Introduction to Finance

Corporate
Corporate Finance. Ross, Westerfield and Jaffe. 9th ed.
What is Corporate Finance?

The purpose of the company is to create value for the owner.

Net
working
The lor is reflected in the conceptual framework
current assets of the simple model of the
capital
company's balance sheet .

long term debt

Fixed assets:

1. Tangible
fixed assets
Shareholders'
2. Intangible
equity
fixed assets

Total asset value Total value of the company

for shareholders
 What is Corporate Finance?
Based on the company's balance sheet model, it is easy to understand why finance can be
thought of as the study of the following three questions: 1. What long-lived assets should the
company invest in?

The types and proportions of assets needed by the company tend to be established according
to the nature of the business. The term capital budgeting is used to describe the process
related to making and managing expenditures to acquire long-lived assets.

How can the company obtain the cash needed for capital expenditures?

It is related to the capital structure , which represents the proportions of the company's
financing between current debt and long-term debt and shareholders' equity.
 What is Corporate Finance?

3. How should short-term operating cash flows be managed?

There is often some imbalance between cash inflows and outflows during
operating activities. In addition, the amount and timing of operating cash flows are
not known with certainty. Financial management should try to manage “gaps” in
cash flows.
From a balance sheet perspective, managing short-term cash flows relates to the
company's net working capital . Net working capital is defined as current assets
minus current liabilities.

From a financial perspective, short-term cash flow problems come from the
mismatch between cash inflows and outflows. This is the issue of short-term
finances.
 Importance of Cash Flows
The most important responsibility of a financial manager is to create value from

the company's capital budgeting, financing, and net working capital activities.
How do financial managers create value? The answer is that the company must: 1. Try to
buy assets that generate more cash than they cost.
. Sell bonds and stocks and other financial instruments that raise more money than they
cost.
Importance of Cash Flows
 Importance of Cash Flows

company must create more cash flow than it uses.

n consequently, t
h

y ctionists

m
bondholders ( F )s than cash
in financial value.
। for the securities
issued by the company
(A)
The company financial markets
invests in assets
Short-term debt
(b) Long-term debt
Current assets Capital actions
Payments
Fixed assets
“7” ’. dendos
yr
WI MBmmhh
udas
(F)

Total asset value Governm

Total value of the
given ent
company for financial
(D)
ados market investors

crea
 Importance of Cash Flows
Much about
of the work
Identification of financial analysis involves extracting information cash flows from financial
statements.
of cash flows

The Midland Company is engaged in the refining and trading of gold. At the
Utility end
of the year, he sold 2,500 ounces of gold for $1 million.
cash flows
The company had acquired the gold for $900,000 in cash at the beginning of
the year.

The company paid cash when it purchased the gold. Unfortunately, the
client to whom he sold the gold has not yet made the corresponding
payment.
 Importance of Cash Flows

Accounting The following table presents a standard accounting statement of Midland's

Profits vs. Cash financial position at the end of the year:
Flows

Sales $1 000 000

— Costs -900 000
Utility $ 100 000

Under generally accepted accounting principles, the sale is recorded even

though the customer has not yet made payment. The customer is supposed
to pay soon .
 Importance of Cash Flows
Utilities From an accounting perspective, Midland appears to be a profitable
I face company. However, the perspective of corporate finance is different.
to cash of Focuses on cash flows:
flows

The corporate finance perspective focuses interest on whether

Midland's gold sales operations create cash flows.

Value creation depends on cash flows. For Midland, value creation

depends on actually receiving $1 million and when that happens.
 Importance of Cash Flows
Periodicity of The value of an investment made by the company depends on the
luxurie periodicity of cash flows. One of the most important principles of finance is
s that it is preferable to receive cash flows sooner rather than later. A dollar
cash received today is worth more than a dollar received a year from now.
The Midland Company must choose between two new product proposals.
Both will produce additional cash flows for four years and will cost $10,000
upfront. The cash flows from the proposals are as follows:

Yo $ or $4 000
Introduction to Finance..............................................................................................................................................................................................1
Corporate...................................................................................................................................................................................................................1
Agency relationships............................................................................................................................................................................................20
Administration objectives....................................................................................................................................................................................21
Do directors act for the benefit of shareholders?.................................................................................................................................................23
Do directors act for the benefit of shareholders?.................................................................................................................................................24
Do directors act for the benefit of shareholders?.................................................................................................................................................24
Financial statements and Flow of cash...................................................................................................................................................................27
Debt and equity....................................................................................................................................................................................................33
 Importance of Cash Flows
Value and cost......................................................................................................................................................................................................35
Generally accepted accounting principles............................................................................................................................................................42
Items that do not represent cash movements........................................................................................................................................................43
Items that do not represent cash movements........................................................................................................................................................44
Time and costs......................................................................................................................................................................................................46

Total $20 000 $16 000

 Importance of Cash Flows
Peri ity of At first it seems that new product A would be the best. However,
o of the cash flows from proposal B are received before those from
cash A.

Without more information, we cannot decide which set of cash

flows would create the most value for bondholders and
shareholders.

This depends on the value of receiving cash from B in advance

being greater than the total additional cash coming from A.

Bond and stock prices reflect this preference for receiving cash
flows as soon as possible, and we will see how they can be used
to decide between A and B.
 Importance of Cash Flows
of th Generally, the amount and timing of cash flows are not known with
cash e certainty. Most investors are risk averse.

The Midland Company plans to expand its operations abroad. Evaluate

Europe and Japan as possible sites.

Europe is considered a relatively safe place, while operating in Japan is

presented as a very risky option. In both cases the company would close its
operations after a year.
After conducting a complete financial analysis, Midland has presented the
following cash flows for alternative expansion plans under three scenarios:
pessimistic, most likely and optimistic.

Europe $75,000 $100 000 $125 000

Japan 0 150 000 200 000
 Importance of Cash Flows
Flow risk of If the pessimistic scenario is ignored, perhaps Japan is the best
alternative. When the pessimistic scenario is taken into account, the
cash choice is unclear. Japan appears to be riskier, but also offers a higher
level of expected cash flows.

What is risk and how can it be defined? We must try to answer this
important question.

Corporate finance cannot avoid facing risky options, and much of this
book is devoted to developing methods for evaluating risky
opportunities.
 The Objective of Financial Administration
Possible targets Assuming that the analysis will be restricted to for-profit businesses, the goal
of financial management is to make money or add value for the owners. This
goal is a bit vague. Objectives tend to fall into two classes.
The first of them is related to profitability. The objectives that refer to sales,
market share and cost control are interrelated, at least potentially, with
different ways of obtaining or increasing profits.

The objectives of the second group, such as preventing bankruptcy and

achieving stability and security, are in some way related to risk control.
These two types of objectives are somewhat contradictory. In everyday life,
the pursuit of profits involves some element of risk, and therefore it is not
really possible to maximize both security and profits. Therefore, what we
need is a goal that encompasses both factors.
 The Objective of Financial Administration
H tive of The financial manager acts in the best interest of shareholders when
financial
e the he makes decisions that increase the value of the shares.
administration Consequently:
The goal of financial management is to maximize value
current for each share of existing capital

If the shareholders win in the sense that the residual and surplus
portion grows, it must be true that everyone else also wins.
It is necessary to learn to identify investments and financing
agreements that have a favorable effect on the value of shares.
In fact, corporate finance could have been defined as the study of the
relationship between business decisions, cash flows, and the value of
a company's stock.
 The Objective of Financial Administration
h As long as they are considered for-profit type businesses, only a slight
e modification is required. The total value of the shares is equal to the value of
the owners' equity. Therefore, a more general way of expressing the goal is as
follows:

Maximize the market value of owners' equity

current

With that definition in mind, it no longer matters whether a business is an

individual, a partnership, or a corporation.

In each of them, good financial decisions increase the market value of the
owners' equity and bad financial decisions decrease it.
The financial manager best serves business owners when he identifies goods
and services that add value to the company because they are desired and
valued in the free market environment.
 The agency problem and control of the corporation

It has been seen that the financial manager acts in the best interest of the shareholders when
he carries out activities that increase the value of the shares.
However, in large corporations, ownership is sometimes distributed among a huge number of
shareholders. In this case, will management necessarily act in the best interest of
shareholders?

Agency relationships

The relationship between shareholders and directors is called the agency relationship . This
exists whenever someone (the principal) hires another individual (the agent) to represent his
or her interests.
In all of these relationships there is always a possibility of a conflict of interest between the
principal and the agent. Such a conflict is known as an agency problem .
The way an agent is compensated is a factor that affects agency problems.
 The agency problem and control of the corporation

Administration objectives

More generally, the term agency costs refers to the costs of conflict of interest between
shareholders and managers. These costs can be indirect or direct.

An indirect agency cost is a missed opportunity.

Direct agency costs come in two forms.

The first type is a corporate expense that benefits management, but comes at a cost to
shareholders.
The second type of direct agency cost is an expense that arises from the need to
supervise the actions of managers.
 The agency problem and control of the corporation

It is sometimes argued that, if it were in their power, managers would tend to maximize the
amount of resources over which they have control or, more generally,
administratio
corporate power or wealth.
n
This objective could lead to placing excessive importance on the size or
growth of the corporation.

Managers tend to overvalue organizational survival to protect their job

security.

Furthermore, management may reject outside interference, and

therefore corporate independence and self-sufficiency may be important
goals.
 The agency problem and control of the corporation

Do directors act for the benefit of shareholders?

Whether directors actually act in the best interests of shareholders depends on two
factors.

First: do the management's goals strictly agree with th

shareholder objectives? This question is related, in part, to the way in least e
which administrators are remunerated. in

Second: can managers be replaced if not shareholders' objectives? they th

This question is related to the company. chase e
control of the
 The agency problem and control of the corporation

Do directors act for the benefit of shareholders?

Director Compensation Management ordinarily has a considerable economic incentive to

increase share value for two reasons.
• First, executive compensation, especially those at the highest levels, is almost always
related to financial performance in general and often to stock value in particular. For
example, managers are often offered the option to purchase shares at bargain prices. The
more the shares are worth, the more valuable this option will be. From the point of view of
shareholders, it is generally more important to relate compensation to company
performance.
• Second, it relates to job prospects. Those who stand out the most in the company usually
receive promotions. More generally, managers who manage to meet shareholder goals
are in greater demand in the labor market and, therefore, can demand higher salaries.
Do directors act for the benefit of shareholders?
Control of the company Ultimately, said control corresponds to the shareholders. They elect
the board of directors, which hires and fires administrators.
 The agency problem and control of the corporation
/An important mechanism that allows dissatisfied shareholders to replace current managers is
called a proxy battle . A power of attorney is the power that a person has to vote on the shares
of someone else.
A proxy battle develops when a group requests proxy powers to replace the existing council
and thus change the current administration.
Another way management can be replaced is through a \ takeover. Companies that have poor
management are more attractive as acquisition targets.
Avoiding a takeover by another company provides management with another incentive to act
in the interests of shareholders. Disgruntled prominent shareholders can propose different
business strategies to the company's top management.
 The agency problem and control of the corporation

This analysis could lead one to think that directors and shareholders are the
Interested
only parties who have participation in the company's decisions.
third
parties Employees, customers, suppliers and even the government have a financial
interest in the company.

Taken together, these various groups are called third parties interested in
the company.

Generally, an interested party is someone other than a shareholder or creditor

who has potential rights to the company's cash flows.
Such groups also try to exert control over it, perhaps to the detriment of the
owners.
Financial statements and Flow
of cash
Corporate Finance. Ross, Westerfield and Jaffe. 9th ed.
 The balance sheet

The balance sheet is a snapshot (taken by an accountant) of a company's book value on a

specific date.
The balance sheet has two sides: on the left side are assets , while on the right are liabilities
and stockholders' equity .

The balance sheet shows what the company has and how it is financed. The accounting
definition on which the balance sheet is based and which describes its balance is:
Assets = PaSiVOS +Ca
singable pital
A three-line equality sign is presented in the balance sheet equation to indicate that, by
definition, it is always valid.

In reality, stockholders' equity is defined as the difference between the company's assets and
liabilities. In principle, stockholders' equity is what remains for shareholders after the company
meets its obligations.
 The balance sheet
U.S. COMPOSITE CORPORATION
Balance sheet 2010 and 2009 (in millions)

Current assets: Current liabilities:

Cash and equivalents $ 140 $ 107 Accounts payable $ 213 $197
Accounts receivable 294 270 Documents to pay 50 S3 205
Inventories 269 280 50 Accumulated expenses 223
Others 58 Total current liabilities $ 486 $ 455
Total current assets $ 761 $ 707 Long term passives:
Fixed assets: Deferred taxes $ 104
Properties, plant and equipment Long-term debt*
$1 423 $1 274 458
Less accumulated depreciation Total long-term liabilities
550 460 $ 588 $ 562
Shareholders' equity:
Net property, plant and equipment 814
Preferred stock
Intangible assets and others $39 $ 39
Common stock ($I par value)
Total fixed assets 55 32
Capital surplus
$1 118 $1 035 347 327
Accumulated retained earnings
390 347
Fewer shares in treasury 1
26 20
Total stockholders' equity
Total liabilities and stockholders' equity^ $ 805 $ 725

Total asset $1879 $1 742 $ 1879 $1 742

 The balance sheet
( The assets on the balance sheet are presented in an order that is based on the "
time that would ordinarily be required for a going concern to
convert into cash. It depends on the nature of the business and the way it is done. that you
choose to manage it.

Management must make decisions about whether to hold cash or purchase marketable
securities, make sales on credit or cash, produce or purchase raw materials, lease or
purchase equipment, the types of businesses in which to engage, and so on. successive.

Liabilities and stockholders' equity are presented in the order in which they would typically be
paid over time. It reflects the types and proportions of financing, which depend on
management's choice of capital structure, that is, the composition between debt and equity,
and between short-term debt and long-term debt.
^11

When analyzing a balance sheet, the financial manager must take into account three aspects:
liquidity, debt and equity, and value and costs.
 The balance sheet
Liquidity refers to the ease and speed with which assets can be
converted into cash (without significant loss in value).

Current assets , which comprise the most liquid assets, include cash
and assets that will be converted to cash within one year from the
balance sheet date.
Accounts receivable are amounts not yet collected from customers for
goods or services sold to them (after an adjustment for potentially
uncollectible accounts).

Inventory consists of raw materials to be used in production, work in

process, and finished goods.
 The balance sheet
Liquide z
Fixed assets are the least liquid type of assets.
Tangible fixed assets include real estate, plant and equipment. These assets are
not converted into cash as a result of the business's normal activities and are
generally not used to pay expenses such as payroll.

Intangible assets have no physical existence, but they can be very valuable.
Some examples of intangible assets are the value of a trademark or a patent.
The more liquid a company's assets are, the less likely it is to experience
problems meeting its short-term obligations.
Unfortunately, liquid assets often have lower rates of return than fixed assets; For
example, cash does not generate investment income. As a company invests in
liquid assets, it sacrifices the opportunity to invest in more profitable investment
instruments.
 The balance sheet
Debt and equity
Liabilities are company obligations that require a cash disbursement within a stipulated period.
Many liabilities are contractual obligations to pay a stipulated amount and interest over a period.
Thus, liabilities are debts and are often associated with nominally fixed cash charges, called
ydebt service , which place the company in compliance with the contract if they are not paid.
eStockholders' equity is a residual and not fixed claim against the company's assets.
In general terms, when the company borrows funds, it grants the Bondholders have first
Aclaim on the company's cash flow. The
N nedor bonds can sue the company if it incurs
compliance with their bond contracts. This can lead to the company going bankrupt.
Stockholders' equity is the residual difference between assets and A ct i 20S — Pa S i 20S =
C api t al qty abI£ s the share of shareholders in the ownership of the company expressed
in accounting terms. The book value of shareholders' equity increases with retained
earnings added. This occurs when the company retains e from its profits instead of
paying them as dividends.
It is
in
one
 The balance sheet
In accordance with generally accepted accounting principles (GAAP) , audited
financial statements of companies in the United States record assets at cost.

ost
Consequently, the terms carrying value and book value are unfortunate.
o
They specifically describe a “value,” when in reality the accounting
figures are based on cost.
Market value is the price at which buyers and sellers are willing to trade
assets.

It would be a simple coincidence if the book value and market value

were the same. In reality, management's job is to create value for the
company that is greater than cost.
 The balance sheet
Value and cost
Many people use the balance sheet, but the information that each person needs to extract is not
the same.

A banker can examine the balance sheet to obtain information about accounting liquidity and
working capital. A supplier might also look at the volume of accounts payable and therefore the
overall promptness with which payments are made.
Many users of financial statements, including managers and investors, want to know the value
of the company but not its cost. This information is not found on the balance sheet.

In reality, many of the company's true resources do not appear on the balance sheet: good
management, intellectual property, existence of favorable economic conditions, and so on.

Whenever we talk about the value of an asset or the value of the company, we will generally talk
about its market value. Thus, for example, when it is stated that the objective of the financial
manager is to increase the value of shares, reference is made to their market value and not to
the book value.
 The balance sheet
Example – Market value and book value
The Cooney Corporation has fixed assets with a book value of $700 and an estimated market
value of almost $1,000.

Net working capital is $400 on the books, but about $600 would be obtained if all current
accounts were liquidated. Cooney has $500 in long-term debt, both at book value and market
value.

What is the book value of stockholders' equity? What is the market value?
Two simplified balance sheets can be prepared, one in accounting terms (book value) and one
in economic terms (market value).
 The balance sheet
Example – Market value and book value

COONEY CORPORATION
Balance sheets
Market value and book value

Books Market Books Market

Net working capital $400 $ 600 long term debt $ 500 $ 500
Net ftps assets 700 1 000 Shareholders' equity 600 1100
$1 100 $1 600 $1 100 $1 600

In this example, stockholders' equity is actually worth almost twice as much as

ist in the books.
The distinction between book values and market values is important precisely because
pre book values can be very different from market values.
of
Statement of income
 Statement of income
example, one year.
of
definition
countable

of
tilities is:
He re a lo

instan
t
 Statement of income
Typically, the income statement includes several sections.

The operations section records the company's income and expenses from its main operations.
A particularly important figure is earnings before interest and taxes (EBIT, or EBIT earnings
before interest and taxes ), which summarizes earnings before taxes and financing costs.
Among other things, the non-operating section of the income statement includes all financing
costs, such as interest expense.

Typically, a second section reports as a separate item the amount of taxes levied on the profits.

The last line of the income statement is the net profit or profit. Net income is often expressed
per share of common stock, that is, earnings per share.
When the financial manager analyzes an income statement, he or she must keep in mind
generally accepted accounting principles, noncash items, time, and costs.
 Statement of income

Generally accepted accounting principles

Income is recognized in the income statement when the profit process is practically completed
and an exchange of goods or services has occurred.

Therefore, the unrealized revaluation arising from the ownership of real estate is not recognized
as profit.
• For example, if the company owns a forest whose value has been
duplicate, inside one year, when your profits coming from others
business decreases, you will be able to increase overall profits by selling some trees.

The principle of equalization requires correspondence between income and expenses.

• Therefore, income is reported when it is earned, or when it is accumulated, even when no
cash flow has necessarily occurred (for example, when goods are sold on credit, sales and
profits are reported).
 Statement of income

Items that do not represent cash movements

• The economic value of assets is closely related to their future incremental cash flows.
However, the cash flow does not appear on the income statement.

• There are several items that do not represent cash movements , which are expenses
versus income, but do not affect cash flow.

• The most important of these is depreciation , which reflects the accounting estimate of the
cost of the equipment used in the production process.

• From a financial perspective, the cost of the asset is the actual negative cash flow incurred
when the asset was acquired and not the depreciation expense.
 Statement of income

Items that do not represent cash movements

Another expense that does not represent a cash movement is deferred taxes . Deferred taxes
result from the differences between the accounting profit and the actually taxable profit.

Actually, the current tax portion is sent to the tax authorities.

For its part, the deferred portion of the tax is not subject to this treatment. Taxes that are not
paid today will have to be paid in the future and represent a liability for the company.
This is presented on the balance sheet as a deferred tax liability. However, from a cash flow
perspective, deferred tax is not a cash outflow.
 Statement of income
• It is often very useful to visualize the entire future time as having two distinct parts: the short
term and the long term .

• The short term is the period in which certain equipment, resources and commitments of the
company are fixed; but the time is long enough for the company to vary its production by using
more labor and raw materials.

• The short term is not a precise period that has to be the same for all industries. However, all
companies that make decisions in the short term have some fixed costs, that is, costs that will
not change due to fixed commitments. Some examples of fixed costs are interest on bonds,
indirect expenses, and property taxes.

• Costs that are not fixed are variable. Variable costs change as the company's production
changes; Some examples are raw materials and wages of production line workers. In the long
term all costs are variable.
 Statement of income

Time and costs

Financial accountants do not distinguish between variable costs and fixed costs. Instead,
accounting costs generally fit within a classification that distinguishes between product costs
and period costs.

Product costs are the total production costs incurred during a period (raw materials, direct
labor, and manufacturing overhead) and reported on the income statement as cost of goods
sold. Both variable and fixed costs are included in product costs.

Period costs are those that are assigned to a certain period; They are called selling
expenses , general expenses and administrative expenses . One of the costs of the period
would be the salary of the president of the company.
Net working capital
Netis equal to current
working capitalassets minus current liabilities.

Net working capital is positive when current assets are

greater than current liabilities. This means that the cash
available over the next 12 months will be more than the
cash that needs to be paid out.
In addition to investing in fixed assets (i.e., capital
expenditures), a company can invest in net working capital, an
operation known as a change in net working capital .

The change in net working capital in 2010 is the difference

between net working capital in 2010 and 2009. The change in net
working capital is generally positive in a growing company.
 Financial cash flow
Perhaps the most important item that can be extractedU.S. COMPOSITE
from the financial statements is the
State
actual cash of a company. An official accounting statement called a statement
CORPORATION Income
of cash flows helps explain the change in accounting cash and its equivalents
Statement
However, cash flows must be examined from a different 2010perspective: the perspective of finance.
In finance, the value of the company is its ability to (ingenerate
millions) financial cash flow.
Total operating income 2,262
tefelflow -tive
Costisofnot
-itSelling,
thesold
goods
is necessary
same as net working capital. For example,
to use
general and cash.
administrative expenses
1,655for inventory
327
- Depreciation
Both inventory and cash are current assets, not net work capital. 90 In this case,
the increase in inventory decreased cash flow. 190
= Operating
Cash flows receivedprofit
from+ the
Other income
firm's assets (i.e., its operations), 29
FE ( A ), must
equal the=cash
UAII flows to the firm, FE ( B ), and to equity investors,219FE ( S ).
FE (^) ≡ FE (B)+FE (S)
- Interest expenses 49
170
= UAI 84
- Current Deferred Taxes 71
13
= net profit 86
43
Addition to retained earnings Dividends
43
Financial cash flow
 The US balance sheet COMPOSITE CORPORATION
Balance sheet
2010 and 2009
(in millions)
Asset 2010 2009 Variation Liabilities and equity 2010 2009 Variation
Current assets: Current liabilities:
Cash and equivalents 140 107 33 Accounts payable 213 197 16
Accounts receivable 294 270 24 Documents to pay 50 53 -3
Inventories 269 280 -11 Accumulated expenses 223 205 18
Others 58 50 8Total current liabilities 486 455 31
Total current assets 761 707 54 Long term passives:
Fixed assets: Deferred taxes 117 104 13
Properties, plant and equipment 1,423 1,274 149 long term debt 471 458 13
- Accumulated depreciation 550 460 90 Total long-term liabilities 588 562 26
Net property, plant and 873 814 59 Shareholders' equity:
equipment
Intangible assets and others 245 221 24 Preferred stock 39 39 0
Total fixed assets 1,118 1,035 83 Common actions 55 32 23
Capital surplus 347 327 20
Accumulated retained earnings 390 347 43
- Treasury shares 26 20 6
Total stockholders' equity 805 725 80
Total asset 1,879 1,742 137 Total liabilities and shareholders' 1,879 1,742 137
equity
 Financial cash flow
U.S. COMPOSITE CORPORATION
Financial cash flow
2010
(in millions)

Company cash flow

Operating cash flows
(Earnings before interest and taxes plus depreciation minus taxes)
capital expenditure $238
(Acquisitions of fixed assets less sales of fixed assets)
Additions to net working capital -173
Total
Cash flow to the company's investors -23
Debt 142
(Interest plus debt cancellation less long-term debt financing ) Capital
(Dividends plus share buybacks less financing with new shares)
$ 36
Total
6

$ 42
 Financial cash flow
The first step in determining the company's cash flows is to calculate the cash flow from
operations .

Cash flow from operations is the cash flow generated by business activities, including
sales of goods and services.

Operating cash flow reflects tax payments, but not financing, capital expenditures, or
changes in net working capital.

Earnings before interest and taxes

$219
Depreciation
90
Current taxes
-71
Operating cash flow
$238
 Financial cash flow
This
anoth component of cash flow is related to changes in fixed assets .
er i The net change in fixed assets is equal to the acquisition of fixed assets minus
the sales of fixed assets.
The result is the cash flow used for capital expenditures:
Capital expenses can also be calculated as:
capital expenditure
Acquisition of fixed assets $198
Sales of fixed assets -25
capital expenditure $173 ($149 + 24 = Increase in real estate, plant and
equipment + Increase in intangible assets)
= Ending net fixed assets — Beginning net fixed assets + Depreciation
= $1,118 — 1,035 + 90 = $173
 Financial cash flow
Cash flows are also used to make investments in net working capital.
Additions to net working capital
= Final net working capital — Initial net working capital
= $275 — 252 = $23
The total cash flows generated by the company's assets are equal to:

Operating cash flow $238

capital expenditure -173
Additions to net working capital - 23
Total cash flow of the company $42
 Financial cash flow
The company's total cash outflow can be separated into:

Cash flow paid to creditors Cash flow paid to shareholders.

The cash flow paid to creditors
•

Creditors are paid an amount called debt service, which is made up of interest
•

payments plus principal repayments. important source of cash flows is the arrangement
of debt
•To
who
Consequently, an increase in long-term debt is the net effect of new borrowing and
m
repayment of overdue obligations plus interest expenses.
 Financial cash flow
The cash flow paid
to creditors can also
be calculated as:
Interests
Debt cancellation
debt service
Funds from long-term debt sales

Cash flow paid to creditors

= Interest paid — Net new loans
Interest paid — (Final long-term debt — Initial long-term debtj

= $49 — (471 — 458) = $36

 Financial cash flow
The company's cash flow is also paid out to shareholders.
It is the net effect of paying dividends plus repurchasing outstanding shares and issuing
new equity shares.

Dividends $43
Share buybacks
Cash for shareholders 49
Funds from issuance of new shares -43
Total
Cash flow paid to shareholders can be determined as:
Cash flow to shareholders
— Net funds from the issuance of new shares — (Shares
= Dividends paid sold — Shares repurchased)
= Dividends paid
 Financial cash flow
The common equity and surplus capital accounts together amounted to $23 +
20 = $43, which implies that the company sold shares worth 43 million.

Treasury shares increased by $6, indicating that the company repurchased 6

million worth of shares.

Therefore, the new net capital is $43 - 6 = $37. Dividends paid amounted
to $43, so the cash flow to shareholders was:
Cash flow for shareholders = $43 - (43 - 6) = $6

1. There are several types of cash flow that are relevant to understanding
the financial situation of the company.
• Operating cash flow , defined as earnings before interest plus
depreciation minus taxes, measures the cash generated by operations
excluding capital expenditures and working capital needs.
 Financial cash flow
• It is usually positive; A company is in trouble if operating cash flow is negative for a
long time, because there is not enough cash to pay operating costs.
The company's total cash includes adjustments for capital expenditures
to net working capital.
nce is negative. When a company grows at a rapid pace, inventories and
fixed assets can be higher than cash flow.
2. Net income is not a cash flow. Generally, the two figures are not the same. When
determining the economic and financial situation of a company, cash flow is most
revealing.