Describe each of the activities that comprise strategy evaluation

Copyright Information (bibliographic)

Document Type: Book Chapter

Title of Book: Financial Management Theory and Practice (16th Edition)

Author(s) of Book: Eugene F. Brigham, Michael C. Ehrhardt

Chapter Title: Chapter 2 Financial Statements, Cash Flow, and Taxes

Author(s) of Chapter: Eugene F. Brigham, Michael C. Ehrhardt

Year: 2020

Publisher: Cengage Learning

Place of Publishing: the United States of America

The copyright law of the United States (Title 17, United States Code) governs the making of photocopies or other reproductions of copyrighted materials. Under certain conditions specifies in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these conditions is that the photocopy or reproduction is not to be used for any purpose other than private study, scholarship, or research. If a user makes a request for, or later uses, a photocopy or reproduction for purposes in excess of fair use, that user may be liable for copyright infringement.

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Financial Statements, Cash Flow, and Taxes

Apple generated an operating cash flow of almost $64 billion in 2017! The ability to

generate cash flow is the lifeblood of a company and the basis for its fundamental

value. How did Apple use this cash flow? It returned over $46 billion to stockholders by

paying $13 billion in dividends and by repurchasing $33 billion of its own stock.

Many other companies also reported large cash flows, but they used the money

differently. For example, Google generated over $36 billion but returned relatively

little to stockholders, paying no dividends and repurchasing only $4 billion of its

stock. Instead, Google spent $10 billion on capital expenditures (mostly technology

infrastructure). Google also put about $18 billion into short-term investments (such as

Treasury securities), saving for a rainy day.

These well-managed companies used their operating cash flows in different ways,

including capital expenditures, acquisitions, dividend payments, stock repurchases,

and saving for future needs. Which company made the right choices? Only time will tell,

but keep these companies and their different cash flow strategies in mind as you read

this chapter.

55

56 Part 1 The Company and Its Environment

Intrinsic Value, Free Cash Flow, and Financial Statements

In Chapter 1, we told you that managers should strive to make their weighted average cost of capital (WACC). This chapter focuses on

firms more valuable and that a firm's intrinsic value is determined FCF, including its calculation from financial statements and its in-

by the present value of its free cash flows (FCFs) discounted at the terpretation when evaluating a company and manager.

The textbook's Web site

contains on Excel file that

will guide you through the chapter's calculations.

The file for this chapter is Ch02 Tool Kit.xlsx, and

we encourage you to open

the file and follow along

as you read the chapter.

WWW

See the Securities and

Exchange Commission's

(SEC) Web site for

quarterly reports and

more detailed annual reports that provide

breakdowns for each

major division or

subsidiary. These reports, called 10-Q and 10-K

reports, ore available

on the SEC's Web site at www.sec.gov under the

heading •EDGAR.• Once

there, you con search by

stock ticker symbol.

Sales revenues

- Operating costs and taxes

•

Required investments in operating capital

Free cash flow (FCF)

K� K� K� Value=-----+-----+···+-----

(1 + WACC)1 (1 + WACC)2 (1 + WACC) "'

Market Interest rates

Market risk aversion

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Finn's debt/equity mix

Finn's business risk

The stream of cash flows a firm is expected to generate in the future determines its fun­ damental value (also called intrinsic value). But how does an investor go about estimating future cash flows, and how does a manager decide which actions are most likely to in­ crease cash flows? The first step is to understand the financial statements that publicly traded firms must provide to the public. Thus, we begin with a discussion of financial statements, including how to interpret them and how to use them. Value depends on after­ tax cash flows, so we provide an overview of the federal income tax system and highlight differences between accounting income and cash flow.

2-1 Financial Statements and Reports A company's annual report usually begins with the chairperson's description of the firm's op­ erating results during the past year and a discussion of new developments that will affect future operations. The annual report also presents four basic financial statements-the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows.

The quantitative and qualitative written materials are equally important. The finan­ cial statements report what has actually happened to assets, earnings, dividends, and cash flows during the past few years, whereas the written materials attempt to explain why things turned out the way they did.

SELF -TEST

What is the annual report, and what two types of information does it present?

Whot four types of financial statements does the annual report typically include?

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See Ch02 Tool Kit.xlsx for

details.

Chapter 2 Financial Statements, Cash Flow, and Taxes

2-2 The Balance Sheet

57

For illustrative purposes, we use a hypothetical company, MicroDrive, Inc., which pro­ duces memory components for computers and smartphones. Figure 2-1 shows Micro­ Drive's most recent balance sheets, which represent "snapshots" of its financial position on the last day of each year. Although most companies report their balance sheets only on the last day of a given period, the "snapshot" actually changes daily as inventories are bought and sold, as fixed assets are added or retired, or as loan balances are increased or paid down. Moreover, a retailer will have larger inventories before Christmas than later in the spring, so balance sheets for the same company can look quite different at different times during the year. The following sections explain the accounts shown in Figure 2-1.