a
decision independently and rationally.
2. Cost Principle
Asset values are recorded at the cost for which they
were acquired.
Financial Statements and Accounting
Principles
o FIVE IMPORTANT ACCOUNTING PRINCIPLES
3. Realization Principle
Revenue is recognized when a transaction is
completed, although cash may be received earlier or
later.
4. Matching Principle
Revenue is matched with the expense incurred to
generate it.
Financial Statements and Accounting
Principles
o FIVE IMPORTANT ACCOUNTING PRINCIPLES
5. Going Concern Assumption
Assume a company will continue to operate for the
predictable future.
Financial Statements and Accounting
Principles
o ANNUAL REPORT
• Summarizes the overall performance of a firm
for the most recent fiscal year
• Information
the company, its products, its activities, and its future
summary of financial performance for the most recent
year
audited financial statements, five-year summary of
financial data
The Balance Sheet
o FIRM ASSETS & FUNDING AT A POINT IN TIME
• Left side of a balance shows assets a firm owns
and uses to generate revenue
• Right side of the balance sheet shows sources
of the funds used to acquire assets
Total Assets 
Total Liabilities  Total Stockholde rs’Equity
(3.1)
Diaz Manufacturing Balance Sheets as
of December 31
The Balance Sheet
o ITEM ORDER
• Assets listed in order of liquidity
• Liabilities listed in order in which they are due
to be paid
• Stockholders’ equity listed last
Common stockholders are entitled to assets remaining
after all other providers of funds are paid.
The Balance Sheet
o CURRENT ASSETS
• Assets likely to be converted to cash within a
year (or one operating cycle)
marketable securities
accounts receivable
inventory
The Balance Sheet
o CURRENT LIABILITIES
• Liabilities scheduled to be paid within a year (or
one operating cycle)
accounts payable
accrued wages
debt with less than a year’s maturity
taxes
The Balance Sheet
o NET WORKING CAPITAL
Net Working Capital  Total Current Assets
– Total Current Liabilitie s
(3.2)
The Balance Sheet
o NET WORKING CAPITAL EXAMPLE
• Diaz Manufacturing
Total current assets = $1,039.8 million
Total current liabilities = $377.8 million
Net working capital = Total current assets
– Total current liabilities
= $1,039.8 million – $377.8 million
= $662.0 million
The Balance Sheet
o INVENTORY ACCOUNTING
• Inventory (least liquid current asset) reported
using one of two methods
FIFO (first-in-first-out) assumes merchandise is sold in
the order it was acquired by a firm.
LIFO (last-in-first-out) assumes merchandise is sold in
the reverse of the order it was acquired by a firm.
The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is increasing
FIFO reporting says a firm sold the less expensive
inventory and leads to
– higher balance in inventory
– lower cost-of-goods-sold
– higher taxable income
– higher income taxes
– higher net income
The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is increasing
LIFO reporting says a firm sold the more expensive
inventory and leads to
– lower balance in inventory
– higher cost-of-goods-sold
– lower taxable income
– lower income taxes
– lower net income
The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is decreasing
FIFO reporting says a firm sold the more expensive
inventory and leads to
– lower balance in inventory
– higher cost-of-goods-sold
– lower taxable income
– lower income taxes
– lower net income
The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is decreasing
LIFO reporting says a firm sold the less expensive
inventory and leads to
– higher balance in inventory
– lower cost-of-goods-sold
– higher taxable income
– higher income taxes
– higher net income
The Balance Sheet
o INVENTORY ACCOUNTING
• Firms may switch from one inventory
accounting method to the other under
extraordinary circumstances but not frequently
The Balance Sheet
o LONG-TERM ASSETS
• Real Assets
land
buildings
equipment
• Intangible Assets
goodwill
patents
copyrights
The Balance Sheet
o LONG-TERM ASSETS
• Real assets decline with use and are depreciated
Depreciation expense reduces taxable income and
income taxes.
Assets are depreciated using either the straight line or
accelerated depreciation method.
• Intangible assets lose value over time and are
amortized (equivalent to depreciated)
The Balance Sheet
o LONG-TERM LIABILITIES
• Long-term debt
bank loans
mortgages
bonds with a maturity longer than one year
The Balance Sheet
o EQUITY
• Common Stock
ownership with control in a firm
• Preferred Stock
ownership without control in a firm
features make it an equity security that resembles debt
The Balance Sheet
o OTHER BALANCE SHEET ACCOUNTS
• Retained earnings
Profit kept and used to acquire assets.
• Treasury stock
Shares of its own stock a firm holds rather than sell
them to the public.
Market Value vs. Book Value
o RECORDING ASSET VALUE
• Assets are traditionally reported at historical
cost on a balance sheet
• Balance sheet amount does not reflect current
market value – only the acquisition cost
Market Value vs. Book Value
o ASSET VALUATION
• Better information is provided to management
and investors by marking-to-market —
reporting balance sheet items at current market
values
difficult to determine market values of assets
• The difference between the market values of
assets and liabilities is a realistic estimate of the
market value of shareholders’ equity
The Income Statement
o INCOME STATEMENT: OVERVIEW
• Measures the profitability of a firm for a
reporting period
• Revenue is income from selling products and
services – for cash or credit
• Expenses include costs of providing products
and services, and asset utilization (depreciation
and amortization)
Net income  Revenues – Expenses
(3.3)
Diaz Manufacturing Income
Statements
The Income Statement
o NET INCOME EXAMPLE
• Diaz Manufacturing
Revenues = $1,563.7 million
Expenses = $1,445.2 million
Net Income = Revenues – Expenses
= $1,563.7 million – $1,445.2 million
= $ 118.5 million
The Income Statement
o DEPRECIATION
• The cost of a physical asset, such as plant or
machinery, is written off over its lifetime. This
is called depreciation, a non-cash expense
• Firms use one of these depreciation methods
straight-line depreciation
accelerated depreciation
– Firms may choose to use one for internal purposes and
another for tax purposes or for statements released to the
public.
The Income Statement
o AMORTIZATION
• Amortization expense is related to using
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