Chapter 3

Financial Statements
Balance Sheet Income Statement Statement of Cash Flows Accounting income v.s Cash flow MVA and EVA

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Topics in Chapter
Income statement Balance sheet Statement of cash flows Accounting income versus cash flow MVA and EVA

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Income Statement
2006 Net Sales Operating costs Deprec. EBIT Int. expense EBT Taxes (40%) Preferred dividends Net income Common dividends Retained earnings
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2007 3,000 2,616.2 100 283.8 88 195.8 78.3 4 113.5 57.5 56

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2,850 2,497 90 263 60 203 81.2 4 117.8 53 64.8

What happened to sales and net income?

Sales increased. Costs increased as expected with sales. Interest expense increased.

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Balance Sheet: Assets

2006 Cash Short term investments Accounts receivable Inventories Total CA Net FA 15 65 315 415 810 870 2007 10 0 375 615 1,000 1,000

Total assets

1,680

2,000

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Effect of Expansion on Assets

Net fixed assets increased. AR and inventory increased. Cash and short-term investments fell.

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Statement of Retained Earnings, 2007

Balance of ret. earnings, 12/31/2006 Add: Net income, 2007 Less: Dividends paid, 2007 Balance of ret. earnings, 12/31/2007
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710 113.5 (57.5)

766
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Balance Sheet: Liabilities & Equity

2006 2007

Accts. payable
Notes payable Accruals

30
60 130

60
110 140

Total CL
Long-term debt Common stock

220
580 130

310
754 130

Ret. earnings
Total equity Total L&E
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710
840 1,680

766
896 2,000
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What effect did the expansion have on liabilities & equity?

CL increased as creditors and suppliers financed part of the expansion. Long-term debt increased to help finance the expansion. The company didnt issue any stock.

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Statement of Cash Flows: 2007

Operating Activities Net Income (before preferred div.) Adjustments: Depreciation Change in AR Change in inventories Change in AP Change in accruals Net cash provided by ops.
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117.5 100 (60) (200) 30 10 (2.5)

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Investing Activities Cash used to acquire FA Sale of Short term investments Net cash provided by inv. act.

(230) 65 (165)

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Financing Activities Change in notes payable Change in long-term debt Payment of cash dividends Net cash provided by fin. act.

50 174 (61.5) 162.5

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Summary of Statement of CF
Net cash provided by ops. Net cash to acquire FA Net cash provided by fin. act. Net change in cash Cash at beginning of year Cash at end of year
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(2.5) (165) 162.5 (5) 15 10

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What can you conclude from the statement of cash flows?

Net CF from operations = -$2.5, because of increases in working capital. The firm spent $165 on FA. The firm borrowed and sold some short-term investments to meet its cash requirements. Even after borrowing, the cash account fell by $5.

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What is free cash flow (FCF)? Why is it important?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A companys value depends upon the amount of FCF it can generate.

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Basic Corporate Valuation Model

Sales Revenues Operating Costs and Taxes Required Investments in Ops. Financing Decisions Interest Rates Firm Risk Market Risk

Free Cash Flows (FCF)

Weighted Average Cost of Capital (WACC)

2 3 2 3

Value

FCF1 (1 WACC )1

Value of the FCF FCF Firm (1 WACC ) (1 WACC )

FCF (1 WACC )

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What are the five uses of FCF?

1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

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What are operating current assets?

Operating current assets are the CA needed to support operations.
Op CA include: cash, inventory, receivables. Op CA exclude: short-term investments, because these are not a part of operations.

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What are operating current liabilities?

Operating current liabilities are the CL resulting as a normal part of operations.
Op CL include: accounts payable and accruals. Op CL exclude: notes payable, because this is a source of financing, not a part of operations.

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What effect did the expansion have on net operating working capital (NOWC)?

Operating Operating NOWC = CA CL

NOWC07 = ($10 + $375 + $615)
- ($60 + $140) = $800.

NOWC06 = $585.
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What effect did the expansion have on total net operating capital (also just called operating capital)? Operating Capital= NOWC + Net fixed assets. Operating Capital 2007 = $800 + $1,000 = $1,800. Operating Capital 2006 = 870 + 585= $1,455.

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Did the expansion create additional net operating profit after taxes (NOPAT)?
NOPAT = EBIT(1 - Tax rate) NOPAT07 = $283.8(1 - 0.4)

= $170.3. NOPAT06 = $157.8.

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What was the free cash flow (FCF) for 2007?

FCF = NOPAT - Net investment in operating capital = $170.3 - ($1,800 - $1,455) = $170.3 - $345 = -$174.7.

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Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital ROIC07 = $170.3/ $1,800 = 9.46%.

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The firms cost of capital is 10%. Did the growth add value?
No. The ROIC of 9.46% is less than the WACC of 10%. Investors did not get the return they require. Note: High growth usually causes negative FCF (due to investment in capital), but thats ok if ROIC > WACC. For example, Home Depot had high growth, negative FCF, but a high ROIC.
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Economic Value Added (EVA)

WACC is weighted average cost of capital EVA = NOPAT- (WACC)(Capital)

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Economic Value Added (WACC = 10% for both years)

EVA = NOPAT- (WACC)(Capital)

EVA07 = $170.3- (0.10)($1,800)

= $170.3- $188
= -$17.7. EVA06 = $157.8 - (0.10)($1,455)

= $157.8 - $145.5
= $12.3
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Stock Price and Other Data

2006 Stock price $26 2007 $23

# of shares

50

50

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Market Value Added (MVA)

MVA = Market Value of the Firm - Book Value of the Firm Market Value = (# shares of stock)(price per share) + Value of debt Book Value = Total common equity + Value of debt

(More)
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MVA (Continued)
If the market value of debt is close to the book value of debt, then MVA is: MVA = Market value of equity book value of equity

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2007 MVA (Assume market value of debt = book value of debt.)

Market Value of Equity 2007:
(50)($23.00) = $1,150.

Book Value of Equity 2007:

$896.

MVA07 = $1,150 - $896 = $254. MVA06 = $1,300 - $840 = $460.

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CHAPTER 12

Cash Flow Estimation and Risk Analysis

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Free Cash Flow

FCF = NOPAT Net investment in operating capital Gross investment in operating capital= Net investment in operating capital + Depreciation Operating cash flow = NOPAT + Depreciation FCF= Operating cash flow Gross investment in operating capital

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Free Cash Flow

FCF=operating cash flows gross fixed asset expenditures ( operating current assets operating current liabilities)

FCF= investment outlay cash flow + operating cash flow + NOWC cash flow + salvage cash flow

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Estimating cash flows:

Relevant cash flows Working capital treatment Inflation

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Proposed Project
$200,000 cost + $10,000 shipping + $30,000 installation. Economic life = 4 years. Salvage value = $25,000. MACRS 3-year class.

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Annual unit sales = 1,250. Unit sales price = $200. Unit costs = $100. Net operating working capital (NOWC) = 12% of sales. Tax rate = 40%. Project cost of capital = 10%.
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Incremental Cash Flow for a Project

Projects incremental cash flow is:
Corporate cash flow with the project Minus Corporate cash flow without the project.

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Treatment of Financing Costs

Should you subtract interest expense or dividends when calculating CF? NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors. They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

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Sunk Costs
Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis?

NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

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Incremental Costs
Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

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Externalities
If the new product line would decrease sales of the firms other products by $50,000 per year, would this affect the analysis? Yes. The effects on the other projects CFs are externalities. Net CF loss per year on other lines would be a cost to this project. Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

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What is the depreciation basis?

Basis = Cost + Shipping + Installation $240,000

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Annual Depreciation Expense (000s)

Year
1 2 3 4
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% X
0.33 0.45 0.15 0.07

(Initial Basis)
$240

= Depr.
$79.2 108.0 36.0 16.8
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Annual Sales and Costs

Year 1 Units Unit Price Unit Cost Sales Costs
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Year 2
1250 $206 $103

Year 3
1250 $212.18 $106.09

Year 4
1250 $218.55 $109.27

1250 $200 $100 $250,000 $125,000

$257,500 $265,225 $273,188 $128,750 $132,613 $136,588

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 Nominal r > real r. The cost of capital, r, includes a premium for inflation. Nominal CF > real CF. This is because nominal cash flows incorporate inflation. If you discount real CF with the higher nominal r, then your NPV estimate is lower than what it should be. Use nominal cash flows and use nominal discount rate.
Continued
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Why is it important to include inflation when estimating cash flows?

Operating Cash Flows (Years 1 and 2)

Sales Costs Depr. EBIT Taxes (40%) NOPAT + Depr. Net Op. CF Cal State East Bay
Year 1 $250,000 $125,000 $79,200 $45,800 $18,320 $27,480 $79,200 $106,680 Year 2 $257,500 $128,750 $108,000 $20,750 $8,300 $12,450 $108,000 $120,450

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Operating Cash Flows (Years 3 and 4)

Sales Costs Depr. EBIT Taxes (40%) NOPAT + Depr. Net Op. CF Cal State East Bay
Year 3 $265,225 $132,613 $36,000 $96,612 $38,645 $57,967 $36,000 $93,967 Year 4 $273,188 $136,588 $16,800 $119,800 $47,920 $71,880 $16,800 $88,680

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Cash Flows due to Investments in Net Operating Working Capital (NOWC)

NOWC (% of sales) $30,000 $30,900 $31,827 $32,783 $0
CF Due to Investment in NOWC

Sales Year Year Year Year Year 0 1 2 3 4 $250,000 $257,500 $265,225 $273,188

-$30,000 -$900 -$927 -$956 $32,783

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Salvage Cash Flow at t = 4 (000s)

Salvage Value Book Value Gain or loss Tax on salvage value Net Terminal CF $25 0 $25 10 $15

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What if you terminate a project before the asset is fully depreciated?

Basis = Original basis - Accum. deprec. Taxes are based on difference between sales price and tax basis. Cash flow from sale = Sale proceedstaxes paid.

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Example: If Sold After 3 Years for $25 ($ thousands)

Original basis = $240. After 3 years, basis = $16.8 remaining. Sales price = $25. Gain or loss = $25 - $16.8 = $8.2. Tax on sale = 0.4($8.2) = $3.28. Cash flow = $25 - $3.28 = $21.72.

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Example: If Sold After 3 Years for $10 ($ thousands)

Original basis = $240. After 3 years, basis = $16.8 remaining. Sales price = $10. Gain or loss = $10 - $16.8 = -$6.8. Tax on sale = 0.4(-$6.8) = -$2.72. Cash flow = $10 (-$2.72) = $12.72. Sale at a loss provides tax credit, so cash flow is larger than sales price!

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Net Cash Flows for Years 1-3

Init. Cost Op. CF NOWC CF 0 -$240,000 0 -$30,000 1 0 $106,680 -$900 2 0 $120,450 -$927

Salvage CF Net CF

0 -$270,000

0 $105,780

0 $119,523

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Net Cash Flows for Years 4-5

3 Init. Cost Op. CF NOWC CF Salvage CF Net CF
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4 0 $88,680 $32,783 $15,000 $136,463

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0 $93,967 -$956 0 $93,011

Project Net CFs on a Time Line

2
119,523

3
93,011

4
136,463

(270,000) 105,780

Enter CFs in CFLO register and I = 10. NPV = $88,030. IRR = 23.9%.
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