Business Finance –ACC501 VU

LESSON 4
THE FIRM AND THE FINANCIAL MARKETS

Financial Markets

· Primary Market
o When a corporation issues securities, cash flows from investors to the firm.
o Usually an underwriter is involved
· Secondary Markets
o Involve the sale of “used” securities from one investor to another.
o Securities may be exchange traded or trade over-the-counter in a dealer market.

Financial Markets

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Dealer vs. Auction Markets

· Auction markets are different from dealer markets in two ways:

o Trading in a given auction exchange takes place at a single site on the floor of the
exchange.
o Transaction prices of shares are communicated almost immediately to the public.
o Listing

The Balance Sheet

· An accountant’s snapshot of the firm’s accounting value as of a particular date.

· The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
· When analyzing a balance sheet, the financial manager should be aware of three concerns:
Accounting Liquidity, Debt versus Equity, and Value versus Cost

The Balance-Sheet Model of the Firm

Net Working Capital

· Net Working Capital = Current Assets – Current Liabilities

o NWC > 0 when Current Assets > Current Liabilities
o NWC < 0 when Current Assets < Current Liabilities
o NWC = 0 when Current Assets = Current Liabilities
· NWC usually grows with the firm for the healthy firms.

The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision

Current Liabilities
· Current Net
Assets Working
Long term
Long-term
Capital
Debt
Fixed Assets How much short-
term cash flow
flo does
· Tangible
Tang b e Shareholders’
hareholders
a company
companp y need to Equity
· Intangible
pay its
p it bill
bills??

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Building the Balance Sheet
· A firm has:
o Current Assets of $100,
o Net Fixed Assets of $500,
o Short-term Debt of $70, and
o Long-term Debt of $200
· Now…
o Total Assets are $100 + 500 = $600
o Total Liabilities are $70 + 200 = $270
o Shareholders’ Equity is $600 – 270 = $330

Building the Balance Sheet

Liabilities and
Assets
Shareholders’ Equity
Current Assets $100 Current Liabilities $70

Net Fixed Assets 500 Long Term Debt 200

Shareholders’ equity 330

Total liabilities and
Total Assets $600 $600
Shareholders’ equity

The Balance Sheet of the XYZ Corporation

XYZ CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt) and
Assets 20X2 20X1 20X2 20X1
Stockholder's Equity
Current assets Current Liabilities
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50
Total current assets $761 $707 Total current liabilities $486 $455
Fixed assets Long-term liabilities
Property, plant, and $1423 $1274 Deferred taxes $117 $104
equipment
Less accumulated -550 -460 Long-term debt 471 458
depreciation
Net property, plant, and $873 $814 Total long-term liabilities $588 $562
equipment
Intangible assets and other 245 221 Stockholder's equity
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 per value) 55 32
Capital surplus 347 327
Accumulated retained 390 347
earnings
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and $1,879 $1,742
stockholder's equity

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Notes:
1. Long-term debt rose by ($471 million–$458 million) $13 million. This is the difference between $86 million new debt
and $73 million in retirement of old debt.

2. Treasury stock rose by $6 million. This reflects the repurchase of $6 million stock.
3. XYZ Corporation reports $43 million in new equity. The company issued 23 million shares at a price of $1.87. The
par value of common stock is increased by $23 million and capital surplus is increased by $20 million.

Balance Sheet Analysis

· When analyzing a balance sheet, the financial manager should be aware of three concerns:
o Accounting liquidity
o Debt versus equity
o Value versus cost

Accounting Liquidity

· Refers to the ease and quickness with which assets can be converted to cash.
· Current assets are the most liquid.
· Some fixed assets are intangible.
· The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-
term obligations.
· Liquid assets frequently have lower rates of return than fixed assets.

The Balance Sheet of the XYZ Corporation

XYZ CORPORATION
Balance Sheet
20X2 and 20X1
$252m = $707- $455 (in $ millions)
20X2 20X1 Liabilities (Debt) and 20X2 20X1
Assets
Stockholder's Equity
Current assets Current Liabilities
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50
Total current assets $761 $707 Total current liabilities $486 $455
Here we see NWC grow to
$275 million in 20X2 from
$252 million in 20X1
$23
$275m = $761m - $486 This increase of $23 million is an investment of the firm.

Debt versus Equity

· Generally, when a firm borrows it gives the bondholders first claim on the firm’s cash flow.
· Thus shareholder’s equity is the residual difference between assets and liabilities.
Shareholders’ Equity = Assets – Liabilities
· The Use of debt in a firm’s capital structure is called “Financial Leverage”
o The more debt a firm has (as a percentage of assets) the greater is the degree of financial
leverage
o Debt acts as a lever in the sense that it magnifies both gains and losses

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Value versus Cost

· The true value of any asset is its market value, which is simply the amount of cash we would get
if we actually sold it.
· The values shown on the balance sheet for the firm’s assets are book values and generally are
not what the assets are actually worth.
· Under the Accounting standards audited financial statements of firms carry assets at historical
cost.
· For current assets, market value and book value might be somewhat similar since they are
bought and converted into cash over a relatively short span of time.
· For fixed assets, it’s very unlikely that the actual market value of an asset is equal to its book
value.
o Example: Land purchased for railroads a century ago
· Similarly the owner’s equity figure on the balance sheet and the true market value of the equity
need not be related.
· For Financial Managers, accounting value of the equity is not a matter of concern rather it is
the market value of the shares that matters.

Market vs. Book Value

· K Corporation has fixed assets with a book value of $700 and an appraised market value of
$1,000
· Net working capital is $400 on the books but approx. $600 would be realized if the current
accounts were liquidated
· K has $500 in long-term debt, both book & market value
o What is the book value of the equity?
o What is the market value?

K Corporation
Balance Sheet
Market Value vs. Book Value
Assets Book Market Liabilities (Debt) and Book Market
Stockholder's Equity
Net working Capital $400 $600 Long-term debt $500 $500
Net Fixed Assets $700 $1,000 Shareholders’ equity $600 $1,100
TOTAL $1,100 $1,600 TOTAL $1,100 $1,600

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