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Training Material
Investment Banking

April 2004

DCF Analysis: Overview
The DCF analysis is based on the premise that ownership is essentially a claim on the cash flows
generated by a firm's assets.
The method entails estimating the unlevered free cash flows (“FCF”) available to all investors and
discounting these cash flows back to the present using an appropriate cost of capital to arrive at a
present value for the assets (Enterprise Value).
The assets may be financed in a multitude of different ways but because the returns generated by
these assets are available to all providers of capital, and to avoid distortions caused by a particular
capital structure, the cash flows should be considered on an unlevered basis, i.e., free from
financing considerations.
The company's operations value (prior to adjustments for non-operating assets) can be broken
down into 2 components:
¾ PV of free cash flows up to a cut point for terminal value calculation

¾ PV of terminal value
Company value = PV(FCF) = Σ +
t=1 (1+r)t (1+r)n

The discount rate r is the Weighted Average Cost of Capital (“WACC”) which reflects the required
returns by both debt and equity investors for investments with the same risk profile

Summary Bullet

DCF Analysis: Overview
Discounted cash flow (“DCF”) analysis is a theoretical valuation technique which values a
company as the discounted sum of its:
¾ Unlevered (before financial costs) free cash flows (this is not operating cash flow) over some
forecast period (usually 5 years), and
¾ Terminal value at the end of the forecast period (Year 5)
Terminal Value
¾ Terminal value is the projected value of the company at the end of the forecast period. Terminal
values are most often derived by assuming the business is sold for some multiple of earnings or
cash flow. Alternatively, terminal values can be calculated based on the ongoing perpetual
value of the company’s cash flows beyond the forecast period
Terminal values may be calculated in one of several ways:
¾ Comparable company multiples of Year 5 cash flow, operating income, net income, etc.
¾ Comparable acquisition multiples of Year 5 cash flow, operating income, etc.
¾ “Perpetual value” of cash flows after Year 5
f Perpetual value = (final year free cash flow x growth rate)/(discount rate - growth rate)
The cash flow stream and terminal value are discounted at the company’s appropriate
weighted average cost of capital
Discount rates are generally based on the weighted average cost of capital of companies in
similar businesses to reflect the relative riskiness (i.e. variability) of the projected cash

DCF Analysis: The Process

Step Projections Project the operating results and free cash
1 flows of a business over the forecast period.

Step Terminal Value Estimate the terminal value of the business,
2 often by using exit multiples, at the end of
the forecast period.

Step Discount Rate Use the weighted average cost of capital
3 to determine the appropriate discount rate

Step Present Value Determine a range of values for the
4 enterprise by discounting the projected free
cash flows and terminal value to the present.

Step Adjustments Adjust your valuation for all assets and
5 liabilities not accounted for in cash flow

Step 1: Projections
The free cash flows from a business can be projected using information about the industry
in which a business operates and information specific to the business.
¾ DCF analysis is an attempt to look at the company’s pure operating results free and clear of
financial leverage, extraordinary items, discontinued operations, etc.
f It is also extremely important to look at the historical performance of a company or business
to understand how future cash flows relate to past performance.
¾ A company’s discounted free cash flows represent the cash generating ability of a particular
company, regardless of its capital structure. As a result, free cash flows are projected on an
unlevered basis – before subtracting interest and financing expense.
¾ DCF projections should be based on:
f Historical performance
f Company projections
f Equity research analyst estimates
f Industry data
f Common sense

Step 1: Projections
Components of Unlevered Free Cash Flow
¾ Unlevered Free Cash Flow is the unlevered after-tax cash flow generated by the Company (including the impact
of any reinvestment). Free Cash Flow is available to all providers of the Company’s capital, both creditors and
¾ Unlevered free cash flow is best determined by considering sources and uses of cash
f It is free from financing considerations, i.e., it assumes that company is 100% equity financed

Calculation of Unlevered Free Cash Flow Calculation of Unlevered Free Cash Flow
Net Income
- Taxes on EBIT
+ After-Tax Interest Expense
+ Depreciation and Amortization
+ Deferred Tax Expense
- Capex
+ Depreciation and Amortization
- Increase / (Decrease) in net working Capital
- Capex
- Any other change in the company’s financials
which cause the company to spend cash or to be a - Increase / (Decrease) in net working Capital
source of cash - Any other change in the company’s financials
= Unlevered free Cash Flow which cause the company to spend cash or to be a
source of cash
= Unlevered free Cash Flow

Step 1: Projections – Sanity Checks on FCF
Confront sales growth assumptions with underlying market industry dynamics
¾ Does the increase in sales reflect a constant market share in an expanding market? If so, why
is the market expanding? Does that assumption agree with industry projections? If it is an
expanding market, why will the company be able to maintain a constant market share? Or does
the increase reflect a rising market share in a stagnant market? If yes, why? Are some firms
leaving the industry? Why? etc.
Check reasonableness of Gross and EBIT margins
¾ Avoid “hockey sticks”. Be clear on the required actions which will cause improvement in
margins (or reasons for decrease in margins). Are the margin levels consistent with structure of
competition? Any risk of new entrants/substitute products that will drive margins down? etc.
Capital Expenditures
¾ Watch out for step-up of production capacity required as sales increase. Is CAPEX level
sufficient for increase in sales? Factor in impact of industry trends on CAPEX (i.e., increased
environmental expenditures, technology changes, etc.)

Step 1: Projections – Sanity Checks on FCF
Working Capital
¾ Are inventory and other working capital forecasts consistent with the sales increase?

¾ What is the pattern in receivable collection period? How is it practically achieved?

¾ Assess bargaining power of customers (receivable terms) and suppliers (account payables)

¾ Are your assumptions in line with industry standards? etc.

Be Critical About Buyer and Seller's Projections
¾ Use due diligence/access to seller's management to gain in-depth understanding of company's
assumptions and challenge them, (if appropriate) on the basis of your analyses
¾ Compare also for instance company's past record of actual versus budgeted results.

¾ Add value/ “manage” client's expectations (both on buy and sell sides) by thorough
understanding of the company's market dynamics and competitive positioning.
Be Realistic About Synergies
¾ When developing a business case, avoid general optimistic statements about synergies. Be as
specific as possible about nature and level of cost savings.
¾ Take into account time to implement cost cuttings/achieve synergies

¾ Consider also costs related to merger such as severance pay, plant shutdown costs that can
diminish synergy benefits.

Step 2: Determination of Terminal Value
Terminal Value Calculation
¾ Since DCF analysis is based on a limited forecast period, a terminal value must be used to
capture the value of the company at the end of the period. The terminal value is added to the
cash flow in the final year of the projections and then discounted to the present.
¾ A company value, based on expected FCF, can be separated into two components:

PV of
of FCF
PV of
of FCF
Company during
during explicit
explicit after explicit
after explicit
= forecast
forecast period
period forecast
forecast period

¾ The second component is the continuing or terminal value.

¾ The ideal DCF analysis forecasts free cash flows far enough into the future (e.g., 20 years or
more) so that the present value of the terminal value does not constitute a large percentage
(e.g., over 40%) of firm value
¾ Terminal value can be estimated using exit multiples, cash flow approaches (perpetuity formula)
or other approaches such as liquidation or break-up value, replacement cost, etc.

Step 2: Determination of Terminal Value
Comparable Multiples Method
Use multiples that produce an enterprise value.
¾ Litmus test: Has interest been subtracted before I arrived at this figure?
f If yes: the multiple gives EQUITY value (for instance, BV)
f If no: the multiple gives an ENTERPRISE value (Sales, EBITDA, EBIT)

¾ Exit strategy in final forecast year drives the selection of multiples
f IPO assumption: Comparable company trading multiples
f Sale assumption: Comparable acquisition multiples

¾ Typically final year’s EBITDA is used

Commonly used method because conceptually easy to implement and to explain.
Be aware of circular reasoning (I am putting a value on what I am trying to value!) and theoretical
difficulties in predicting multiples at the end of the forecast period.
Provide a range of multiples (i.e., implied valuation for say 6.0x, 7.0x and 8.0x EBITDA) to increase
reasonableness of results.

Step 2: Determination of Terminal Value
FCF Perpetuity - Growth Rate Method
¾ Perpetuity formula based calculations implicitly assume that you will own the company and be
entitled to the FCF to perpetuity (theoretically more correct than multiple approach).
¾ Assuming that Cash Flow after explicit forecast period grow at a constant rate, the value of the
terminal value is given by the growing FCF perpetuity formula:
FCFn: Free Cash Flow in year n
TVn = FCFn*(1 + g)
r: Discount rate
g: Perpetual growth rate of FCF
n: Forecast horizon (terminal year)
¾ Perpetual growth rate must be realistic. It can be estimated as the expected long-term rate of
consumption growth for the industry's products plus inflation (starting point could be forecasted
nominal GNP growth).
¾ Cross check the reasonableness of your terminal value calculation by linking the multiple and
perpetuity methods (i.e., calculate implied perpetual growth rate for a range of EBITDA multiples
or conversely check how the perpetual growth rate translates into EBITDA multiples) at different
discount rates.

Step 3: Determination of Discount Rate
The discount rate is a function of the risk inherent in any business and industry, the degree
of uncertainty regarding the projected cash flows, and the assumed capital structure.
¾ In general, discount rates vary across different businesses and industries.

¾ The greater the uncertainty about the projected cash flow stream, the higher the appropriate
discount rate.
¾ Providers of capital (both debt and equity investors) in any given industry require returns
commensurate with the perceived riskiness of their investment.
The best measure of the riskiness of projected cash flows – and the best way to determine
the correct range of discount rates – is the weighted average cost of capital (WACC) of
similar businesses.
¾ WACC should be thought of as the opportunity cost of capital, the return an investor expects to
earn in an alternative investment of equivalent risk.
¾ The WACC to be used in a DCF analysis is specific to the asset being valued, and should
depend neither on how the asset will be financed nor on the potential buyer’s or seller’s cost of
The relative “weights” applied to the costs of equity and debt used in computing WACC for
an asset represent the “optimal” capital structure for that asset

Step 3: Weighted Average Cost of Capital
Mathematical Expression of WACC

Cost of
WACC(1) =
Cost of Debt x
Proportion of Debt
in Capital Structure + Equity x
Proportion of Equity
in Capital Structure

Cost of Risk-Free
= Rate + Levered
x Equity Market Risk Premium ;

Levered Unlevered
x 1 + (1 - Tax Rate) x (Debt/Equity Ratio)
= Beta

¾ Intuitively, we have to pay our equity holders their required rate of return and we have to pay our
debt holders their required rate of return.
f Because dividends– the theoretical absolute return to an equity holder – are not tax-
deductible, our true cash cost of equity is reflected as a pre-tax result.
f Because interest – the return to a debt holder – is tax-deductible, our true cash cost of debt is
reflected as an after-tax result.
¾ To determine the WACC of a company, one must ascertain for a target capital structure, the
costs of the various sources of capital for the company.

(1)Assumes capital structure is only debt and equity. Other sources of capital (i.e. preferred stock) would need to be included if present.
(2)Cost of Equity calculated using the Capital Asset Pricing Model (CAPM).
(3)Assumes beta of debt is zero.
Correct formula is: BetaUNLEV EQ = BetaDEBT x (D x [1 – t]) / [E + D x (1 – t)] + Beta LEV EQ x E / [E+ D x (1-t)].
Step 3: WACC – Target Capital Structure
Prior to calculating the cost of equity and debt for the company you are valuing, you need to define a
target capital structure based on the appropriate market value weights (i.e., D/D+E and E/(D+E)) for the
WACC calculation. The target capital structure should reflect the debt to equity ratio that is expected to
prevail over the life of the business.
You can use a combination of the following three approaches:
¾ Estimate the current market value based capital structure of the company.
f Estimate the market values of the debt and equity components of the capital structure and review how they
have changed over time. If a company's common stock is publicly traded and its other source of financing is
traded corporate bonds, just multiply the number of each type of outstanding security by its respective
market price. If the debt is not traded, estimate the market value by comparing with publicly traded similar
debt. If the company is not traded, use the other two approaches.
¾ Review the structures of comparable companies.
f Assess the average market capital structure prevailing in the company's sector, which provides a good
indication of a capital structure for your company.
¾ Review the management's financing philosophy.
f When possible, discuss with the management their financing policy and their explicit or implicit target capital
structure on a normalized basis. If you don't have access to management, look for any statements in press,
research reports, annual report, etc. that give hints on the company's medium to long term financing

Step 3: WACC – Conceptual Issues
Various challenges exist in calculating a cost of capital that is entirely
consistent with finance theory. In reality most practitioners use judgment and
approximations. Some of the issues one comes across often:
¾ The Risk Free Rate
f Theory recommends using a “true” risk-free rate that has the same term as the cash flows
f Since long bond rates have intrinsic interest rate risk factored in, theorists suggest making a
“liquidity” adjustment to the long bond rate representing the term premium implicit in those
rates. This is, however, rarely done in practice by Wall Street.
¾ The equity risk premium
f The equity risk premium must be consistent with the risk-free rate. For example, if your risk
free rate is the 20-year bond, the risk premium must represent return in the equity market
relative to the 20-year bond.
f Ibbotson, the most commonly referred-to source, uses actual annual stock market returns
since 1926 to compute the equity risk premium. Some argue that use of this period over-
estimates the premium, and that data over a more recent period would suggest a lower
f Equity premia from as low as 3.5% to 8.0% are used on the Street.
– Goldman Sachs Equity Research: 3.5%
– CSFB Equity Research (April 1999): 4.3%
– Ibbotson (long-term, from 1926–1998): 8.0%

Step 3: WACC – Conceptual Issues
Various challenges exist in calculating a cost of capital that is entirely
consistent with finance theory. In reality most practitioners use judgment and
approximations. Some of the issues one comes across often:
¾ Beta
f Beta represents a measure of the systematic (as opposed to unique or diversifiable) risk that
exists in an asset, and is central to the CAPM.
f Beta = COV[Rasset, Rmarket] / VAR[Rmarket], or equivalently
= CORR[Rasset, Rmarket] x STDasset / STDmarket
f Historical betas of publicly traded equity securities can be calculated based on an analysis of
the actual returns on the security vs. the actual market returns.
f Unfortunately, historical betas can be poor predictors of expected beta, which is what we
need in our analysis.
f BARRA, a financial research firm to which CSFB subscribes, computes predicted betas for
public companies.
f There are many sources for beta: BARRA, Bloomberg, Value Line.
¾ Levering / Unlevering Beta
f “Observed” betas of companies are by definition levered (to the extent the companies have
debt). Unlevering is required to arrive at the beta of the assets (as opposed to the equity) of
the company.
f Increasing leverage will, according to theory, increase the beta of a firm’s equity and hence
its cost of equity. Theorists differ on the most appropriate adjustments to make for the
effects of leverage.

Step 3: WACC – Unlevering Beta
The formula presented previously is the one we use at CSFB and is perhaps the most widely recognized
(and also the simplest).

β unlevered = βU =
⎛ comp ⎞
⎜1 + (1 - τ ) * D ⎟
⎜ comp ⎟
⎝ E ⎠

Where: τ is the tax rate
Dcomp the market value for the debt and
Ecomp the market value of the equity

¾ The βcomp is based on market returns, not book returns. That is why you should unlever this β using the
market value of equity and debt for the comparable.
¾ If the market value of debt is not easily calculated, use the book value of debt.

¾ Once you have the βu for the company, you have to relever it with the debt to equity ratio you have chosen for
your company or asset:
f βlevered=βu* (1+(1- τ) * D/E)
f where D/E is our target debt to equity ratio

The Recommended Way
In practice we make the following assumptions:
¾ Risk Free Rate
f 30 year US Treasury coupon bond yield for US WACC calculation. WACC calculation for
international assets, particularly emerging market assets, is harder and has to be considered
on a case-by-case basis.
¾ Tax Rate
f Marginal tax rate (usually 35%).
¾ Cost of Debt
f Risk free rate + current corporate spread over treasury for comparable credits.
¾ “Optimal” Debt/Equity
f Average of ratio of debt and equity market capitalization of selected comparable companies.
¾ Beta
f Simple average of unlevered predicted betas of comparable companies as derived from
BARRA levered predicted betas (available on-line).
¾ Equity Market Premium
f Ibbotson equity market premium (approx 8.0%), calculated based on historical return of
equity market relative to 30 year treasury bond.
In general, WACC calculation is not a science; there are no exact answers, judgment and
reality checks are essential

Step 3: Example WACC Analysis
Risk Free Rate Assumptions:
US Treasury Bond Rate: 5.67% (1) Equity Risk Premium: 7.40% (2)
Country Risk Spread 0.00% (3) Tax Rate (Foreign): 33.00%
Risk Free Rate: 5.67% Tax Rate (U.S.): 35.00%
Corporate Credit Premium: 0.40% (4)
Estimated Pre-tax Cost of Debt: 6.07%

Industry Statistics
Levered Market Debt/Market Levering Unlevered
Comparable Companies Beta (5) Debt Cap.(6) Cap. Ratio Factor (7) Beta (8)

ANADARKO PETROLEUM 0.63 1,109.7 4,021.0 27.6% 1.18 0.54
APACHE CORP 0.61 1,405.1 3,105.8 45.2% 1.29 0.47
BURLINGTON RESOURCES 0.55 1,800.0 7,570.9 23.8% 1.15 0.47
ENRON OIL & GAS 0.53 824.8 3,136.0 26.3% 1.17 0.46
KERR MCGEE 0.61 713.2 2,756.4 25.9% 1.17 0.52
NOBLE AFFILIATES 0.56 695.0 2,146.4 32.4% 1.21 0.46
UNION PACIFIC RESOURCES 0.45 5,058.7 4,487.7 112.7% 1.73 0.26
UNION TEXAS PETROLEUM 0.64 891.3 2,505.2 35.6% 1.23 0.52
UNOCAL 0.59 2,949.0 8,885.4 33.2% 1.22 0.48
VASTAR RESOURCES 0.53 715.7 4,291.8 16.7% 1.11 0.47
Average 0.57 37.9% 0.47

Cost of Capital Pre-tax Cost of Debt 3.6% 4.1% 4.6% 5.1% 5.6% 6.1% 6.6% 7.1% 7.6% 8.1%
After-tax Cost of Debt 2.3% 2.6% 3.0% 3.3% 3.6% 3.9% 4.3% 4.6% 4.9% 5.2%
Corp. Credit Spread -2.1% -1.6% -1.1% -0.6% -0.1% 0.4% 0.9% 1.4% 1.9% 2.4%

Debt/ Debt/ Average Levering Levered Cost of Debt/
Capital Equity Unlev'd Beta Factor Beta (9) Equity (10) Capital WEIGHTED AVERAGE COST OF CAPITAL (11)
0.0% 0.0% 0.47 1.00 0.47 9.1% 0.0% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1%
20.0% 25.0% 0.47 1.17 0.54 9.7% 20.0% 8.2% 8.3% 8.4% 8.4% 8.5% 8.5% 8.6% 8.7% 8.7% 8.8%
25.0% 33.3% 0.47 1.22 0.57 9.9% 25.0% 8.0% 8.1% 8.2% 8.2% 8.3% 8.4% 8.5% 8.6% 8.6% 8.7%
30.0% 42.9% 0.47 1.29 0.60 10.1% 30.0% 7.8% 7.9% 8.0% 8.1% 8.2% 8.3% 8.4% 8.5% 8.6% 8.6%
35.0% 53.8% 0.47 1.36 0.63 10.4% 35.0% 7.5% 7.7% 7.8% 7.9% 8.0% 8.1% 8.2% 8.3% 8.5% 8.6%
40.0% 66.7% 0.47 1.45 0.67 10.7% 40.0% 7.3% 7.5% 7.6% 7.7% 7.8% 8.0% 8.1% 8.2% 8.4% 8.5%
45.0% 81.8% 0.47 1.55 0.72 11.0% 45.0% 7.1% 7.2% 7.4% 7.5% 7.7% 7.8% 8.0% 8.1% 8.3% 8.4%
50.0% 100.0% 0.47 1.67 0.78 11.4% 50.0% 6.9% 7.0% 7.2% 7.4% 7.5% 7.7% 7.8% 8.0% 8.2% 8.3%
55.0% 122.2% 0.47 1.82 0.85 11.9% 55.0% 6.6% 6.8% 7.0% 7.2% 7.4% 7.5% 7.7% 7.9% 8.1% 8.3%
60.0% 150.0% 0.47 2.01 0.93 12.6% 60.0% 6.4% 6.6% 6.8% 7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2%
65.0% 185.7% 0.47 2.24 1.05 13.4% 65.0% 6.2% 6.4% 6.6% 6.8% 7.0% 7.3% 7.5% 7.7% 7.9% 8.1%
70.0% 233.3% 0.47 2.56 1.19 14.5% 70.0% 6.0% 6.2% 6.4% 6.7% 6.9% 7.1% 7.3% 7.6% 7.8% 8.0%

(1) 30-year US Treasury Bonds as of June 22, 1998. (7) Levering Factor: 1 + [( 1 - tax rate ) * (Debt / Equity Market Value Ratio
(2) Average historic spread, based on the arithmetic mean, between common stock returns and (8) Unlevered Beta: ( Beta / Levering Factor ).
long-term US Gov't bonds (Ibbotson Associates, 1/96). (9) Levered Beta: ( Beta * Levering Factor ).
(3) Credit Suisse First Boston Estimate. (10) Cost of Equity (Re):
(4) Based on average Spread to 10-year Treasury for AAA and A rated industrials. Re = Rf + Beta * (Rm - Rf), or the risk free rate plus beta times the eq
(5) July 1997, Barra US Equity Beta Book predictions. (11) WACC: Rd = Return on Debt Re = Return on Equity
(6) Stock prices as of June 26, 1998. WACC = [ Rd * (1 - tax rate ) * ( D / ( D + E ) ] + [ Re * ( E / ( E + D ) ]

Step 4: Present Value
Time Value of Money – A dollar today is worth more than a dollar tomorrow.
of Discounting – The process of finding the present value of a future sum
Discounting Very Simple Example (Assume the WACC is 10%.)
Year 1 2 3 4 5
Cash Flow $10.0 $15.0 $20.0 $24.0 $30.0

Discount Rate 10%

Discount Factor 0.909 0.826 0.751 0.683 0.621

Disconted Value $9.09 $12.40 $15.03 $16.39 $18.63

NPV $71.53

The total NPV is the sum of the present values of the individual cash flows.
The NPV calculation assumes that cash flows occur at the end of the period.
Mid-Year ¾ Assuming that cash flows are received at mid year (i.e., spread evenly over the
Convention year) comes down to moving all cash flows by half a period
¾ This amounts mathematically to multiplying by (1+WACC)½ the NPV calculation.

Step 5: Corporate Adjustments
DCF analysis calculates the Enterprise Value (Adjusted Market Value) of a company.
Value of The Equity Value (Market Value) of a company is the Enterprise Value less Corporate
the Company Adjustments.
¾ Corporate Adjustments include the company’s net debt plus other obligations, less other
assets not included in the DCF

+ Long Term Debt (including current portion) – Cash

+ Short Term debt – Cash Equivalents

+ Minority Interest – Investments in Affiliates

+ Preferred Stock – Value of other assets not in DCF

+ Capitalized Leases

+ Contingent Liabilities

The Equity Value per diluted share is the Equity Value divided by the number of fully-diluted
¾ Number of diluted shares = Basic shares + shares underlying “in the money” exercisable
options / warrants + shares from the conversion of “in the money” convertible debt and
convertible preferred stock
¾ Incremental common-equivalent shares are typically calculated using the treasury stock

¾ The commonly used DCF method consists in estimating the after tax free cash flows available
to all investors and discount them back to the present at the Weighted Average Cost of Capital
¾ The DCF analysis is as good as the projections used. You should step back from the numbers
by doing repetitively sanity checks and thinking through the implications of your assumptions
¾ Produce a set of sensitivity analysis on the key model variables to bound the company's
(intrinsic) value
¾ Particular care should be given to the last year of the explicit forecast period and the calculation
to the terminal value as it often represents a significant portion of the total value of the company.
Terminal value can be calculated using exit multiples and perpetuity approaches. Ideally, you
should develop the two approaches independently and compare the results obtained
¾ The WACC reflects the opportunity cost for each type of investors, i.e., the respective rates of
return these investors could expect to earn on other investments of equivalent risk. The Capital
Asset Pricing Model (CAPM) establishes a simple relationship between risk and return which
allow to estimate the cost of equity of a project/company for a given risk level
¾ The value obtained by discounting the free cash flow and the terminal value should be adjusted
for non-operating assets or liabilities to yield the firm's asset value. The equity value is then
derived by deducting all non working capital debt and obligations