Financial Statements, Cash
Flow, and Taxes
ven in today’s era of financial crises, $14.6 billion is a lot of money. This is the amount of cash flow that Hewlett-Packard’s (HP) operations generated in 2008, up from $9.6 billion in 2007, despite the recession. The ability to generate cash flow is the lifeblood of a company and the basis for its fundamental value. How did HP use this cash flow? HP invested for the future by making over $11 billion in acquisitions. Other companies also generated large cash flows from operations in 2008, but they used the money differently. For example, Walgreens generated over $3 billion from its operations and used over $2 billion for capital expenditures, much of it on new stores and the purchase of worksite health centers.
Procter & Gamble generated $15.8 billion. P&G made relatively small capital expenditures (abut $3 billion) and returned the lion’s share (over $12 billion) to shareholders as dividends or through stock repurchases. Apple generated about $9.6 billion (up from $5.5 billion the previous year) but made relatively small capital expenditures, acquisitions, or distributions to shareholders. Instead, it put about $9.1 billion into shortterm financial securities like T-bills. These four well-managed companies used their operating cash flows in four different ways: HP made acquisitions, Walgreens spent on a mix of internal and external growth, P&G returned cash to shareholders, and Apple saved for a rainy day. Which company made the right choice? Only time will tell, but keep these companies and their different cash flow strategies in mind as you read this chapter.
Part 1: Fundamental Concepts of Corporate Finance
Intrinsic Value, Free Cash Flow, and Financial Statements
erage cost of capital (WACC). This chapter focuses on
FCF, including its calculation from financial statements
and its interpretation when evaluating a company and
In Chapter 1, we told you that managers should strive to
make their firms more valuable and that the intrinsic
value of a firm is determined by the present value of
its free cash flows (FCF) discounted at the weighted avSales revenues –
Operating costs and taxes
Required investments in operating capital
Free cash ﬂow
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
cost of capital
Market interest rates
The textbook’s Web site
contains an Excel file that
will guide you through the
The file for this chapter is
Ch02 Tool Kit.xls, and we
encourage you to open
the file and follow along
as you read the chapter.
A source for links to the
annual reports of many
companies is http://www
Firm’s debt/equity mix
Market risk aversion
Cost of debt
Cost of equity
Firm’s business risk
A manager’s primary goal is to maximize the fundamental, or intrinsic, value of the firm’s stock. This value is based on the stream of cash flows the firm is expected to generate in the future. But how does an investor go about estimating future cash flows, and how does a manager decide which actions are most likely to increase 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. Because value depends on usable, after-tax cash flows, we highlight the difference between accounting income and cash flow. In fact, it is after-tax cash flow that is important, so we also provide an overview of the federal income tax system.
2.1 FINANCIAL STATEMENTS
A company’s annual report usually begins with the chairman’s description of the firm’s operating results during the past year and a discussion of new developments that will affect future operations....
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