Enterprise Finance Lectures

Lectures 1 - 10
ENTERPRISE FINANCE
LECTURES
FREE CASH FLOW PAGES 2 – 21
VALUE PAGES 22 – 36
ROIC PAGES 37 – 58
CREDIT HEALTH PAGES 59 - 61
1
Lectures 1 - 10
FREE CASH FLOW
2
Lectures 1 - 10
VALUE
3
Lectures 1 - 10
ROIC
4
Lectures 1 - 10
CREDIT HEALTH
5
£m t0 t1
Cash flow -9.1 10
Net cash flow 0.9
£m t0 t1
Cash flow -9.1 10
Discount at 3% * 1/1.03
Present value (Cash flow) -9.1 9.7
Net present value (Cash
0.6
flow) NPV
£m t0 t1
Cash flow -9.1 10
0.0
flow) NPV
t0 t1
Cash flow -3.3 5.5
1.5
flow) NPV
t0 t1
Sales 5.5
Depreciation -3.3
Accounting profit (AP) 2.2
less Capital charge
3.3 * 15% -0.5
Economic profit (EP) 1.7
Discount at 15% * 1/ 1.15
PV(EP) 1.5
Row
ISt1 $m BSt1 BSt0 BS incrementt1 CFSt1
number
1 Sales 100.0 Debtors 0 0 0 Customers 100.0 NOPAT 8.3
2 Stock 0 0 0 add back:
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7 Tax expense 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3 EBIT 8.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3 add back:
6 EBIT 8.3 Depreciation 10.0
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0 EBITDA 18.3
8 Cash 0 0 0 Cash increase 0 less:
9 EBI or NOPAT 1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0 WC increment 0
10 Interest 0 Interest creditor 0 0 0 Interest paid 0 CFO 18.3

11 Debt 0 0 0 Debt issue 0 CAPEX -13.3
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0 Tax paid 0
13 Equity shares -50.0 -50.0 0 Equity issue 0 FCF 5.0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
Financial Finance cash
15 Finance loss1 -8.3 -58.9 -55.6 -3.3 -5.0
capital1 flow 1
IS Income Statement BS Balance Sheet CFS Cash Flow Statement
EBITDA Earnings Before Interest Tax Depreciation and Amortisation IC Invested Capital
NOPAT Net Operating Profit CFO Cash From Operating
WC Working Capital CAPEX Capital Expenditure
FA Fixed Asset FCF Free Cash Flow
NOPAT 1 8.3
Interest
0
expense
Earnings 8.3
Dividend -5.0
Retained -3.3
Finance loss -8.3
Row
ISt1 $m BSt1 BSt0 BS incrementt1 CFSt1
number
1 Sales 80.60 Debtors 8.86 6.29 2.57 Customers 78.03
2 Stock 0.44 0.31 0.13
3 Expenses -13.01 Creditors -21.48 -15.23 -6.25 Suppliers -6.89
4 EBITDA 67.59 WC -12.18 -8.63 -3.55 CFO 71.14
5 Depreciation -7.33 FA 226.95 226.95 0.00 CAPEX -7.33
6 EBIT 60.26
7 Tax expense -18.08 Tax creditor -0.60 -0.45 -0.15 Tax paid -17.93
8 Cash 71.86 50.97 20.89 Cash increase -20.89
9 EBI or NOPAT 1 42.18 IC increment1 286.03 268.84 17.19 FCF1 24.99
10 Interest -0.50 Interest creditor 0.00 0.00 0.00 Interest paid -0.50
11 Debt -2.76 -2.59 -0.17 Debt issue 0.17
12 Dividend -24.65 Dividend creditor 0.00 0.00 0.00 Dividend paid -24.65
13 Equity shares -23.48 -23.48 0.00 Equity issue 0.00
Financial Finance cash
15 Finance loss1 -42.18 -286.03 -268.84 -17.19 -24.99
capital1 flow 1
Debtors
01-Jan b/f 0
P&L Sales 100 CFS Customers 100
31-Jan c/f 0
t0 t1 t2 t3 t4 t5 t6 to perpetuity
Free cash
5.0 5.5 6.1 6.7 7.3 8.1
flow FCF
Discount
15% 1/(1.15) 1/(1.15)2 1/(1.15)3 1/(1.15)4 1/(1.15)5 1/(1.15)5
at
1/(0.15 - 0.10)
PV(FCF) 100.0 4.3 4.2 4.0 3.8 3.6 80.1
t0 t1 t2 to perpetuity
Cash flownew opportunity 8.33 * 40% = - 3.33 3.33 * 25% = 0.83
Discount 15% 1/0.15
PV(CF) -3.33 5.55
t1 to perpetuity
NPV 2.22
growing at 10%
Discount 15% 1/(0.15 -0.10)
PV(NPV) or Goodwill 44.4
Book 55.6
Value 100.0
t0 t1 to perpetuity
Dividend 5.0
growing at 10%
Discount at 15% 1/(1.15 - 0.10)
PV(Dividend) 100.0 100.0
Debt 0
Value 100.0
t0 t1 to perpetuity
Earnings 8.33
Discount at yield 8.33% 1/0.0833
Debt 0
Value 100.0
t0 t1 to perpetuity
Earnings 8.33
growing at 6.7%
Discount at 15.00% 1/(0.15 - 0.067)
Debt 0
Value 100.0
Lectures 1 - 3
How to calculate Free Cash Flow
1 Juxtapose Income Statement, BS and CFS to create a matrix

Suppose we juxtapose the three primary statements, that is the Income Statement, the Balance
Sheet and the Cash Flow Statement, and we separate investing from financing. The result is a
matrix:
Table 1
Row IS ISt1 BS BSt1 BSt0 BS CFS CFSt1
number
incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
INVESTING
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7

4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 EBI or NOPAT1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
FI N A N C I N G
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0

13 Equity shares -50.0 -50.0 Equity issue 0
Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 Finance cash
15 -5.0
flow1
You can use this primary statement matrix to reconcile any accounting number to any other
accounting number and to cash flows. Accounting numbers and cash numbers are used more
intelligently when their relationships are made explicit, as they are in this matrix.
The investing story is told in the top half of the matrix and runs as follows. You make a profit
of £8.3, of which you invest £3.3, delivering a free cash flow of £5.
The financing story is told in the bottom half of the statement and runs as follows. You make a
profit of £8.3 of which you distribute £ 5 and retain £3.3. You invest £3.3, which you finance
with equity reserves increment. You deliver a free cash flow of £5, which is wholly paid out as
dividend.
Here we concentrate on two relations. The first is the relation between the three statements
(the clean surplus relation), illustrated by each row, and the second is the relation between the
top half and the bottom half (the investing-to-financing relation), illustrated by each column.
Note that the bottom line of the income statement is labelled net operating profit after tax
NOPAT, which is a more precise name than simply accounting profit AP.
1
Lectures 1 - 3
In order to build this matrix we reorder the statements from their published order. The clean
surplus relation and the investing-to-financing relation dictate a certain ordering and that is the
order we have adopted.
2 Use the clean surplus relation (CSR)

The clean surplus relation (CSR) describes the relation between the Income Statement, the
Balance Sheet and the Cash Flow Statement such that:
IS less Balance Sheet increment = Cash Flow Statement
We now describe each row in turn beginning with the investing rows and row 1.
Row BS
number
IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
row1 Sales £100 less Debtors increment £0 = Cash from customers £100
P&L sales equal CFS cash from customers because there is no change in the BS debtors.
Each row can be configured as a ledger account, for example row 1:

Table 2
BS Debtors
01-Jan BS b/f 0
IS Sales 100 CFS Customers 100
31-Jan BS c/f 0
100 100
Increase the debtors by £100 then £0 cash is collected from the customers. This cash is held up
in debtors, awaiting collection. None of the customers pay.
Row BS
number
incrementt1
1 Sales 100.0 Debtors 100.0 0 100.0 Customers 0
2
Lectures 1 - 3
Now we describe rows 2 and 3 together.

Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
2 Stock 0 0 0
rows 2 and 3 Expenses -£81.7 less Stock increment £0 and Creditors increment £0 = Cash paid to
suppliers -£81.7
Table 3
BS Creditors
01-Jan BS b/f 0
CFS Suppliers 81.7 BS Stock 81.7
31-Jan BS c/f 0
81.7 81.7
Table 4
BS Stock
01-Jan BS b/f 0
BS Creditors 81.7 IS Expenses 81.7
31-Jan BS c/f 0
81.7 81.7
Increase the creditors by £81.7 then £0 cash is paid to the suppliers. This cash is held up in
creditors, awaiting payment. None of the suppliers are paid.
Row BS
incrementt1
2 Stock 0 0 0
3 Expenses -81.7 Creditors -81.7 0 -81.7 Suppliers 0
Now we describe row 4.

Row BS
incrementt1
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
row 4 EBITDA £18.3 less WC increment £0 = CFO £18.3
Cash flow from operating is an interesting subtotal being the net cash inflow of cash collected
from customers less cash paid to suppliers. From the above relation we can see that EBITDA
(an IS number) can be used as a proxy for CFO (a CFS number) if the working capital
incremental investment (or disinvestment) is £0.
Increase the working capital by say £11 then CFO falls to £7.3. The proxy relation breaks
down.
Row BS
incrementt1
4 EBITDA 18.3 WC 11.0 0 11.0 CFO 7.3
3
Lectures 1 - 3

Row BS
incrementt1
row 5 Depreciation -£10 less FA increment £3.3 = CAPEX -£13.3
Table 5
BS Fixed assets
01-Jan BS b/f 55.6
CFS CAPEX 13.3 IS Depreciation 10
31-Jan BS c/f 58.9
68.9 68.9
We can see that the cash outflow of £13.3 on fixed assets consists of spending to replace assets
used up during the year of £10, plus spending to grow of £3.3.
Leave the fixed assets unchanged and the CAPEX falls to £10, now all replacement spending,
with no growth.
Row BS
incrementt1
5 Depreciation -10.0 FA 55.6 55.6 0 CAPEX -10.0

Row BS
incrementt1
6 EBIT 8.3
row 6 EBIT £8.3 less BS increment N/A = CFS N/A
Row 6 simply calculates an IS subtotal being EBIT, which follows EBITDA and precedes
EBI.

Row BS
incrementt1
row 7 Tax expense -£0 less Tax creditor increment £0 = Tax paid -£0
We can see that the tax expense (IS number) is only the same as the tax paid (CFS number) if
there is no change to the tax creditor in the BS.

Row BS
incrementt1
Cash
8 Cash 0 0 0 0
increase
row 8 IS N/A less Cash increment £0 = Cash increase £0
4
Lectures 1 - 3

Row BS
incrementt1
EBI or IC
9 8.3 58.9 55.6 3.3 FCF1 5.0
NOPAT1 increment1
row 9 NOPAT £8.3 less IC increment £3.3 = FCF £5
This row is very important. It totals all the investing rows 1 – 8. It defines free cash flow as:
FCF = NOPAT – IC increment
With no incremental investment in the balance sheet, that is the manager fails to find a
positive NPV opportunity, then NOPAT equals FCF.
Row BS
incrementt1
EBI or IC
9 8.3 55.6 55.6 0 FCF1 8.3
NOPAT1 increment1
With incremental investment in the balance sheet greater than NOPAT, then FCF is negative.
Row BS
incrementt1
EBI or IC
9 8.3 75.6 55.6 20 FCF1 -11.7
NOPAT1 increment1
Now we start the financing rows, beginning with row 10.

Row BS
incrementt1
Interest Interest
10 0 0 0 0 Interest paid 0
expense creditor
row 10 Interest expense -£0 less Interest Creditor increment £0 = Interest paid -£0
Table 6
BS Interest creditor
01-Jan BS b/f 0
CFS Interest paid 0 IS Interest expense 0
31-Jan BS c/f 0
0 0
There is a small point to note about the position of the interest expense. The published IS
account positions the interest expense before the tax expense but the matrix moves it further
down to after tax and after NOPAT. The published IS recognises that interest is a tax
deductible expense, hence positions it before the tax expense. The matrix recognises that
interest is a financing expense rather than an investing expense so positions it with financing.
This means that the published IS’s PAT is also after interest while the matrix’s NOPAT is
before interest.
5
Lectures 1 - 3

Row BS
incrementt1
row 11 IS N/A less Debt increment £0 = Debt issue £0
Table 7
BS Debt
01-Jan BS b/f 0
CFS Issue 0
31-Jan BS c/f 0
0 0
Increase the BS debt £11.7, then the CFS shows £11.7 as issued. This issue could finance the
negative free cash flow in the previous scenario.
Row BS
incrementt1
11 Debt -11.7 0 -11.7 Debt issue 11.7
Now we describe row12.

Row BS
incrementt1
Dividend
12 Dividend -5.0 0 0 0 Dividend paid -5.0
creditor
row 12 Dividend -£5 less Dividend Creditor increment £0 = Dividend paid -£5
Table 8
BS Dividend creditor
01-Jan BS b/f 0
CFS Dividend paid 5 IS Dividend expense 5
31-Jan BS c/f 0
5 5
The dividend in the IS is not described as an expense because it is considered to be an

appropriation of their profit by the equity investors. This dividend equals the dividend paid
because there is no change to the creditor.
6
Lectures 1 - 3

Row BS
incrementt1
Equity
13 50 50 0 Equity issue 0
shares
row 13 P&L N/A £0 less Equity shares increment £0 = Equity issue £0
Table 9
BS Equity shares
01-Jan BS b/f 50
CFS Issue 0
31-Jan BS c/f 50
50 50
Increase the BS equity shares £11.7, then the CFS shows £11.7 as issued. This issue could
finance the negative free cash flow in the previous scenario.
Row BS
incrementt1
Equity Equity share
13 -61.7 50 -11.7 11.7
shares issue

Row BS
incrementt1
Equity
14 Retained -3.3 -8.9 -5.6 -3.3
reserves
row 11 Retained Profit -£3.3 less Equity increment -£3.3 = CFS N/A
Table 10
BS Equity reserves
01-Jan BS b/f 5.6
IS Retained 3.3
31-Jan BS c/f 8.9
8.9 8.9
We can see that the equity reserves increment (BS) is wholly explained by the retained profit
(P&L) and this is always the case so there is never a CFS number generated.
7
Lectures 1 - 3

Row BS
incrementt1
Finance Financial Finance
15 -8.3 -58.9 -55.6 -3.3 -5.0
loss1 capital1 cash flow1
row 15 Finance loss -£8.3 less Financial capital increment -£3.3 = Finance cash flow -£5
This row totals the financing rows 10 – 14.
This completes the analysis of the clean surplus relation row by row. We now look at the
second relation, the investing-to-financing relation, column by column.
8
Lectures 1 - 3
3 Use the investing-to-financing relation

The investing-to-financing relation describes the relation between the top half of the matrix
covering investing and the bottom half of the matrix covering financing.
Investing = -Financing
We explain each column in turn beginning with column 1.

ISt1 £m
Sales 100.0
Expenses -81.7
EBITDA 18.3
Depreciation -10.0
EBIT 8.3
Tax expense 0
EBI or NOPAT1 8.3
Interest expense 0
Dividend -5.0
Retained -3.3
Finance loss1 -8.3
column 1 IS Net Operating Profit After Tax £8.3 from investing = - P&L Finance loss £8.3
from financing.
You earn a profit of £8.3. The financing section explains what you do with it. You use it for
interest £0, for dividend £5.0, and you reinvest in the company £3.3.
Now we explain column 2.

BS
£m BSt1 BSt0
incrementt1
Debtors 0 0 0
Stock 0 0 0
Creditors 0 0 0
WC 0 0 0
FA 58.9 55.6 3.3
Tax creditor 0 0 0
Cash 0 0 0
IC increment1 58.9 55.6 3.3
Interest creditor 0 0 0
Debt 0 0 0
Dividend creditor 0 0 0
Equity shares -50.0 -50.0 0
Equity reserves -8.9 -5.6 -3.3
Financial capital1 -58.9 -55.6 -3.3
column 2 BS Invested Capital increment £3.3 = - BS Financial capital increment £3.3
You invest an incremental £3.3 so that invested capital grows by £3.3. This incremental
investment is wholly financed by an increase in equity reserve of £3.3.
9
Lectures 1 - 3
Now we explain column 3.

CFSt1 £m
Customers 100.0
Suppliers -81.7
CFO 18.3
CAPEX -13.3
Tax paid 0
Cash increase 0
FCF1 5.0
Interest paid 0
Debt issue 0
Dividend paid -5.0
Equity issue 0
Finance cash flow1 -5.0
column 3 CFS Free Cash Flow £5.0 = - CFS Dividend paid £5.0
You have a net cash inflow for the year of £5.0, which is described as free because it is free to
be paid out in interest and dividend or to repurchase debt or equity. In this case the free cash
flow is all paid out as dividend.
10
Lectures 1 - 3
4 Reconcile any number to any number in the matrix
You can use this matrix to reconcile any accounting number to any other accounting number.
The accounting numbers are those numbers in the P&L and in the balance sheet. You can also
reconcile any accounting number to any cash number (in the cash flow statement).
We take a look at a couple of the more important reconciliations.
Reconciliation 1
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
13 Equity shares -50.0 -50.0 0 Equity issue 0
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 Finance cash flow1 -5.0
Table 11
NOPAT 8.3
add back:
Tax expense 0
EBIT 8.3
add back:
Depreciation expense 10.0
EBITDA 18.3
less:
WC increment 0
CFO 18.3
CAPEX -13.3
Tax paid 0
Cash increase 0
FCF 5.0
This reconciliation starts with IS NOPAT, works its way back up the IS to EBIT, then swings
across the BS change in WC to hit the cash flow statement CFS at cash from operating CFO,
and works its way down the CFS to finish at free cash flow FCF.
In this way we can reconcile any number to any number.
11
Lectures 1 - 3
Reconciliation 2
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 Finance cash flow1 -5.0
Table 12
NOPAT 8.3
less:
Interest expense 0
Earnings 8.3
less:
Retained 3.3
Dividend 5
This reconciliation starts with profit and, staying within the IS, finishes with dividend, running
through earnings.
12
Lectures 1 - 3
5 Calculate relations as ratios and calculate growth

Note these ratios which you use in the next chapter.
Ratio 1
Retained profit can be expressed as a fraction of NOPAT as follows:
Investment rate1 = Retained1 / NOPAT1
In this example the investment rate is £3.31/£8.31 = 40%
Ratio 2
NOPAT can be expressed as a fraction of Invested capital as follows:
ROIC1 = NOPAT1 / IC0
In this example ROIC is £8.31/£55.60 = 15%
Where ROIC is Return on Invested Capital. Note that this ratio has other names, for example
Return on Net Assets RONA, Return on Capital Employed ROCE.
Think of invested capital as debt + equity then where NOPAT is expressed as a fraction of just
the equity component of invested capital, the return is Return on Equity ROE.
Table 13
Invested capital IC 55.6
Interest creditor 0
Debt Debt 0
Dividend creditor 0
Equity shares Equity -50.0
Equity reserves -5.6
Financial capital -55.6
In this example ROIC and ROE are both 15% because there is no debt.
Finally calculate the NOPAT growth rate g as follows:

g = ROICincremental investment * Investment rate
In this example growth is 25% * 40% = 10%.
Note that, in the example, the ROIC on the incremental investment is not the same as the
ROIC1. ROICincremental investment cannot be calculated from the matrix.
13
Lectures 1 - 3
6 Apply the CSR and the investing-to-financing relation

Fill in the missing numbers using the relations of the rows (the clean surplus relation) and the
columns (the investing-to-financing relation):
Table 14
$m
incrementt1
Row
number
CFSt1
BSt1
BSt0
ISt1
BS
1 Sales 80.60 Debtors 8.86 6.29 Customers
2 Stock 0.44 0.31
3 Expenses -13.01 Creditors -21.48 -15.23 Suppliers
4 EBITDA WC CFO
5 Depreciation -7.33 FA 226.95 226.95 CAPEX
6 EBIT
7 Tax expense -18.08 Tax creditor -0.60 -0.45 Tax paid
8 Cash 71.86 50.97 Cash increase
9 EBI or NOPAT 1 IC increment1 FCF1
10 Interest expense -0.50 Interest creditor 0.00 0.00 Interest paid
11 Debt -2.76 -2.59 Debt issue
12 Dividend Dividend creditor 0.00 0.00 Dividend paid
13 Equity shares -23.48 -23.48 Equity issue
14 Retained -17.03 Equity reserves -259.8 -242.76
Finance cash
15 Finance loss1 Financial capital1
flow1
14
Lectures 1 - 3
Solution
Table 15
$m
incrementt1
Row
number
CFSt1
BSt1
BSt0
ISt1
BS
1 Sales 80.60 Debtors 8.86 6.29 2.57 Customers 78.03
2 Stock 0.44 0.31 0.13
3 Expenses -13.01 Creditors -21.48 -15.23 -6.25 Suppliers -6.89
4 EBITDA 67.59 WC -12.18 -8.63 -3.55 CFO 71.14
6 EBIT 60.26
7 Tax expense -18.08 Tax creditor -0.60 -0.45 -0.15 Tax paid -17.93
8 Cash 71.86 50.97 20.89 Cash increase -20.89
9 EBI or NOPAT 1 42.18 IC increment1 286.03 268.84 17.19 FCF1 24.99
10 Interest expense -0.50 Interest creditor 0.00 0.00 0.00 Interest paid -0.50
11 Debt -2.76 -2.59 -0.17 Debt issue 0.17
12 Dividend -24.65 Dividend creditor 0.00 0.00 0.00 Dividend paid -24.65
13 Equity shares -23.48 -23.48 0.00 Equity issue 0.00
Finance cash
15 Finance loss1 -42.18 Financial capital1 -286.03 -268.84 -17.19 -24.99
flow1
In this scenario, the company earned a profit of £9 but invested £31 so generating a negative
free cash flow of £22, which they financed with a debt issue. The debt issue also financed
interest and dividend payments. Was the investment of £31 a positive NPV opportunity?
Nearly half (£14 of £31) is an investment in Debtors. If the company collected its debtors and
refrained from paying a dividend they could have avoided (£14 + £6) £20 of the debt issue,
leaving only an issue of £11 to cover the CAPEX growth component.
15
Lectures 1 - 3
7 Reconcile NOPAT to NPV via economic profit (EP)

Suppose we invest £3.3m at t0, at 25%, to get £5.5m at t1. The asset has a life of only one year.
We can configure this scenario as a matrix as follows:
Table 16
incr
IS t1 BS t0 t1 t1 CFS t0 t1
2 Stock
3 Expenses Creditors Suppliers
4 EBITDA WC CFO
5 Depreciation -3.3 FA 3.3 0 -3.3 CAPEX -3.3 0
6 EBIT
7 Tax expense Tax creditor Tax paid
8 Cash Cash increase
9 NOPAT 1 2.2 IC increment1 3.3 0 -3.3 FCF1 -3.3 5.5
Capital charge £3.3 * 15% 0.5 Discount 15% 1/1.15
Economic Profit EP1 1.7 PV(FCF) -3.3 4.8
Discount 15% 1/1.15 NPV0 1.5
PV(EP)0 1.5
We should take this investment opportunity since the NPV is positive at £1.5. The realisation
of this NPV is monitored by economic profit. The matrix shows us how to reconcile NPV 0 to
NOPAT1.
Table 17
NOPAT 1 2.2
less:
Capital charge £3.3 * 15% 0.5
Economic profit EP1 1.7
Discount 15% 1/1.15
PV(EP)0 = NPV0 1.5
The actual/historical turns out exactly as expected. The expected NPV0 was realised as
actual/historical EP1. Note that NOPAT overstates the NPV but that the PV(EP) hits the NPV.
We return to EP and its application to corporate governance in chapter 6. EP is sometimes
referred to as Residual Income (RI) or Economic Value Added (EVA).
We can express the relations we have used as follows:
EP1 = NOPAT1 – Capital charge1
and
NPV0 = PV(EP1 - t) = PV(NOPAT1 - t – Capital charge1 - t)
16
Lectures 1 - 3
8 Recognise a breakdown in the clean surplus relation CSR
The clean surplus relation states:

IS less BS increment = Cash Flow Statement
However this relation breaks down when:

1. SORIE accounting
1.1 remeasurement of FA profit
1.2 remeasurement of Retirement benefits provision by actuary profit or loss
1.3 remeasurement of hedge(d) asset
1.4 retranslation of Investment in foreign subsidiary CR FX profit or loss
and when:
2. Balance Sheet accounting
2.1 lease of FA
2.2 bonus issue
2.3 acquisition or disposal of an associate or subsidiary during the year
In these cases the matrix requires additional columns as follows:
Table 18
BS BS
IS ISt1 SORIE1 BS BSt1 BSt0
incrt1
CFS CFSt1
Accounting1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
Finance cash
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 -5.0
flow1
Statement of Recognised Income and Expense SORIE
17
Lectures 1 - 3
2.9 Summary
We used two relations:

IS less BS increment = Cash Flow Statement
Investing = -Financing
We defined free cash flow.

We reconciled NOPAT to FCF via CFO:

Table 2.11
NOPAT 8.3
add back:
Tax expense 0
EBIT 8.3
add back:
Depreciation expense 10.0
EBITDA 18.3
less:
WC increment 0
CFO 18.3
CAPEX -13.3
Tax paid 0
Cash increase 0
FCF 5.0
We noted the ratios:

Pay out rate = Dividend / Earnings
Investment rate = Retained / Earnings = 1 – Pay out rate
ROIC1 = NOPAT1 / IC0
We calculated a growth rate.

g = ROICincremental investment * Investment rate
We reconciled NOPAT to NPV via EP:

EP1 = NOPAT1 – Capital charge1
NPV0 = PV(EP1 - t) = PV(NOPAT1 - t – Capital charge1 - t)
18
Lectures 1 - 3
2.10 Quick questions

1. List the three primary financial accounting statements
2. Identify the clean surplus relation (CSR)
3. Reconcile Net Operating Profit After Tax (NOPAT) to Free Cash Flow (FCF)
4. Reconcile Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) to Cash
from Operating (CFO)
5. Define NOPAT
6. Define Working capital (WC)
7. If the pay out rate is 100% what is the investment rate?
8. If ROIC is 10% and the pay out rate is 75% what is growth?
9. Is the interest paid, part of the free cash flow, or part of the financing flow?
10. When is dividend paid equal to free cash flow?
11. What does a negative free cash flow imply?
12. When is the CFO positive?
13. What is the difference between a P&L expense and a CFS cash outflow?
14. What would you advise a company with a very high free cash flow?
15. Define EP
16. By how much does NOPAT overstate NPV?
Answers
1. IS, BS and CFS
2. IS less BS increment = Cash Flow Statement
3. NOPAT less IC increment = FCF
4. EBITDA plus depreciation less WC (excluding cash) increment = CFO
5. Sales – Expenses – Depreciation - Tax
6. Debtors + Stock + Creditors + Tax Creditor + Cash
7. 0%
8. 10% * (1-75%) = 2.5%
9. financing flow
10. When there is no interest paid and no debt and equity share issues
11. IC increment > NOPAT
12. When customers > suppliers
13. BS increment for creditor
14. Look for positive NPV investment opportunities or buy back their debt and equity
15. EP = NOPAT – Capital charge
16. By the discounting effect
19
Lectures 4 - 8
How to calculate value and ROIC
1 Meet four valuation models

Is your company valuable for its cash flows, for its dividends, for its earnings or for its
positive NPV investment opportunities? There are four valuation models in general use, one
for each of these performance measures. The four models are:
(1) THE DISCOUNTED CASH FLOW (DCF) MODEL

This model discounts cash flows and values the whole company
Value of company0 = PV(FCF1-t)
Alternatively
Value of company0 =PV(NOPAT1-t - IC increment1 - t)
(2) THE DISCOUNTED STREAM OF DIVIDENDS MODEL (DDM)

This model discounts dividends and values only the equity component
Value of equity0 = D1/(r – g)
See the present value of a constantly growing perpetuity from chapter 1.3.3
Alternatively
Value of equity0 = D1/Dividend yield
(3) THE DISCOUNTED STREAM OF EARNINGS MODEL

This model discounts earnings and values only the equity component
Value of equity0 = PV(Earnings1-t - IC increment1-t)
Note the similarity to model (1) above
Alternatively
Value of equity0 = Earnings1 * PER
Alternatively
Value of equity0 = Earnings1/Earnings yield
Note the similarity to model (2) above
Model (3) collapses into either model (1) or model (2).
(4) THE DISCOUNTED STREAM OF NPVs MODEL

This model sums book and the present value of investment NPVs and values the whole
company
Value of company0 = Book0 + Goodwill0 or (NPVs)
Note that (1) and (4) value the whole company, that is debt plus equity, whereas (2) and (3)
value only the equity component and must have the debt component added to get the whole
company value. Think of invested capital as debt + equity.
Table 13 from Lectures 1-3 repeated
Invested capital IC 55.6
Interest creditor 0
Debt Debt 0
Dividend creditor 0
Equity shares Equity -50.0
Equity reserves -5.6
Financial capital Debt + Equity -55.6
We will apply each model in turn, to the company data matrix of chapter 2, and illustrate that
all the models are equivalent. They generate the same value for the company regardless of
which model you choose.
1
Lectures 4 - 8
2 Use the discounted cash flow (DCF) model (1)
We input the free cash flow from the chapter 2 matrix.

Table 1
Row BS
P&L P&Lt1 BS BSt1 BSt0 CFS CFSt1
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
9 NOPAT 8.3 IC increment 58.9 55.6 3.3 FCF 5.0
15 Finance loss -8.3 Financial capital -58.9 -55.6 -3.3 Finance cash flow -5.0
We forecast the FCF to grow at 10% a year for the first five years and indeed to continue to
grow at 10% to perpetuity.
Table 2
Free cash flow
5.0 5.5 6.1 6.7 7.3 8.1
FCF
2 3 4 5
Discount at 15% 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15)5
growing at 10%
1/(0.15 - 0.10)
PV(FCF) =
Value of 100.0 4.3 4.2 4.0 3.8 3.6 80.1
company
This growth rate is calculated as follows:

gconstant = ROICincremental investment * Investment rateconstant where
Return on Invested Capital ROICincremental investment = NOPATincremental/ICincremental
= say 25% (not available to be calculated from table 3.1)
and
Investment rateconstant = Retained profit1/NOPAT1
= £3.3/£8.3 = 40% (calculated from table 3.1)
so g = ROICincremental investment * Investment rate = 40% * 25% = 10%
Alternatively
Value of company0 =PV(NOPAT1-t – IC increment1 - t)
This alternative expression can be derived from model (1) as follows:
Value of company0 = PV(FCF1-t) (model(1))
FCF = NOPAT – IC increment (definition of FCF in chapter 2.4)
Value of company0 =PV(NOPAT1-t – IC increment1 - t) (substitution)
2
Lectures 4 - 8
3 Use the discounted stream of dividends model (DDM) (2)
Value of equity0 = D1/(r – g)
Where D1 = dividend1 and r = discount rate for equity and g = growth rate
We input the dividend from the chapter 2 matrix.

Table 3
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
We forecast the dividend to grow at 10% to perpetuity.

Table 4
t0 t1 to perpetuity
Dividend 5.0
Discount at 15% growing at 10%
1/(0.15 - 0.10)
add Debt 0
Value of company 100.0
This formula is essentially the formula for the present value of a constantly growing
perpetuity, which you met in chapter 1.3.3.
The growth rate of 10% is calculated as in 3.2.
alternatively
Value of equity0 = D1/Dividend yield
This alternative expression can be derived from model (2) as follows:
Value of equity0 = Dividend1/(r – g) (model (2))

r = Value of equity0/Dividend1 + g (rearranged)
Dividend yield = Value of equity0/Dividend1 (definition)
r = Dividend yield + g (substitution)
Dividend yield = r – g (rearranged)
Value of equity0 = D1/Dividend yield (substitution)
3
Lectures 4 - 8
4 Use the discounted stream of earnings model (3)
Value0 = PV(Earnings1-t less IC increment1-t)
Table 5
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
Finance cash
15 Finance loss -8.3 Financial capital -58.9 -55.6 -3.3 -5.0
flow
We forecast the earnings less IC increment to grow at 10% a year for the first five years and
indeed to continue to grow at 10% to perpetuity.
Table 6
Earnings less
5.0 5.5 6.1 6.7 7.3 8.1
IC increment
2 3 4 5
Discount at 15% 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15)5
growing at 10%
1/(0.15 - 0.10)
PV(Earnings
less IC 100.0 4.3 4.2 4.0 3.8 3.6 80.1
increment)
add Debt 0
Value of
100
company
Note that we reconciled NOPAT to earnings in L1

Table L1.12 repeated
NOPAT 8.3
less:
Interest expense 0
Earnings 8.3
Model (3) collapses into model (1), which discounted FCF
4
Lectures 4 - 8
Alternatively
Value of equity0 = Earnings1 * PER
This is a multiple based model rather than discounting based, the multiple being PER. PER is
Price0/Earnings1 where price is used here synonymously with value
Table 7
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
Finance cash
15 Finance loss -8.3 Financial capital -58.9 -55.6 -3.3 -5.0
flow
Table 8
NOPAT1 8.3
less:
Interest expense 0
Earnings1 8.3
PERcomparable company 12
Value of equity0 100
add Debt0 0
Value of company0 100
Alternatively
Value of equity0 = Earnings1/Earnings yield
The multiple based model can be reconfigured as a discounting model so long as the discount
rate used is the earnings yield. The reciprocal of P/E is E/P, which is yield. In this example the
yield would be 1/12 or £8.3/£100 or 8.3%. So instead of multiplying by PER, divide by
earnings yield.
Table 9
NOPAT 8.3
less:
Interest expense 0
Earnings 8.3
Earnings yield 1/ 8.3%
Value of equity 100
add Debt 0
Value of company 100
This version of model (3) collapses into model (2), which used dividend yield with dividends.
We now use earnings yield with earnings.
5
Lectures 4 - 8
Note the relation of dividend yield and earnings yield and the discount rate r.
Where
r = dividend yield + g
In our example:
15% = 5% + 10%
and
r = (earnings yield – incremental investment/value) + g
In our example:
15% = (8.3% - 3.3%) + 10%
Some investment managers treat earnings yield as the discount rate r to be applied to cash
flows in an NPV appraisal. Since the yield is likely to be lower than the discount rate r these
managers may over invest (invest in –ve NPV investment opportunities).
Some individual investors assume that a low PER, that is a high yield, company has low
growth when in fact it may be that the company’s cash flows are high risk.
Yield 8.3% = r 15% + incremental investment/value 3.3% - g 10%.
Table 10
yield r measures incremental g
risk investment/value
12 or 8.3% 15% 3.3% 10%
high PER or low earnings yield
? ? ?
say 120 or 0.8%
low PER or high earnings yield
? ? ?
say 2 or 50%
6
Lectures 4 - 8
5 Use the discounted stream of NPVs model or the two component model (4)
Value0 = Book0 + Goodwill0 or PV(NPVs) or PV(EPs)
We input the incremental investment from the chapter 2 matrix.

Table 11
Row BS
number incrementt1
2 Stock 0 0 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
6 EBIT 8.3
First we calculate the NPV of the investment of £3.3 at t 1

Table 12
Cash flowincremental investment 8.33 * 40% = - 3.33 3.33 * 25% = 0.83
Discount 15% 1/0.15
PV(CF) -3.33 5.55
NPV 2.22
This formula is essentially the formula for the present value of a perpetuity, which you met in
chapter 1.3.3.
We can use economic profit (EP) instead of NPV

Table 13
NOPAT 8.33 * 40% = - 3.33 3.33 * 25% = 0.83
Less capital charge 15%*3.33 0.50
EP 0.33
Discount 15% 1/0.15
PV(EP) 2.2
Then we calculate the PV of a stream of growing NPVs at t 0

Table 14
t0 t1 to perpetuity
NPV 2.22
1/(0.15 - 0.10)
PV(NPV) 44.4
Normal earnings 8.3
Discount at 15% 1/0.15
Book 55.6
7
Lectures 4 - 8
This formula is essentially the formula for the present value of a constantly growing
perpetuity, which you met in chapter 1.3.3. The book value component is valued as a stream of
normal earnings. Normal earnings are earnings which just cover the discount rate, in this case
£8.3/£55.6 = 15%.
8
Lectures 4 - 8
6 Maximise cash flow in order to maximise value?
Value0 = PV(FCF1-t)
We may increase the free cash flow (FCF) but only by investing in riskier opportunities.
Table 15
t0 t1 to perpetuity
Free cash flow FCF 5.0
Discount at 5% 1/(0.05)
PV(FCF) = Value of company 100
Table 16
t0 t1
Free cash flow FCF 50.0
Discount at 51% 1/(0.51)
PV(FCF) = Value of company 98
Maximising cash flow ignores the trade off which is the risk of the cash flow. The value is not
the sum of the cash flows but the sum of the risk adjusted cash flows.
7 Maximise dividend in order to maximise value?
Value0 = D1/(r – g) + Debt0
We may increase the dividend1 but only by foregoing growth and the resulting sacrifice of
future dividends.
Table 17
t0 t1 to perpetuity
Dividend 5.0
1/(0.15 - 0.10)
add Debt 0
Table 18
t0 t1 to perpetuity
Dividend 8.3
1/(0.15 - 0.00)
add Debt 0
Maximising the dividend at t1 ignores the trade off which is future dividend.
9
Lectures 4 - 8
8 Maximise earnings in order to maximise value?
Value0 = PV(Earnings1-t less IC increment1-t)
We may maintain earnings but only by increasing invested capital increment.

Table 19
t0 t1 to perpetuity
Earnings 8.3
IC increment 3.3
Free cash flow 5.0
Discount at 15% growing at 25% * 40% = 10%
1/(0.15 - 0.10)
PV(Dividend) 100 100
add Debt 0
Value of company 100
Table 20
t0 t1 to perpetuity
Earnings 8.3
IC increment 4.2
Free cash flow 4.1
Discount at 15% growing at 20% * 50% = 10%
1/(0.15 - 0.10)
PV(Dividend) 82 82
add Debt 0
Value of company 82
Maximising the earnings ignores the trade off, which is the level of investment required to
earn those earnings.
9 Maximise NPV in order to maximise value
Value0 = Book0 + Goodwill0 or PV(NPVs)
Only one variable, NPV, bears a direct relation with company value such that maximising it
will also always maximise company value. There are no trade offs with NPV.
10
Lectures 4 - 8
10 Maximise internal rate of return (IRR) in order to maximise value

The IRR of an investment is the discount rate, which makes the NPV equal to zero.
In opportunity 1 the IRR is 32% when the NPV is £1.8.

Table 21
t0 t1
Cash flow -9.1 12
Discount at IRR = 32% * 1/1.32
Net present value (Cash flow)
0.0
NPV
Table 22
t0 t1
Cash flow -9.1 12
1.8
NPV
In opportunity 2 the IRR is 21% when the NPV is £9.

Table 23
t0 t1
Cash flow -91 110
Discount at IRR = 21% * 1/1.21
Present value (Cash flow) -91 9.1
0.0
NPV
Table 24
t0 t1
Cash flow -91 110
Present value (Cash flow) -91 100
9
NPV
Although 32% beats 21% nevertheless £9m beats £1.8m!

Table 25
IRR NPV
Opportunity 1 32% £1.8
Opportunity 2 21% £9.0
Opportunity 1 wins Opportunity 2 wins
Maximising the IRR ignores the trade off which is the size of the cash flows.
11
Lectures 4 - 8
11 Maximise accounting rate of return (ARR) in order to maximise value?

Maximising cash flow ignores the trade off which is the risk of the cash flows. Maximising
IRR ignores the trade off which is the size of the cash flows. Maximising ARR ignores two
trade offs, which are the risk and the size of the cash flows.

The accounting rate of return (ARR) fails to capture both size and risk of the cash flows so
maximising ARR fails to maximise the value of the company.
ARR has many names: Return on Capital Employed (ROCE), Return on Net Assets (RONA)
and Return on Invested Capital (ROIC). ROIC is used here and is measured as:
ROIC1 = NOPAT1/IC0
12 Minimise payback period in order to maximise value?

Minimising the investment payback period, that is the period until the net cash flow is an
inflow, ignores the trade off which is the post payback cash flows.
However some companies, operating in very high risk environments, estimate such high
discount rates that distant cash flows are discounted back to zero. Such aggressive discounting
is almost equivalent to using payback as a selection measure.
12
Lectures 4 - 8
12 Summary
The CEO is aiming to maximise value. This is why he is incentivised on Total Shareholder
Return (TSR).
So he manages value
TSR = Value1 – Value0 / Value0
Which implies he manages free cash flow

Which implies he manages NOPAT and IC increment

Which implies he manages ROIC and growth

NOPAT/IC = ROIC
where
gconstant = ROICincremental investment * Investment rateconstant
and where
Investment rateconstant = Retained profit1/NOPAT1
13
Lectures 4 - 8
13 Quick questions
1. List the five valuation models
2. What is wrong with maximising cash flow?
3. What is wrong with maximising dividends?
4. What is wrong with maximising earnings?
5. What does a high PER imply?
6. What does a high yield imply?
7. Define IRR
8. What is wrong with maximising IRR?
9. What is wrong with maximising ARR?
10. What is the unique property of NPV, which makes it the only efficient investment
selection measure?
11. Which investment selection measure may be used in very high-risk environments?
Answers
1. (1) the discounted cash flow approach
(2) the current earnings plus future investment opportunities approach
(3) the stream of dividends approach
(4) the stream of earnings approach
(5) the PER multiple approach
2. Cash flows ignore risk
3. Dividends ignore growth
4. Earnings ignore size of investment
5. Either high g or low risk
6. Either low growth or high risk
7. The discount rate where NPV = £0
8. IRR ignores the size of the cash flows
9. ARR ignores size and risk of the cash flows
10. Maximising the investment’s NPV always maximises the company’s value because only
NPV bears a direct relation with value such that
Value = Book + Goodwill or PV(NPVs)
11. Payback
14
Lectures 6 - 8
Profitability and Margin

Strategic Plan
Cash flow
improve ROIC g
Return on Invested Capital growth strategy
£10m/£100m to £20m/£100m £10m/£100m to £20m/£200m
competitive advantage from competitive advantage from

doing it cheaper doing it better
cost leadership strategy differentiation strategy
same quality lower cost same cost higher quality
cut P&L costs cut BS costs sell at a price premium

margin productivity or
sell more
Strategic Plan and Margin
cut P&L costs

margin
The ROIC Tree
ROIC
NOPAT/IC
14.0%
Pretax ROIC Tax rate

NOP/IC Tax Xp/NOP
22.9% 39.1%
Margin Productivity
NOP/Sales Sales/IC
37.4% 0.61
CoS/Sales Variable Xp/Sales Fixed Xp/Sales Depreciation/Sales WC/Sales FA/Sales

43.0% 0.9% 17.9% 0.8% 49.1% 113.9%
The ROIC Tree and Tax
ROIC
9.15%

NOP/IC Tax Xp/NOP
10.2% 10.0%
The ROIC Tree and Margin
Pretax ROIC
10.2%
Margin Productivity
NOP/Sales Sales/IC
7.5% 1.35
The ROIC Tree and Expenses
Margin
NOP/Sales
7.5%
CoS/Sales Variable Xp/Sales Fixed Xp/Sales Depreciation/Sales

50.0% 5.0% 31.2% 6.3%
Highlights
 The margin can be presented as a pie

chart
 Each year has its own pie chart
 The pie chart provides an at-a-glance
view of the margin ratios
Data Sheet in £000s
P&L Sales £100.00 100%

Expenses:
CoS £50.00 50.0%
Variable £5.00 5.0%
Fixed £31.20 31.2%
Depreciation £6.25 6.3%
Profit £7.50 7.5%
Data Sheet and CoS
P&L Sales £100 100%

Expenses:
Cost of Sales:
Production raw materials £33 33%
Production wages £11 11%
Production other 1 £6 6%
Production other 2 £0 0%
Retail goods £0 0%
Data Sheet and Variable Xp
P&L Sales £100 100%

Expenses:
Variable Expenses:
Variable 1 £5 5%
Variable 2 £0 0%
Data Sheet and Fixed Xp
P&L Sales £100 100%
Expenses:
Fixed Expenses:
Advertising £14 14%
Distribution £15 15%
Administration £1 1%
Insurance £1.2 1.2%
Fixed other 1 £0 0%
Fixed other 2 £0 0%
Data Sheet and Depreciation
P&L Sales £100 100%

Expenses:
Depreciation 1 £1.25 1.25%
Depreciation 2 £5 5%
Depreciation 3 £0 0%
Margin Logic
 £Cos + £Variable + £Fixed +

£Depreciation + £NOP = £Sales
 Cos% + Variable% + Fixed% +
Depreciation% + NOP% = Sales%
 50.0% + 5.0% + 31.2% + 6.3% + 7.5% =
100%
 1 - (50% + 5.0% + 31.2% + 6.3%) = 7.5%
Tax Logic
 Pretax ROIC * (1 - Tax rate) = ROIC

 10.2% * (1 – 10.0%) = 9.15%
Margin Interpreted
 For every £100 of sales the company

earns £7.50 profit
 For every £100 of sales the CoS is £50
 For every £100 sales the variable
expenses are £5, the fixed expenses
are £31.20 and depreciation is £6.30
Tactics and Margin
 How would you improve the margin

from 7.5% to say 8%?
 Cut 0.5% from CoS
 Cut CoS to £45 from £50
The ROIC tree calculates:
 each expense as a % of sales
Lectures 6 – 8
continued
Profitability and
Productivity
Strategic Plan
Cash flow
improve ROIC g
Return on Invested Capital growth strategy
£10m/£100m to £20m/£100m £10m/£100m to £20m/£200m
competitive advantage from competitive advantage from

doing it cheaper doing it better
cost leadership strategy differentiation strategy
same quality lower cost same cost higher quality
cut P&L costs cut BS costs sell at a price premium

margin productivity or
sell more
Strategic Plan and Margin
cut BS costs
productivity
The ROIC Tree
ROIC
NOPAT/IC
9.15%

NOP/IC Tax Xp/NOP
10.2% 10%
Margin Productivity
NOP/Sales Sales/IC
7.5% 1.35
CoS/Sales Variable Xp/Sales Fixed Xp/Sales Depreciation/Sales WC/Sales FA/Sales

50% 5% 31.2% 6.3% 49.3% 25%
The ROIC Tree and Productivity
Productivity
Sales/IC
1.35
Fixed Assets (FA)/Sales Working Capital (WC)/Sales

25% 49.3%
Highlights
 The productivity can be presented as a

bar chart
 The bar chart provides an at-a-glance
view of the relative size of the fixed
assets and the working capital
Data Sheet and WC
BS Working capital (WC)

Stock £40
Debtors £20.1
Creditors for CoS £15
Creditors variable xps £0
Creditors fixed xps £7.083
Creditors taxation xp £0.755
Cash £12
Data Sheet and FA
BS Fixed Assets (FA)

Fixed asset 1 Intangibles £5
Fixed asset 2 Tangibles £20
Fixed asset 3 Investments £0
Data Sheet and Stock
BS Stock
Production raw materials £0
Production in progress £0
Production finished goods £40
Retail goods £0
Data Sheet and Debtors
BS Trade Debtors £20

Insurance prepayment £0.1
Data Sheet and Creditors for CoS
BS Creditors for Cost of Sales:

Production materials creditor £10
Production wages creditor £0
Production other 1 creditor £5
Production other 2 creditor £0
Retail goods creditor £0
Data Sheet and Creditors
Variable Xp
BS Creditors Variable Expenses:

Variable 1 creditor £0
Variable 2 creditor £0
Data Sheet and Creditors Fixed
Xp
BS Creditors Fixed Expenses:

Advertising creditor £7
Distribution creditor £0
Administration creditor £0.083
Fixed other 1 creditor £0
Fixed other 2 creditor £0
Productivity Logic
 IC/Sales = WC/Sales + FA/Sales

 74.3% = 49.3% + 25.0%
 or
 Sales/IC = 1/(WC/Sales + FA/Sales)
 1/74.3 = 1.35 = 1/(49.3 + 25.0)
Productivity Interpreted
 Every £1 invested generates £1.35 of

sales
 £49.3 of WC generates £100 of sales
 £25.00 of FA generates £100 of sales
Productivity Interpreted and WC
 to improve productivity from 1.35

 to say 1.5
 what do you need to do?
Productivity Logic and WC

 1.5 = 1/(41.7 + 25.0)
 you need to cut the WC investment
from £49.30 to £41.70
 how do you do this?
Tactics and WC
 Cut stock but avoid stock outs

 Cut debtors but avoid missed sales
 Add to creditors but avoid non delivery
 Cut cash but avoid non payments
Productivity Interpreted and FA
 to improve productivity from 1.35

 to say 1.5
 what do you need to do?
Productivity Logic and FA

 1.5 = 1/(49.3 + 17.4)
 you need to cut the FA investment
from £25.00 to £17.40
 how do you do this?
Tactics and FA
 Dispose of unproductive assets

The ROIC Tree Calculates
 WC as a % of sales
 FA as a % of sales
Trade off between Margin and
Productivity
 If the FA are old then:
 Productivity high because FA/Sales low
 But
 Margin low because Expenses/Sales
high because asset keeps breaking
down because old
Lectures 9 - 10.xlsdebt policy
Market imperfections create an opportunity to offer financial services to the investor and so achieve financial competitive advantage (value added from financing):
debt policy market imperfection/asymmetry financial service value added from financing
if an investor wants leveraged equity Modigliani and Miller "… you can't
the investor can borrow to buy shares make the pizza bigger by slicing it differently …"
the arbitrage proof: by giving a bigger slice to debt
if Vleveraged > Vunleveraged say profit = 10 and Ke = 15% and Kd = 5%: return%
then arbitrage opportunity E (= Dividend/Ke) + D (= Interest/Kd) = profit/WACC 30% Ke (see topic 1)
but arbitrage forces convergence E (=7.5/0.15)= 50 + D (=2.5/.0.05)= 50 = 10/0.1 = 100
so Vleveraged = Vunleveraged WACC = 15% * (50/50+50) + 5% * (50/50+50) = 10% 15%
say add leverage: 10% WACC
Value and WACC stay the same 10/0.1 = 100 5% Kd
E (=6.0/0.3)= 20 + D (=4.0/0.05)= 80 = 10/0.1 = 100 D/E
WACC = 30% * (20/20+80) + 5% * (80/20+80) = 10% 50/50 80/20
D/E
as Ke from 15% to 30%
so E from £50 to £20
Note that weights must be market values
15%*50/100 + 5%*50/100 = 30%*20/100 + 5%*80/100
BUT not the same asset:
high debt tax law interest shields profit from tax tax saving = interest * tax rate
high profit asymmetric treatment of only available where see topic 13 for examples of calculations
companies debt interest 1. profit to be shielded the examiner uses an after tax WACC
equity dividends 2. FC for security
why not 100% debt ?
limited by financial distress costs
high debt agency theory limits directors' discretionary spending agency cost saving
high cash flow asymmetric behaviour of of free cash flows
companies agent under debt P 10 10 see MBO and LBO industry
FCI -ve or nil NPV equity company finances
-10
agent under equity WCI managers to buy out an ugly duckling
Free Cash Flow 0 10 ugly duckling = plus agency costs
Dividend is discretionary 0 unwanted by its parent focusing on value = good supply
Interest is not discretionary -10 leverage
Financing flow 0 -10 and sell on to a new investor company as a swan
high debt informaton asymmetry between debt issue informs the market that new issue discount in after market cost saving
low profit manager and investor not making a share issue so
companies such that debt issue = good news 1. shares not overpriced
equity issue = bad news may even be underpriced
2. debt not exhausted
high debt credit risk asymmetry use company's credit rating investors' interest cost saving
high credit rated between company and individual
companies such that company cheaper
Vleveraged = Vunleveraged + PV(tax savings) + PV(agency cost saving) + PV(new issue discount in after market cost saving) + PV(investors' interest cost saving)

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Lectures 1 - 10

FREE CASH FLOW PAGES 2 – 21

CREDIT HEALTH PAGES 59 - 61

FREE CASH FLOW

10 Interest 0 Interest creditor 0 0 0 Interest paid 0 CFO 18.3

9 EBI or NOPAT 1 42.18 IC increment1 286.03 268.84 17.19 FCF1 24.99

P&L Sales 100 CFS Customers 100

How to calculate Free Cash Flow

1 Juxtapose Income Statement, BS and CFS to create a matrix

3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7

12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0

2 Use the clean surplus relation (CSR)

IS less Balance Sheet increment = Cash Flow Statement

Each row can be configured as a ledger account, for example row 1:

Now we describe rows 2 and 3 together.

Now we describe row 4.

Now we describe row 5.

Now we describe row 6.

Now we describe row 7.

Now we describe row 8.

Now we describe row 9.

Now we start the financing rows, beginning with row 10.

Now we describe row 11.

Now we describe row12.

The dividend in the IS is not described as an expense because it is considered to be an

Now we describe row 13.

Now we describe row 14.

Now we describe row 15.

This row totals the financing rows 10 – 14.

3 Use the investing-to-financing relation

We explain each column in turn beginning with column 1.

Now we explain column 2.

Now we explain column 3.

4 Reconcile any number to any number in the matrix

We take a look at a couple of the more important reconciliations.

In this way we can reconcile any number to any number.

5 Calculate relations as ratios and calculate growth

Finally calculate the NOPAT growth rate g as follows:

6 Apply the CSR and the investing-to-financing relation

7 Reconcile NOPAT to NPV via economic profit (EP)

We can express the relations we have used as follows:

EP1 = NOPAT1 – Capital charge1

8 Recognise a breakdown in the clean surplus relation CSR

The clean surplus relation states:

However this relation breaks down when:

In these cases the matrix requires additional columns as follows:

We used two relations:

We defined free cash flow.

We reconciled NOPAT to FCF via CFO:

We noted the ratios:

Investment rate = Retained / Earnings = 1 – Pay out rate

ROIC1 = NOPAT1 / IC0

We calculated a growth rate.

We reconciled NOPAT to NPV via EP:

NPV0 = PV(EP1 - t) = PV(NOPAT1 - t – Capital charge1 - t)

2.10 Quick questions

How to calculate value and ROIC

1 Meet four valuation models

(1) THE DISCOUNTED CASH FLOW (DCF) MODEL

(2) THE DISCOUNTED STREAM OF DIVIDENDS MODEL (DDM)

(3) THE DISCOUNTED STREAM OF EARNINGS MODEL

(4) THE DISCOUNTED STREAM OF NPVs MODEL

2 Use the discounted cash flow (DCF) model (1)

Value of company0 = PV(FCF1-t)