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Peter Breugel, The Elder, ”The Blind Leading the Blind” (1568)

Peter Breugel, The Elder, ”The Blind Leading the Blind” (1568). Questions about Widget, Inc – Should we buy? Is business solid? Any problems? How much should we pay? What’s company’s value? Given problems, any protections we should get?. Module IV – Corporate Finance.

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Peter Breugel, The Elder, ”The Blind Leading the Blind” (1568)

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  1. Peter Breugel, The Elder, ”The Blind Leading the Blind” (1568) Chapter 9 Numeracy for Corporate Lawyers

  2. Questions about Widget, Inc – • Should we buy? Is business solid? Any problems? • How much should we pay? What’s company’s value? • Given problems, any protections we should get? Chapter 9 Numeracy for Corporate Lawyers

  3. Module IV – Corporate Finance Chapter 9Numeracy for Corporate Lawyers Bar exam Workshop 1 Corporate practice The great bonus ! Law profession Financial accounting Fundamental formula Accounting statements: Balance sheet, income statement, cash flow statement Accounting statement analysis Business valuation Future vs. present value Accounting value vs. market value Income vs. cash flow Discounted cash flow Workshop 2 Citizen of world Chapter 9 Numeracy for Corporate Lawyers

  4. Accounting basics Chapter 9 Numeracy for Corporate Lawyers

  5. Fundamental equation: • Assets = Liabilities + Equity • Accounting entries • ID accounting event • Value event • Record event • Disclose event • Financial statements • Balance sheet • Income statement • Cash flow statement “Cookie jar” business You go into business, buying and selling items from your cookie jar. To keep track of your money-making efforts you keep accounts. Chapter 9 Numeracy for Corporate Lawyers

  6. Accounting entries Assets = Liabilities + Equity Put $12 in cookie jar $12 $0 $12 Borrow $10 from Mom (put in IOU)  $22 $10 $12 Buy two felt-tip pens for $2 each $22 $10 $12 Buy $5 scissors on credit $27 $15 $12 Sell one of the felt-tip pens for $3 $28 $15 $13 Repay the $5 scissors debt $23 $10 $13 Pay $2 rent for using the jar $21 $10 $11 Take our $5 to go to movies $16 $10 $6 Chapter 9 Numeracy for Corporate Lawyers

  7. Balance sheet (assets = liabilities + equity) Income statement (sales – expenses = net income) Cash flow statement (cash at beginning – cash out + cash in = cash balance) Where do financial statements come from? Chapter 9 Numeracy for Corporate Lawyers

  8. Balance sheet (assets = liabilities + equity) Chapter 9 Numeracy for Corporate Lawyers

  9. Balance sheet (at end of Day 1) What if market price of scissors goes up? or down? What if you don’t show the IOU to Mom? ?? ?? Chapter 9 Numeracy for Corporate Lawyers

  10. Income statement (sales – expenses = net income) Chapter 9 Numeracy for Corporate Lawyers

  11. What if you treat jar as “asset” not “expense”? Income statement(Day 1) Chapter 9 Numeracy for Corporate Lawyers

  12. Statement of cash flows(cash at beginning – cash out + cash in = cash balance) Chapter 9 Numeracy for Corporate Lawyers

  13. Is the “cookie jar” business healthy? sustainable? Cash flow statement(Day 1) Chapter 9 Numeracy for Corporate Lawyers

  14. Balance sheet - terms Chapter 9 Numeracy for Corporate Lawyers

  15. Assets Current assets Cash Accts receivable Inventories Prepaid expenses Fixed assets Land Buildings  Machinery Office equipment Less accumulated depreciation Intangible assets Liabilities Current liabilities Accounts payable  Notes payable Accrued expenses payable Long term liabilities Owner’s equity Common stock Paid-in capital Retained earnings Balance sheet(as of date) How is “inventory” valued? Avg cost / FIFO / LIFO? What does it mean to “write off” a loss? Chapter 9 Numeracy for Corporate Lawyers

  16. Balance sheet analysis Liquidity analysis – can Widget pay its current debts? Check “current ratio” Debt analysis – can Widget take on new debt? Check “debt-equity ratio” Equity analysis – does Widget have value to its owners? Check “book value” Chapter 9 Numeracy for Corporate Lawyers

  17. Assets Current assets Cash Accts receivable Inventories Prepaid expenses Fixed assets Land Buildings  Machinery Office equipment Less accumulated depreciation Intangible assets Liabilities Current liabilities Accounts payable  Notes payable Accrued expenses payable Long term liabilities Owner’s equity Common stock Paid-in capital Retained earnings Liquidity analysisBalance sheet Current Ratio Current Assets divided by Current Liabilities FY 2 = 1.62 FY 1 = 1.29 Chapter 9 Numeracy for Corporate Lawyers

  18. Assets Current assets Cash Accts receivable Inventories Prepaid expenses Fixed assets Land Buildings  Machinery Office equipment Less accumulated depreciation Intangible assets Liabilities Current liabilities Accounts payable  Notes payable Accrued expenses payable Long term liabilities Owner’s equity Common stock Paid-in capital Retained earnings Debt analysisBalance Sheet Debt/Equity Ratio Long-term debt divided by Equity FY 2 = 1.32 FY 1 = 1.79  Chapter 9 Numeracy for Corporate Lawyers

  19. Assets Current assets Cash Accts receivable Inventories Prepaid expenses Fixed assets Land Buildings  Machinery Office equipment Less accumulated depreciation Intangible assets Liabilities Current liabilities Accounts payable  Notes payable Accrued expenses payable Long term liabilities Owner’s equity Common stock Paid-in capital Retained earnings Equity analysisBalance Sheet Book value Assets minus Liabilities FY 2 = $1,510,000 FY 1 = $1,120,000 Chapter 9 Numeracy for Corporate Lawyers

  20. Income statement - terms • Is Widget, Inc profitable? • Net income • EBITDA • Operating margin • Return on equity Chapter 9 Numeracy for Corporate Lawyers

  21. Income statement analysis • Net sales • Operating expenses • Cost of goods sold  • Depreciation • Selling and administrative expenses • Research and development • Operating income  • Interest expense  • Income before taxes  • Income taxes  • Special income • Net Income Widget net income (after expenses, depreciation, Interest, taxes) FY 2: $390,000 FY 1: $254,000 FY 0: $226,000 Chapter 9 Numeracy for Corporate Lawyers

  22. Income statement analysis Widget EBITDA (Earnings before Interest, taxes, depreciation, amortization) FY 2: $1,170,000 FY 1: $1,005,000 FY 0: $923,000 Net sales Operating expenses Cost of goods sold  Depreciation Selling and administrative expenses Research and development Operating income  Interest expense  Income before taxes  Income taxes  Special income Net Income Chapter 9 Numeracy for Corporate Lawyers

  23. Income statement analysis • Widget • operating margin • (net sales minus • operating expenses, • divided by net sales)  • FY 2 = 920/7500 = 12.3% • FY 1 = 765/7000 = 10.9% • FY 0 = 723/6800 = 10.6%  Net sales Operating expenses Cost of goods sold  Depreciation Selling and administrative expenses Research and development Operating income  Interest expense  Income before taxes  Income taxes  Net Income Chapter 9 Numeracy for Corporate Lawyers

  24. Compare income statement / balance sheet • Widget • return on equity (ROI) • (net income divided by • stockholders' equity • as of prior year)  • FY 2 = 390/1120 = 34.8% • FY1 = ??  Chapter 9 Numeracy for Corporate Lawyers

  25. Cash flow analysis • Is Widget healthy? • Cash flow • Changes in accts Chapter 9 Numeracy for Corporate Lawyers

  26. FY 2FY 1 ($175,000) $16,000 Cash flow analysis • From Operating Activities • Net income • Decrease (increase) in accts receivable  • Decrease (increase) in inventories • Decrease (Increase) in prepaid expenses • Increase (Decrease) in accounts payable • Increase (Decrease) in accrued expenses payable • Depreciation • From Investing Activities • Sales (Purchases) of machinery • Sales (Purchases) of office equipment • From Financing Activities • Increase (Decrease) in short-term borrowings • Increase (Decrease) in long-term borrowings • Increase (Decrease) in Cash Position What happened? Chapter 9 Numeracy for Corporate Lawyers

  27. From Operating ActivitiesFY 2FY 1 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 exp payable $15,000 $7,000 Depreciation $250,000 $240,000 From investing Activities Sales (Purchases) of machinery ($65,000) ($378,000) Cash flow analysis Why did accounts receivable increase by $201,000? Chapter 9 Numeracy for Corporate Lawyers

  28. From Operating ActivitiesFY 2FY 1 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 exp payable $15,000 $7,000 Depreciation $250,000 $240,000 From investing Activities Sales (Purchases) of machinery ($65,000) ($378,000) Cash flow analysis Why did inventories increase by $177,000? Chapter 9 Numeracy for Corporate Lawyers

  29. From Operating ActivitiesFY 2FY 1 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 exp payable $15,000 $7,000 Depreciation $250,000 $240,000 From investing Activities Sales (Purchases) of machinery($65,000) ($378,000) Cash flow analysis Why did machinery purchasesdecrease by $313,000? Chapter 9 Numeracy for Corporate Lawyers

  30. Group hypos[click here] Chapter 9 Numeracy for Corporate Lawyers

  31. Module IV – Corporate Finance Chapter 9Numeracy for Corporate Lawyers Bar exam Workshop 1 Corporate practice The great bonus ! Law profession Financial accounting Fundamental formula Accounting statements: Balance sheet, income statement, cash flow statement Accounting statement analysis Business valuation Future vs. present value Accounting value vs. market value Income vs. cash flow Discounted cash flow Workshop 2 Citizen of world Chapter 9 Numeracy for Corporate Lawyers

  32. Chapter 9 Numeracy for Corporate Lawyers

  33. What is the value of $1,000? Which would you prefer – $800 today or $1,000 in three years? Chapter 9 Numeracy for Corporate Lawyers

  34. Time value of money $800 * (1+ .10)3 = $1064.80 Chapter 9 Numeracy for Corporate Lawyers

  35. Time value of money $800 * (1+ .05)3 = $926.10 Chapter 9 Numeracy for Corporate Lawyers

  36. Future value FV = PV * (1+ i)n 7 6 FV 5 4 3 2 0 1 PV Chapter 9 Numeracy for Corporate Lawyers

  37. You are offered $1,000 in three years from now. What is its present value? Why is this called “discounting”? Chapter 9 Numeracy for Corporate Lawyers

  38. Discounting to present value $1,000 / (1+ .20)3 = $579 Chapter 9 Numeracy for Corporate Lawyers

  39. Present value 7 PV = FV / (1+ i)n 6 5 FV 4 3 2 1 0 PV Chapter 9 Numeracy for Corporate Lawyers

  40. You put $10,000 in the bank at 3.6% annual interest. How much will you have after 20 years? What about 7.2% in 10 years? 2. You are a superstar at your law firm. You are promised an $85,000 bonus if you stay at the firm for 5 years. How much is it worth now? (Law firm’s borrowing rate is 12%.) You consider buying a vineyard that has annual cash flow of $300,000. It’s risk is similar to that of an apple orchard (discount 20%). Value the vineyard. You look at another vineyard. It has cash flow this year of $250,000, but its cash flows have been increasing each year by 7.5%. Assume a higher discount rate of 25%. Value the vineyard. Pop Quiz [answers] Corporations: A Contemporary Approach Chapter 9 Numeracy for Corporate Lawyers Page 41 of 52

  41. Business valuation “Accounting is two-dimensional; valuation is three-dimensional” Corporations: A Contemporary Approach Chapter 9 Numeracy for Corporate Lawyers Page 42 of 52

  42. Consider the following valuations: Salvage Current production Future production Market price Book value Comparables (ratio) Capitalization of earnings Discounted cash flow “Old Man and Apple Tree” Corporations: A Contemporary Approach Chapter 9 Numeracy for Corporate Lawyers Page 43 of 52

  43. “Old Man and Apple Tree” The old man figures he’ll have cash flows from the tree of $50 for 5 years, then $40 for 10 years. And then sell the tree as firewood for $50. What is the present value of cash flows? Chapter 9 Numeracy for Corporate Lawyers

  44. Chapter 9 Numeracy for Corporate Lawyers

  45. Time value of “perpetuity” Mathematically PV = Pymt / i PV = Pymt * (1/i) *** Suppose a business earns $10,000 per year, with a DR = 15%. It’s PV = $66,666 Corporations: A Contemporary Approach Chapter 9 Numeracy for Corporate Lawyers Page 46 of 52

  46. Time value of “growing perpetuity” Mathematically (Gordon-Shapiro model) PV = Pymt1 / (d – g) $10 * 1.03 / (.08 - .03) = $10.30 / .05 = $206 ________________ approximately PV = Pymt / (d – g) What if somebody offers you $10 each year – growing at 3%, forever! How much do you pay for it, assuming an 8% discount rate? Chapter 9 Numeracy for Corporate Lawyers

  47. End of Lecture(group work in class) Chapter 9 Numeracy for Corporate Lawyers

  48. Valuation of Widget, Inc.(for whom are we doing the valuation?) Chapter 9 Numeracy for Corporate Lawyers

  49. Valuation methods: • Asset value • Market comparables • Income • Earnings • P/E multiplier • Cap multiplier • Discounted cash flow • Perpetuity • Spreadsheet Chapter 9 Numeracy for Corporate Lawyers

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