• Differentiate between accounting value (or “book” value)

and market value.

• Distinguish accounting income from cash flow.
• Explain the difference between average and marginal tax
rates.
• Determine a firm’s cash flow from its financial statements.

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2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Cash Flow

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• The balance sheet is a snapshot of the firm’s assets (firm
owns) and liabilities (firm owes) at a given point in time.

• Assets
– Left-hand side (or upper portion)
– In order of decreasing liquidity
• Liabilities and Owners’ Equity
– Right-hand side (or lower portion)
– In ascending order of when due to be paid

• Balance Sheet Identity

– Assets = Liabilities + Stockholders’ Equity

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• Assets are listed in order of liquidity
– Current asset: less than one year
– Fixed asset: long life
• Tangible or intangible
• Liabilities
– Current: less than one year (accounts payable)
– Long-term

• Liquidity
– Speed and ease of conversion to cash without significant loss of
value
– Valuable in avoiding financial distress

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• Share holders’ equity
– Common equity or owner’s equity
– Shareholders’ equity = Assets - Liabilities
• Net Working Capital
– Current asset – current liability
– Usually positive for a healthy firm

Balance Sheet

Debt
(=Liability)
Asset
Equity

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Working
Capital
Management

Financial
Structure

Capital
Budgeting

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• Book value = the balance sheet value of the assets,
liabilities, and equity
• Market value = true value; the price at which the assets,
liabilities, or equity can actually be bought or sold

• Market value and book value are often very different. Why?
– Balance sheet show the historical cost
• Which is more important to the decision-making process?

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 MarketValue 1,600
= = 1.45 > 1.00
BookValue 1,100
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• The income statement measures performance over a
specified period of time (period, quarter, year).
• The income statement is more like a video recording of the
firm’s operations for a specified period of time.

• Report revenues first and then deduct any expenses for the
period.
• End result = Net Income = “Bottom Line”
– Dividends paid to shareholders
– Addition to retained earnings
• Income Statement Equation:
– Net Income = Revenue - Expenses

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• GAAP: Generally Accepted Accounting Principles
– Common set of standards and procedures by which audited
financial statements are prepared
• Recognize revenue when the earnings process is virtually
complete and the value of an exchange of goods or services
is known
– Not at the time of collection but At the time of sale
• Match revenues with the costs associated with producing
them.
– Not the representative of the actual cash inflows and outflows
– Matching principle – GAAP say to show revenue when it accrues
and match the expenses required to generate the revenue
– Depreciation

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Professor Sol Kim 14
"선진국 제약사 회계처리 기준 국내사에 동일한 적용은 무리“

[더벨]산은, 상반기 비이자이익 급감...IFRS9 영향

IFRS9 도입 첫해 , 은행권 대손충당금 1조4000억원 늘어

[더벨]티맥스소프트, IFRS 도입 한창…해외 결산 기대

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• Noncash Items
– Expenses charged against revenue that do not affect cash flow
– Depreciation
– Purchase a fixed asset for $5,000
– Instead of deducting the $5,000 as an expense, depreciate the asset
over a specific period (ex. 5 years)
– If straight-line, $1,000 (=$5,000/5) each year
– Another application of the matching principle

• Earnings management
– Discretion over their reported earnings
– Smoothing earnings or Steadily growing earnings
– GAAP leaves “wiggle room”

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 http://dart.fss.or.kr/

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• One of largest cash outflows
• Determined through the tax code
• The one thing we can rely on with taxes is that they are
always changing
• Marginal vs. average tax rates
– Marginal – % tax paid on the next dollar earned
– Average – total taxes paid / taxable income
– If considering a project that will increase taxable income by $1
million, which tax rate should you use in your analysis?

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 Tax Code
Taxable Income Tax Rate Taxable Income = $200,000
0 - 50,000 15%
.15($50,000) = $7,500
50,001 - 75,000 25% .25($75,000-50,000) = $6,250

75,001 - 100,000 34% .34($100,000-75,000) = $8,500

.39($200,000-100,000) = $39,000
100,001 - 335,000 39%
= $61,250
Total Tax = $61,250
Average Tax Rate Marginal Tax Rate =39%
=$61,250/200,000=30.625%

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Tax Liability on $4,000,000
Corporate Tax Rates Taxable Tax
Taxable Income Levels Tax Rate Income Liability
$ - $ 50,000 15% $ 50,000 $ 7,500
$ 50,001 $ 75,000 25% $ 25,000 $ 6,250
$ 75,001 $ 100,000 34% $ 25,000 $ 8,500
$ 100,001 $ 335,000 39% $ 235,000 $ 91,650
$ 335,001 $ 10,000,000 34% $ 3,665,000 $ 1,246,100
$ 10,000,001 $ 15,000,000 35%
$ 15,000,001 $ 18,333,333 38%
$ 18,333,334 - 35%
$ 4,000,000 $ 1,360,000
Average Rate = 34%
Marginal Rate = 34%

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• Annual Salary: 100,000,000 won
1,200-0 =1,200*0.06*1.1 79
1,200-4,600 =(4,600-1,200)*0.15*1.1 561
4,600-8,800 =(8,800-4,600)*0.24*1.1 1,109
8,800-10,000 =(10,000-8,800)*0.35*1.1 462
Total Tax 2,211
649
After-tax salary 7,789
per month
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• Flat rate tax
– Marginal tax rate = Average tax rate

• Marginal tax rate is relevant for financial decision making.

– New cash flows, changes in existing ones

• Modified flat-rate tax

– TI = $1,000,000, MTR = 34%, ATR = 34%
– TI > $50,000,000, MTR = 35%, ATR = 35%

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• Cash flow
– One of the most important pieces of information that a financial
manager can derive from financial statements
– The difference between the number of dollars that came in and the
number that went out.
– The statement of cash flows does not provide us with the same
information that we are looking at here

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• Discuss how to calculate cash flow and point out how the
result differs from that of standard financial statement
calculations.
• We will look at how cash is generated from utilizing assets
and how it is paid to those that finance the purchase of the
assets
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors +
Cash Flow to Stockholders

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• Cash Flow From Assets
=Operating Cash Flow – Net Capital Spending – Changes in Net
Working Capital
– Operation ⇒ Cash ⇒ Fixed Asset & Current Asset
• Operating Cash flow
– the cash flow from the firms’ day-to-day activities
• Net Capital spending
– net spending on fixed assets (purchases of fixed assets less sales of
fixed assets)
• Changes in Net Working Capital
– net increase in current asset over current liabilities

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• Operating Cash Flow
– Revenues - Costs
– Doesn’t include
• Depreciation: not cash outflow
• Interest: financing expense
– Include
• Taxes: paid in cash
1) EBIT + Depreciation –Taxes
= revenues – cost – depreciation + depreciation – taxes
= revenue – cost - taxes
2) NI + Depreciation + Interest
= revenues – cost – depreciation – interest – taxes + depreciation + interest
= revenue – cost – taxes

– Whether or not a firm’s cash flow from its business operations are
sufficient to cover its everyday cash outflows.

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• Net Capital Spending
= Money spent on fixed asset - Money received from the sale of fixed
assets
= Ending net fixed assets – (Beginning net fixed assets – Depreciation)
– Example
• Ending net fixed assets: 1,709
• Beginning net fixed assets: 1,644
• Depreciation: 65
• Net investment in fixed asset: ?
– Can be negative

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• Change in Net Working Capital
– changes of current assets and liabilities
– The difference between the beginning and ending net working
capital

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• 예) 이번 달 둘리네 가게의 현금흐름은?
– 월 평균 도매상에서 과일 500만원 구입 후 1000만원에 판매
– 각종 비용 100만원, 세금 50만원
– 영업현금흐름 350만원
– 반찬코너 신설로 냉장고 100만원 구입, 밑반찬 30만원 구입
– 현금흐름 = 세후영업이익 – 새 냉장고 구입 – 밑반찬 구입
– 220만원 = 350만원 – 100만원 – 30만원
– =Operating cash flow – Net Capital Spending – Changes in Net
Working Capital

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• Cash flow to creditors
– interest paid – new borrowing
• Cash flow to stockholders
– dividends – net equity issued
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors
+ Cash Flow to Stockholders

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• Operating Cash Flow (I/S)
= EBIT + depreciation – taxes = $670 + $89 – $126 = $633
= NI + depreciation + interest = $474 + $89 +$70 = $633
• Net Capital Spending (B/S and I/S)
= ending net fixed assets – (beginning net fixed assets –
depreciation)
= $1709 - $1644 + $89 = $154
• Changes in NWC (B/S)
= ending NWC – beginning NWC
= ($1403 - $389) - ($1112 - $428) = $330
• CFFA = $633 – $154 – $330 = $149

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• CF to Creditors (B/S and I/S)
= interest paid – net new borrowing
= $70 – ($454 - $408) = $24
• CF to Stockholders (B/S and I/S)
= dividends paid – net new equity raised
= $165 – ($640 - $600) = $125
• CFFA = $24 + $125 = $149

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• Current Accounts
– 2019: CA = 1500; CL = 1300
– 2020: CA = 2000; CL = 1700
• Fixed Assets and Depreciation
– 2019: NFA = 3000; 2020: NFA = 4000
– Depreciation expense = 300
• LT Liabilities and Equity
– 2019: LTD = 2200; Common Equity = 500; RE = 500
– 2020: LTD = 2800; Common Equity = 750; RE = 750
• Income Statement Information
– EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends =
1250

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• OCF = 2700 + 300 – 1000 = 2000
• NCS = 4000 – (3000 – 300) = 1300
• Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100
• CFFA = 2000 – 1300 – 100 = 600
• CF to Creditors = 200 – (2800 – 2200) = -400
• CF to Stockholders = 1250 – (750 – 500) = 1000
• CFFA = -400 + 1000 = 600
• The CF identity holds.

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• What is the difference between book value and market
value? Which should we use for decision making purposes?
• What is the difference between accounting income and cash
flow? Which do we need to use when making decisions?
• What is the difference between average and marginal tax
rates? Which should we use when making financial
decisions?
• How do we determine a firm’s cash flows? What are the
equations and where do we find the information?

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